Market Watch: The Latest Fad of 'Indexing' Fails in Bear Markets

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Latest Fad: Indexing
 
Indexing has become the hottest trend in decades. Over the last two years, investors have purchased over 924 billion dollars in index funds. The largest index of all is the S&P 500 and is actively managed by the S&P 500 Committee at Standard and Poor’s. The S&P 500 is a market-weighted index; this means the bigger the company market capitalization, the larger percentage holding in the S&P 500 Index. The largest five stocks account for about 12% of the Index and the top ten stocks account for 20% of the index. On average, between ten and forty stocks are replaced every year.

The current concern with indexing is that everyone is doing it. For example, in 1999 the trend was to buy Cisco, Intel, Yahoo and Lucent. Today’s indexing trends are buying the same type of tech stocks such as Apple, Google, Facebook, Microsoft and Amazon, the top five companies in the index.

We have seen some research that indexing beats over 90% of the market over a ten to fifteen year period. How is it possible that a committee at Standard and Poor’s outwits 90% of the active fund managers? Either they are the smartest people in the world or something else is affecting the results. One answer is that they have about a small fee advantage.  The more likely answer is that the S&P 500 has become the benchmark and most managers are either now indexing or shadowing the index. We are witnessing a replay of the Nifty 50 of the 1960s and the 1999 Tech Bubble, as market cap weighted indexes are all essentially utilizing the same fifty stocks.

Indexing Fails in Bear Markets

The effect to all of this is that a very substantial portion of the entire world is buying the same 500 stocks. Recent research found in contrast to the success in Bull Markets that in bear markets, index funds underperformed. Indexes were able to beat active managers between 34% – 38% of the time. In the next bear market, indexing will likely fare worse than those numbers because there is so much money concentrated in index funds. Despite the popularity of this latest fad, I believe over the next five years active managers will outperform the indexes market. Savvy investors will their funds with professional active managers, like MaxOut Savings Advisors.

Valuation Matters

Listeners of the MaxOut Savings Show know that we are very concerned about valuations in the stock market.  One number that has been of particular concern is the price-to-sales ratio. As can be seen by the red line in the graph below the only time in recent history the price-to-sales number has been this high was in the 1999 Tech Bubble. The Price-to-Earnings ratio the number is not as close to the bubble peak but price-to-sales is. The likely reason for this discrepancy is that S&P 500 companies are over-earning by cutting costs and not investing in R&D or new plant and equipment. In effect, they are maximizing short-term profits at the expense of long-term growth. 

The second line in the chart is the total equity market capitalization divided by the GDP. This number is also approaching the 1999 Tech Bubble high mark. The total market cap-to-GDP valuation parameter has been mentioned as a market valuation concern by the Federal Reserve recently. The bottom line the stock market is very expensive and priced for perfection. Signs point to a market correction, are your retirement assets professionally managed to help protect against losses during a market correction?

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Notice we are at 1999 Tech Bubble peaks in both valuation parameters.

Jobless Generation

The Census Bureau chart below shows a huge jump in the percentage of young people living at home with their parents. In the United States today, there are more young adults living with their parents than there are young adults living with a spouse. We have had a generation trapped at home living with parents, a sad commentary on the jobless recovery we have had since 2008. The Federal Reserve and Barrack Obama were able create an asset bubble, but no jobs.  Going forward, we should concentrate on job growth, not asset prices.

We should define success as providing a future for our children. As we all weather this period of economic uncertainty, it is more important than ever to enlist a financial advisor. Don’t leave your retirement savings at undue risk!

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Tax Bill Outlook

We are starting to make real progress on the tax bill and Obama care. Expect to see some sort of deal to repeal Obamacare in the next couple of weeks in the House. It will then be sent to the senate where we could see more changes before it passes. The Trump Tax proposal is a great start. The cut in corporate taxes by 50% and programs to repatriate the almost $2 trillion in corporate cash overseas is very bullish for jobs in the economy. The middle class tax cuts will help middle class families.

The Trump proposal is somewhat different from the House proposal, put forth by Paul Ryan. Ryan would like a Boarder Adjustment Tax (BAT) and wants to eliminate the carried interest provision. Both will be very bullish for the US economy. It will take at least 5 to 6 months to pass a tax bill; in the interim, expect a stock market correction.

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