A Longtime Analyst Warns Dumb Index Cash Is ‘Tail Wagging Dog’

(Bloomberg) — While academics increasingly argue the passive revolution is a myth, there are plenty of market players who would beg to differ.

Vince Deluard, the outspoken macro strategist at StoneX Financial Inc., is the latest to warn of mounting evidence that index-tracking cash is messing with the equity market, driving up valuations, disrupting returns and upending the natural order for big stocks.

He calls it the “passive singularity,” after the concept that artificial intelligence will ultimately be powerful enough to unleash its own exponential growth. To survive, he says traders must embrace it, exploit distortions and seek opportunities in sectors shunned by popular gauges.

“The passive sector is creating the reality it was designed to mirror: the tail is wagging the dog,” he wrote in a note this week. “As the passive share of the market grows, prices are set by the interaction of the passive sector’s mechanistic rules and trading algorithms, rather than the emotions and analyses of biological brains.”

Deluard, a Ned Davis Research alum who started out with TrimTabs Asset Management in the mid-2000s, identifies at least six symptoms of a market that’s being distorted by passive flows. His point is this: Each can be explained by other factors, but taken together it’s persuasive evidence that the singularity is upon us.

The six symptoms are:

Valuations structurally higher and risingCorrections are rare and shorterLarger stocks outperformPrices are disconnected from fundamentalsIndex returns are disconnected from economic indicatorsExecutive compensation has soared

If he’s correct, a clutch of recent academic research papers arguing the market is as active as ever are missing the wood for the trees. They posit that the design and deployment of index strategies amounts to discretionary investment in all but name. But to Deluard, there are simply too many tell-tale signs that passive power is at work.

Read more: Stock Market Is as Active as Before $11 Trillion Index Invasion

To be clear, Deluard isn’t anti-indexing. He describes it as a “natural evolution” of markets that is powering the current bull run and insists investors must embrace it. “A core allocation to cap-weighted index funds is the simplest way to benefit from this rising tide,” he wrote.

At the same time index inclusions and exclusions, construction flaws in some funds and options strategies capitalizing on the new volatility regime could all be ways to gain an edge, he argues.

Meanwhile, anyone who wishes to avoid the passive bubble should look to the stocks ignored by index funds, Deluard said. Old-school energy names and big tobacco companies are among them.

A lack of buyers is causing a “structural discount in their valuations,” he said — though investors will need to be patient.

“The ‘index leftover premium’ will be realized over decades, not months,” he wrote.

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