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The Indiscriminate Inflow Threat

Updated: May 17, 2022

Michael Burry, the doctor-turned-hedge fund manager who foresaw the bursting of both the tech and subprime bubbles, has just revealed what he believes to be the latest bubble: passive investing. He should be listened to. But first, a short primer on bubbles - no pun intended.

"The unwind could be very ugly indeed. It is just a matter of when"

Use of the world ‘bubble’ with respect to financial markets dates back to 1720 and the passing in June of that year by the British Parliament of The Bubble Act - a response to the 87% collapse in the stock price of the South Sea Company and consequent bankruptcy of numerous and important investors.

Since then, bubbles have been defined in various ways, but all seem to relate in some way to prices rising far above intrinsic value.

Yale’s Robert Schiller defined a speculative bubble as “a social epidemic whose contagion is mediated by price movements. News of price increase rich enriches the early investors, creating word of mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fuelling “new era” stories and so on in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy”.

Physicist Didier Sornette is another who has been drawn to financial bubbles. He described bubbles simply as “significant persistent deviations from fundamental value” and realised that a financial bubble could be studied as a so-called complex system.

Other examples of complex systems are the weather and ant colonies, and while the three may not at first appear related, they are all driven by a multitude of positive and negative feedback loops that can be described using a common framework.

In order to establish a formal framework for studying bubbles, Sornette founded the Financial Crisis Observatory in the aftermath of the 2008/9 financial crisis. He wanted to understand how a few hundred billion dollars of losses in one small corner of the financial world - US subprime lending - triggered a $5 trillion contraction in world GDP and almost $30 trillion of losses in global stock market capitalization. Also, whether the carnage was directly related to the 30 or so years of stability - known as the Great Moderation - that preceded it.

Sornette has had some success in identifying ex ante a number of asset bubbles. In September 2007, he predicted that the bubble in Hong Kong and Chinese shares would “change regime” by the end of the year and that there “might be a crash”.

More recently, in May 2013, he noted that the US stock market was on an unsustainable trend and that there would be a correction - as indeed there was - but that this was only part of a “massive bubble in the making”.

Burry, whose story was featured in the best-selling book an Oscar-winning movie The Big Short, recently asserted that there is a bubble in passive investing, based on the uncontroversial idea that money has been pouring indiscriminately into large cap stocks in recent years.

According to Bloomberg, Burry believes that, “…index fund inflows are now distorting prices for stocks and bonds in much the same way that CDO purchases did for subprime mortgages more than a decade ago”. The flows will reverse at some point, he said, and “it will be ugly when they do”.

If it turns out that the stock purchases Burry sites have to a great extent being driven by the cheap credit available since the 2007/6 financial crisis, the unwind could be very ugly indeed. It is just a matter of when.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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