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There's a real, clear, and present danger with more than $3.3 trillion parked in passive investing indexed mutual fund and ETF vehicles.
If something triggers so-called passive investors into actively dumping the index funds they're loaded to the teeth with, a black swan-like negative feedback loop could send stocks lower and lower and lower.
Here's how dangerous things are, what could trigger initial selling, what a negative feedback loop would look like, what you need to watch out for, and how to prepare for what could turn into a market crash.
Let's get to it.
When it comes to the market, it's all good until it isn't.
Sure, the more than eight-year-long bull market could continue. In fact, based on my analysis and calculations, the market could double in five years.
But that doesn't mean it will continue to climb in what looks like a straight line since March 2009.
Besides the fact that we haven't had a meaningful correction, which typically shakes out weak-link stocks, the passive investing buying spree floats everything higher, including lots of "loser stocks."
Not only does money flooding into index funds lift all leaky boats with the tide, it makes the big-capitalization, market-leading stocks more and more expensive all the time.
That happens because there are so many "indexes" that are now investable products.
There are whole market indexes, broad market indexes, big-cap, mid-cap, and small-cap indexes – even foreign market indexes. There are loser stocks in all those indexes, and they get bought up when investors buy index funds they're a part of.
That's because the sponsors of index funds have to buy all the stocks that make up the index product they're selling. That's how they track indexes.
On the opposite end of the barbell from loser stocks, there are the big-cap leadership stocks, especially the big tech darlings like Facebook, Amazon, Apple, Google, and Microsoft, and the giant money-center banks that have been garnering a lot of attention and have been soaring. The more they go up, the more their capitalization increases, the more weight they carry in the indexes they're a part of.
So when passive investors buy index funds with big-cap stocks weighing so much, sponsors buying all the underlying stocks that make up the index have to buy even more and more of the big-cap stocks that are already big winners.
That makes them more and more "expensive" on a relative basis. In other words, popular benchmark market indexes are getting top-heavy.
That's all good, until it isn't.
These Are The Triggers to Watch Out For
With investors increasingly being made aware (including passive investors chasing the passive investing trend) that indexes are getting top-heavy, that loser stocks are being brought up that don't deserve to be in a portfolio, that leadership stocks increasingly bear the burden of the whole market, if some trigger gets pulled and investors take some of the massive profits they're sitting on, a cascade of selling could result.
Investors would want to take profits to get out of "overbought" stocks, to get out of crappy stocks that have been bought up simply because they're in index products, and maybe get out of the way of the long overdue correction everyone knows is out there somewhere.
Short-sellers would jump on "overbought" stocks, expecting profit-taking in them and sell-short loser stocks that were bid up simply because they're in indexes.
Profit-taking will start with a trigger being pulled. Here are the big triggers to watch out for:
- North Korea firing a missile and hitting a target
- A U.S. first strike
- Chinese military involvement in any conflict
- North Korea invading South Korea
- An uncontainable Washington/U.S. leadership crisis
- U.S. debt default
- A major country default or currency devaluation
- A big bank failure
- A major stock market malfunction, like the 2010 flash crash
Or some other black swan spreading its wings. There are plenty of triggers out there.
And when one of them is pulled, it's going to cause chaos.
Beware the Negative Feedback Loop
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.