Guess what? Retail investors are fading the tech rally without even realizing it. Or so says JPMorgan.

Part and parcel of the idea that this market increasingly resembles what Howard Marks has variously described as a “perpetual motion machine” is the idea that passive flows into cap-weighted indexes are creating a self-fulfilling prophecy. Here’s Marks (more here):

The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise.  Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced. 

Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever.  If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.  It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch.  In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.

Earlier this year, Goldman made some waves by noting that the outperformance of a handful of names is increasingly making those names synonymous with things like low vol. and (by definition) momentum. That suggests the best performing sectors (e.g. info tech) will end up benefiting from the proliferation of smart beta products. The result: a never-ending bid for the winners that feeds on itself. Hence the “perpetual motion machine” characterization.

This is creating a truly hilarious scenario where, in order to keep from underperforming, active managers have to effectively go on what Wells Fargo recently described as a “seller’s strike” that involves simply buying the same high-flying names and overweighting the same sectors and simply riding the wave; a wave which, by virtue of that seller’s strike, becomes larger still. It’s Heisenberg’s “wave paradox.” Here’s Wells: