Last year, well-known investor Michael Burry predicted that index funds were in a bubble that would collapse in a similar manner to the subprime mortgage bubble of the 2000s. Burry, whose exploits were chronicled in Michael Lewis's 2010 book, "The Big Short," and who was played by actor Christian Bale in the 2015 film of the same name, obviously knows a little bit about bubbles and unstable financial structures.
With that being said, it's not enough to look at someone's past record and assume they will be right about everything going forward. Let's look at why he made this claim and where we stand now.
Too much money chasing too few stocks
Burry's main argument last year was the flows into index funds were artificially driving the price of their constituent stocks higher - in other words, that the sum demand for the indexes was greater than the demand for the individual stocks on their own. He analogized this situation to the one that he profited from in 2008, when investor demand for collateralized debt obligations far outstripped the value of the underlying mortgages.
The huge amount of money - trillions of dollars - that is attached to these indexes does not line up with the comparatively small amount of money - millions of dollars - that trade in the stocks themselves. Moreover, since the companies that comprise these indexes are not - for the most part - being analyzed on a bottom-up basis, the valuations and price targets attached to the indexes are not tethered to anything concrete.
The problem that Burry sees with index funds is that if exchange-traded fund holders begin to liquidate their holdings en masse in the event of a financial panic, the volume of stock sold will far exceed the average outflows from these companies, leading to a collapse in their share prices.
This can help to explain why the March bear market was the steepest on record. This event certainly seems to support Burry's thesis that the interactions between index funds and the stocks that make them up can amplify both up and down movements in the market. And now that the major stock indexes are at a higher level than they were at the start of the year, this question is once again a pertinent one. Real fundamental analysis always starts from the bottom up.
Read more here:
- Charlie Munger: Be Rational, Not Brilliant
- Bill Nygren Explains How to Look Beyond GAAP Accounting
- Warren Buffett Explains How to Improve Financial Regulation​
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
Also check out:
