Passive investing funnels money into the market without accounting for business fundamentals. It simply allocates funding by looking at sector and market cap. It's the definition of dumb money.
As long as companies can make it into the index, passive investors will funnel money into buying stock of these companies, no matter how badly these companies are run.
Doesn't that passive process reverse at some point?
The trillions that mechanically and automatically flowed into index funds in pensions and 401k accounts must mechanically and automatically flow right back out after retirement, right?
Especially when younger generations are too poor to save for retirement and most companies don't offer pensions to younger workers any more, where will the inflows come from to offset the outflows?
As long as the money supply keeps increasing, excess money has few places to go (bank deposits, stocks, real estate, and physical goods). Most of it will go into the stock market, since it's quite liquid with and has good investment returns.
Also, a significant part of the stock market is driven by foreign investment. The US has few capital controls and is an easy market for foreigners to invest in. Around 1/3rd of US stocks are owned by foreigners.
Even if the older generation sells during retirement, foreign investment will be more than enough to replace it.
Simple. Most "passive investors" are ETFs and pension funds that sometimes by law, sometimes by statute/sales prospect are limited to being low-risk, i.e. the monthly contributions go towards "safe" asset classes, and in addition retail customers prefer low-fee (and thus low-management) funds.
That in turn means that a lot of the invested money goes towards ultra-safe stuff like government bonds, which is about the only thing keeping the US government afloat (if there is always a healthy amount of buyers, you can go into debt no matter if it is sustainable), and what remains of the hundreds of billions of dollars that flow into these funds each month (and [1] is just pension funds, not 401k and other forms of privately-held retirement assets) and is not earmarked for such safe asset classes spills onto the ordinary stock market, i.e. S&P 500, NASDAQ et al.
And here comes the trap with low-fee investment funds... when the ETF or pension fund's policy is "we'll track NASDAQ 100" and SpaceX enters NASDAQ 100, they have no choice than to shift billions of dollars worth of assets into SpaceX at whatever is the market price at that point. No matter if the fund managers think that the valuation is excessive, if SpaceX has a long term viable business strategy, nothing can prevent this.
To make it worse: once in NASDAQ 100, you as a company have no incentive to behave. You cannot be punished by free-market means (aka going under), simply because your inclusion in the NASDAQ 100 means that any significant loss in value would wipe out way too much value in pension funds.
The US' idea to completely tie pensions to the stock market will fry the US economy alive. We've already seen this during and past Covid... first, lockdowns got relaxed because it fried the stock markets too heavily, thus giving us four massive waves until vaccine distribution caught up, and then remote work that was allowed in many countries by law got slowly axed because REITs (real estate investment trusts) got screwed by companies quitting expensive rental contracts for office space. But that pales in comparison to what we'll see when the AI bubble pops.
Isn't a counter argument that there are index funds for just about everything? Ie, I'm sure there will be an index for "Everything in S&P Except SpaceX" for those who think SpaceX doesn't belong there. There are even "anti-index index funds" that are defined by being the opposite of another ETF.
As long as companies can make it into the index, passive investors will funnel money into buying stock of these companies, no matter how badly these companies are run.