Markets are behaving oddly these days. The ‘term premium’, which reflects the compensation for investing in longer-term debt, is zero in the US and it is inverted globally.
It should be positive at this stage of the business cycle. Pension schemes’ appetite for new corporate debt remains high, despite its rapidly falling quality. House prices keep rising in many economies, despite increasing interest rates. US equities are sought after, despite their poor valuations. Gold and the Vix measure of volatility are falling, despite geopolitical turmoil.
Why? A common theme is investor overconfidence or complacency, driven by loose monetary policy.
Like money manager capitalism, this will weaken capitalism and decrease economic growth, since capital is less efficiently allocated
Perhaps, though, there is a larger trend at play. Maybe these seemingly disconnected oddities are symptoms of a next stage in the evolution of markets. Let’s call this ‘index capitalism’, a nod to the American economist Hyman Minsky, who observed the evolution of “money manager capitalism” from the 1980s onwards.
At the time, he noted with alarm that market economies revolved increasingly around stock-picking by institutional investors rather than small-scale investing and entrepreneurship.
Fundamentals are fading
But the world has changed. ‘Fundamental’ investors – institutional or otherwise – who actively pick stocks based on the quality of a company, now manage a mere 10 per cent of trading volume, according to Marko Kolanovic at JP Morgan. Capital is increasingly moving into index management.
Index capitalism might be today’s evolution of money manager capitalism, helping to explain what would otherwise be considered an abnormality. What unites them is that prices keep deviating from what would seem to be their fundamental value.
This makes sense in a world where fundamental investors are on their way out. Their role in the system is to develop a view on a company’s value – when a price falls below this they buy, when it rises above justifiable levels, they sell.
If they do their homework on the company’s health and prospects, fundamental investors ensure prices never stray too far from the underlying companies’ values. This is not to say they are rational investment machines, but their long-term behaviour stabilises markets and channels capital to its most productive use.
Following the herd
Index capitalism, however, does not do this. It is dominated by passive investors, who allocate capital based on mechanical rules, disconnected from the underlying company’s features.
Market valuations are driven by investment flows to and from index funds, stock buybacks and the relative popularity of different investment strategies, such as momentum-seeking, trend-following and mean-reversion. These investment approaches drive stock prices, with no reference to a company’s profit or productivity.
Of course, in money manager capitalism, financial markets also occasionally become divorced from the real economy. Every now and then investors go into a frenzy, forget fundamentals and pursue the froth in the market.
But index capitalism simply does not distinguish fundamentals from froth and frenzy. The market becomes a self-referential system with mechanical rules.
Get used to the new world
There are very few fundamental investors left to counteract price deviations from fundamentals. In index capitalism, features that were anomalies in the old system of fundamental investors become the norm.
Like money manager capitalism, this will weaken capitalism and decrease economic growth, since capital is less efficiently allocated. It will also change financial market dynamics in ways that we do not yet understand.
Recent market quirks may well be today’s new normal; whether we like it or not, index capitalism is here to stay.
It is already branching into distinct varieties, like factor investing, already popular with UK pensions funds, but perhaps we need to update our frame of reference to understand index capitalism’s logic, just as Minsky did in his time. Goodbye fundamental investor, hello index capitalist.
Stefan Lundbergh is head of insights at fiduciary manager and consultancy Cardano. Dirk Bezemer is professor of economics of international financial development and Joeri Schasfoort is PhD student, both at the University of Groningen.
