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QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

Index tracking funds and ETFs
OhNoNotimAgain
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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#499827

Postby OhNoNotimAgain » May 11th, 2022, 1:07 pm

hiriskpaul wrote:
OhNoNotimAgain wrote:You are quite correct about the "free float" point. However, it should not matter to an investor who owns the rest of a company, whether it is other funds, the founders or overseas holders. All he wants is to participate in the financial return of the company and decide what proportion of his portfolio to allocate to it. Illiquidity due to limited free float is a well known way of pushing up valuations. When that happens the mkt cap tracker naturally follows and new money is allocated accordingly in line with the free float adjusted index weight, irrespective of any considerations of value or economic return.


Right, so we are agreed that if company A has a free float of $1T and company B $1B a cap weighted index fund would buy $1m of A for every £1k of B. Now you say "Illiquidity due to limited free float is a well known way of pushing up valuations". Hardly well known as this is first time I have heard of it. Can you point towards evidence or is this just a new spurious accusation made by active managers attempting to undermine index funds? As before, if this was true then it presents an opportunity for active fund managers to make money at the expense of index funds, which as I have previously explained cannot happen.


Well, the guy who pushed it to extremes was Mr Woodford who invseted in unlisted companies and said the valuation was what he paid and no one else could trade against him. Fine as long as money was flowing in, but not so good when you want to offload.

More generally the South African mining conglomerates in the eighties, Cons Gold, GenBel, Anglo, De Beers were well know for their interlocking shareholdings that reduced their vulnerablity and inflated their valuations. But perhaps the best example was the Japanese stock market in the seventies and eighties where valuations reached stratospheric (Nikkei at 40,000) levels due to their interlocking shareholdings.

Your point about overseas holddings in the previous post is also very valid. However, don't forget that AIM is not part of the FTSE All All share so funds can buy small stocks, push up prices which gets reflected in fund valuations and then, hey presto, the manager can claim to have beaten the market. But like, going overseas, they beat the market by investing outside it, and, in this case, supercharging returns by weight of money in a thin market.

hiriskpaul
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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#499836

Postby hiriskpaul » May 11th, 2022, 1:41 pm

OhNoNotimAgain wrote:
hiriskpaul wrote:
OhNoNotimAgain wrote:You are quite correct about the "free float" point. However, it should not matter to an investor who owns the rest of a company, whether it is other funds, the founders or overseas holders. All he wants is to participate in the financial return of the company and decide what proportion of his portfolio to allocate to it. Illiquidity due to limited free float is a well known way of pushing up valuations. When that happens the mkt cap tracker naturally follows and new money is allocated accordingly in line with the free float adjusted index weight, irrespective of any considerations of value or economic return.


Right, so we are agreed that if company A has a free float of $1T and company B $1B a cap weighted index fund would buy $1m of A for every £1k of B. Now you say "Illiquidity due to limited free float is a well known way of pushing up valuations". Hardly well known as this is first time I have heard of it. Can you point towards evidence or is this just a new spurious accusation made by active managers attempting to undermine index funds? As before, if this was true then it presents an opportunity for active fund managers to make money at the expense of index funds, which as I have previously explained cannot happen.


Well, the guy who pushed it to extremes was Mr Woodford who invseted in unlisted companies and said the valuation was what he paid and no one else could trade against him. Fine as long as money was flowing in, but not so good when you want to offload.

More generally the South African mining conglomerates in the eighties, Cons Gold, GenBel, Anglo, De Beers were well know for their interlocking shareholdings that reduced their vulnerablity and inflated their valuations. But perhaps the best example was the Japanese stock market in the seventies and eighties where valuations reached stratospheric (Nikkei at 40,000) levels due to their interlocking shareholdings.

Your point about overseas holddings in the previous post is also very valid. However, don't forget that AIM is not part of the FTSE All All share so funds can buy small stocks, push up prices which gets reflected in fund valuations and then, hey presto, the manager can claim to have beaten the market. But like, going overseas, they beat the market by investing outside it, and, in this case, supercharging returns by weight of money in a thin market.

Unlisted shares are often valued according to the last funding round. If there is no or a very limited market it requires significant work to do otherwise. That is not true of broad liquid equity markets that cap weighted funds invest in. There are good reasons why there are no AIM or UK small cap tracker funds.

I recognise that there was a bubble in Japanese shares and that there were many crosss holdings between companies, but where is your evidence that the cause of the bubble was the cross holdings?

I don't deny that illiquidity can sometimes be a problem for index fund managers. There are mitigation strategies they can use such as representative sampling, but no perfect solution. One of the things that distinguishes between index fund managers and shows up in tracking differences is how well they handle difficulties like that.

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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#500662

Postby JohnW » May 16th, 2022, 2:52 am

In an efficient market, prices accurately reflect all known information. If people think a stock will go up and buy it (pushing up the price), but they were wrong and it soon goes down, they have reduced the efficiency of the market during the time the stock price was wrongly high. Those people are the active traders who lose out to the active traders who are on the winning side of the active trading community. So it’s some active traders who are creating market inefficiencies.
Or, in the words of the professor (Eugene French): ‘So most of the trading by these (winning active) investors just offsets the dumb things that other active managers do. So active management doesn't always make the market more efficient. Sometimes it makes it less efficient because people make bad bets.’. https://rationalreminder.ca/podcast/200

OhNoNotimAgain
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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#500691

Postby OhNoNotimAgain » May 16th, 2022, 9:25 am

JohnW wrote:I So active management doesn't always make the market more efficient. Sometimes it makes it less efficient because people make bad bets.’.


Indeed, that is the one of the points of the argument. The market is always efficient, i.e. incorporating all known information, but is subject to distortion by various factors.

Since 2007 the volume of QE, together with ultra-low interest rates, has virtually removed the penalties for investing in high risk assets. While that money flow was positive it was a one-way bet and massively distorted the market.

Now inflation and interest rates are rising it is unwinding but not after inflicting huge damage through misallocation of capital.

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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#500699

Postby JohnW » May 16th, 2022, 9:47 am

Deleted. For correcion of ‘French’ to ‘Farmer’ in previous post.

hiriskpaul
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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#501507

Postby hiriskpaul » Yesterday, 11:38 am

OhNoNotimAgain wrote:
JohnW wrote:I So active management doesn't always make the market more efficient. Sometimes it makes it less efficient because people make bad bets.’.


Indeed, that is the one of the points of the argument. The market is always efficient, i.e. incorporating all known information, but is subject to distortion by various factors.

Since 2007 the volume of QE, together with ultra-low interest rates, has virtually removed the penalties for investing in high risk assets. While that money flow was positive it was a one-way bet and massively distorted the market.

Now inflation and interest rates are rising it is unwinding but not after inflicting huge damage through misallocation of capital.

The risk of not doing QE was a world-wide depression/deflation. Inflation has been rising recently due to rising energy prices and the Ukraine war, not because of QE.

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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#501509

Postby Newroad » Yesterday, 11:55 am

Hi HiRiskPaul.

I'm sure the history books will address this argument, but my guess is QE is playing its delayed part as well (but like you, I think they needed to do a fair bit - though perhaps not all of it - due to Covid).

If you want one potential causal route, the fact that bank and investment balances for many built up over the period and now things are easing, those inflated balanced are chasing goods and services (in particular, ones like travel/holidays) all at the same time - filling capacity and forcing up prices. Without the increased balances, the propensity to spend would currently be lower.

Regards, Newroad

OhNoNotimAgain
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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#501545

Postby OhNoNotimAgain » Yesterday, 1:58 pm

hiriskpaul wrote:The risk of not doing QE was a world-wide depression/deflation. Inflation has been rising recently due to rising energy prices and the Ukraine war, not because of QE.


You can't avoid the consequences of a banking crisis by printing money. You can delay it, and pretend to the public for a while that everything is fine.
But the consequences of creating an asset bubble in property and equities is that it benefits those that already own them and disadvantages those that don't but want to.
That is the core of the Trump, Brexit, FN vote. The dispossed feel pissed off that the system is rigged against them.
Now that inflation has jumped this group that exist in the cash economy are being screwed again. And they won't be happy.
Inflation is entirely a monetary phenomenom of debasing the currency and that hurts the poor most.
QE set the background for massive demand that cannot be met.

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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#501581

Postby GoSeigen » Yesterday, 5:00 pm

OhNoNotimAgain wrote:
hiriskpaul wrote:The risk of not doing QE was a world-wide depression/deflation. Inflation has been rising recently due to rising energy prices and the Ukraine war, not because of QE.


You can't avoid the consequences of a banking crisis by printing money. You can delay it, and pretend to the public for a while that everything is fine.
But the consequences of creating an asset bubble in property and equities is that it benefits those that already own them and disadvantages those that don't but want to.
That is the core of the Trump, Brexit, FN vote. The dispossed feel pissed off that the system is rigged against them.
Now that inflation has jumped this group that exist in the cash economy are being screwed again. And they won't be happy.
Inflation is entirely a monetary phenomenom of debasing the currency and that hurts the poor most.
QE set the background for massive demand that cannot be met.


I believe I've already volunteered for the other side of this bet, that inflation disappears almost as fast as it's appeared.

The argument above is faulty. The consequences of that banking crisis weren't avoided by printing money. They weren't even avoided actually: there was a banking crisis and there were consequences. If Rob means that the counterfactual did not occur, then that arguably was more to do with 1. Governments taking equity stakes in their banks and 2. the abandonment of mark-to-market rules in March 2009 than QE. The initial QE was miniscule and probably had no effect whatsoever on the bank situation.

GS
EDIT: Worth also noting that hiriskpaul's comment was mangled in the above response: he didn't even mention the banking crisis, he talked about QE in the context of deflationary pressures.

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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#501653

Postby OhNoNotimAgain » Today, 8:40 am

GoSeigen wrote:
OhNoNotimAgain wrote:
hiriskpaul wrote:The risk of not doing QE was a world-wide depression/deflation. Inflation has been rising recently due to rising energy prices and the Ukraine war, not because of QE.


You can't avoid the consequences of a banking crisis by printing money. You can delay it, and pretend to the public for a while that everything is fine.
But the consequences of creating an asset bubble in property and equities is that it benefits those that already own them and disadvantages those that don't but want to.
That is the core of the Trump, Brexit, FN vote. The dispossed feel pissed off that the system is rigged against them.
Now that inflation has jumped this group that exist in the cash economy are being screwed again. And they won't be happy.
Inflation is entirely a monetary phenomenom of debasing the currency and that hurts the poor most.
QE set the background for massive demand that cannot be met.


I believe I've already volunteered for the other side of this bet, that inflation disappears almost as fast as it's appeared.

The argument above is faulty. The consequences of that banking crisis weren't avoided by printing money. They weren't even avoided actually: there was a banking crisis and there were consequences. If Rob means that the counterfactual did not occur, then that arguably was more to do with 1. Governments taking equity stakes in their banks and 2. the abandonment of mark-to-market rules in March 2009 than QE. The initial QE was miniscule and probably had no effect whatsoever on the bank situation.

GS
EDIT: Worth also noting that hiriskpaul's comment was mangled in the above response: he didn't even mention the banking crisis, he talked about QE in the context of deflationary pressures.


The banking crisis was mitigated by a combination of government and CB action.

In a "normal" world RBS would have have gone bust, depositers would have lost their money, homes would have been repossesed and businesses
would have collapsed. That didn't happen because they are all voters and governments want to get re-elected and CB governors want another term.
(remember Volcker, who killed inflation with double digit interest rates, only served one term)
Instead, people have doubled down, invested even more in housing, unprofitable web businesses and continued buying stuff, pushing demand and, now, inflation.
Like so much in history this event has been gestating for a long time.

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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#501678

Postby NotSure » 40 minutes ago

I wouldn't say the initial QE (2008) was 'miniscule'. In UK, it was around £200B, or nearly £4,000 each for every adult and child. It only looks miniscule now as we have become inured to extremely big numbers with dollar signs in front.

To an uninformed observer as myself, it looks like central banks/governments were very pleased with themselves about the results of the 2008 QE - it did avert some of the disaster and did not lead to rampant price inflation as predicted by many. Hence, rather than unwind the QE after the crisis passed, they started to QE when given any excuse - there was another bout in about 2013 (Eurozone crisis?) then the same again a few years later (I cannot even remember what the crisis was). Finally, the biggest splurge yet for Covid - real helicopter money in US and to some extent here ('stimmies'/furlough). I think they really stared to believe that the "Magic Money Tree" was real - print what you like , and it's all upside.

Now we finally do have double-digit (price) inflation, along with a great deal of asset inflation, and though some it can be blamed on Russia, even core inflation is well above historical norms. CBs appear to be starting to lightly soil their underwear. Maybe MMT really was an illusion created by cheap foreign labour and free trade? Interesting times. If CBs are forced to really unwind 15 years worth of QE in the face of persistent high inflation, I would guess it may be messy.

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Re: QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

#501686

Postby GoSeigen » 1 minute ago

NotSure wrote:I wouldn't say the initial QE (2008) was 'miniscule'. In UK, it was around £200B, or nearly £4,000 each for every adult and child. It only looks miniscule now as we have become inured to extremely big numbers with dollar signs in front.


It only looked big then because central banks had not issued any new money for several decades.

GS


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