Great reminder that the market is driven by its own ruthless logic, not by optimistic narratives.
I also recently read a paper on index investing. The authors showed that there are economic mechanisms that actually decrease correlation between assets inside the index. This effect is offset by capital inflows, so it is invisible. But suppose the regime changes, retail loses trust in the stock market, and inflows drop. In that case, stocks can become super-sensitive to fundamentals, and valuation will matter more than ever.
Definitely agree with the impact of passive flows prolonging bubbly market behaviors. Because passive equity AUM surpassed active AUM for the first time, an ever-increasing number of passive investors rely on an ever-reducing number of active investors to price securities.
This creates a very interesting combination: more frequent mispricings (undervaluation and overvaluation) due to fewer active managers, exacerbated by passive flows that don't consider whether the index components are overvalued or undervalued.
I know many active managers blame passive flows for making it difficult to beat S&P benchmarks. However, I don't think small caps will stay undervalued for a long time due to a lack of active investors. In fact, Substacks like yours are contributing to more accurate pricings of small-caps.
I argue that valuation is most important when most neglected.
"Valuation discipline is your high ground. The passive flows and algorithmic momentum will eventually reverse. When they do, the old rules namely multiple contraction, flight to safety, desperate searches for cash flow and dividends over distant growth promises, will return with force."
Great article. Very much encapsulates the dynamics of Walmart at 50x. As someone who lived through the China crash over 2022-2024, would caution that valuation doesn't fully protect you when the flows reverse and everything on the benchmark falls. What really protects you is positioning - is there some reason investors think this stock is safe and encourages them to be diamond hands? Where is the pod shop money?
completely agree on the importance of positioning when liquidity reverses; still remember when everyone was catching falling knives on Alibaba at a 30x P/E, claiming it was insanely cheap for an internet company.. so again: while valuation is one of the most critical factors to consider, it can never be the only one.
Criminally underrated account: keep it up!
Great reminder that the market is driven by its own ruthless logic, not by optimistic narratives.
I also recently read a paper on index investing. The authors showed that there are economic mechanisms that actually decrease correlation between assets inside the index. This effect is offset by capital inflows, so it is invisible. But suppose the regime changes, retail loses trust in the stock market, and inflows drop. In that case, stocks can become super-sensitive to fundamentals, and valuation will matter more than ever.
Definitely agree with the impact of passive flows prolonging bubbly market behaviors. Because passive equity AUM surpassed active AUM for the first time, an ever-increasing number of passive investors rely on an ever-reducing number of active investors to price securities.
This creates a very interesting combination: more frequent mispricings (undervaluation and overvaluation) due to fewer active managers, exacerbated by passive flows that don't consider whether the index components are overvalued or undervalued.
I know many active managers blame passive flows for making it difficult to beat S&P benchmarks. However, I don't think small caps will stay undervalued for a long time due to a lack of active investors. In fact, Substacks like yours are contributing to more accurate pricings of small-caps.
I argue that valuation is most important when most neglected.
"Valuation discipline is your high ground. The passive flows and algorithmic momentum will eventually reverse. When they do, the old rules namely multiple contraction, flight to safety, desperate searches for cash flow and dividends over distant growth promises, will return with force."
Great article. Very much encapsulates the dynamics of Walmart at 50x. As someone who lived through the China crash over 2022-2024, would caution that valuation doesn't fully protect you when the flows reverse and everything on the benchmark falls. What really protects you is positioning - is there some reason investors think this stock is safe and encourages them to be diamond hands? Where is the pod shop money?
completely agree on the importance of positioning when liquidity reverses; still remember when everyone was catching falling knives on Alibaba at a 30x P/E, claiming it was insanely cheap for an internet company.. so again: while valuation is one of the most critical factors to consider, it can never be the only one.