It's Over: The Stock Market Bubble Just Popped

What's up, guys? It's Graham here, and it's no surprise that everything is expensive. Housing costs more today than it ever has in history. The big short's Michael Burry warns that stocks are heavily overvalued and poised to tumble. Experienced investors are calling for a stock market sell-off, and short sellers are increasing their bets.

Well, I'm still out here trying to figure out what's for dinner. I'm thinking Chipotle. Okay, but for real, at the heart of all of this lies one topic that's quietly making an appearance, and arguably this would not only impact all of us but also the entire market, and that would be an index fund bubble.

To make matters worse, the creator of the index fund himself, Jack Bogle, issued a statement about the dangers of index investing right before his passing. So, as a self-proclaimed Index Fund connoisseur, we should dive deeper to determine whether or not index funds are creating a bubble that could burst into oblivion. Discuss why so many experts are suddenly calling for a stock market sell-off and then, most importantly, how you could use this information to make you money.

All of that and more on today's episode of Taco Bell is finally bringing back the Mexican pizza! Even though that has nothing to do with Index Fund investing, it's pretty cool. And before we start, if you appreciate all the research that goes into making a video like this, it would help me out tremendously if you tap the like button for the YouTube algorithm. That's all I ask, and as a thank you for doing that and subscribing, here's a picture of a sand-sifting goby. So thank you, guys, so much, and now let's begin.

Alright, so in order to break this down and discuss what's going on, we have to start off at the very beginning. An index fund is basically just a big basket of stocks that you can invest your money into, and from there, you'll get to own a small piece of everything. For example, you could spend four hundred dollars to own a small percentage of the entire top 500 publicly traded stocks in the U.S. stock exchange. That way, you're not buying one stock into one company because you found it intriguing on Wall Street Bets, but instead, you'll get to own a small piece of everything.

Plus, index funds cover just about every single investment that you could think of. Like for thirty-one dollars, you could own a small portion of every single international stock out there, or for a hundred and seven dollars, you could own a small portion of the entire U.S. equities market. The list just goes on and on and on, like an Energizer Bunny.

Most likely, if you could think of something, there's an index fund that tracks it. No, seriously! There's an index called "cow" that tracks livestock prices or the Obesity index, appropriately with the ticker symbol "slim." However, the benefit of buying index funds isn't just being able to get a whole bunch of different stocks for one low price, but rather, it's extremely profitable.

In fact, several studies have shown that 92% to 95% of professional portfolio managers could not outperform the market index over a 15-year period, resulting in more profit for you just by taking a more passive approach. Warren Buffett even went so far to say that attempting to buy and sell individual stocks is a mistake for 99% of the population. Then he put his money to the ultimate test by betting a collection of hedge fund managers a million dollars that they couldn't beat the market over a 10-year period. And guess who won? Warren Buffett and the index fund.

So given all this, we can't deny that the excitement of index fund investing has seen a huge mainstream popularity boost over the last few years, especially with a significant portion of new investors having just recently started since the COVID shutdown. But the real question still remains: Could index fund investing pose a huge threat to the entire market if and when it collapses?

Well, according to Michael Burry, the investor who constantly deletes his Twitter account and predicted the 2008 subprime loan crisis, as featured in the movie The Big Short, says that index funds are artificially inflating the price of the stock market. This is because people are driving up those values through investing in index funds, which creates an imbalance between where a stock is trading at and what it's actually worth.

Now, if that sounds insanely confusing, let me break it down a little further. When you're investing in an index fund, what you're really doing is investing into a big basket of stocks. That means anything within the basket automatically gets your money, and the more money it gets, the higher the price will go. Or, basically, as he suggests, if everyone is just investing their money into these giant stock baskets, those companies will constantly see money flowing into them just because they're lucky enough to be in the basket and not because of their actual performance. Hence, it becomes a bubble that people keep buying into only because they believe the price is going to be higher in the future.

Some people criticize the ARK ETF for a similar reason. Its Innovation Fund held some of the most successful stocks throughout 2020, and as people saw those gains, they poured money into the fund, which then had to go and buy more of those underlying stocks. However, as demand waned, people began to cash out; they sold the funds, sold off, and then prices substantially fell.

Second, he also warned of what would happen if everyone wanted to sell their index fund at the exact same time and how that would negatively affect all of these smaller stocks held within the index. His reasoning is that there's a lot of money invested in small companies that don't have a large trading volume, even though they're in the same basket of stocks held within the index. So, if we see a sudden and catastrophic sell-off, there's not going to be a lot of buyers for the smaller companies, and that would exacerbate a sell-off.

For example, the Russell 2000 is an index fund that tracks the top 2000 small-cap stocks in the West. Half of those dogs have a trading volume of less than 5 million a day, and one-fourth of the stocks have a trading volume of under a million dollars a day. So, a large sell-off of index funds would mean that those stocks are hit much harder, and that would potentially devastate the overall market.

However, we gotta ask ourselves: Is there actually any truth to this? Well, before we go into Jack Bogle's warning from a data-driven standpoint, Michael Burry is right. A lot of money is pouring into index funds. For example, in 2002, just 2% of the U.S. stock market value was held in an index fund, but now they control 20% to 30% of the entire market and growing. In fact, it was even said that for 9 out of 10 companies in the S&P 500, their largest single shareholder is one of the three big investment firms: Vanguard, BlackRock, and State Street.

However, is Michael Burry correct that once a stock is in an index, it'll automatically have money invested into it causing the price to go up? Well, to find that out, we gotta look at the facts—wrong facts! When a stock is going to be added to an index, it's announced ahead of time. Before fund managers could actually get around to buying it, this leaves time for the individual investors, speculators, and Wall Street Bets to buy in with anticipation of it eventually being added to an index and trying to make a profit.

Now, when it was researched, it was found that stocks actually do go up in price after the announcement of being added to an index. But once they're actually added to the index, the pent-up demand slows down prices fall, and eventually, it returns back to a new normal. But surprisingly, long-term, it was found that adding a stock to an index has no permanent effect on the price. It was even studied that the stocks' premium for being added to an index completely wore off after two months, usually returning to the same price before it was ever announced.

Overall, studies have shown that the stocks traded within an index did not see any superior performance in demand over stocks that were not traded within an index. Likewise, it was also found that stocks that were removed or bumped down from an index did not see any large drop in price now that they were no longer being bought by the index. Much of this really has to do with how those indexed funds are bought and sold.

First, to be a part of the index, you actually have to have the merits to join, including a history of profitability, size, brand recognition, stability, and other market attributes to be considered. Second, the way index fund investing works is that the fund is weighted towards the biggest companies that make up the largest volume. This means that only the largest companies get most of the index investments since those make up the biggest portion of the basket.

Third, once a company is added to an index, it must actually perform well, and much of its stock price movement is going to be from its earnings, profitability, and growth. Otherwise, if it doesn't perform well, demand goes down, and the overall index tends to go down right alongside with it.

But what about Michael Burry's warning here? Is it actually in a bubble, and is it true that the longer it goes on, the worse the crash is going to be? Well, like I said, index funds work by weighting the average and buying in direct proportion to how big the company is when compared to the overall index.

For instance, within the S&P 500, the top 10 companies make up 28% of the overall holdings. That means the other 490 companies split their way for that extra 72%, and the smallest companies only get a fraction of a percent. When you passively throw your money into an index fund, or in other words, it would be like investing a hundred dollars and giving Ralph Lauren one and a half cents. So, Michael Burry's argument that index funds would cause liquidity issues is somewhat of a moot point.

An index fund really just tracks the broad market, and even in the event of a sell-off, each stock is only bought in direct proportion to how big it is to the entire index. So, everything should, in theory, be affected equally. Plus, even in the event of a mass sell-off of index funds or a catastrophic crash in the market, that would just end up creating a buying opportunity for investors to swoop in, buy up undervalued companies, and eventually return them to their normal baseline anyway.

In terms of what the inventor of the index fund now thinks, here are his thoughts because he did have some critical things to say about the direction that we're going. Those unaware, Jack Bogle created the first index fund in 1975 to track the S&P 500, and fun fact: that's now known as the Vanguard S&P 500 Index Fund. The more you know!

Anyway, even though it was off to a slow start, over time the passive index fund began to take off, and now their holdings make up a significant part of the market. Jack Bogle said this is becoming a problem. See, normally when you buy a stock, that entitles you to some voting rights in the company, and if you own enough of a stock, you could eventually do a hostile takeover and own Twitter. But in this case, when you're buying into an index fund, you're really owning a small piece of the basket with its value based on the contents within it, not the stocks themselves.

That means if this trend continues, three fund managers would dominate 81% of the voting content to virtually every large U.S. corporation. Not to mention, it's nearly impossible for any other fund manager to compete because of a high barrier to entry, and it would be extremely difficult to replicate. So, that's absolutely worrisome.

The Harvard law professor John Coates argued that in the near future, just 12 management professionals—meaning a dozen people, not a dozen management committees or firms, mind you—will likely have practical power over the majority of U.S. public companies. In response to this, Jack Bogle said that he does not believe that such concentration would serve the national interest.

In its place, he offered several suggestions to ensure that index fund concentration didn't give too much collective power to too few people. But even though index funds do have the collective power to overtake voting control, does that mean that Michael Burry is right and we are in an index fund bubble?

Well, in terms of any immediate danger, probably not. As most of you know, price movements are caused by active trading volume, which means how many people are buying and how many people are selling. In this case, Vanguard did the research to find out how much of an impact index funds have on the market, and the result was not much.

In fact, they found that index funds only accounted for 1% of all daily trading volume, and the other 99% was from active traders, hedge funds, and individual investors. This means that day-to-day index fund investing was not distorting the market. Of course, if they did start to push stock prices into bubble territory, then one would assume that actively managed funds would be able to spot the inefficiencies, make a wild profit, and begin to outperform. But that has not happened, and it may not ever happen.

But let's take it a step further and just assume that everyone goes and only buys index funds and no one goes and buys individual stocks. Then what would happen? Well, hypothetically, I suppose that those individual stock prices wouldn't drop, even if those companies stopped performing or earning money. That would lead to some really big opportunities for those individual traders to finally go out, buy the individual stocks, and make a big profit.

So, given all of this, no, I do not personally see any signs of an index fund bubble, and nothing that I could find would point to any cause of concern. Of course, with the S&P 500, you do have a high concentration of tech stocks, with the top 10 making up almost 30% of the overall index. Although an easy way around this is simply going for an equally weighted fund and calling it a day.

The other concern here is that yes, voting control could be an issue in the future, but assuming they have their investors' best interest at heart, they should be voting in your favor. Not to mention, let's be real here, when is the last time you've cast a vote for a stock? Seriously, tell me when!

Anyway, when it comes to all of this, companies still trade on their fundamentals, even when they are added to an index, and any inefficiencies in the market should eventually be balanced out by active investors who try to make a quick profit.

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