Horizon Kinetics commentary for the first quarter ended March 31, 2017; titled, “We’re Going Mainstream.”
In past reviews, we’ve titillated you with some of the more startling and story-worthy examples of the distortions caused by the indexation vortex, as we sometimes call it. Such as the iShares Frontier Markets ETF (FM), labelled as 91% lower risk1 than the S&P 500, because of its Beta of 0.09. That magic number says you can ignore the 10% weighting in Pakistan, which is now contem-plating the greater wisdom of a nuclear first-strike strategy against India, as well as the 20% in Kuwait, smaller than New Jersey and surrounded by Saudi Arabia, Iraq and, 5 miles off its Persian Gulf coast, Iran. Or that almost 50% is in financial stocks. Another was the iShares Italy ETF (EWI), fascinating for the fact that seven of the top 10 holdings get an average 72% of their sales from outside Italy.
Why choose examples like those? To direct one’s attention, through all the noise of conflicting information from the financial news media, toward the bubble conditions that ETFs have wrought. We’re in a dangerous period. But I fear that these examples from the edge might have been too easily ignored or forgotten precisely because they focused on more marginal sectors of the markets.
Because how many readers thought that those examples really applied to them, either at all or more than periph-erally? How relevant were they to your portfolios? We know that other people drive distracted and too fast on highways late at night, but not us.
So, in this letter we’ll go mainstream and see what’s going on in the most basic portfolio building blocks, the bread and butter asset classes: first, the S&P 500 itself, and then a typical mainstream growth fund and a mainstream value fund that an everyman or everywoman would use. The kind of fund that is relevant.
The Broad Market – The Active and Passive Camps Agree
We had the privilege of debating with the esteemed Vanguard Group founder Jack Bogle several weeks ago at the Grant’s (Interest Rate Observer) Spring Conference. The discussion mostly circled the advisability of index funds for the average investor and the prospective returns they should expect. Oddly enough, we agreed on just about every point. Mr. Bogle is America’s most ardent advocate of investors making a virtually singular asset allocation decision: buy the appropriate X% and Y% in stocks and bonds; make it categorical by buying the broad market, like the S&P 500; and stay there for the long haul, without any fancy footwork. He’s a true believer in equities. Yet, even he publicly cautions that if they’re looking forward 10 years, investors should no longer expect more than about 4% from stocks. We’re in general agreement, but perhaps less optimistic. Here’s why.
Problem #1: Valuation
Using the broadest, most straightforward measures, the market is a hair’s breadth away from historically peak valuations, the aftermaths of which were disastrous.
- Current Price-to-Earnings Ratio and Average P/E Ratio The S&P 500 now trades at 23.4x trailing 12-month reported earnings (as opposed to analyst-doctored ‘operating’ earnings that exclude accounting charges and the ever-recurring non-recurring ‘items’). Paying almost 24 years’ worth of earnings for a basket of mega businesses is understood to be really high, but this level has often been exceeded due to the significant vari-ability in reported earnings in any given year.
The approach preferred by many economists and chief investment strategists uses price relative to the aver-age earnings of the prior 5 or 10 years, in order to smooth out temporary and episodic noise; they find it more reliable. By this measure the S&P 500 trades at 29x earnings, which has been exceeded only twice before in the past 130+ years: in 2000, the Internet Bubble Peak, and in 1929.
- Total Market Capitalization-to-GDP Ratio Even simpler, more understandable and less arguable than P/E is this measure. The combined market value of all U.S. stocks, as measured by the Federal Reserve, is now near the 2nd highest on record. At 125% of GDP as of October 2016, it was just below the level reached in early 2000, the peak of the Internet Bubble. If one considers the market’s appreciation since October 2016, the ratio may have exceeded the 2000 level.
To suggest that this will iron out over time, irrespective of valuation, is a spurious interpretation of indexation. Today, just over 17 years after the Internet Bubble peak in March 2000, and after an 8-year bull market, the S&P 500 returned 4.7% a year. The SPDR S&P 500 ETF (ticker SPY) returned 2.7%, the difference largely due to the frictional costs of trading. And those results, such as they are, only pertain if everybody stayed in, which they didn’t. How could they, when the turnover of SPY is 1,900% a year. That’s 100% every three weeks.
A variety of studies have measured that, because of their own market timing decisions, the average investor in an S&P 500 index fund gets but a small fraction of the return of the index. A relatively short-term example from Credit Suisse: the published return of the index over the past 10 years might have been 7%, but because of people putting money in following market appreciation and taking it out following market declines, the return on the average dollar invested in the index was more like 3 ½%.
Problem #2: Age – Of the Index, That Is
The growth profile and earnings power of the S&P 500 and other large-cap indexes has changed beneath our feet; it is no longer what it once was, and the historical result cannot be replicated.
- Future growth from the top of the index: The money flows of mass market indexation have created structurally automatic bids for the major index companies. These, particularly the branded consumer products businesses like Coca-Cola and Procter & Gamble, are mature and generally have stagnant or declining revenues. They represent the great bulk of the value of the S&P 500.
- Future growth from the bottom of the index: Historically, the smaller companies in the S&P 500 represented the future growth. While their early weightings and market capitalizations were small, they were sufficiently large relative to the balance of the index that they could ascend in position and have a meaningful impact on the index return. Today, though, the high weightings of the mature companies are largely fixed in place, and their presence suppresses the earnings growth from the bottom of the index.
A Visit With A Mainstream Value Manager and Growth Manager
Based on financial news articles and television shows, everyone should be aware that money is being constantly withdrawn from active managers and placed into ETFs and other index funds. This has been happening since 2007. Undoubtedly, the active managers are striving with even greater urgency to beat the indexes against which they are judged. They are seeking some edge. Here are two typical large-company, blue-chip strategies. One is value oriented. For this one, the idea is that the manager selects, only from within the benchmark index, those stocks that are the least