US stock market is in a very peculiar situation where leading index stocks are overbought but the majority of the stocks are oversold.
@Jaggumalu How are you determining that index are overbought and that stocks are oversold? RSI numbers?
Last month, FT (article might be behind a paywall) reported that 3/4 into 2021 funds flow into ETFs have surpassed the entire 2020.
More people buying into ETFs will inflate companies that are part of an index, whether the increase is justified or not.
For what it’s worth, people have been saying that ETFs have been overbought since 2018
I don’t think I would agree to that. Look at the difference between AMZN and GOOGL, YTD.
Neither of them has any idiosyncratic news, significant enough, to justify, such large a difference, either!
Yeah - that’s fair. “Will” might be too strong of a word. Typically one is a function of the other. Specifically, the larger the shareholder base of a company that is part of ETFs, the more funds flow can affect share price of the company.
- Take Amazon for example (company number 3 in S&P 500). The top four ETF providers (Vanguard, BlackRock, T Rowe Price, SsGA) combined has 15.91% of AMZN shares
- In contrast, for Under Armour (company number 502 in S&P 500), the top four ETFs owned a combined 22.5%
So if more people pile into S&P500 ETFs, inevitably Under Armour will inflate, more than the expected increase based on its business alone. Someone way smarter than me has probably studied this in greter detail.
As a side note, mispricing between ETF and NAV (sum of all underlying stocks in a fund) is an HFT strategy.
Note: opinions are my own - not investment advice
Update: Someone smarter than me has studied this: here
The BIS study says that
“An increase in passively managed portfolios could also affect the pricing of securities through greater portfolio-wide trading in the market. Passive managers buy and sell the entire basket of index constituents in response to fund inflows and outflows. This trading pattern can induce higher co-movement in the prices of the constituents of the index. It might also magnify any pricing differences with securities not included in the index (Wurgler (2010)).”
Yes, good research.
Coming to this topic, of course, it is a fact, that whenever we purchase a Mutual Fund or an ETF, all that we purchase, in the end, are its constituents. Hence, it has to happen, that the holdings percentages, of, say, the S&P 500’s constituents, by fund houses, will be dramatically larger, than a security, that isn’t a constituent of it.
However, the point that I disagree to, is, the fact, that because the fund houses purchase and hold these securities in their portfolios, their share prices will stay inflated, too.
Consider this conclusion from the author of the article you shared:
"First, it seems plausible that the portfolio-wide investing and trading of passive funds could bring about greater correlation of index securities and reduce the security-specific information contained in prices."
This is the perfection, that the imperfect human brain, all the time, wants to see, but, has never historically managed to do so. That is because of a reason: idiosyncratic behaviour of securities, based on their fundamentals or otherwise.
Traders always exist to take advantages of the differences between an existing market value, and their perceived value of a security. This is the reason why AAPL has CAGRed at alomst 40% since the launch of the iPod, whereas the index CAGRed at 9.4%, during the same time.
The same could also be said for MSFT, NVDA, AMD, ADBE and many others, with the factor being, a change in their fundamentals.
This is what I basically wanted to convey: even when a stock becomes a part of an index, whereas its trading behaviour may replicate its index’s because of passive instruments, this factor, is as good as any other factor that might deviate its trading from this behaviour, be it, due to a change in its fundamentals or a perception of a justification of a multiple expansion (say, the dotcom bubble, or the App Store) or a perception of taking on the hEdGiEs