Many times I have commented about the massive proliferation of passive investing and how it is impacting trading mechanics.  According to the Index Industry Association, benchmarking giants like S & P Global Inc., MSCI Inc., and the London Stock Exchange Group PLC, has created 438,000 new indexes over the 12 months through June 30.

According to the same group, there are more than 3.7 million benchmarks globally, dwarfing the roughly 50,000 stocks that trade on exchanges around the world.

The greatest annual growth in indexes are factor based and smart beta gauges that track stocks with characteristics like momentum or low volatility and often use these features rather than market capitalization to determine how much of these companies to include in a measure.

Fixed income indexes—concentrated primarily in sovereign debt– now make up about 16% of all indexes.  Two years ago 95% of indexes were focused in equities.

Indexes focused on environmental and social concerns jumped about 60% from about a year ago.

Wow!  I readily acknowledge that I do not have any idea of the capitalization or structure of each of these indexes but the data is staggering.  Talk about slicing and dicing.  Depending upon the source traditional stock research departments have declined from 50% to 75% since 2008, the direct result of this massive move to passive/indexing investing.

What I find interesting that according Society Generale 90% of all stocks, only 10% of their ownership is concentrated in ETFs, investment vehicles similar to that of indexes.  Conversely 10% of companies comprise 90% of ETF capitalization.

In my view today’s trading mechanics have never been stress tested.  How will the markets respond to a crisis?

As widely noted the major indices are down about 10%-12% in relative quick order.  In my view the declines would be greater if it were not for retail investors buying ETFs in the face of selling from institutions.  What happens if the retail investor stops buying, an environment that may be developing today given the lack of a recovery from the recent rout?

Will the popular indices decline another 15% to 20% which could perhaps cause a massive obliteration of indexes?  Will a major sponsor experience financial issues, issues that would create the next financial crisis?

Historically whenever there is massive proliferation of investment vehicle, the first time these vehicles are stress tested it typically ends poorly.  Will today be different?

Commenting upon yesterday’s market activity, AAPL dragged the averages lower and is another FAANG company that is now in “bear market territory,” defined as declining over 20% from its highs.  Shares peaked about a month ago.  Facebook is down over 35% from their July peak and Amazon is off 22% since early September.  Netflix has dropped about 33% since last June.  Google is the best performer, off about 18.5% from July’s apex.

In my view the decline of these mega sized companies have been orderly with many not yet recognizing or accepting the magnitude of these drops believing a recovery will imminently occur.  As noted earlier, this perspective may now be changing.

What will happen today?

Last night the foreign markets were mixed.  London was up 0.15%, Paris down 0.22% and Frankfurt up 0.08%.  China was up 1.36%,  Japan down 0.20% and Hang Sang up 1.75%.

The Dow should open moderately higher on potential trade optimism and Wal-Mart’s earnings and same stores beat. Oil is nominally higher.  Goldman is suggesting crude will rebound to $75 barrel by the first quarter if OPEC reduces production by the amount it has telegraphed to the market.   The 10 year is up 5/32 to yield 3.11%.


The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. The information contained herein has been compiled from sources believed to be reliable; however, there is no guarantee of its accuracy or completeness. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. The material provided in Daily Market Commentaries or on this website should be used for informational purposes only and in no way should be relied upon for financial advice. Please be sure to consult your own financial advisor when making decisions regarding your financial management. Members of FINRA and SIPC, Capitol Securities Management is a privately owned full-service retail brokerage and investment advisory firm headquartered in Richmond, Virginia. For nearly 30 years, we have been serving the needs of our investors. Today, more than 200 Capitol Securities Management investment professionals and support staff serve approximately 18,000 customer accounts from Southern Florida to the New England coast.