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Greenlight Capital’s David Einhorn has long been talking about how markets are “fundamentally broken”, but he reckons things will get much worse before they get better — if they ever do get better.

FT Alphaville listened in on Einhorn’s talk at a conference organised by Norwegian asset manager Skagen Funds yesterday, and the scourge of Lehman once again argued that the greatest danger facing markets today was the “breakdown in the market structure”.

You can see why he’s worried. Last year was the worst ever for stockpicker flows, with over $500bn gushing out of actively managed equity funds globally.

The flipside was of course another record year for ETFs. According to Einhorn, in the second half of 2024 you could almost feel the torrential flow of money out of stockpickers and into, cheap index funds, which he argues worsened the stock market’s mounting concentration problem.

And if these flows ever reverse it could cause “carnage”, Einhorn predicted on Thursday:

Overvalued can become more overvalued, and undervalued becomes more undervalued, and you’re not having capital efficiency in the way that the markets are designed to create. And this creates what I call a very, very stable disequilibrium . . . And I don’t know if or when this will ever reverse. If it ever does, there’s going to be a ton of carnage that will come from that.

It’s true that the US equity market looks egregiously top-heavy at the moment — just 26 stocks account for over half the entire S&P 500’s value, a record low — but the argument that this is caused or even exacerbated by passive investing has a lot of holes.

FTAV is planning to write an egregiously long and detailed examination of the micro and macro impact of passive investing sometime this year (and yes, we will go into Grossman-Stiglitz, Sharpe’s Law, the Inelastic Markets Hypothesis, etc).

But for now this post from November will have to do, and here’s a lightly edited transcript of the relevant highlights from Einhorn’s talk. Our recording was a bit glitchy in places so some things might be slightly off, but we think we got the main bits:

Take it away, Dave:

I view what’s going on right now as part of market structure being fundamentally broken. It’s passive flows, and other people who are investing money mostly care about price, not value. They don’t have an opinion about value. And so things become untethered from their actual value, and that creates a fundamentally risky situation.

. . . Many of these companies are trading for far more than they can conceivably be worth. And it does seem that over some probably long period of time — or maybe much sooner than everybody expects — things eventually tend to revert towards value.

Things were better before:

You know, if the idea of markets is to allocate capital and the idea of investing is to buy undervalued things, things that are worth more — not a view on price, but actual undervaluation —[then] your investment is actually contributing to market efficiency.

When I go back in my career, the big money — the important money, the money that was driving the market . . . was a bunch of people sitting at long-only institutions saying, ‘I think this.is worth a per cent more than where it’s trading today’. And that didn’t mean it was a value stock. It could have been whatever the most exciting growth stock was at the time, it could have been Coca-Cola, you know, which was the leading stock in the 1990s . . . It might take them 10 years to be right and make the S&P 500 plus two . . .

That investor has now been fired. That person does not exist. There are no committees that are doing these things. It is a tiny portion of the actual trading volume.

Blame multi-manager hedge funds and index funds.

. . . [It is mostly] index funds which are passively buying everything based on what it was previously worth, and trading which is based on anticipating everyone else’s orders, people who have very short term opinion about price. And I don’t mean the price six months from now. I mean the price when my options expire this Friday.

What we call ‘pod shops’ have some fundamental [views], but they basically care about what’s the next one or two things that are going to happen. ‘Am I going to be right this week? Am I going to be right next week?’ These people do not care what the value is, they’re interested in what the prices is.

The result is that we now have broken markets. Overvalued can become more overvalued, and undervalued becomes more undervalued, and you’re not having capital efficiency in the way that the markets are designed to create. And this creates what I call a very, very stable disequilibrium . . . And I don’t know if or when this will ever reverse. If it ever does, there’s going to be a ton of carnage that will come from that.

What does this mean for traditional stockpickers that still care about value?

Oh, it’s gone. From a professional community. It’s gone. These people have been fired, and they’re not coming back. These large long-only complexes used to have analysts on every call. They used to have five people in every meeting. They used to have enormous research staff. They needed to know everything that was going on at every company. And now vast majority of their money has been transferred to index [funds], which pays, I don’t know, six basis points or something like that?

And what’s left over for active [managers] has been cut from a 1 per cent fee to 40 basis points, or 35 base points. So they’re running, you know, half the assets at a third to 40 per cent of the fees. They have fired the people that used to be doing all of this work. It doesn’t mean they’re not following any companies, but they’re certainly not following every company, and they’re terrified. These businesses are gone.

It’s a bit weird to say that traditional long-only equity management is “gone” when Fidelity and Capital Group alone probably manage close to $10tn. But Einhorn is probably right that there’s fewer analysts and PMs following each individual company these days.

Those that survive the current environment might eventually enjoy rich pickings, but the cull is still in full swing:

. . . I think that creates a real opportunity for those that remain. You know, it’s a much less competitive business and you’re going to find much greater levels of mis-valuation.

But on the other side of that, there’s a continued secular trend of firing these people, taking their money, making them redeem the value stocks that they already have, and having it redeployed into the into the into the market cap weighted indices.

And we saw that being prevalent yet again in 2024. I think that’s a lot of what happened in the late part of the year. You could almost feel the flows coming out of active management at the end of the year and being redeployed in the indices, as you saw the enormous divergence between the megacap stocks in the United States and pretty much everything else which was collapsing, it just felt like it was like year-end redemptions from active managers.

This is an ongoing phenomenon and something that is a headwind for people who are trying to buy undervalued things, and not just buying things based on, hey, you know, it has a big weighting in the S&P.

Self-serving/full disclosure further reading:
— Trillions (Penguin Random House)