One of the more remarkable aspects of this year’s market advance is exactly that: the market has advanced. Higher taxes in the form of tariffs, persistent inflation, less spending, a hit to consumer and investor sentiment due to economic anxiety, a weaker dollar—in the past, negatives such as these would have sunk, or, at a minimum, held back most financial markets, with the possible exception of gold and other commodities. Instead, in the contrary year in which we find ourselves, market barometers have repeatedly risen to record highs.
An old quip on Wall Street—that a stock is going up because there are “more buyers than sellers”—may provide a clue regarding the surprising market strength. Many in the investment business have suspected that the years-long massive flow of money into index funds (so-called “passive” investment vehicles) is creating persistent upward pressure on security prices. Index funds by definition must own the securities represented by the index they represent, regardless of price, valuation, or other factors that “analog” investors traditionally take into account. A feedback loop develops; as the fund’s assets under management grow (i.e., more money flows in), it automatically purchases more of the same securities, putting upward pressure on demand. The uplifting effect of the new money generates more interest, and higher prices—hence greater inflows—and so on.
The exact magnitude of the impact of this process has never been quantified, but it is believed by investment professionals to be significant. Recent (2022) academic financial research discussed in the Financial Times suggests these suspicions are correct. The studies indicated that money-flows into and out of the markets did have a meaningful impact that persisted over time and was not negated by subsequent transactions. Furthermore, the effect was quantified: a $1 market inflow was found to have a $5 impact on the market as a whole. Multiply that by hundreds of billions of dollars and it is clear that the impact is significant. Flows related to index funds don’t explain allof market strength in recent years, but they have played an important role. The impact has so far been positive, but what would happen if flows were to reverse, leading investors to abandon passive vehicles? The feedback loop could quickly turn negative, especially if some unforeseen event leads to a stampede out of financial assets.
As an interesting aside, one of the negatives this year—a weakening dollar—may actually reflect the money flooding into US stock markets. Foreign interest in American equities, driven by the current technology and AI excitement, remains high. However, fund managers abroad are growing concerned about US economic policy and its potential effect on the dollar. In response they have been hedging the currency to dampen the impact of dollar exchange rate moves. Such hedging entails, in effect, selling dollars on a forward basis, creating pressure on the currency’s value. In other words: more sellers than buyers.
* * *
Last month in the Financial Times, columnist Robert Armstrong penned a piece entitled “Stock allocations are historically high and cash allocations historically low. Is that scary?” A better question would be: why should we care?
In our view, forecasts of market direction are largely doomed to failure. In fact, we have never so much as made an earnings forecast (how’s that for being a “financial analyst”!). What we do find useful to undertake, however, are assessments of current market conditions—not for prediction but as indicators of risk. In this regard, cash allocations are interesting tools; as Armstrong points out in his article, very low cash levels tend to be followed by periods of low stock returns, if not losses, and vice versa. Cash holdings (money funds or “cash equivalents” such as treasury bills) reached a nadir at the end of the dotcom bubble, for example, preceding a “lost decade” for buyers of stocks, as it took them that long to recover the cost of their purchases. Now, once again, cash has reached very low levels, suggesting a coming period of disappointing equity returns.
The flip side to cash allocation is the level of exposure to equities. This measure stands at an all-time high for the last 75 years. The rise in exposure reflects market value appreciation, but also sentiment, a qualitative factor that influences the willingness to purchase securities, even at higher prices. Sentiment encompasses attitudes and emotions, such as enthusiasm over prospects for stocks, or the notorious “FOMO,” or fear of missing out. Current stock allocations, too, are typically associated with sub-par returns going forward.
While interesting, cash and stock allocations should really be of concern only for unsophisticated “investors” or investment institutions for whom FOMO reflects business and career threats. Serious investors need have little concern for allocations as such, keeping in mind that cash and securities exposures fluctuate with the waxing and waning of interest in markets. Cash levels tend to rise in casino-like markets, as sale opportunities multiply, and candidates for purchase disappear. Conversely, cash declines sharply in bear markets when bargains in securities abound. A smart investor zigs when others zag.
Another useful gauge of risk is market valuation, which, like cash levels, also tends to be correlated with subsequent investment results. Here mathematics adds concreteness to the relationship. If a security reliably pays $1 per year in perpetuity, then a $10 price translates into a 10% return, dropping to 5% at $20. If the long-term average return is 10%, then paying for a 5% yield mightgive the investor pause. Likewise, 20% at $5 could indicate a bargain. Concurring with cash levels and stock allocations, current market valuations also suggest limited returns to stocks going forward.
An interesting valuation-related barometer of market conditions measures the relationship between total equity market value and the country’s gross domestic product (“GDP”); this particular barometer is known as the “Buffett Indicator,” after the well-known investor, who proposed its use. In March 2000, on the eve of the Dotcom crash, this measure reached 175% before subsequently falling below 100%. Before the Financial Crisis in 2007 it climbed to about 140%. More recently it stood at a record 220%. Above 200%, Buffett has said, investors are “playing with fire.” This indicator, like any market barometer, is subject to interpretation. For example, there is no absolute number that flashes red for danger: on the eve of the Financial Crisis it had come nowhere near to retracing its high prior to the 2000 crash. But precision isn’t necessary in this case. As a gauge of risk, it is enough to show that the needle is in the red zone.
* * *
One of the oddest manifestations of speculative frenzy burst onto the financial scene this year in the form of so-called “crypto-treasury” companies. Simply put, these are publicly-traded companies that purchase crypto currencies (initially Bitcoin, the most popular and liquid). Despite many of these companies having nondescript and unprofitable operating businesses in industries ranging from healthcare to hotels, they have been able to raise huge sums of money in the public markets to fund the “business model” of accumulating a crypto hoard. The fact that the stock prices of some of these companies have skyrocketed (some have market values representing multiples of the value of their crypto holdings) suggests why this has become an attractive strategy for some company managements.
This facet of the crypto craze began several years ago when an enterprising operator transformed his struggling company by beginning to accumulate Bitcoin. In subsequent years the firm raised billions of dollars through equity and debt issuance to increase the hoard. At one point this summer the share price had risen 3000% since the beginning of the crypto buying spree, and at $115 billion the market value was double the value of its Bitcoin, earning the CEO the title of “crypto evangelist.” Word of this record spread quickly, so it is not surprising that the heads of other companies in various types of business, all sharing mediocre prospects and weak stock prices, jumped on the crypto bandwagon, changing corporate names to include the word “crypto,” and raising money not to expand their operations, but instead to purchase a variety of crypto currencies. In early August the Financial Times reported that in 2025 to date, 154 companies had raised $98 billion to carry out the strategy.
It is easy to see how this scheme might unravel in ways that could be painful for all involved (with the possible exception of the promoters). The entire enterprise is based on the value of an asset—crypto currency—which is of dubious intrinsic value: its market value, on the other hand, is being pumped up by the very companies that have bet their fortunes on the strategy. There is the matter of leverage, as the crypto hoarders raise money through debt offerings. In fact, debt is central to the scheme as it raises the number of Bitcoin (or other crypto currency) per share . Bitcoin is crypto; debt, however, is real money which must be repaid. Sure enough, signs of one potential future for crypto enthusiasts began appearing in September as the market for such offerings got indigestion. Shares of some of the weaker hoarders dropped by 70% (even the originator company lost about a fifth of its value) and observers began to talk of an “irrationally overheated” market. For a speculative strategy dependent on irrationality for its very existence, this “vibe shift” was not good news.
A well-known economic principle is the supply, demand, and price relationship: as demand for a good increases, prices will rise, in turn stimulating the production of the good, which then dampens prices. On Wall Street this process happens very quickly, as new supply of financial goods is easily conjured. This can be seen in dramatic speculative events, such as SPACs a few years ago, and most recently in the crypto hoarder craze. All suffer the same fate, as the laws of economics assert themselves. Eventually supply overwhelms demand, and prices sink. Another reason why, when it comes to investments, doing what everyone else is doing is not a sound principle.
Dennis Butler, MBA, CFA
Commentary