The “Big Short” Guy Says the Stock Market Crash Will Get Much Worse

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Michael Burry rose to fame by betting against mortgage-backed securities (or MBS) during the 2007–08 housing market bubble. Banks created MBSs as a way to free up their capital. They bundled their mortgages together and then sold pieces of the bundle to investors. Burry showed a keen eye for market analysis, which paid off handsomely. He won his bet against the market.

Burry has a similar bearish bet against passive investing. But first, some backstory.

Bubbles then

Burry showed the world that he could see the housing market bubble coming, when no one else could. He recognized the signs of securities trading far above the actual value of their underlying assets. This led to him shorting MBSs and turning a neat profit.

He did it by buying credit default swaps from investment firms like Goldman Sachs. Many of his investors got cold feet and pulled their money out of his fund. But when the crash came, Burry amassed a fortune for himself and his remaining investors.

Bubbles now

In 2007–08, Burry predicted a decline in real estate, which the market had long thought was “infallible.” Last year, Burry made a similar prediction about passive investing, especially index funds. Burry believes the new influx of cash into index funds, especially over the past decade, has many parallels with the bubble before the 2008 crash.

Can he be right again? His predictions made waves in the market and got mixed responses from other experts. Famous billionaire investor Carl Icahn shared similar views. On the other side, devotees of Vanguard founder Jack Bogle claimed they would boost their holdings in index funds. A Bloomberg intelligence analyst noted that index funds were only a fraction of the market value lost in the final week of February 2020.

What does it mean for you?

It’s important to consider Burry’s index fund prediction in context. He is not against investing in stocks, but he is worried about the amount of investing money being directed toward index funds. Burry’s current focus is on identifying and buying undervalued small-cap stocks.

Many people prefer investing in index funds rather than individual stocks because it’s easy, relatively inexpensive, and has been proven successful. The popularity of index funds has grown so much that passive equity funds alone have garnered a US$3 trillion market in the past decade.

If Burry’s prediction comes true, how it will affect you depends heavily upon your portfolio distribution. How much of it depends on individual stocks in dependable aristocrats like the Royal Bank of Canada, Enbridge, and Fortis? What portion of your portfolio is in index funds?

Even though the chance of an index fund losing 100% of investors’ money is very low, its performance and returns can be seriously diminished. An index fund’s recovery can also be significantly slower than some individual securities. Some of the companies in an index fund may go bankrupt, and some may offer lower returns for a while.

Even if the passive investment bubble bursts, as Burry predicts, the underlying stocks of an index fund may recover over time. But how the repercussions of the bursts, and the eventual (hopefully) recovery be transferred to you is hard to predict.

Foolish takeaway

Burry said that in the end, it wouldn’t matter what causes the index fund bubble to burst, but the chances are that it will burst.

You could things around a bit by redirecting your current capital toward good businesses. Everything in the market is on sale right now. Many established businesses are likely to weather this onslaught. If you can capitalize on a good bargain, it may balance things out for you.

Also, unlike mortgage-back securities, the underlying companies of index funds don’t belong to a single sector of the broad market (as was the case with the housing market and MBSs). So even if the index fund bubble does burst, the outcome for investors might not be the same as it was for investors in the 2008 recession.

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Fool contributor Adam Othman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Enbridge.