When valuation loses its voice
26 AUG, 2026
By David Goodman from LIONTRUST
Markets need valuation guardrails. Why? Because price and value can rapidly part company.
What investors pay for a share and what the underlying business is worth can be very different things. In markets driven by enthusiasm, momentum or fear, the gap can widen quickly. Fundamental investors challenge it. They sell, trim or refuse to buy when prices run too far ahead and step in when pessimism has gone too far.
For much of modern market history, active managers supplied a large share of that valuation-driven capital. They did not prevent bubbles and they were not always right. But they gave markets a counterweight to momentum by asking whether a price already reflected too much optimism or too much fear.
That counterweight has weakened as fundamental investors have become a smaller share of market assets. Passive funds do not set prices on their own, they are still made at the margin. But if less marginal capital is valuation sensitive, valuation may take longer to matter.
Passive investing has accelerated this shift. By the end of 2025, passive funds represented a majority of US long-term mutual fund and ETF assets. That is not a criticism. Passive investing has lowered costs and widened access. But passive funds are designed to reflect prices, not challenge them.
When a company becomes a larger part of an index, each new dollar flowing into a market capitalisation weighted passive fund allocates more capital to it, regardless of valuation. This is valuation ambivalent demand: rational for many investors but limited as a force in price discovery. It takes the market price and transmits it through new flows.
Its influence grows when it meets other forces indifferent to valuation. Retail investors may be drawn to a compelling story. Momentum strategies buy because prices are rising. Professional managers feel pressure not to be underweight the strongest performers. Leveraged ETFs add a mechanical layer as the exposure must be reset regularly. They may add exposure in rising markets and reduce it in falling ones. This amplifies buying after prices rise and selling after they fall.
The process is clearest on the way up. A company captures investors' imagination and its share price rises. Sometimes that is justified by better profits, higher returns on capital or a larger addressable market. The risk comes when the price starts to validate itself and expectations move faster than the business can support.
As market value increases, the company becomes a larger part of major indices. Passive inflows allocate more dollars to it. Momentum follows the price. Managers who doubt the valuation face pressure as the stock drives benchmark returns. Success attracts capital and capital reinforces success. This is the momentum flywheel.
The same process can work in reverse. When fresh buyers thin out, confidence fades and the share price stops validating the story. Momentum investors reduce exposure. Retail investors sell because the narrative no longer feels safe. Leveraged products may cut exposure. Passive funds remain price reflectors rather than value judges. Fundamental investors may begin to see value, but if they are a smaller part of the market, there may not be enough valuation-driven capital to absorb the selling. A stock that rose too far above reasonable value can then fall too far below it. Momentum does not know whether a stock is expensive or cheap, it only knows direction.
The full cycle is not a neat move from excess back to fair value. Prices can move too far in both directions. On the way up, valuation excess may be recognised by fundamental investors but they are not powerful enough to stop the advance. On the way down, selling can be driven less by a fresh assessment of fair value than by fading confidence, risk reduction and the need to find liquidity. Momentum can overshoot both ways.
When valuation regains influence, the market asks a different question; not which companies have risen fastest, but which businesses are worth more than the market believes. This only matters if the business value remains. Some falling stocks deserve to fall and others are punished beyond what the fundamentals justify.
Leadership can then change. Former winners may remain excellent businesses but if expectations become too demanding, future returns can disappoint. A great business can still be a poor investment if too much has already been priced in.
Out-of-favour companies may have strengthened balance sheets, improved returns on capital and compounded earnings with less attention. They needed investors willing to look past recent momentum and ask whether the market had become too pessimistic.
While the rise of passive investing has been good for investors, the market also needs participants whose job is not to own the index but to question it. This is the role fundamental investors play when valuation begins to matter again.
Valuation never disappears. It simply loses its voice for a while.
