A Cocktail Party Stuck in Overdrive
The cocktail party theory... Everybody wants to be a stock tout... We're stuck in overdrive... The relentless passive bid... Passive investing isn't really passive... How to prepare for the coming hangover...
What kind of party is this, anyway?...
Investing legend Peter Lynch answers that question in his 1989 classic One Up On Wall Street, where he describes four different stages of a market cycle based on how guests act at cocktail parties.
In Stage 1, the market has been down for a while, and nobody at the cocktail party is talking about stocks. A guest approaches Lynch and asks what he does for a living. When he answers that he runs an equity mutual fund, the guest smiles, nods, and walks away. Folks are more interested in talking to a dentist about plaque than to Lynch about stocks.
In Stage 2, the market is up a little. Guests linger a moment when Lynch says he runs an equity fund, but only to comment on how risky the market is. They're still more interested in talking about plaque than stocks.
By Stage 3, the market is up substantially, and the dentist is alone in the corner while a crowd encircles Lynch. Guests corner him all night asking for stock picks.
In the fourth and final stage, everyone at the party is obsessed with the market. But this time, guests don't want stock picks. They want to give Lynch picks. Everybody he meets has a different stock to pitch, including the dentist. Lynch looks up all the picks the next day and, sure enough, they've all soared. He writes:
When the neighbors tell me what to buy and then I wish I had taken their advice, it's a sure sign that the market has reached a top and is due for a tumble.
Lynch's cocktail party theory relies on a regularly recurring cycle. But things seem different today... There are no stage one or two parties nowadays.
Everybody wants to be a stock tout...
Reddit, the social platform X, Instagram, and TikTok will forever be filled with an endless stream of "gurus" who know very little about investing but claim to have the secret to big, fast gains.
I can imagine these so-called experts becoming less popular during a steep bear market. But they'll never go away for long. It's just too easy to open an account and start touting your pet stock or crypto. The market for touts has no barrier to entry.
On X, I routinely see accounts claiming so-and-so is the best trader in the world and can help you easily make $10,000 a week.
Meanwhile, the traditional financial media is obsessed with the market, acting as the world's most voracious consumer of stock tips.
I (Dan Ferris) have been a guest on a handful of media outlets, and it's all the same.
You spend time traveling to a TV studio, then wait half an hour to appear for five minutes... only to have some teleprompter reader dismiss your research conclusions with snark.
It's a waste of guests' and viewers' time and goodwill. That's why we work hard at Stansberry Research to give our readers the advice we'd want if our positions were reversed. We dig deep and keep our standards high.
A handful of those appearances was enough to put me off mainstream financial media for the rest of my life. I avoid it like a mugging victim avoids bad neighborhoods.
The market's gears are jammed in a permanent state of overdrive...
The pedal is to the metal, and it seems like the buying will never end. Every decline is a buyable dip.
Stansberry Venture Value editor Bryan Beach recently gave a presentation at an internal Stansberry Research meeting on the relentless bid for stocks that we all know as passive investing. This type of investing through 401(k)s and other retirement accounts is helping the market stay in permanent Stage 3 behavior.
Without a thought, investors are unwittingly begging for stock tips every two weeks. Through indexes, they're buying the same stocks they already own, over and over again –forever. And because they're putting money in index funds weighted by market capitalization, they're always buying more of the biggest-market-cap stock picks than any others.
Bryan surmised that the average 401(k) contributor buys about $10 worth of Apple (AAPL) stock every two weeks through index funds. That's more than they put into any other stock, without a thought for Apple's fundamentals or whether it deserves the biggest slice of their capital.
Bryan said he doesn't know how – or if – the relentless bid will end. I raised my hand and offered a thought that regular Digest readers might remember...
Passive investing isn't really passive at all...
Index funds are like primitive active investors who buy everything in the index and occasionally sell when a stock is taken out of the index. They're following an algorithm that says, "Receive $1 of capital, buy $1 of equity."
I foresee a day when the algorithm is reversed, perhaps because large amounts of investors retire and need the money or for some other reason. Then it would be, "Demand $1 of cash, sell $1 of equity."
I offered a hint of what this might look like in the October 25, 2023 issue of The Ferris Report, when I reported on the market's action during the March 2020 pandemic panic:
During the monthlong bear market, the S&P 500 fell 34% from February 19 through March 23 – a total of 24 trading days. Even so, Vanguard – the company that basically invented passive investing by offering the first-ever index fund in 1976 – reported in June 2022 that...
"During the 2020 downturn, despite the increase in trading, less than 1% of households abandoned equities completely."
Roughly half a million households abandoned equities, and the market fell 34% in 24 sessions. I wonder what would happen if 1 million households were to abandon equities... or 2 million... or 8 million...
Based on Gallup investor polls and the number of households in the U.S., I estimate 80 million households own stocks. Can you imagine the horrendous market rout that would result if just 10% of them sold? The stock market could lose 80% or 90% of its value.
Please note: I'm not predicting this event. I'm simply identifying the systemic risk of which most investors seem blissfully unaware.
It sounds scary, and no one could blame you for refusing to believe it will ever happen. After all, it hasn't happened yet. But consider this...
A year ago, Morningstar reported that flows into passive investment funds overtook those into active funds for the first time ever. The latest decent-looking estimate I've seen is that passive funds owned between 33.5% and 41% of the market as of 2021.
Vanguard founder John Bogle said in a 2018 Wall Street Journal article that if passive investing reached 50% of assets, he didn't believe it "would serve the national interest." His complaint was about corporate governance. He didn't want too much power in the hands of the firms that sell passive investing funds.
Others, like Simplify Asset Management's Mike Green (who originally pointed out the 1% March 2020 statistic to me), believe a large concentration in passive strategies leads to weird outcomes that present huge potential risks to investors.
For example, take the soaring performance of MicroStrategy (MSTR), the software company that sells debt and equity and buys bitcoin. The company's market cap is so big that it was recently added to the Nasdaq 100 Index.
So even though it trades at double the value of its bitcoin holdings – a risky, ridiculous valuation – anyone with a Nasdaq 100 fund in their 401(k) is pouring a relentless stream of capital into it. That's despite the fact that it's pursuing an unsustainable strategy, which will go into reverse and collapse the stock the next time bitcoin plummets (as it has many times in its 16-year history). Any strategy that depends entirely on the rising price of any asset, let alone a highly speculative one, is doomed.
Passive dynamics will probably make the situation worse by helping to support MicroStrategy's share price, prolonging its ability to sell more equity and debt and buy more bitcoin.
We saw a similar dynamic with meme-stock poster child AMC Entertainment (AMC). The stock soared after a short squeeze, and management did the rational thing and raised a ton of equity at higher prices. It spent the money poorly and now the stock is trading 99% below its meme-stock highs.
The legions of die-hard individual investors who refused to sell the stock because they believed it would return to its former highs have lost everything.
The AMC story is a pristine example of how a soaring asset price can be the absolute worst thing for investors, as we discussed last week.
Passive investing amplifies the perils of soaring asset prices by shoving billions of investor capital into already exorbitantly priced assets every two weeks.
Like Bryan, I can't claim to know how it ends, but I'm confident that it will end.
Prepare, don't predict...
In Lynch's book, he warns about trying to predict markets (and even goes on to say the market ought to be irrelevant) after he explains his cocktail party theory. He says...
Don't expect me to bet on the cocktail party theory. I don't believe in predicting markets...
The market ought to be irrelevant. If I could convince you of this one thing, I'd feel this book had done its job... "As far as I'm concerned," [Warren] Buffett has written, "the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish."
Instead of trying to predict the market, Lynch says the same thing I've been repeating over and over again in these pages...
I believe in buying great companies – especially companies that are undervalued, and/or underappreciated...
If you had bought stocks in great companies back in 1925 and held on to them through the Crash and into the Depression (admittedly this wouldn't have been easy), by 1936 you would have been very pleased at the result.
In short, buying great companies for good prices is a great way to prepare for the massive hangover that's coming when the party finally ends.
New 52-week highs (as of 1/23/25): Abbott Laboratories (ABT), Amazon (AMZN), American Express (AXP), AutoZone (AZO), Alpha Architect 1-3 Month Box Fund (BOXX), Constellation Energy (CEG), Ciena (CIEN), Cisco Systems (CSCO), CyberArk Software (CYBR), Dick's Sporting Goods (DKS), iShares U.S. Aerospace & Defense Fund (ITA), JPMorgan Chase (JPM), Meta Platforms (META), Neuberger Berman Next Generation Connectivity Fund (NBXG), Invesco S&P 500 Equal Weight Technology Fund (RSPT), Visa (V), Vanguard S&P 500 Fund (VOO), Vertiv (VRT), Vistra (VST), Westlake Chemical Partners (WLKP), and Zebra Technologies (ZBRA).
In today's mailbag, a thank-you note for Digest editor Corey McLaughlin... and thoughts on Argentinian President Javier Milei's speech yesterday at the World Economic Forum and on China's economy, which were covered in yesterday's edition... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"Thank you, Corey. Excellent reporting of what matters most. And sequenced in such a compact space that allows for very worthwhile insights and valuable inferences to be drawn. As far as I know that can't be found anywhere else. Much appreciated." – Subscriber Russ L.
Corey McLaughlin comment: Thanks, Russ. This made my day, and it's good timing to perhaps slide in my annual review! Glad to hear you feel you can't find what we're doing anywhere else. Providing that is one of my goals. But please know it's not just me. We've got a great team of editors, analysts, proofreaders, layout folks (who set up the e-mail you get each evening), etc., who help make it all work behind the scenes.
"Hello, the speech from Milei was great. He might be invited back [to Davos] just for the novelty, because that's the way the global elites would probably view him. They are interested in power: not justice or freedom for all." – Subscriber John F.
"China has been in a recession for over two years. Europe is heading towards a recession and will be followed by the U.S. China has a trade surplus of [almost] a trillion dollars last year, which I find stunning." – Subscriber S.A.
Good investing,
Dan Ferris
Medford, Oregon
January 24, 2025