Will The Rise Of ETFs Be The Market’s Downfall?

The rise of exchange traded funds (ETFs) is one of the more interesting topics in light of the ongoing general equity bull market. For the first time in history there are more indexes than stocks! Hence, the rising popularity of ETFs (which track indexed strategies) comes as no surprise.


Source: Bloomberg
Investors are piling more and more money into passive investment strategies and it is causing huge misallocations of capital. This has resulted in many people calling for a crash in the stock market to correct the imbalance.  The following presentations by Steven Bregman explain the situation well.

[VIDEO] Steven Bregman: The ETF Divide

[AUDIO] Steven Bregman: The Greatest Bubble Ever

The gist of the interviews is investors are simply buying stocks without any regard to valuations. Bregman points out that, in aggregate, all the major active investors are underperforming the indexes’ for the last few years (the first time in history). This unusual outcome makes one take notice. Is the poor performance of active investors anomalous or is it the outperformance of the market? 

Active investors tend to buy undervalued stocks and short overvalued ones. However, if the majority of money inflows go to passive investment strategies, where there is no valuation analysis, the constant buying will drive up the prices of the underlying stocks. As people chase the momentum, buying begets more buying. Furthermore, a rising share price could force any shorts to cover and drive that stock up even further.

Meanwhile if a genuinely undervalued stock is not held within an index/ETF, then no one buys it and it stays perpetually undervalued.  This all leads to the underperformance of the active investors.

What’s true for the general equities is also true for resource stocks. Last year we saw many resource stocks explode higher because of all the money pouring into the GDX and GDXJ. When the resource market turned up, investors piled money into the passive investment strategies, not the active ones. If a stock was held between both indexes, then it received twice as much buying pressure. Then when the market cooled off late last year, and money pulled out of the ETFs, we saw the reverse. Meanwhile, stocks not held within the GDX and GDXJ were much more stable in their price swings.

I have clients, with speculative investment objectives, whose accounts held up much better than the GDX and GDXJ, despite being in more risky stocks. Since none of their stocks were held in the ETFs, they weren’t subject to arbitrary selling pressure.

This could prove to be a nice feature of the speculative stocks we buy. Because they are too small to be held within an ETF, they should be better protected from arbitrary outflows of capital. They don’t benefit from arbitrary inflows either, but that’s okay. In the long run, the investment community will see the inherent value of these companies and bid them appropriately.

I am, however, deliberately holding select names that are held in both the GDX and GDXJ. When investors come back into the sector they will buy the ETFs again and should give those stocks double the buying pressure.

But what will happen to resource stocks if the general stock market crashes?  Many believe the next crash will be like the last one in 2008 where every asset class suffered except the USD. I tend to disagree. True, many of the problems that existed then still exist today, and are worse. However the crash in 2008 was precipitated by a wave of defaults on subprime debt because of rapidly rising interest rates. Borrowers couldn’t afford the payments and defaulted on the loans. Those loans were packaged and repackaged throughout the industry and wreaked havoc on many balance sheets, especially those of banks. Since no one knew how bad the defaults would be or the true contents of those “packages,” collateral was quickly priced at zero forcing a wave of selling as entities needed to shore up their balance sheets. This is what led to quantitative easing and the push to make the financial system liquid again. 

Today’s market conditions are more reminiscent of the 2000 period. Asset prices were way overvalued, particularly the tech stocks, and eventually they came back down to earth. That is where we’re at today with the current market. Interest rates are not escalating like they were from 2005-2007 and those concerned about a crash are not basing the call on debt defaults. Pundits are pointing out the extreme overvaluation of general equities and how those valuations are unsustainable. Therefore, they conclude, the next crash should bring current valuations back down to earth à la 2000.  

The crash in 2000 did not really register on the price of gold or resource stocks. They were already at extreme lows and didn’t have much room to go down further. The situation is similar today. Despite the multi-year rally in general equities, resource stocks are still at lows last seen in the early 2000s. The price of gold in real terms (using Shadow Stats alternate inflation rate) is near what it was in 2000. So resource stocks, and possibly gold, don’t have much room to go down from here, especially compared to 2008 when the resource sector had already been in a multi-year bull market with lots of room to go down.

The chart below highlights the relative price of gold stocks compared to the S&P 500. Note the difference between now, 2008, and 2000.


Source: StockCharts.com

Also, note the price of gold relative to the S&P 500 during the crashes of 2000 and 2008. In 2000 gold held its value pretty well. In 2008, despite a volatile couple months, gold ended up doing very well compared to the S&P 500 as you can see from the spike.


Source: StockCharts.com

The picture I’m painting for you is that holding gold should benefit you during the next market meltdown. Take a look at the last 6 months of the S&P 500, VIX, and gold price. In three of the four spikes in volatility, gold has gone up. And despite the rising S&P 500, the price of gold is holding up. Is this foreshadowing what’s to come?  Maybe gold will finally start acting like the safe haven we expect it to be?

Source: Stockcharts.com

If the gold price does well, gold stocks should hold up.Should. After all, gold stocks are stocks too and could get swept into the selling, especially if margin calls force investors to sell anything they can. 

To be safe, I have been buying puts on the S&P 500 to hedge my portfolios. If the S&P 500 crashes, my clients will be pleasantly surprised.

A critical part of this hedge is buying the puts (insurance) as cheaply as possible so that the cost is a mere fraction of the account value. That way if a crash doesn’t occur, the cost is small and can be made up elsewhere.  With volatility so low right now, the cost of this insurance is low too.

When I go through this hedging strategy with some people, they want to bet big on it because they are convinced the market will crash.  That is a mistake.  The key to this hedge is being able to keep it going as long as possible which means not being greedy and spreading out your cash out over a longer time frame. 

There is one fly in the ointment of the argument for the market being on the edge of a collapse.  As I said in the beginning, many people, too many, are talking about the overvaluation of the market and the likelihood of a pullback. That means many people are short and could be forced to cover if their timing is wrong. This would cause a huge short squeeze taking stocks even higher. Even so, this should be temporary and set the stage for an even bigger decline.

In summary, I believe the general stock market is due for a pullback in the months and years to come. If or when this happens, I expect gold to hold up well. Resource stocks being stocks may not hold up as well. Purchasing protective puts on the S&P 500 is one way to benefit from market turbulence and potentially offset losses associated with a general equity sell off.

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About the Author: Sprott Money