Passive Investing Strategy Popularity Is An 'Important & Timely Warning'

2016 has been a tough year. Traders and investors who thought they were generating Alpha because they were smart are now struggling to find any good ideas.

One trader I speak with during the normal course of business mentioned he would quit trading if this environment continued. That was at the end of October, a month which saw the S&P 500 Price Only Index decline by almost 2 percent.

There is a clear sense of confusion and frustration hovering over the traders I interact with, which runs the gambit from retail players to the institutional players and hedge funds.

Nothing appears to make sense anymore. Valuations are being skewed and accepted because there is no other choice. If we elect to not join in on the magic act (rising stock market) and call it out for what it is (Fed driven, cheap money rally), then the audience (investors and colleagues) become upset because they can no longer enjoy the show (blindly invest in a managed market).

I've been seeing this happen since I first called out the ridiculous manipulation by OPEC in 2016, when the unregulated entity generated fake rumors for months to drive up oil prices.

Back in 2014, I shared Goldman Sachs' comments that equity returns are being driven by appealing PE multiples, not the future prospects of business as determined by earnings. 

It's no wonder traders are furious with this market.

The following chart comes courtesy of Zero Hedge and annotates the ridiculous impact the Fed comments have on the algorithms that trade S&P 500 e-mini futures. None of this price action represents broad U.S. civilian trust in the companies that make up the S&P 500.

If you don't believe the impact that algo "front-running" has on prices, just refer to the myriad of rumors that have popped up in chatrooms, on Twitter, and on blogs in the past few months which drove target stocks materially higher/lower. The automated market with its knee jerk reactions ahead of predictions of order flow and not ahead of an adjustment to intrinsic value are killing the integrity and character of the U.S. equity markets we knew of before Reg-NMS.

As if the growth in passive investment isn't bad enough, Wall Street Journal discussed a new startup, Instavest, that "aims to do to asset management what Airbnb is doing to hotels." Retail investors have been rung dry and this equity machine, much like the CDS/CDO chaos in 2006/2007, is finding ways to bring in new money to keep the party going.

All of the above are impacting the mental state of the remaining human traders. As one looks at these examples, it would be understandable to freak out, get MEGO (my eyes glaze over), or just assume that no one knows anything about the market.

When this mindset happens, we see people begin to assume that perhaps others are smarter, more capable of understanding the market. This has lead to the surge in passive investing and 720 Global has put together the following note to sum up the larger issue tied to the recent surge in passive investors in one of the most controlled "free-markets" ever known.

Trade the perception, invest in the reality.

This column does not necessarily represent the views of Benzinga.