The ever-increasing dominance of passive investing is fundamentally changing how markets function – often in ways that most investors don’t perceive. As Mike Green explains in this revealing conversation, the shift toward passive investing is creating significant distortions that undermine the very efficiency that markets are supposed to embody.
At the heart of this issue is what academics now call “inelastic markets.” Contrary to what efficient market theory suggests, research shows that markets are highly inelastic – meaning small changes in supply and demand can lead to dramatic price movements. For passive funds, which operate on a simple algorithm of “did you give me cash? If so, buy; did you ask for cash? If so, sell,” this inelasticity creates a self-reinforcing cycle.
When new money flows into market cap weighted indices, the funds must buy more of the stocks that have already risen in price. This creates a feedback loop that pushes those stocks even higher, regardless of their fundamental value. The largest stocks experience this effect most dramatically. Research shows that for the largest stocks in the market, a single dollar flowing in can create a multiplier effect approaching 100x – meaning $1 of inflow can generate $100 in market capitalization. This completely contradicts efficient market theory, which assumes a dollar of inflow should create just one penny of market cap.
This dynamic has profound implications for how we assess valuation. Traditional value managers, trained to identify when prices have diverged from intrinsic value, find themselves increasingly marginalized. Once they sell their positions because valuations appear stretched, they lose their “vote” in the market. Their voices warning about overvaluation become irrelevant – like “shouting that the emperor has no clothes in a nude beach.”
The result is a market where price discovery is increasingly disconnected from fundamentals. When asked what’s priced into today’s market, the unfortunate answer is “nothing.” The market is driven not by fundamental insights but by a simple question: do the majority of Americans still have jobs that allow them to continue contributing to their 401(k) plans?
This passive dominance also creates hidden risks in credit markets. As equity values become inflated through passive flows, credit investors gain a false sense of security. They assume the inflated equity values provide a substantial cushion against default risk. In reality, if the passive flows reverse, equity values could rapidly decline, leaving bondholders exposed to much higher default risk than they anticipated.
Perhaps most concerning is what happens when this dynamic reverses. The same passive mechanism that pushes markets higher on inflows works in reverse when outflows occur. If Americans start withdrawing more from investments – either due to unemployment, retirement needs, or simple profit-taking – the passive selling pressure could create a downward spiral. Since these funds make no assessment of fundamental value, there’s no floor based on intrinsic worth.
This isn’t merely theoretical. We’ve seen similar dynamics play out in historical bubbles. Mike identifies the dot-com bubble as “Passive 1.0” – caused partly by index funds using futures to replicate market exposure, which unintentionally created outsized demand for low-float tech stocks. A similar dynamic played out in China between 2014 and 2015, when its stock market rose 500% in six months before collapsing when Western investors tried to exit.
The implications for investors are profound. The traditional tools of fundamental analysis haven’t stopped working – they’ve just been overwhelmed by structural flows that pay no attention to them. Success in this environment requires understanding these structural forces rather than fighting against them. As Mike puts it, you can argue that the car’s brakes don’t work, but that’s only a problem once you start going downhill.