With the blue-chip S&P 500 index soaring to new highs at the start of the month, there has been some discussion over what has been driving some fairly expensive stocks ever upwards.
While a more supportive Federal Reserve and – at the time – a US-China trade deal in the offing may have helped boost investor confidence, some have questioned whether other forces could be at work.
Indeed, Michael Horan, head of trading, Europe, Middle East & Africa at BNY Mellon subsidiary Pershing, said there had been some signs that all was not what it seemed.
He explained: “While there are some positive company and macroeconomic factors driving the strong equity performances, the market as a whole has been artificially inflated in a number of ways.
“Most importantly, the growth of passive and ETF [exchange-traded fund] investment since the global financial crisis has seen unprecedented levels of capital flow into liquid large-cap stocks, shifting the industry into a pedestrian investment environment.”
Horan added: “At the same time, the soaring demand for ETF products is triggering lower liquidity in smaller stocks that do not benefit from inclusion.
“This is concentrating investor allocation into a comparatively small number of stocks, reducing liquidity across the rest of the market and causing artificial highs in major indices.”
Performance of S&P 500 over 3yrs in US dollar
Source: FE Analytics
ETFs have become increasingly popular since arriving on the scene in the 1980s, fostered by a combination of lower fees, a push for index investing, and technology.
And those focused on US equities remain among the most popular asset classes for ETF investors given the market’s efficiency and dominance of growth stocks.
“The US equity market is efficient, meaning that it’s a difficult one for active managers to consistently outperform,” said Dan Pereira, investment research analyst at Square Mile Investment Consulting & Research. “Valuation-based approaches have been out of favour in recent years as the growth style continues to lead market returns.”
He added, however, that we have seen brief periods of strong value rallies, such as in 2016.
“A vast number of investors will access the US market through ETFs and other passive vehicles for their lower costs, wide availability and to avoid the risk of getting such active calls, which can be pronounced, wrong,” said Pereira.
Yet, Francis Radano, senior portfolio manager at Aberdeen Standard Investments, pointed out a “unique feature” of the US stock market that may also be contributing to the S&P 500’s recent strong performance .
Radano said 15 April is the date for income tax returns in the US and during that month the stock market is a flurry of transactions by investors trying to optimise their tax bills.
“It’s the time when many people invest money into their individual retirement accounts [IRAs],” explained Radano. “It’s also when people realise their capital losses by selling some investments and claiming the losses on their taxes,” he said, adding that the market experiences an extra little bump every April.
Monthly performance of S&P 500 over 3yrs in US dollar
Source: FE Analytics
Having said that, Radano acknowledged the market influence of ETFs, noting that passive investment managers were not valuation-sensitive like active managers.
“They pour money in [these big companies],” he said. “They push a button and buy the stock irrespective of valuation.”
The result, he said, has pushed some S&P 500 valuations to quite extraordinary levels, although this had been supported by strong earnings growth among a narrow range of companies in recent years.
“Such earnings growth on a decade-long expansion is clearly unprecedented, certainly in my career,” he said.
Narrow leadership by a handful of technology stocks has been profitable for some US ETF investors, but could pose a future problem, however, particularly if that strong earnings growth comes to an end.
“We believe a broader range of market leadership or a reduction of liquidity could swing the pendulum in favour of actively managed strategies that have an experienced investor at the helm to navigate through the more difficult periods.”
In addition, Square Mile’s Pereira said the surge of ETF trading since the crisis is not without potential risks to the financial system.
“ETFs indiscriminately buy or sell the underlying index they follow. Such emotionless trading can lead to more pronounced share prices moves, both on the up and downside,” Pereira said.
Pereira further noted the role of algorithmic trading in the process.
“According to research by Goldman Sachs, over the past 15 years algorithmic trading has rapidly increased and now accounts for over half of the trades undertaken within the US equity market. ETFs will indiscriminately buy and sell shares as a result of flows, and they pay little attention to the fundamentals or valuations of the shares traded,” he added.
As the weighting of stocks in most major indexes and the ETFs tied to them, are based on market capitalisation, large companies can pull the index more than the little ones. 
And the bigger the company, the more money flows into it.
“Investors allocating to equites in general should be aware that algorithmic trading is affecting the market and that share price moves can now be more pronounced, more so than ever, both on the upside and downside,” Pereira said.
Flows into US equity ETFS have also been supported by regulatory changes, such as European directive MiFID II, which Pershing’s Horan said has lower coverage of small and mid-cap stocks leading to much lower liquidity at the smaller end of the market and more capital flow into large-caps.
“This, combined with the broader shift to passive investments and continued inflows into ETFs and index-tracker funds, is artificially increasing prices and causing investors to herd into large-caps,” he explained.
While ETFs focused on companies further down the market capitalisation scale also exist, they face certain challenges such as increased trading costs and a lower level of liquidity, said Square Mile analyst Pereira, although this is more of a domain for active managers.
“The market is also less efficient further down the capitalisation scale, therefore a potentially more supportive environment for active management,” he explained.
As such, Pershing’s Horan said financial markets were at an “inflection point,” where increasing regulation, global macroeconomic risks, and the consequences of a rise in passive investing, have placed significant strain on global market infrastructure.
“New record highs for equity markets cannot continue forever, and the return of volatility seen in 2018 – as well as the recent Treasury yield curve inversion – were warning signs to the global financial system,” he said.
Going forward, Horan said, it remains to be seen how the new market environment will handle a bear market or regular bouts of volatility, “but the warning signs of significant liquidity pressures are there”.