Bear Market Signal: Robos Get Quiet As Top-Heavy Index Funds Hit The Limit

We all say our clients laugh off every correction. But do they? Underneath the bland benchmarks the market is changing too fast for everybody’s comfort.

Early this year the market corrected and automated investment systems crumpled. Site after site went down, feeding suspicions that robo platforms weren’t ready for prime time.

It wasn’t that the investment models running the robo broke down. “Buy and hold the index” kept working as well as ever.

But this time, there’s a twist. The technology seems to be holding up. It’s just the market assumptions that are bending under the strain.

Defensive posture holds

If any of the prominent robo platforms have had any trouble in the past month, nobody’s talking about it. My guess is that there’s a combination of factors making this correction different.

First, they’ve had almost a year to scale their networks to deal with stormy market weather. Modern technology corrects fast. Once the developers notice a problem, they figure out how to make sure it never happens again.

But I suspect that what’s really going on here is that their client behavior has changed. They really aren’t swamping the system logging in to make emergency trades when the market shudders.

They might not be signing up fast right now but they definitely aren’t overriding the robo to sell everything on the dip. And when they don’t panic, the load on the system evaporates.

We see this outside the robo universe too. The biggest selling volume so far in this correction weighs in at barely 75% as intense as what we survived in February.

That’s no flood of algorithmic selling no matter what the market channels want people to think. It’s not a stampede. People see a light at the end of the tunnel.

They’re like your clients. They believe in the long-term return on equity and they’re willing to stomach a little short-term risk along the way.

Naturally they cherish efficiency along that random walk to wealth. They’re fans of the market as a whole, the index approach.

That’s where things might get a little icy.

Are the indexes broken?

As I write this, the S&P 500 is drowning in zombie stocks. Don’t get me wrong, they’re good, dynamic companies. But the stocks themselves just don’t reflect that story.

Figure 350 of those 500 companies are down 10% or more. More than half of that group is in active bear market territory.

It’s not just numbers. On a weighted basis 60% of the big benchmark is down a lot.

Apple, Amazon, Facebook and Alphabet are the problem. When things looked great, they were four of the only stocks anyone had to buy to capture most of the market’s upside.

But each of them has blown out at least once in the last couple of quarters. All of them radiate a sense that the best days are behind them now.

That’s classically a sign that it’s time for nimble investors to rotate. In this case, there’s zero consensus where they should go, so many are staying right where they are.

And if everything that was working so well is breaking down, there’s not a lot of strength elsewhere on the index.

People who get cold feet when they see the index dropping will simply sell the index. They won’t cut old winners and rotate into other themes.

So if the FANG is finally broken, the index will need time to rebuild internal leadership before it can get back to work. 

With a third of the index dancing with the bear and another third closer to being down 20% than record territory, immediate leadership prospects are scattered at best.

Looking around, a lot of them are on the defensive side. Media. Car parts. Medical devices. Consumer staples. 

The strength is now in the classic companies that don’t grow fast but they’re still priced to deliver shareholder value over the long haul. 

They’re not sexy. They’re not even high income plays that will suffer as the Fed keeps making cash more attractive.

Come to think of it, they look a lot like the classic star stocks that great stock pickers would stuff into client accounts. Own a few of them, your core is covered.

The active manager reborn

But it takes stock picking skill to find those stocks in the index wreckage. Index managers can’t see them. Robo isn’t interested.

Meanwhile the beta gauges throughout the market are bending the math from the other side. If the index strategy has starved the world for alpha — the ability to beat the market — then rising Treasury yields force managers to grab for higher returns.

When zero-risk government paper paid zero, just playing the index made you look like a hero to just about everyone.

But with the short end already above 2% and looking to climb another 1% over the next year, the hero needs to deliver even higher numbers to demonstrate value and justify fees.

That’s the elephant in the room around the yield curve now. It’s not about flattening or bond rates getting too high for the market to survive.

It’s just about opportunity costs and risk-return profiles. The index reliably generates 10-11% a year over long periods. In exchange for that return, investors shoulder volatility along the way.

If low-risk bond yields are rising and the market as a whole stalls, the market as a whole becomes a problem. People need ways to outperform the index. That means picking some stocks and avoiding others.

Can robo do that? We haven’t seen it happen yet. But will clients accept a random walk when a more conscientious approach provides higher return potential relative to risk?

That’s a question we’ll need to answer soon. This is the kind of environment where active management can shine. Let the index go where it can. You’re here to talk to your clients about their stocks.


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