The vulnerability of the market to booms and busts has increased with the decline of active management, Vertium Asset Management highlighted in a recent market note.
According to the fund manager, the current market, dominated by passive investing, is likely to be followed by a painful market correction.
Looking at historical events, Vertium highlighted the presence of key characteristics in boom-bust cycles, including a departure from “rational valuations”, often driven by “herd mentality and speculative fervour”.
“A hallmark of both booms and busts is the escalating concentration of a few dominant companies,” the fund manager said, warning that the current market exhibits the highest concentration in US history, signalling a fourth major boom.
Vertium compared the current boom, which began in 2018, to the Nifty Fifty era where large established giants like Walmart and Costco were valued like “market darlings”.
“A universal characteristic of all boom periods is the emergence of excessive valuations for a few large companies. As speculation intensifies, these companies gain disproportionate weight within the market indices, exerting significant influence on overall market movements,” it said.
Current examples include Apple in the US and Commonwealth Bank in Australia, which currently account for 7 per cent and 10 per cent of their respective indices.
“Their elevated price-to-earnings (P/E) ratios compared to their benchmarks highlight their significant valuation premium for the largest stock in each index,” Vertium said.
It warned that this trend of elevated valuations extends beyond these individual examples, noting that the P/E ratios of the top 10 S&P 500 companies currently rival those observed during the Nifty Fifty bubble and are approaching the peak levels witnessed during the dotcom era.
But Vertium highlighted a point of difference between the current boom period and that seen historically, noting that the current period of elevated market concentration is also “unprecedented” in its duration.
“Prior to the current boom (Go-Go Years, Nifty Fifty, Dotcom), the period of increasing market concentration leading up to the peak typically lasted around 3–5 years. The current extreme market concentration that commenced in 2018, has now persisted for over seven years,” it said.
A crucial factor contributing to this prolonged period of elevated concentration is the dramatic rise of passive investing, Vertium said, with funds increasingly being moved into index funds and exchange-traded funds.
“The market share gain of passive investments at the expense of active managers has fundamentally altered market dynamics,” it said.
Vertium emphasised that with fewer active managers, asset prices are becoming more susceptible to “self-reinforcing” rather than self-correcting mechanisms.
It explained that an efficient market typically relies on the collective judgement of a diverse group, the so-called “wisdom of crowds”; however, this wisdom erodes when that crowd lacks diversity.
“Essentially, when all managers are ‘on one side of the boat’, it’s easier to inflate a boom, but it also increases the risk of a sudden and dramatic market correction,” it said.
“This is evident in more frequent mini boom-bust cycles in recent years.”
Ultimately, Vertium warned: “Just as night inevitably follows day, the current market exuberance is likely to be followed by a painful market correction.”
