Is The Market Broken?
Is The Market Broken?
How Passive Indexing Destroys Price Discovery & Signs Of A Bubble
I was planning to write an update on the coal companies I own this week (Peabody Energy BTU 0.00%↑ and Warrior Met Coal HCC 0.00%↑), but I wanted to wait until both 10-K forms come out so I can read the full financial statements, so I’ll get into that next week. With earnings season in full swing over the last couple weeks, it has been interesting to watch the market reaction to stocks in the portfolio as well as stocks outside of the portfolio. Anyone actively following financial markets probably keeps at least one eye on the major indices like the S&P 500 SPY 0.00%↑ and Nasdaq 100 QQQ 0.00%↑, and the stocks that drive them. Today, that’s the Magnificent Seven or whatever nickname/acronym is popular this year (i.e. FAANG, FANMAG, or the newest thing that financial media comes up with next).
In the past, it was Black Tuesday after the Roaring 20s, the Nifty 50 in the 60s and 70s, the Dotcom bubble in the 90s into 2000, or real estate into 2008/2009. Even if you go back further, to Tulip Mania, or the South Sea Bubble, you have exuberant sentiment that drives prices far beyond any rational level. Eventually, it starts to feed on itself and prices go parabolic shortly before collapsing. I’m not going to try to call a blowoff top, or short any of the stocks that I think are extremely overvalued, because your guess is as good as mine on timing. I do think we are seeing signs of exuberance today, specifically around certain stocks in the semiconductor industry. While past manias were driven by sentiment and human psychology, there are other distortions in today’s financial markets that are layered on top of this dynamic.
Trading algorithms and high frequency trading, derivatives, 0DTEs (Zero day to expiry options), and last but not least, passive investing, have all had an impact on the market. I would argue that all of these things distort financial markets and actually make them less efficient. It is definitely frustrating for active investors with a long-term time horizon, but I do think it creates an opportunity for those that are willing to go against the grain. This post was prompted by a recent podcast where well-known hedge fund manager David Einhorn argues that passive investing and fund flows have broken financial markets, and he talks about the impact that passive investing has had in recent years as it has continued to grow. He also goes through different things he looks for now when picking investments, and how he thinks about the influence of passive investing on his own investment decisions. If you have the time, it’s definitely worth a listen.
Passive Flows & Index Investing
This has been a topic that has become more and more prevalent over the last couple years due to the extreme concentration in large indices like the S&P 500 and Nasdaq 100. If the trend of the last couple years continues, it’s a topic that is likely to get more and more attention over the next couple years. Mike Green, a frequent guest on several financial podcasts I listen to, has touched on this topic several times recently. He likes to call it the mindless machine that acts in the background of financial markets. If you give Blackrock or Vanguard money to invest (or ask them to sell one of your holdings), it’s not an employee that turns around and transacts for you. If you give the machine money, it buys, if you ask the machine for money, it sells.
This approach relies heavily on the idea that markets are reasonably efficient due to the active investors that make more informed buy and sell decisions every day. Green estimates that passive has about 44% market share today, and he thinks that share will continue to grow. If you think about all the money in 401k plans and IRA that is on autopilot and buys index funds every two weeks, it’s not surprising that the market share of passive investing is set to grow, but I think it could cause problems sooner rather than later. Like a lot of things in financial markets, I think that strategies that worked for the last 40 years will probably have mixed results over the next decade. I’ll paraphrase a bit to get the point across, but a recent quote from one of the podcasts lays out Green’s opinion on passive investing.
Q: Thinking five years and beyond, what has you most worried and what has you the most optimistic?
A: What I’m most worried about is the dynamics around passive investing. It’s really frightening that as Americans we have outsourced our retirement to the market. That’s not what markets are supposed to do. Markets are not supposed to deliver a return to individuals that allows them to be supported into their old age. It could be part of the solution. I can choose to allocate capital into public equities as a component of my portfolio, but this somewhat ridiculous idea that I should just mechanically put money into stocks for the long run, and that I should get returns delivered to me that allow me to achieve those objectives is fundamentally flawed….
If you’re not putting in the work and you’re not paying for the product, you are the product. What they want is your assets, and they’re marketing to you. So when Vanguard is offering you a three basis point index fund, and encouraging you to put your money aside on a continuous basis, they may think they are working in your best interests, but if everybody does it at the same time, and everybody does it together, it creates systemic risks that hadn’t existed before.
Bubblicious: Signs of Froth In Semiconductors
If you pay the slightest bit of attention to financial media, you will probably be familiar with the darling stocks in the semiconductor/AI sector. Nvidia NVDA 0.00%↑ and Super Micro Computer SMCI 0.00%↑ are two stocks that have basically gone parabolic, but recent IPO ARM Holdings ARM 0.00%↑ has also had a strong run in recent weeks. I was trying to have this post finished yesterday, but I’m glad I waited. Nvidia reported earnings on Wednesday, and the stock was up more than 16% yesterday. Super Micro Computer was up almost 33%. By tomorrow, both could be down double digits, but who knows? I prefer to watch from the cheap seats on stocks like these, even though it is tempting to short or buy puts.
Nvidia
Nvidia is the 800 pound gorilla of AI semiconductor chips, and I’ll be the first to admit that the business has had impressive operating results over the last couple years. I wrote a bit about Nvidia in my post last June on Artificial Intelligence, where I opined that while AI is an important technological evolution, I think it is closer to a bubble. I was obviously wrong on the assertion that investors buying and holding Nvidia would probably regret it (at least for now), as the market cap has grown from one trillion to just under two trillion dollars today.
Nvidia’s revenues and profits have exploded over the last couple years, but I think if you take a step back and look at the valuation, it doesn’t make a whole lot of sense. With the stock’s 16% move yesterday, the stock added approximately 300 billion in market cap. For reference, Nvidia’s revenues over the last 12 months are approximately 60 billion. Short-term, I wouldn’t be surprised if Nvidia plays round number bingo and goes to $1,000 per share this year, but I just can’t understand a bullish thesis based on long-term fundamentals and valuation.
They will have to answer questions as far as the business goes. Do competitors catch up in the next couple years? Semiconductors are notoriously cyclical, so will we see margin compression over the next couple years? Can demand for AI chips continue to grow at a rapid rate? My answer to those questions is I don’t know. I don’t think the current growth rates are sustainable though. I might be wrong, but I do wonder what Nvidia’s market cap will be in 2026? 5 trillion? 10? 20? Before I move onto the other stocks, I wanted to make a couple comparisons that show the absurdity of the valuation.
I’m comparing apples to oranges here, but a chart like this only makes me more bullish on the energy sector. That was from a couple weeks ago, so the gap is only wider today. The other comparison is that Nvidia now has a larger market cap than the entire Chinese stock market. I’m not interested in buying Chinese stocks (I learned my lesson on that one), but I don’t understand how Nvidia grows into its valuation from here.
Super Micro Computer
SMCI is one of the only stocks that has outperformed Nvidia over the last couple years. It’s up over 1000% in the last year and more than 240% since the start of 2024. We will see if the run can continue, but I think the move in the stock price is just as unsustainable as Nvidia. I’m not going to go into as much detail on this one since it’s a smaller company, but I did see some posts that show the exuberant sentiment surrounding the sector.
Speculators, call buyers, and market makers have probably enjoyed SMCI’s run, but one speculator last week blew up his account buying short term calls on the stock. SMCI was down approximately 20% in one day last week and I wouldn’t be surprised if the stock stays volatile. If your investment strategy is begging for help on Reddit after buying weekly options, you might have better luck in Vegas. My favorite part of this is “Things seemed risk-averse with the steady price movements.” This isn’t something that typically happens unless sentiment on a stock or sector is overheated. If you want to speculate, I would stick with Valaris warrants, but that’s just me.
ARM Holdings
ARM Holdings is the last stock I wanted to briefly highlight. If I remember correctly, Softbank still owns over 90% of the shares, so the low float probably had something to do with the massive move after earnings a couple weeks ago. I’m going to point readers to another great Substack, which laid out the differences between ARM, and a stock that I own, Peabody Energy BTU 0.00%↑. Both companies had $724M of cash flow for 2023. Peabody now has a market cap of $3.24B, and they are sitting on more than $600M of net cash. ARM is sitting on $2.4B of cash and the market cap is just under $127B. Do cashflows from a coal company deserve the same multiple as the multiple of an AI company? Definitely not, but should ARM be worth nearly 40 times more than Peabody? I don’t think so, but I’m probably a bit biased with that opinion.
Conclusion
So are semiconductor stocks in a bubble, or are we on the edge of the AI revolution? I’m skeptical that AI will play out how some of the bulls think, but I’m very skeptical of the current valuations on the semiconductor stocks. I also think that this is exacerbated by passive flows, with Nvidia accounting for more than 3% of the S&P 500 and nearly 5% of QQQ. As the stock gets more expensive, that percentage will only increase. With SMCI and ARM we have the rich valuations like Nvidia, but I think we are also seeing signs of exuberance that won’t last forever. Like I said, I’m not trying to call a top, but I think watching from the sidelines on these stocks makes more sense than trying to participate in continued upside, or short on the downside.
I think watching from the sidelines on the large indices like the S&P 500 is also the best approach, but the valuations, while still rich, aren’t as egregious as the valuations on the AI semiconductor stocks. If the financial markets aren’t broken by passive investment, they are at the very least distorted by it. I think that passive investment and fund flows have been a virtuous cycle for the largest stocks for years, but if it that dynamic reverses and investors start selling index funds, it will turn into a vicious cycle as that same dynamic starts to work in reverse. It’s an interesting market dynamic to keep an eye on for the next couple years, but I think it sets up a contrarian stock picker’s paradise for investors willing to go against the grain.
Disclaimer
I own shares of Warrior Met Coal, shares and calls of Peabody Energy, and Valaris warrants. You should do your own research before making any investment decisions. Different investment strategies have different risk/return profiles which should be considered before making any decisions.