This time is different. Stocks will always go up. And pigs can fly. Given that pigs are highly intelligent, don’t bet against them. That said, investors might want to take at least the first two statements with a grain of salt.
In the 1990s, stocks continued to rise relentlessly for years, even after then Fed Chair Greenspan warned of irrational exuberance in late 1996.
Last decade, the rally in home prices continued as ever more people appeared convinced that home prices never fall.
This time around, we are eight years into a bull market. As in those times, investors have all but given up betting against conventional wisdom. Much of that is because it has cost investors dearly to bet against the markets. In fact, it has been so costly to bet against the market that some advisors who have been cautious are no longer in business. And I’m not just talking about short sellers, but also many who have - in our view prudently - diversified beyond a traditional “60/40” stock/bond portfolio. We know of advisors who positioned their portfolios more aggressively not because they thought the markets were going higher, but because they were losing clients for underperforming the S&P 500.
Some things are different.
The investment industry has evolved to provide ever more index products, with lots of touting how active management is dead. If that were true, we wouldn’t have a plethora of index funds for many slices of the market as selecting anything but a market portfolio is the very definition of active management. Then again, when “everything” goes up, does it really matter what you buy, so long as investors buy something? So what is different?
- A new breed of liquidity providers
In the old days, we had banks and floor traders provide liquidity. Dodd Frank has significantly cut back the type of trading banks may engage in. And floor traders have been replaced by computers. Floor traders on the New York Stock Exchange used to have a duty to make orderly markets with the ability to slow down trading to match buyers and sellers. That philosophy lost out to the philosophy that speed is more important than price, meaning that if an investor wants to trade, let them trade instantaneously, even if the price needs to adjust sharply.
Today’s liquidity providers include ETF market makers and hedge funds. They will provide all the liquidity in the world, so long as everything appears orderly. But let the algorithms flag an abnormality, and their systems may go offline. Without going into the arcane details how market making works, let’s take a common model (there are others) how ETFs trade:
- A so-called lead market maker gets incentivized to offer a tight spread for an ETF (the incentive comes from the exchange giving the market maker a rebate on the price, i.e. giving them a price advantage through actual cash; the rebate comes from the exchange fee investors are paying).
- There’s a plethora of other market makers also providing liquidity, enabling what appear to be mostly efficient markets. These other market makers also get incentives from the exchange, albeit lower ones than the lead market maker. As a result, it creates a structure where all market makers can offload their risk to the lead market maker. This makes it comparatively easy for market makers to make markets in thousands of ETFs, as they don’t need to understand too well the ETF they are providing liquidity for; all they need to know is that they can offload their risk to the lead market maker.
- This system works great until the lead market maker has a glitch and takes its systems offline. When that happens, other market makers see that the party that is supposed to be best informed (the lead market maker) is stepping away. Not surprisingly, everyone else also steps away, causing spreads to widen.
- A flash crash can then happen if investors place large market orders just as liquidity providers are offline.