ETFs Are a Ticking Time Bomb - Vivek Kaul's Diary
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ETFs Are a Ticking Time Bomb

Feb 9, 2016


RANCHO SANTANA, Nicaragua - Stocks sold off on Friday. The Dow fell 211 points.

Leading the retreat were tech stocks with the Nasdaq, where they tend to hang their hats, down more than 3%.

'Tech sector leads sharp sell-off,' said a Wall Street Journal headline.

Steps to the Moon

'Did you see what happened to professional social network company LinkedIn?' asked Exponential Tech Investor editor Jeff Brown, who was down here with us at Rancho Santana.

'It was a disaster. The company announced earnings, which were pretty much in line with what the market expected. But its forward guidance was down a little.

'Investors dropped it like a hot potato. The stock dropped by almost 50% - and investors lost about $11 billion - in 20 minutes of trading.'

Jeff is a believer in new technology: self-driving cars. Virtual reality goggles. Artificial intelligence.

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'Computers are already smarter than PhDs,' he reported.

'In what discipline?' we wanted to know. 'There are Cocker Spaniels that are smarter than PhDs in economics.'

'There is a huge difference between a regular company and a company that is on the cutting edge,' he went on.

'The difference is exponential. A regular company may grow 5% to 10% per year. A good tech company grows exponentially, at 100% a year or more.

'Just imagine that you are walking. You get somewhere by putting one foot in front of the other. If you are like a regular company, you step at a time.

'At a step a day, you've gone 30 paces in a month. But if you are able to walk exponentially - one step, then two steps, then four a month - you could have covered the distance from here to the moon.'

Many tech investments don't go anywhere, Jeff admitted. But when you get it right, you get a moonshot.

That may be true. But it is also true that from time to time, investors feel they have gone too far. That seems to be the case now...with a broad sell-off in the entire tech sector.

Look Where No One Is Looking

There are 'facts and dreams', said Churchill. Many of those dreamy, techy satellites...launched into space in the Bubble Epoch...are beginning to fall to Earth. Look out below!

Also present here in Nicaragua is our old friend and super stock picker Chris Mayer. The occasion was the Family Wealth Forum, a meeting for our premium family wealth advisory, Bonner & Partners Family Office, in which we discuss both sides of the 'family money' formula.

'There are two things you need in order to have family money,' we say gravely, 'family and money'. Several people spoke to all the things that could go wrong in a family. Chris was speaking to what could go wrong with the money.

'Right now, hundreds of billions of dollars are being invested in the stock market by investors who don't know anything about the companies they own.

'They buy exchange-traded funds [ETFs] - passively managed groups of stocks - that typically track the performance of a stock market index. These ETFs distort the market.

'Some well-known stocks are so heavily bought by ETFs that their prices are completely out of line with the real value of the company. And the ETFs are set up in such a way that there is no judgment at all involved.

'They are bought automatically, almost regardless of what is actually going on in the companies themselves.'

Chris believes that the opportunities for serious investors are increasing simply because there are so many unserious investors in the market.

ETFs favour the big companies in the big indexes, such as the S&P 500. That leaves the lesser known companies often unstudied and unbought.

'Even though stock prices are generally high,' said Chris, 'there are many stocks that are actually cheap. You just have to look where the ETFs are not buying.'

Not Your Grandfather's Investor

This was the second time in the last few days we had been alerted about the effect of ETFs.

Earlier in the week, my colleague David Stockman warned that a market sell-off would trigger a rout in ETFs...which would collapse the value of many overbought stocks...and potentially wipe out the leading market makers in the ETF sector - Vanguard, State Street, and Blackrock.

'Yes, ETFs add a new danger,' said Chris.

'The ETF buyer is not your grandfather's stock market investor. He was drawn into the market by greed. He'll be driven out by fear. And when he exits, the ETFs will be forced to sell stocks at any price.

'We could see some of the steepest crashes in history.'

How to protect yourself?

On high alert, we hereby take the 'passively managed' fund concept to a whole new level.

We propose a new category of investment - a 'passive aggressive' fund. It won't do anything with your money. Just sit on it and sulk.

And maybe 'forget' to take out the trash.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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