(Bloomberg) – As scientists increasingly argue that the passive revolution is a myth, there are many market participants who disagree.
Vince Deluard, the outspoken macro strategist at StoneX Financial Inc., recently warned of mounting evidence that index-tracking cash is upsetting the stock market, driving valuations up, disrupting returns, and upsetting the natural order for large stocks represents.
He calls it the “passive singularity,” according to the concept that artificial intelligence will ultimately be strong enough to unleash its own exponential growth. To survive, traders must embrace it, exploit bias, and look for opportunities in sectors shunned by current standards.
“The passive sector creates the reality it should reflect: the tail wags the dog,” he wrote in a note this week. “As the passive market share grows, prices are determined by the interaction of the mechanistic rules and trading algorithms of the passive sector and not by the emotions and analyzes of the biological brain.”
Deluard, an alum from Ned Davis Research who started TrimTabs Asset Management in the mid-2000s, identifies at least six symptoms of a market distorted by passive flows. His point is this: Anyone can be explained by other factors, but taken together, it is compelling evidence that the singularity is upon us.
The six symptoms are:
- Valuations structurally higher and rising
- Corrections are rare and shorter
- Larger stocks outperform
- The prices are separate from the fundamentals
- Index returns are separate from economic indicators
- The remuneration of executives has increased
If he’s right, a slew of new academic research arguing that the market is as active as ever is missing the forest for the trees. They assume that the design and use of index strategies equates to a discretionary investment, except for the name. But for Deluard, there are just too many tell-tale signs that passive power is at work.
Read more: The stock market is as active as it was before the $ 11 trillion index invasion
To be clear, Deluard is not anti-indexing. He describes it as the “natural evolution” of the markets that is fueling the current bull run and insists that investors must embrace it. “A core allocation to capitalization-weighted index funds is the easiest way to capitalize on this rising tide,” he wrote.
At the same time, index inclusions and exclusions, design flaws in some funds, and option strategies that capitalize on the new volatility regime could all be ways to gain an advantage, he argues.
In the meantime, anyone looking to avoid the passive bubble should watch out for the stocks that index funds are ignoring, Deluard said. These include old energy companies and large tobacco companies.
A lack of buyers causes a “structural discount in their valuations,” he said – although investors need to be patient.
“The ‘residual index premium’ is realized over decades, not months,” he wrote.