Rise and Fall of Index Funds

Index funds have no price discovery. They track whatever basket of companies they're supposed to track. When money comes in, they buy according to a pre-set distribution. When money is withdrawn, the same distribution is sold. It's therefore incorrect to suggest that index funds are forced to load up with Game Stop shares due to its recent price rise. Only fresh money going into index funds containing Game Stop will have to buy this company at present prices. If no money is coming in or going out, the index fund remains passive.

However, some passive investors may have caught onto the fact that Game Stop is sending the price of certain index funds higher, and conclude from this that it may be a good idea to leave these funds for now, awaiting buying opportunities in the future or buying into something unrelated. If so, there will be an outflow of money from funds containing the Game Stop company. Game Stop will have to be sold together with whatever other companies the index holds. The meteoritic rise of Game Stop will in this way have the perverse effect of sending other companies down for no other reason than their loose affiliation with Game Stop through index funds. This will in turn affect other indexes that contain some of the same stocks, but not Game Stop. The sell off will spread beyond indexes containing this company, resulting in an overall unwind in all stocks.

This is technically different from the inclusion of Tesla into the S&P 500 index. In that case, index funds were forced to buy Tesla. They could not remain passive. They had to sell certain stocks in order to load up with Tesla. However, some may find Tesla too speculative for their taste and decide to sell the S&P 500 in favour of something less speculative. If so, the effect of Tesla's inclusion into the S&P 500 may be similar to that of Game Stop. The inclusion of Tesla and the over-representation of Game Stop are both signalling a move towards trash. It's indicative of a market top.

The prudent investor will take some chips off the table at this point. A natural safe harbour will be cash and gold as outlined in my investment thesis. If a large enough portion of small investors do this, we'll see prices drop for all stocks, especially the ones considered safe, because it's the prudent investor that will cash out first. They will sell their index funds that contain mostly conservative brands.

When speculative brands start dominating the investment scene, conservative brands suffer. This pulls the broader marked down. More people start pulling down their positions, and the process continues. As things stand at the moment, the entire market is priced at historically high levels relative to earnings. There's a scary looking trumpet formation in the charts, indicative of general instability, and some index funds are already experiencing relatively high outflows. Everything points towards an imminent market collapse. The upside potential is tiny while the down side may be a stunning 80% relative to cash or 95% relative to gold.

GameStop

By Mike Mozart from Funny YouTube, USA - GameStop, CC BY 2.0, Link