Stock market showing cracks

The explosion of passive trading, fear of missing out, and blind faith in "celebrity CEOs" have contributed to the foaming at high-growth tech companies, according to Harvard lecturer and renowned writer Vikram Mansharamani.

The author, who is best known for spotting market bubbles with his book Boombustology: Spotting Financial Bubbles Before They Burst, says another bubble could be about to burst.

"I believe there is a bubble brewing in the passive investing space and there are signs of it bursting," Mansharamani said on Yahoo Finance's Future of Finance. "In many sectors, capital flows have been driving prices more than fundamentals. And that's partly because of the huge amounts of money flowing into some of these indices.

Passive investments, which track a market-weighted index or portfolio, now account for more than half of all publicly traded US stock index funds, according to Bloomberg Intelligence. Funds have seen explosive growth, in part because they charge much lower fees because of the way they're managed. However, Mansharamani, who is also a Harvard University lecturer, argues that the outsize influence of passive investing has distorted stock prices as the market becomes increasingly driven by capital flows and momentum-driven algorithms.

As an example, he points to the growth of funds focused on environmental, social and governance (ESG) issues. Driven by an increasing awareness of climate-related issues, nearly $650 billion flowed into ESG-focused indices by the end of November last year, according to data from Refinitiv Lipper, leading to a record 2021. However, Mansharamani argues that demand does not necessarily match supply in the market.

As a result, capital inflows from funds with an ESG mandate have been largely concentrated in a handful of stocks, leading to inflated valuations of companies considered sustainable investables, he said.

"These funds didn't have a lot of opportunities to park as much money as they received. And so these flows drove stocks to levels that they might not have had if it weren't for this ESG-like bubble that's been building along the way brewing," he said.

Visionary Logic Mansharamani said valuations were fueled by a fear of missing out and the "storytelling power" of prominent CEOs, citing Tesla (TSLA) as a prime example. CEO Elon Musk's outsized influence over the company and his ability to sell potential investors "a fantastic new world" has driven the stock price higher and a disconnect between the company's fundamentals and the price at which investors are valuing the company , created, he said.

Social media has only widened this discrepancy.

"There's this visionary logic that says everything is in the future. Everything will come. We have self-driving cars, we have robo-taxis, we have solar zones, we have batteries... we fly to Mars and ship in Car to Mars. Whatever it is, it's all believable for those who want to believe in the mountain. The moment the mood changes, you can see the mood change quickly," he said. "I think if you got rid of the pressure on the stock, maybe the stock wouldn't be where it is.

Recent moves in Tesla stock may indicate that this shift in sentiment is already underway. Shares are down more than 25% from their peak last fall, even as the company reported record profits in its most recent quarter.

In addition to the electric car maker, other high-tech growth stocks have also fallen on fears of higher interest rates, pushing valuations lower and closer to reality, Mansharamani said.

"Higher prices equal higher demand, leading to a self-fulfilling cycle," he said. "By the way, this will also happen in the downtrend. Lower prices, less demand, lower prices, less demand".