On the eve of a major drop on Friday, David Einhorn, who became famous for profiting during the Lehman crisis: The structure of the U.S. stock market is collapsing

Overnight non-farm data exceeded expectations, and the market's hopes for a smooth rise in U.S. stocks this year have completely evaporated, with the S&P 500 index "returning to square one overnight".

Before the non-farm data was released, David Einhorn, the founder of the renowned hedge fund Greenlight Capital, issued a warning, believing that the current structure of the U.S. stock market is "fundamentally collapsing." Einhorn gained fame for shorting Lehman Brothers during the 2008 financial crisis.

At a recent meeting organized by the Norwegian asset management company Skagen Funds, he stated, that the rise of passive investing and investors' greater focus on price rather than value has led to overvalued stocks becoming more overvalued and undervalued stocks becoming more undervalued. This phenomenon distorts market value and sows the seeds of significant risk.

"Many companies' stock prices are far above their actual potential value. This situation may persist for a long time, but ultimately, the market always returns to value."

The Rise of Passive Funds and the Decline of Value Investing Philosophy

Einhorn stated, that traditional stock pickers have disappeared from the professional investment community. In the past, investors would conduct in-depth research to find undervalued quality companies to invest in, thereby pushing the market towards more efficient resource allocation.

"In the past, those large long-term investment institutions would send analysts to every conference call, with five people attending each meeting, supported by large research teams. They needed to understand everything about each company."

However, this traditional value investing philosophy is now fading. Most funds have shifted to index funds, which charge very low fees. The fees for the remaining actively managed funds have also dropped from 1% to 0.35%-0.4%. As a result, these institutions have had to lay off a large number of personnel engaged in in-depth research.

Einhorn believes that the "culprit" behind this situation is the popularity of multi-manager hedge funds and index funds. Index funds passively buy all assets based solely on past performance, while multi-manager hedge funds focus more on short-term price fluctuations rather than the intrinsic value of companies.

He stated:

"What we now call 'pod shops' may have some fundamental views, but they are basically only concerned with what will happen in the next one or two instances. 'Will I be right this week? Will I be right next week?' These people do not care about what the value is; they are only interested in the price."

Once the Capital Flow Reverses, the Market May Face a "Massacre"

Einhorn described the current market as "a very, very stable state of imbalance."

"Overvalued may become more overvalued, and undervalued may become more undervalued, and you are not achieving capital efficiency as designed by the market. I do not know if or when this situation will reverse. If it does happen, it will bring about a massive massacre." He believes that this situation has created a fundamentally risky scenario, as stock prices are disconnected from their actual values.

Einhorn acknowledges that although traditional value investing seems to be fading, it may not necessarily be an opportunity for investors who persist. With the decrease in value investors, the phenomenon of market mispricing will become more common, providing more profit opportunities for those skilled in deep research.

"This is a much less competitive industry, and you will find a greater degree of misvaluation."

However, he also points out that there is still a persistent long-term trend of firing these traditional analysts, redeeming the value stocks they hold, and reallocating funds into market-cap-weighted indices.

The market trend at the end of 2024 well illustrates this point. By the end of the year, there was a significant outflow of funds from active funds, which were reinvested into index funds, leading to a huge divergence between large U.S. tech stocks and other sectors. Einhorn believes this is precisely the effect caused by the redemptions from active funds at year-end