Passive investing1 has enjoyed several tailwinds throughout the post-financial crisis recovery. One of the most influential has been the expansion of global central banks’ balance sheets. In aggregate, the balance sheets of the world’s six largest central banks are approaching $20 trillion, essentially the equivalent of US gross domestic product.

The excess liquidity resulting from rapid global central bank balance sheet expansion is not flowing through economic activity in the form of loans to commercial industries or for construction activity. Rather, it shows up directly into the prices of risk assets and has a disruptive effect on price discovery, as well as an easing effect on credit availability and volatility suppression.

Put together, these phenomena have the potential to distort stock market performance. As a result, many stocks may have performed better than their fundamentals indicate. These effects may also have allowed passive funds to deliver returns well above historical averages.

Liquidity can cause distortions
An incremental slowdown in – or reduction of – liquidity can also have a negative effect. The US Federal Reserve stopped its quantitative easing program several quarters ago and has begun a very modest contraction of its balance sheet. In addition, the European Central Bank is likely to begin to shrink its balance sheet, lifting rates abroad and causing interest rates in the US to rise in concert.

When credit markets begin to normalize, there will likely be more stock price dispersion and increased market volatility. If liquidity becomes constrained, indiscriminate stock buying can turn into indiscriminate stock selling. This significant shift in investor behavior could drive a real separation between passively managed index funds and actively managed stock funds.

How demographics influence stock prices
The number of willing buyers for securities can also influence stock price movements. Since the early 1980s, the Baby Boomer generation have traditionally been willing buyers. Now, many Boomers are transitioning from investing in the stock market to becoming net stock sellers as they tap their retirement savings.

As Boomers reach the age of required minimum distributions over the coming years, there will likely be incrementally more selling pressure – rather than buying momentum – as it relates to price movements on a go forward basis. By the back half of the next decade, selling may well begin to outpace buying in retirement accounts.

Potential reasons for caution
Similar to liquidity, buying doesn’t need to go negative to affect stock prices. It just has to be less positive. Further, we believe stock valuations are already quite stretched and investors will be looking for reasons to book profits and pull back. Declining liquidity and incrementally more sellers than buyers offer plenty of reasons to be more cautious and more particular about investments.

Separating active2 and passive
The net results of shifting demographics and tightening liquidity depict a meaningfully different stock market than that of the past decade. As both factors play an increasing role, there could be a real separation between stocks that are trading at levels that are warranted based on fundamentals, skillful management teams, and solid product bases, and those that have traded upwards purely based on flows. There may also be a separation between returns from passive index funds and actively managed funds with skillful stock-pickers at the helm.

Look at challenges ahead – not in the rearview mirror
Investment challenges could develop as liquidity declines and we move through 2018. Cyclicals and industrials – normally considered more defensive stocks – have already seen improved performance, but stock prices haven’t yet reflected their newly uncovered strength.

Investors tend to invest based on the rearview mirror. It’s easy to look back for the last three to five years at an index that’s been compounded at a mid-teens rate and extrapolate forward. In reality, it could be increasingly difficult for indices to compound performance at recent levels.

Successfully navigating these challenges – including the three D’s of debt, demographics and disruption – through skillful stock-picking may be required to generate potential returns going forward.
1 Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio.

2 Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index.

Liquidity risk exists when particular investments are difficult to purchase or sell, possibly preventing the sale of these illiquid securities at an advantageous price or time. A lack of liquidity also may cause the value of investments to decline.

It is not possible to invest directly in an index.

Unlike passive investment strategies1, there are no indexes that an active investment strategy attempts to track or replicate. Thus, the ability of an active investment2 to achieve its objectives will depend on the effectiveness of the portfolio manager.

All investing involves risk, including the risk of loss.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.