High inflection points in life, such as high inflection points in the stock market, are both humiliating and instructive. One moment, you think you have the world by the tail. The next moment, the carpet escaped under your feet.
With regard to the stock market, several critical factors are revealed as a result of a high inflection point. These factors are not always obvious at first. But they become apparent over time. In particular, it was revealed that the period before the high inflection point was more suspect than previously understood.
The stock market, represented by the S & P 500, has become a kind of money-making machine over the last decade. Quarter after quarter, year after year, investors opened their brokerage statements to the delight of a bloated portfolio. Investing was fun – and easy.
Without much interruption, investors benefited more from the market than they had invested. They also pulled more from the market than the underlying economy justified. The stock market gave an illusion of prosperity that many investors confused with reality.
Yes, the economy has progressed and corporate profits have increased. However, thanks to debt-based buybacks generated by the Fed's cheap credit, the rise in stock prices far outpaced profits. Share valuations have skyrocketed. And stocks have become increasingly expensive.
The end of a bull market close to a decade brings new clarity and new thinking about the abundance of errors accumulated during the favorable recovery. For example, the assurance of ever-increasing returns on equities over such a long time has taught a wide range of investors a very dangerous lesson. He can become rich without using his brain.
Chaos and Catastrophe
Over the past decade, investment has been reduced to an unthinking enterprise. Why bother to break down a company's balance sheet when you can buy the market via a passive index fund? Why browse a long list of companies looking for rough diamonds laden with value, while the entire gross behaves like a diamond?
For almost a decade, buying the market by investing in an index fund, or an exchange-traded fund (ETF), was a simple and effective strategy for building investment wealth. A person who invested $ 100 in the S & P 500 about 10 years ago would have more than $ 300 today. This is not a bad return for blindly deploying investment capital in the market.
The next decade, however, will probably be very different for investors in the last decade. On the one hand, bull markets of a decade are not the norm; they are an aberration. Over the next decade, we expect that a passive indexing strategy will encounter a series of problems that many index fund enthusiasts ignore.
In fact, John Bogle, founder of Vanguard and architect of the world's first index fund, has reservations about the innovation he created nearly 40 years ago. In mid-2017, at the Berkshire Hathaway shareholders meeting, he said:
"If everyone indexed, the only word you can use is chaos, disaster. The markets would fail.
The chaos and disaster that Bogle warns is a function of two things: (1) the popularity of passive index fund investments; and, (2) the volume of passive investments that the market can accommodate while functioning as a market.
Index funds and ETFs have certainly brought many benefits to investors. More importantly, they managed to reduce the exorbitant fees that mutual fund managers charged investors for what was often just indexing. But index funds, like a second serving of chocolate cake, have come close to the point where too many good things are getting bad.
The disadvantage of investing without thinking
An economy, in theory, should reward honest and productive activities and quell waste and incompetence. In practice, and largely thanks to government intervention, unproductive activities, such as federally subsidized corn ethanol production, are often rewarded.
There is also case where an economy rewards idiots, like the Kardashians, for a shameless search for attention or other unproductive vulgarities. But on the whole, a freely functioning economy rewards productive enterprises and ingenuity.
Similarly, the stock market should theoretically effectively direct capital towards its most productive and best use. In this respect, investors must be discriminating and discriminating against the companies in which they invest. Yet, in practice, this is hardly the case. People are quickly investing in fads or winners last year without much thought or justification.
In addition, passive investment in index funds has made the investment an insane and mechanical enterprise. And as a growing percentage of the stock market is composed of passive index investments, the stock market is becoming more and more distorted. Without a judicious assessment of companies, which can reward good companies and punish bad businesses, investments, in the form of passive index funds, are ceded to corporate charity.
Early December, control of index funds 17.2% US listed companies – up from 3.5% in 2000. In addition, 81% of all indexed assets are under management by BlackRock, State Street and Vanguard. In other words, these three asset managers hold approximately 14% of all assets registered in the United States.
Within the limits of a prolonged bull market, where liquidity is predominant, investors in index funds can sell their holdings at any time without any issues. The operation of these index funds during periods of sustained panic, when liquidity is scarce, has not yet been tested at the current size and composition of the market. For this reason, among other things, we expect the bear market for this bear market to be much stronger than expected: the S & P 500 could even fall below 1,000.
After the withdrawal, opportunities for value investors will be immense. After years in the dark, active managers will also have another day in the sun.