Individual Stocks Move With The Market

I have reread this great article 3 times.  Indeed, I can clearly see this - Passive Investing and ETF are so dominant, that individual stock CANNOT MOVE INDEPENDENT OF "The Market".  I think this applies both Technically (for this group) and Fundamentally (for investors).   I see this more and more every year...no matter what the technical setup is on an individual stock, the Passive Investing and EFT Market movements dominate.  It does not seem to matter (as much) any more if a stock is a complete dog (losing money, no cash flow, declining sales, high debt,....) it will go up with the market.  It does not seem to matter (as much lately) if a stock has a perfect bull flag, inverse head and shoulders, support level,.....the "market movement" will dominate.  Very frustrating.

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Policy in a World of Pandemics, Social Media and Passive Investing

he behavior we are seeing in public markets is not a signal of collective decision making, “the wisdom of crowds” or the Efficient Market Hypothesis at work.  Instead, it’s an indication of a market that has been twisted into a shadow of its former self by two forces – passive investing and synthetic attempts to generate yield by systematically selling volatility.  This should not be a surprise.  Using the words of John Bogle himself: 

  “If everybody indexed, the only word you could use is chaos, catastrophe…The markets would fail.”

         – John Bogle, May 2017

Over the past 25 years, we have experienced unprecedented growth in passive investing.  Most Americans and market participants are unaware that this has become the primary mechanism by which investments occur.  Regulatory changes, heavily influenced by the lobbying activities of Vanguard and Blackrock, have led to an inexorable flow of capital towards passive investing. Today, more than 100% of gross flows into the stock market are passive (meaning discretionary managers are facing gross redemptions) and nearly 85 cents of every incremental retirement dollar now flow into a target date fund. Roughly half of all 401Ks hold a target date fund as their sole security.

The theory behind passive investing relies on a very simple concept, the Efficient Market Hypothesis, which posits that current prices reflect all available information.  As a result, trying to “beat the market” is a fool’s errand and investors should simply try to passively participate.  Unfortunately, the assumptions behind passive
investing are critical -- no transactions costs, costless information, homogenous expectations, and perfectly rational investors.  These do not hold in the real world. 

  The arguments for passive index investing over active investing received a further shot in the arm from a simple thought exercise by William Sharpe in 1991, “The Arithmetic of Active Management”.  Again, Sharpe’s work is seductive in its simplicity: 

  If "active" and "passive" management styles are defined in sensible ways, it must be the case that 

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and 

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

  This observation set the stage for a revolution in investing with fees for managing assets collapsing over the last three decades.  These declines have taken the form of reduced annual fees, reduced sales load fees and reduced commissions.  This appears to be the ultimate free lunch for investors; but what if the assumptions are wrong?  Looking closely at Sharpe’s work, it is clear where an error lies:
  A passive investor always holds every security from the market, with each represented in the same manner as in the market. – Sharpe, 1991

There is a key assumption within the articulation that the investor holds the market portfolio.  How does the investor get in? Apparently magic.  How does the investor get out? This would also be magic.  These assumptions were successfully challenged in a 2016 paper by Lasse Pedersen, “Sharpening the Arithmetic of Active Management” where the author noted that changing index construction requires passive participants to trade. Pedersen’s work, however, did not go far enough.  As the above flows charts highlights, “passive” investors are forced to trade every single day due to incoming flows.  Each new dollar invested into passive index funds must purchase the securities in the benchmark index.  These purchases exert an inexorable influence on the underlying securities.  Per Sharpe’s own work, these are not passive investors – they are mindless systematic active investors with zero interest in the fundamentals of the securities they purchase.
 
If incremental investor dollars were increasingly flowing into market capitalization indices, we would expect to see two clear phenomena.  First, we would expect to see momentum rewarded as securities that rose in price would capture an increasing fraction of each incremental investment dollar.  Second, we would expect to see a rise in correlation as securities become increasingly traded as a group.