ETF CRASH incoming says Michael Burry of The Big Short, are we double phucked?
Michael Burry, widely known for his role in the prediction of the 2008 subprime mortgage crisis and the collateralized debt obligations bubble, now predicts the same fate for Index funds and ETFs.
The Big Shot's hero has indicated that the massive inflow into the ETF market precedes a crisis that could cripple the entire system in the long run. The contrarian explained that the influx of index funds is now affecting the prices of stocks and bonds, creating a bubble that could adversely affect the market investors at some point.
He also pointed out the risks that could be faced in this case – which we attempt to explain in a few steps through this piece. But first, we take a step back to the world of ETFs and how they work:
ETFs: How Do They Work?
ETFs (also known as Exchange Traded Funds) represent securities that could be traded on a platform or through a broker. These securities can be bonds, stocks, commodities, and are associated with the ease by which stocks are traded.
These funds are represented by the shares of underlying assets, designed to track those assets' performance and value in the market. Here, the fund's shareholders or investors are just a part of the fund but not the underlying asset.
One thing you need to understand about ETFs is that they are subject to market dynamics and trade at a price that mostly differs from those of the underlying asset. They are there as a means to trade a collection of assets without buying them individually.
ETFs Bubble Analysis
If you remember the movie “The BIG SHORT” and Christian Bale's portrayal of Micheal Burry the real life character that not only predicted the crash of the CDO market of 2007-2008 and made a mint off of it.
One of my favorite parts of the movie was where he was in Goldman Sachs bond department looking to create “THE BIG SHORT” of which he has to negotiate to create the actual products he wanted as they did not exist because like now, people were STUPID and just could not see what was coming.
Think of the current situation like this: Imagine you find out one day the boogeyman was somebody who loved and cared for you all of your life, like your parents, then one day those same loving people decided to eat you when you were at your best and most happy, yup they turned out to be an EVIL PHUCKING CANNIBALS!
This is pretty much the current situation we are in with the FED and U.S. government as they start buying for the first time ever ETFs, corporate bonds and whatever other TOXIC debt ridden crap that no good book keeper or sane individual who could count would want.
God help us all as with this new unlimited and unhinged QE the FED has unleashed would make Pandora's box look like a 5 year olds plastic windup jack in the box.
From Michael Burry's analysis of the recent pump into the ETF and Index Funds, the creation of a bubble in the system is evident. The move to accumulate new business in the ETF landscape climaxed in 2019 when about $93.5 billion was injected into ETFs and index funds.
Reports show that the influx propelled a 10.65% finish compared to the previous year. The rise had been linked to the top players like Vanguard springing up a price war and leading to rival players refitting their business models to accommodate the demands.
Michael Burry foresaw this as a bubble and warned that the inflow could experience a reversal in time and cause a big crash.
The disappearance of Price Discovery
Burry believes that in a move that parallels the slow disappearance of price discovery from credit markets by Central Banks and Basel III, Passive investing is slowly taking the cap off price discovery in the equity markets.
Technically, the simple models of trade on ETFs and Index funds no longer require fundamental analysis for the true price discovery. The logic behind this can be explained with a circle of three players: Experienced Investor/ market player, the ETF manager, and Retail Investor.
There, we have the actual assets or Indices to be traded in a primary market. The experienced investor bases the trading decision to be made on fundamental analysis and might decide to sit it out.
Then, the ETF manager overlooks the fundamental aspect, injects his funds into it – creating an aggressive price war, near-pseudo liquidity, and upping demands in the market.
These demands create a bubble that an inexperienced investor, say a retail investor, could buy into without so much considering the fundamentals.
In other words, the prices in the marketplace are no longer pushed by the fundamentals but based on the bubble price liquidity in the long run.
This highlights Burry's “no price discovery notion” – a feat that bodes negative effect on the financial markets. The worst of this is that, like with the CoronaVirus, almost everybody is not prepared for the financial hell it will no doubt unleash.
Burry stated that “the secret of the passive index is the distribution of daily dollar value traded among the securities within the indexes they mimic.” He based his statement on the fact that a vast majority of stocks have low volumes traded with lower values and yet passive investing makes it such that these stocks are indexed to trillions of dollars.
Burry foresaw less liquidity in the market in the long run.
A simple explanation for this is through the introduction of a market maker to the analogy mentioned above. Here, we have the primary and secondary market – driven by the simple laws of demand and supply.
In some cases, the ETF prices get influenced by the price of the underlying asset in the primary market as well as demands in the secondary market leading to discrepancies in both markets.
Now, the market maker sees through this, and bids or sells as he deems fit while benefiting from the spreads of both markets. The major issue that Michael Burry pointed out is that if the prices in the primary market begin to dwindle, the market maker might decide to sit out on buying in the secondary market due to liquidity issues in the primary market.
As such, the players in the secondary market willing to sell get stuck with their shares that the market maker is not willing to take them off their hands. In other words, if the index trading volume is low, there could be a crash.
Derivatives Market Risks
Further concerns were leveled on the derivatives market. According to Burry, there might be an issue with unwinding derivatives involved in the market. He highlighted that “naked buy or sell strategies” tethered to many of the ETFs and Index funds “pseudo-match flows and prices” all the time.
Derivatives trading has been one of the most viable ways of maximizing profits in the most liquid markets. It is a form of security in the financial market with its value tied to an underlying asset or a combination.
Now, in some cases, derivatives trading can be seen as a side bet – which is like an insurance and additional means of gaining from the market. While this trade system has its benefits, the flip side of it could be really devastating.
This is so because in likely events of a crash, there are possibilities of defaults in payments. For our case study, we have an OTC agreement between the ETF manager, a counterparty party and the experienced investor.
Banking on his experience, the experienced investor takes a look at the market, does an analysis and decides that the market has false liquidity due to overpriced assets.
Then, he bets the counterparty a certain amount that there would be a reduction in price. Then, the ETF manager sees the opportunity and also makes a bet with the counterparty.
Now due to the mode of trading, the bets are merely binded by a contractual agreement over a period of time.
The major issue is that this could go in two ways for the parties involved. In the case of the financial crisis, counterparties in the derivatives market get wiped out, and other parties involved, such as the ETF manager that might have been involved in derivatives trading, are affected.
This is so because there are no standardized agreements between the parties. Consequently, the shares involved especially in the secondary get overpriced with limited exit.
What You Need to Know
Here is what this bubble means and what it could do in the future to us all. We call it the Double Phuck:
There are possibilities of the government and other market players inflating their money supplies to high levels to buy ETFs/ Corporate bonds- thus creating false liquidity in the market.
So, simply put the U.S. government and the FED coming in to SAVE us all and make us all FAT AND HAPPY!!! YAY!!!
However, in reality this will only work till at least all the TOXIC effects of the inequalities embedded across our society takes hold, along with the social ills we have worked so hard to ignore.
Now, the first PHUCK is going to be where the government prints TONS of helicopter money in the form of STIMULUS bills from the U.S. government and many governments of the west.
This in itself is not the problem alone, it is the corrupt way in which the money will be used. For example, the U.S. is going to start buying ETFs/Corporate Bonds. Now if it was their money then great buy all you want, but it is not… It is the TAX PAYERS money! It is every citizen’s money after all we are all in this together!
So, the FED/Govs will inflate their money supplies to who the phuck knows levels and you will be on the hook for it in the future as the debt ceilings are crushed. For now, the illusion is that the government/FED are working together to save us all which is equal to themselves such as in Donald Trump's case.
He needs the market to go way up so he can get re-elected president and damn it all! Buy it all! Make the prices go up!!!
The second PHUCK comes where people are going to buy/ retail because they see the prices go up without fundamental analysis or price discovery.
This looks great till the music stops and people look and see there are no chairs to sit down on as they all have been pulled from under us. Then, the pendulum keeps swinging with the government printing money and the public buying their artificial manipulation of the gov/fed.
Now, the problem is there is no real economic reason or good value here because instead the public is buying into a bubble twice and later on likely a time after the elections will wake up to a very very sore in a sexually explicit manner as you were “DOUBLE PHUCKED”.
From Burry's point, the crash looks inevitable, mainly because the money managers involved market indexed passive products at lower values. He explained that it is obvious they will make up for whichever lapses that could occur due to the lowered fees in scale. So technically, there is an underlying issue to be tackled.
So how can Michael Burry and the Big Short save us from losing out on this:
Simply by paying attention to what is going on with the government and what the Feds are doing – the suspected manipulation of markets/prices by artificial inflation with taxpayer funds and increment of debts.
So, as would-be investors looking to diversify or say buy long in this field i.e. the ETFs field, you can only look through history to hedge against turbulent periods. The positive part of this is that you don't get to do particularly worry about thorough fundamental analysis – simply pay attention to the market before swiping through your board.
An additional merit of trading through this supposed bubble is that you are exposed to lower fees on trading, and you get to beat active managers. However, with the looming volatility and predicted crash, a comprehensive understanding of the underlying assets – the value and the dynamics involved is recommended.
You should be able to analyze the risks involved in ETFs and the general marketplace to avoid losing out on your investments, nose-diving into extreme turbulence or pulling up short in the face of less liquidity.
Chicken or the Egg?
In conclusion, understand the chicken and the egg and how they are connected. We will end this with the Watchman. The Watchman TV show on HBO? Yes, that is correct as we are coming into historic cycles and questions of whether any of what we are seeing is a product of free will or a predestiny.
As mentioned above, the Super Historical Cycles and why this crazy is just kinda normal and as odd as this might seem to us, well that is just the flavor of our time. Much of this has happened many times before in different ways and the nice thing is we can learn from our history thanks to the digital age.
You see, through history in all markets, we have had a cycle- whether you call them K-Waves, Elliot Waves and the many variations of what past market historians have recorded.
Today, we can see a simple pattern of repeating behavior of these cycles in their timing which is not always perfect- but when statistically averaged can give a pretty good idea of a span to expect future turbulence and protect yourself against it.
As Mark Twain once said: “History doesn't repeat itself, but it often rhymes.” Cycles that work with markets/humans are averaged out as 22.5 years, 45 years or 90 years. These cycles are made to correspond with our life/family cycles with some various overlaps and variance implied.
Now, let’s examine the last great cycle around 90 years ago (1929) to today i.e. 90 years later (2020). Let's change the variable a bit and go the other way 90 years back from 1929 as well i.e. 1837 where few would tell you now that the U.S. had a major depression that lasted until the mid 1840s.
From the estimation, you can see that there is no perfect measure but many of these, if studied can be seen repeating the aforementioned cycle – in if not a perfectly timely manner then a fairly succinct one.
So as crazy as our times are with unlimited money printing and the corona virus impact on us and our everyday lives, we can only look at this being a repeat of history. And lastly, going back to the unforgettable scene in “The Watchman” ‐ which I highly recommend for if nothing else, its good use of quantum mechanics for the layman to conceptualize.
As in the show, the answer to the chicken or the egg question is this: The chicken and the egg happen at the exact same time because time is relative… Mark Twain, Michael Burry or Dr.Manhattan all have a good story to tell in the past, present & future.