At some time in the future (I'm not predicting when), this long bull market in equities will come to an end. The cause will be, as it nearly always is, rising interest rates and a concurrent tightening of financial market liquidity conditions. If the rise in interest rates is driven merely by a strengthening economy, without a significant rise in inflation, the extent of the rate increase may be modest, and might be offset by rising corporate profits. However, rising interest rates are likely to cap, or perhaps compress, P/E multiples, limiting stock price increases to the rate of growth of earnings. Nevertheless, if inflation exceeds the Fed's 2% target, the FOMC will tighten monetary policy much faster and more severely than the current investor consensus expects. Bear in mind that every recession in the post-World War II period has been precipitated by the Fed, with the one exception being the 2008 credit bust.
Now this is all pretty elementary and fundamental stuff, hardly worthy of a memorandum such as this. The difference this time is the exponential rise in the years since the Great Recession in the value of both equity and bond ETFs. As of this writing, the total value of the US equity market is $28.9 trillion. The value of all equity ETFs exceeds $2.5 trillion. The value of all domestic bond ETFs exceeds $400 billion. Warren Buffet once referred to financial derivatives as weapons of mass destruction. 2008 proved him prescient. Few investors today are aware of the dangers posed by ETFs during a selloff in equities and/or bonds.
Whenever a broad decline in stock prices begins, for whatever reasons, equity ETFs will be forced to liquidate some of their holdings in order to maintain valuation parity with the aggregate value of the stocks they own. These underlying holdings in ETFs, especially bond ETFs, will prove to be much less liquid than the shares of the ETFs themselves, which will be forced to liquidate them into an environment of shrinking investor demand. This will exacerbate the speed and depth of the overall market decline. The selloff will be vastly greater than current economic and corporate profits would suggest. It may well be analogous to October 19th, 1987, when the collapse of the "surefire" portfolio insurance scheme triggered a 20%+ decline in stock prices in one day, which was way out of proportion to the then-existing economic and corporate fundamentals.
The reason this is so analogous is because as investor demand for ETFs increases, the ETFs must issue additional shares, the proceeds of which are used to buy more shares in order to maintain parity with the values of the individual holdings in the fund. The recent steep rise in stock prices has been turbocharged by money flows into the ETFs. The same dynamic will work in reverse. As shares which make up an ETF decline in value, the ETF itself will be forced to liquidate holdings to maintain valuation parity, and it will be doing this into an environment of shrinking investor demand. This is particularly true of bond ETFs, where the liquidity of the constituent holdings is vastly less than that of the ETFs themselves. If any reader wants a more detailed explanation of the mechanics of this process, please feel free to call us.
In any event, when this dynamic plays out, investors will become frightened, and will likely suffer enormous losses as they react to the decline by selling shares at the bottom of the correction. Many pundits are forecasting a 10% correction in the US stock market sometime this year. We would wager that a decline of that magnitude will trigger a far greater sell-off, from which only a few high-conviction investors will take advantage of the buying opportunity presented to them.