How the stock market REALLY works

(Can Frankenstein’s monster ever be undone?)

It amazes and saddens me that so many people out there still believe we have a normal stock market, — in which individual stock prices are determined by buyers and sellers with different convictions about a specific company's prospects, and the stock market is the consolidated result of free market actions on individual stocks. Such a market ceased to exist over 2 decades ago (but especially after 2008)! We no longer have a market of stocks but a market of (hundreds of) funds, with a life of its own (hence Frankenstein’s monster). Individual stocks now move less by their own merit and more in accordance to the monster. The following writeup is an attempt to simplify the complex workings of this monster. But in essence, it’s all about the creatures of financialization (money mangers, financial advisors, funds of all kinds, etc.) prospering by building a (perpetual) machine which systematically grows their Assets Under Management (AUM) while driving up the major market indices (via the monster) in a self-reinforcing manner. In the process, delineation of good companies from bad (per the old discipline of “stock picking”) had been relegated arcane. let’s analyze the drivers of this distorted system:

Factors driving stock prices up

1. Passive Investing: in the 1990s, financial institutions discovered it’s a lot easier to make money by charging 1% fee on selling growing varieties of funds (“baskets of securities”) they themselves created instead of making commissions on their clients’ transactions of individual stocks. Hundreds of ETFs (they are actually derivatives) were created to promote this passive investing culture. In effect, the commission model was turned into an annuity model. Clients were told not to worry about individual stock performance but to keep cost-averaging into “funds” of an ever increasing number of “flavors” (including “funds of funds”). Since most of these funds all own the same largest cap stocks (Apple, Google, Microsoft, Amazon etc) as 30% or so of their contents (but often leveraged up through Futures contracts as opposed to the actual underlying securities), mindless contributions made by passive investors drive up the valuation of these stocks in a self-reinforcing manner. This is why these largest cap stocks declined so little this year (holding the entire S&P500 index to only 20% loss) when the broader market of individual stocks declined far more.
2. Derivatives and strategies thereof: rapid growth of hedge funds in the 2000s gave rise to an explosion of “quant models”, — clever algorithms hedging risk while maximizing leverage by using derivatives like options and Futures contracts to manage value at risk (VAR). Derivatives have long since outsized underlying securities and become the tail that wags the dog. Far more often, the stock market moves up not because of people buying stocks (for their own fundamental merits) but because of programs buying them in order to algorithmically meet position requirements per options strategies. Further, in an up-market driven by other factors (see point 3 below), these algorithms reflexively reinforce the prevailing uptrend. This is what drove a relentlessly upmarket for over a decade since 2008.
3. Stock Buybacks: AAPL alone had bought back $580B of its own stocks over the past decade (significantly boosting its own stock price, executive bonus payouts, not to mention the entire S&P500 index). This is more than the entire market cap of the bottom 490 companies of the S&P 500. The other top 9 companies (Google, Microsoft, Amazon etc) in the S&P 500 index have been doing likewise. This too have been a major force behind the relentlessly market “melt-up” since 2008.
4. Yield-starved financial institutions: pension funds have to generate 8% annual return in order to meet distribution requirements (dictated by the realities of demographics). For decades, they have been unable to do so prudently by investing in government bonds with the Fed artificially keeping interest rates at zero. They therefore increasingly add risk-assets to their portfolios, driving up the stock market in the process.
5. Foreign Capital Inflow: Under the current interest rate hike regime by Jay Powell, The US dollar has been relentlessly rising, worsening financial and economic conditions in the rest of the world far more severely than inside the US itself. Accordingly, foreign capital flees to the US in search for the “cleanest among dirty shirts”. Under normal circumstances, such capital inflow will seek the safety of U.S. Treasuries. But there is nothing normal about current times. In 2022, the Treasury market (supposedly the safest haven) actually declined more precipitously then the stock market in aggregate. So all capital (including foreign inflow) continue to go into the stock market. TINA (There Is No Alternative) is in charge, pure and simple.

It's not hard to imagine the preceding factors working in unison to supply the “electricity” that continually energizes Frankenstein's monster.

Factors driving stock prices down

1. Redemptions: As long as contributions keep being made to 401K and other pension plans (all of which own tons of funds of all kinds), mutual funds, hedge funds, index funds etc. (all of which own a lot of ETFs), the equity market will keep melting up per the mechanics previously described. Only material redemptions from such funds will put the choo choo train in reverse. This hasn't happened, as yet (see point 3 below).
2. Mass Rotation into Bonds: Money has to go somewhere. As long as TINA is in charge, money has only one place to go, — the stock market. Only after interest rates have peaked, making bonds an attractive investment alternative to stocks once again, will money flow meaningfully from stocks to bonds. At the earliest, we're half a year away from that.
3. Black Swan(s): Lehman was the Black Swan of 2008. Black Swans will be the monster killer! It will turn the mechanics that the creatures put in place in reverse and drain all the electricity that sustains the monster.

Now you can see why I titled my October update “Waiting for Lehman”.