There’s been a lot of words thrown around lately saying that indexing has been leading to overvaluation of the US stock market. I’m here to tell you that is wrong. I have two reasons for that:
1) Active managers have been pseudo-indexing for a long time. The moment they get benchmarked to an index they do one of two things:
a) accept it, gain funds for mandates that are like the index, and then they constrain their investing so that they are never too different from the index, and hopefully not in the fourth quartile of performance, so they don’t lose assets. This is the action of the majority.
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b) Ignore it, get less fund flows, and don’t let the index affect your investment decisions. The assets should be stickier over time if you explain to clients what you are doing, and why. Only a minority do this.
This has been my opinion since my days of writing for RealMoney. All of the active managers out there add up to something close to a passive benchmark, less fees. It can’t be otherwise.
The one exception of any size would be stocks excluded from indexes because they don’t have enough free float available for non-insiders to own/trade. Even that is not very big — it might be 5% of the total stock market, though this is just a wild guess.
2) If you want to talk about valuation issues, you really want to talk about the trade-off between stocks and bonds, or stocks and cash. Stock valuations are never absolute — it is always a question of the other assets you are measuring the stocks against, and how you desirable those other assets will be in the future, and how sustainable the profitability of stocks will be over time. I broke apart some of these issues in my piece The Dead Model. Desirability of stock investing can be broken into three components: maturity risk, credit risk and business risk. At present, the first two are getting thinner. The last one is thicker, and at least at present, there is no great rush to encourage people to trade slack cash for newly issued shares of stock. If anything, stock is getting retired on net. (Just a guess.)
Part of this stems from demographics: the Baby Boomers and others still sock away money so that they can get payments in the future, when they are too old to work much. That’s the maturity risk that I mentioned above, and the reward from that is low because so many are trying to do it. Flat yield curve and low overall yields are the cause of a lot of worries for investors. The same thing applies to credit spreads: people are searching for yield, and it leads them far afield — that said, I don’t see a lot of obvious places where credit metrics look bad, aside from auto loans, student loans, and overleveraged governments.
The demographic effect means that nothing looks safe and cheap. Yields are low, and price/earnings multiples are high. The question is what could lead those to change. When the markets are pricing in something like continued perfection, sometimes it doesn’t take much to jolt them out of what is an unstable equilibrium. (Note: contrary to neoclassical economics, most economic equilibria are unstable.)
Profit margins could fall, but most of the factors underpinning high profit margins look pretty strong — using technology to make labor more productive, ability to shift work globally to talented people who are paid less, and clever uses of accounting to reduce taxable income and tax rates seem intact, if not growing.
That said, remember my saying:
Governments are smaller than markets; markets are smaller than cultures.
There is always the possibility of a shock happening that no one expects:
- War, even if undeclared
- Cultural unrest leading to political change: remember the partial nationalization of Amazon and Google that took place in 2030? They got broken up and parts were turned into utilities by the US government because they were so pervasive, and then foreign governments expropriated their local assets, and banned them in their countries.
- Another example could be a type of Luddite behavior that attempted to force corporations to hire people proportionate to the profits.
- Hyperinflation in Japan, or somewhere else big.
- China has a bigger credit crisis than its last one, leading to drops in commodity prices, and further global deflation.
Point 2 was a joke, but meant to illustrate how cultural systems abhor entities that get too powerful.
I do think stock valuations are high, but the best way to see that is in my quarterly post on stock valuations. It takes into account the changing preferences economic actors have regarding what assets they hold — this is one indicator that explicitly reflects actual changes in stock and bond issuance and retirement, as well as changes induced by the Fed in creating more cash and credit, or, destroying it.
Passive investing is a sideshow as far as stock valuations go. Pay attention to the supply and demand for stock on the whole, and the factors that might lead supply and demand to change.
Article by David Merkel, The Aleph Blog