SUPPLEMENTING MY WRITING OF MARCH 17, 2025. HERE CONSIDERING PASSIVE INVESTING’S DUMBING DOWN OF FUNDAMENTAL ANALYSIS WHILE SHINING A LIGHT ON TECHNICAL ANALYSIS TO BEST DECIFER THIS MARKET’S BEST EQUITY OPPORTUNITIES.
This writing largely narrates continuing brilliant thinking about passive investing risks by Michael Green of Simplify Asset Management found here:
https://youtu.be/Zay_YJ9Nd8?si=aYJOsHAg_8GiioCX
Consider my space here as an opportunity to provide additional thoughts about Mike Green’s presentation, certainly not a substitute to your listening to him first hand!
Dan Steele’s Emphasis and Commentary Concerning Mike Green’s Presentation:
Mike Green observes that capital markets have always been about information flows:
Fundamental analysis estimates/projects “fair value” determining if corporate cash flows will be better than what other people expect and whether corporate cost of capital will be lower than people expect. Technical analysis observes what’s actually happening to stock price, capturing in each candlestick exactly what you want to know – market impulses and divergences: You expect to identify where the intensity of buying or selling is starting to change in its underlying behavior. Richard Wyckoff (circa., early 20th century) stated that price trend never repeats itself exactly and price trend must be studied in context with past behavior. Each price move is unique and its context only has meaning when compared to price’s past behaviors. Thus, for technical analysis purposes context is extra important.
Thus, Michael Green submits that historically, technical analysis has always had equal footing with fundamental analysis. But now with almost fifty percent of market flows consisting of “passive” investing, technical analysis is getting “a shot in the arm.” He submits that price analysis is a really valid way of approaching this “passive” new world in which information flows have become misdirected within two crucial frameworks:
One is the sheer size of the dollar flow. Imagine that you invest $1,000 into a Vanguard Total
Market Index Fund, a passive fund: Of that investment you necessarily buy shares in Delta Airlines and Apple. Proportionately .002 dollars are going to buy Delta and about $70 dollars are going to buy Apple. Delta’s market capitalization is about one hundred times smaller than Apple, but in terms of actual volume that is being traded, i.e., the liquidity of the trade, Apple is only five times more liquid than Delta. This means that the larger company, because of its size alone, is experiencing a higher multiplier. This is totally a consequence of mechanical output alone absent any other fundamental information about “fair value” based on corporate cash flows or costs of capital, the bedrock of fundamental analysis!
Mike Green’s second framework concerns the efficient market hypothesis underpinning the ideas behind passive investing: that traditional markets have been highly elastic, i.e., are highly capable of absorbing incoming flows with no real impact on price. Mike Green states that recent actual empirical data suggests a very subtle distinction when taking into account pricing of a security: “The reality is that [price] all depends on how motivated the buyer is and how motivated the seller is.”
A May 10, 2024 detailed study by Pouya Behmaram (McGill University – Desautels Faculty of Management) titled From Active to Passive: The Consequences for Demand Elasticity extensively investigated this exact issue – the impact of the rise of passive investing on asset demand and price elasticity in the U.S. equity market. This study provides new insights into how the shir from active to passive investing has affected investor behavior and market dynamics (just as Mike Green is referring to a buyer’s and seller’s degree of motivation).
Empirical analysis reveals several key findings that support Mike Green’s thesis: the rise of passive investing has contributed to approximately 15% of the overall inelasticity of demand for stocks. This finding is based on a panel regression analysis that links changes in aggregate stocklevel elasticity to passive investment behavior causing declining price elasticity having important implications for market efficiency, volatility, and liquidity, especially impacting large-cap stocks in the post-2013 period, all coinciding with the acceleration of passive fund inflows. “The findings [of the Behmaram study] contribute to the growing literature on the implications of passive investing for asset prices and market dynamics.”
This critical study concludes as follows:
Looking ahead, the increasing dominance of passive investments is likely to further amplify the effects documented in this paper. As more capital flows into index funds and ETFs, these investments may experience even greater price pressure and lower elasticity.
In conclusion, this paper demonstrates the significant impact of the rise of passive investing on asset demand, price elasticity, and stock returns in the U.S. equity market. By introducing a novel measure of passive ownership and integrating it into a demand system framework, this study provides a more comprehensive understanding of how the shift to passive investing has reshaped market dynamics. The findings have important implicaMons for investors, policymakers, and researchers seeking to navigate the evolving landscape of financial markets in the era of passive invesMng.
Exactly what does greater price pressure and lower elasticity mean for us investors? Inelasticity refers to a situation where the demand for a stock doesn’t change significantly even when its price fluctuates. This creates a disconnect between demand and price. Essentially, a 1% change in price is expected to translate in less than a 1% change in the quantity demanded. This contrasts with elastic demand, where a price change results in a proportionally larger change in demand.
Mike Green likens passive investing to irrational mob mentality consistently pushing one way versus traditional bargain hunting behavior: “when the price of steak goes on sale we buy more of it; when the price of chicken is not on sale we buy less of it.” Passive market behavior is exactly the opposite: Likening equity shares to the price of steak, when it increases, via passive investing, we buy more presuming its price is inevitably correct and/or will not reverse. So, “price” tainted with passive investing negates a foundational precept of trading and investing as well as basic of human instincts: buy low sell high! Such is the “inelasticity” in our financial markets – today’s face of passive investing.
While equity markets have always been subject to anomalies and inefficiencies resulting from investor emotions, e.g., fear, greed, cognitive biases, herd behavior, etc., this one – passive investing – has been brought on by the financial industry itself, sanctioned by regulators, and its damage has become self-sustaining. Mike Green proposes that when the damage of passive investing becomes evident and painful, there will come a time to hold these entities responsible and, as in the work of the 1933-1934 Pecora Commission, an edict will follow: “Wall Street’s purpose is not ramped speculation, but to attract investment that requires a degree of honesty and trust and good behavior [due diligence] in markets.” Mike Green projects at that point a realignment and reforms will be implemented, carrying financial markets into a new era of success and honest administration.
Until then, buyer beware!
For your financial health and well-being, Dan Steele
