The Passive Megafire: When Equity Market Feedback Becomes Fuel for Correlated Risk
Sam Peters
One of the most important lenses investors apply to studying financial markets on a systems level is feedback. Feedback is, arguably, the main engine that drives markets in the long arc between fear and greed. However, feedback also helps shape the structural changes that are constantly affecting markets — something to which we, as active managers, must continually adapt.
Feedback can ultimately take two forms. Positive feedback amplifies moves and can push markets to extreme divergences. Negative feedback, on the other hand, provides a stabilizing force that prevents extreme moves and keeps markets in a sustainable range. There is one important caveat: Delayed negative feedback can be very destabilizing when a system is pushed to extreme levels and feedback reverses.
In the decade leading up to the turn of the century, the early careers of most of today’s equity managers were defined by learning from active value managers. Those managers’ collective beliefs, built on mean reversion around value, defined investors’ market views. This created negative feedback as market prices often stayed anchored to a shared belief around underlying value. However, we believe that the nature of feedback has changed over the past few decades, creating material changes in markets and a career-defining moment for active managers like ClearBridge.
We have seen this active negative feedback continually eroded by the growth of increasingly powerful positive feedback from inelastic passive buying. With active management consistently losing 2% to 3% of market share annually to passive, passive investing captured the dominant share of invested assets in 2024.
We believe that much of this growth in the power of positive feedback can be explained by the Inelastic Market Hypothesis — a theory which suggests that for every $1 invested in the market, the aggregate market capitalization increases by $5. Michael Green, chief market strategist at Simplify, argues that the IMH is a growing risk to functioning capital markets and that this multiplier has increased to at least 8x. If the hypothesis is true, this will continue to increase until markets reach an unsustainable extreme.
This critical level is estimated to be 65% passive share of U.S. equity AUM — a level which, by several estimates, is only two to four years away. At 65% passive, there is no longer enough active capital to absorb the volatility that emerges from increasingly dominant passive flows and U.S. equity markets risk a cascading market collapse. Basically, positive feedback becomes so dominant there is not enough liquidity from negative feedback to absorb volatility, and the market no longer functions effectively. As a result, the delayed negative feedback, which we warned about, feeds on itself and creates intense positive feedback on the downside.
A similarly destructive example of these dynamics was the U.S. Forest Service’s longstanding policy of aggressively extinguishing small wildfires, which allowed large parts of forests to build up dry, and highly flammable, detritus. The unforeseen consequence could be seen from space – larger, more destructive (albeit less frequent) fires that have caused tremendous devastation across the Western U.S. over the last few years. The determinant for whether a fire remained a localized event or a multi-state emergency can be attributed to one simple variable: a spark in the wrong place.
The similarities to equity markets are striking–the growth of passive investment traded a series of smaller, uncorrelated events for the risk of large, concentrated events that feed on themselves. Too much passive investing is building up fuel in market systems that used to clear more regularly from active negative feedback. When regular volatility can no longer be cleared easily, we run the risk of a megafire in markets.
Fortunately, we may not have to test this critical market threshold, as two new sources of negative feedback are emerging: First, the disappearance of net share buybacks as companies increasingly use their free cash flow on AI capital spending. Second are the mega IPO of SpaceX and the pending public debuts of Anthropic, and OpenAI.
Prior to this year the U.S. public equity market had been consistently and increasingly “de-equitizing,” shrinking across two important dimensions. The first is that the actual number of listed companies dropped by more than 50% over the last two decades, and the second is that net share issuance was negative over the last few years as companies bought back more equity than they issued, totaling more than $100 billion across 2024 and 2025.
Things are about to shift dramatically on the new equity supply side. SpaceX on June 12 raised more than $85 billion in the largest IPO in history, while Anthropic and OpenAI have filed for offerings to raise an estimated minimum of $25 billion each in IPOs tentatively scheduled for the fall. In addition, Google unexpectedly raised $80 billion in new capital last week, which will very likely be followed by more large equity raises from competing hyperscalers as the ante of the AI high-stakes poker game rises.
The combined changes in equity capital flows are dramatic. ClearBridge estimates that the combined net swing in equity supply in 2026 will range from $300 billion to $500 billion, or more. Using the previously mentioned IMH multiplier of 5x, the resulting negative feedback on market cap would be $1.5 trillion to $2.5 trillion, or 2% to 4% of total U.S. equity market capitalization.
This may not seem like much, but the last big IPO year of 2021 was followed by less-than-stellar returns in 2022. In addition, hedge fund manager Paul Tudor Jones, co-chairman and CIO of Tudor Investment Corp., recently mentioned on a podcast that his call on the 1987 stock market crash was partly precipitated by a flood of new equity issuance. When locked-up shares from that year’s IPOs hit the market with new supply, portfolio insurance created a dramatic example of a violent reversal in feedback.
Not surprisingly, the new IPOs of 2026 are coinciding with changes in index inclusion, which have been relaxed to allow much earlier entry. The explicit motivation here seems to be to fully capture the inelastic passive bid. This takes to a whole new level the greater-fool dynamic of ignoring fundamentals and buying overvalued assets. It creates the risk that the market will one day soon only include foolish investors tied to passive flows. This may be a big test of the fools, who seem largely blind to this potential risk given recent speculative buying fervor.
To be perfectly clear, we are not forecasting an equity market crash. However, we are observing this change in feedback dynamics very carefully and expect the one-way momentum market we have experienced so far in 2026 to face some real tests in coming months.
We are currently observing a lot of changes that the market seems to be ignoring. Perhaps this bliss in the presence of change simply reflects the increasingly inelastic and willfully blind nature of markets in a world dominated by passive investing. Nevertheless, we believe that some big challenges await investors in the rest of the year and beyond.
Sam Peters is a portfolio manager at ClearBridge Investments.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.