Will ETFs be the downfall of the US bull run?

The summer has been a quiet one for markets (so far at least). Trading and volatility are low. Indeed, the VIX index recently recorded its longest ever run of nine days below 10.

Will ETFs be the downfall of the US bull run?


According to Montanaro Asset Management, the previous record at this significant level was just four days, way back in 1993 when Meat Loaf’s Bat out of Hell was Top of the Pops and the Dow Jones was a mere 3,764.

Fast-forward nearly a quarter of a century and the Dow Jones is above 22,000 and still very much in an upward trend. The story for the S&P 500 is a similar one: over the past seven years it has trounced other developed and emerging markets. A recent white paper from GMO highlighted the fact that, with 15% annualised returns over the period, every dollar invested has compounded to $2.72. No wonder investors are still piling in.

But valuations are extraordinary. They are three times the 2009 low and we’ve only seen the CAPE Schiller inflation-adjusted figure higher on two previous occasions: 1929 and 2000.

The main driver at the moment seems to be ETF buying – where valuation isn’t a consideration. Credulousness among investors seems to be high, while risk aversion is low. New market highs are a possibility, but the probability of a substantial correction is increasing.

Index or passives have risen from about 7% of total managed assets to around a third – in no small part due, I’d surmise, to a growing a belief that active managers can no longer deliver performance and that therefore cheapest is best.

But there are inherent dangers to this approach. More and more money is flowing into fewer and fewer stocks – the FANGs (Facebook, Amazon Netflix and Google) for example. When this happened with the Nifty 50 in the early ’70s, and tech stocks in the late ’90s, neither trend ended well.

When markets do correct, as they undoubtedly will, investors will hit the ‘sell’ button and market falls could be significantly amplified – as we saw when gold ETFs suffered significant outflows a few years ago.

The GMO white paper looks at the four components of market returns: earnings, dividends, margins and price-to-earnings (P/Es). Looking back over the past 20-30 years, margins and P/Es have been relatively flat and the returns have largely been achieved through dividends.