Passive investment blamed for inflating stock market bubble

The trillions of dollars that have flooded into passive funds in recent years have inflated valuations, radically reshaping the US stock market and insulating it from the threat of a sustained bear market, research has claimed.

Vincent Deluard, global macro strategist at brokerage StoneX, argued that the unprecedented flows have led to structurally higher stock valuations disconnected from company fundamentals, benefited large and growth stocks at the expense of value and small-cap shares and resulted in fewer, and shorter lived, market corrections.

“A preponderance of evidence suggests that the rise of passive has played a major role in the stock market bubble of the past decade,” Deluard said. “If the rise of passive is the main cause for this bull market, a sustained bear market can only occur if the passive sector shrinks.”

As of the end of July, $7.3tn was held in passive open-ended and exchange traded funds that invest primarily in US equities, according to Morningstar, outweighing the $6.6tn in comparable actively managed funds, although passive’s overall share is lower when direct investment outside funds is taken into account. Index-based investment has also grown rapidly in some European countries.

Deluard argued this shift from “price-sensitive” active investors to “value-agnostic” passive ones has played a part in pushing up stock valuations.

His data show the cyclically adjusted Shiller price/earnings ratio of the S&P 500 index “had no discernible trend” between 1881 and 1993, when the SPDR S&P 500 ETF (SPY), the first US ETF, was launched, averaging 15.4 over this period.

The Shiller p/e measure has risen sharply since 2003, however, and now sits at a record high 38 times.

Deluard does not attribute all this rise to the growth of passive funds. The collapse in interest rates and colossal central bank asset purchases witnessed since the global financial crisis “probably played a bigger role” in increasing stock multiples, he said.

Nevertheless, Deluard estimated that the rise of value-agnostic passive funds accounted for 27 per cent of the increase in the cyclically adjusted Shiller ratio.

He believed this pattern held internationally as well, with there appearing to be a positive correlation between passive share in a given market and valuations, at least when expressed by the price-to-sales ratio.

Moreover, his data suggested that stock market corrections have become rarer and price declines shallower, which he attributed to passive investing creating “a steady buyer which can step in when investors’ sentiment sours”.

Drilling down further, cheap “value” and small-cap stocks have underperformed in the US since 2006, a reversal of the return premia that these two style factors have traditionally provided.

While other factors such as falling interest rates, which benefit growth stocks, could be responsible, Deluard argued the pattern may also be due to “continued outflows from the…