There's no disputing stocks had a great first quarter – the S&P 500 tacked on more than 4.6%. In my Capital Wave Forecast service, we notched some nice double- and triple-digit gains, as well.
The market's exchange-traded funds (ETFs), in particular, smashed records. Worldwide, investors plowed more than $197 billion into the popular vehicles, and this is coming after a record-breaking $390-plus billion ride in 2016.
All good, right?
See, the surging popularity of ETFs isn't a bad thing, per se, but it's taking place at the same time as a surge in passive investing.
And passive investing isn't a bad thing, either, per se, especially not when stocks are going ballistic.
But the two together – passive investing and ETFs – could have an absolutely catastrophic impact on the markets and unprepared investors.
But, as I'll show you in a minute, there's a juicy, fast opportunity in this…
Investing Has Changed, Investors Have Not
As I said, on their own, both buying into ETFs and investing passively make sense.
But loading up passive investing portfolios with ETFs – especially benchmark and market index-tracking ETFs, which are precisely what passive investing calls for – is the equivalent of rubbing two sticks together over a mountain of dry kindling.
For the rapidly growing passive investing crowd, the new crusaders, and millions of former mutual fund investors who think there's a new foolproof way to invest, the fact that markets go down may not be so worrisome. That's because they think passive investing is some kind of miracle investing scheme that always makes money because fallen markets will rise again and, lately, seem to continue making new higher highs.
In the past, mutual fund investors were lured into parking trillions of dollars in fund families based on essentially the same premise.
Those investors (hopefully) know better now.
When the next market sell-off comes – and it is coming – passive investors are going to get hit hard with the reality of markets.
Now, investing has changed, but the pain investors feel when they see their life savings dwindling before their eyes hasn't changed.
Passive investors will become active sellers, especially if the initial sell-off is unexpected (which it has to be at this point in the up-cycle), steep, and front-page news – not just in the financial press, either.
And that will be when the marriage of ETFs and passive investing strategies will start to burn the masses.
The biggest and most important ETFs are market benchmark indexed funds. That means they are market proxies, and that's why passive investors park money in them.
Essentially, they are the market. And, if the market's selling off, they will be falling in price while…
…the underlying stocks they hold will be going down in price.
And of course the ETFs themselves will be going down, because investors will be selling them.
And professionals and the authorized participants who work them up and down will be shorting them and the stocks underlying them.
See how it works? All that selling and shorting will cascade down upon itself, creating a negative feedback loop that could potentially devastate stocks.
It will be bad. It will be a vicious, expensive negative feedback loop.
But there are ways to protect yourself – and even make some money when that happens.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of 10X Trader, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade.
Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps.
Shah is a frequent guest on CNBC, Forbes, and Marketwatch, and you can catch him every week on Fox Business's "Varney & Co."
He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.