S&P indexing is moronic right now

[stahleyp]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

Do you have evidence of this?

[clutch]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

It's not so clear. Imagine a world where there are 100 people and only one person is an active market participant. The rest of 99 people follows this person's capital allocation a la "indexing". Is this equivalent to a bubble in the overall market?

[Guest Cameron]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

It's not so clear. Imagine a world where there are 100 people and only one person is an active market participant. The rest of 99 people follows this person's capital allocation a la "indexing". Is this equivalent to a bubble in the overall market?

 

The percentage of people participating doesn't matter, if those 99 people are indexing because they heard some billionaire tell them to do so without regard to the fundamentals is that any different than any other bubble we have had, its easy to tell people to index when we are in a bull market.

 

There is a reason that ETF's and Index funds are now regarded as shadow banking, its nothing more than a glorified money market fund. The money can leave just as fast as it came in.

[stahleyp]

From inception, a $10,000 investment in VFINX would have turned into $751,983 (and $827,396 in the actual index). The average large blend fund comes in at $624,918. This is all before taxes, too.  Also at a time when markets were, allegedly, less efficient.

 

[Cigarbutt]

"Do you have evidence of this?"

Trying to look at this objectively with data.

 

The growth in ETFs has been matched to some degree by investors getting out of mutual funds.

So, in a way, what we see may just be a new distribution of the same pool of investors.

However, some numbers suggest that, overall, the level of "passive" investing is on the rise.

Nothing wrong with that if guiding lights are rational and act based on fundamentals.

The inherent risk is that crowd psychology associated with passivity can go both ways.

 

In terms of evidence, have you been in a moving crowd recently?

Better hope that the crowd is moving in the right direction.

https://www.amazon.ca/Crowd-Study-Popular-Mind/dp/1773230190/ref=sr_1_3?s=books&ie=UTF8&qid=1510349533&sr=1-3&keywords=the+crowd+le+bon

 

Data from GS:

 

http://www.goldmansachs.com/our-thinking/public-policy/directors-dilemma-f/report.pdf

 

Having said all that, if your time horizon is 20 years or more, with time, these "crowd" issues become progressively inconsequential.

[clutch]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

It's not so clear. Imagine a world where there are 100 people and only one person is an active market participant. The rest of 99 people follows this person's capital allocation a la "indexing". Is this equivalent to a bubble in the overall market?

 

The percentage of people participating doesn't matter, if those 99 people are indexing because they heard some billionaire tell them to do so without regard to the fundamentals is that any different than any other bubble we have had, its easy to tell people to index when we are in a bull market.

 

Bubbles will be created only in the assets with greatest capital allocations made by the sole investor. But that does not equate to the entire market being in a bubble.

 

For instance, market-cap based indexing will lead to bubbles in the highest market-cap stocks. Not all stocks will be in the bubble territory. In fact, it will lead to more neglected stocks being neglected, which actually could present more opportunities for active investors.

[LC]

If indexing were creating a bubble, should we not see SP500 companies trading at outlandish valuations compared to non-SP500 companies?

 

Or is the argument that indexing is in equities in general, not just the SP500? Then should we see equities trading at crazy valuations compared to other asset classes?

 

Or is the argument that indexing is creating a bubble in all financial assets? In that case, how is indexing the culprit?

[Nomad]

It's still relatively early in the indexing game. Less than half of the US market is in passive strategies, so as of today there are still plenty of active investors who are driving price discovery. What happens if/when that indexing number gets to something like 70% or 80% is the interesting question. Just how many active participants does a market need to be considered relatively efficient?

 

On an unrelated note, the ubiquity of the VTSAX / "100% equities" cheerleaders these days may be a great contrary indicator, if you put stock in such things. ;D

[Guest Cameron]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

It's not so clear. Imagine a world where there are 100 people and only one person is an active market participant. The rest of 99 people follows this person's capital allocation a la "indexing". Is this equivalent to a bubble in the overall market?

 

The percentage of people participating doesn't matter, if those 99 people are indexing because they heard some billionaire tell them to do so without regard to the fundamentals is that any different than any other bubble we have had, its easy to tell people to index when we are in a bull market.

 

Bubbles will be created only in the assets with greatest capital allocations made by the sole investor. But that does not equate to the entire market being in a bubble.

 

For instance, market-cap based indexing will lead to bubbles in the highest market-cap stocks. Not all stocks will be in the bubble territory. In fact, it will lead to more neglected stocks being neglected, which actually could present more opportunities for active investors.

 

If I buy an index of cypto's that doesn't make cypto's any less of a bubble. Whether I buy a large cap cypto index or not.

 

Buying an index doesn't mean your taking on less risk which is what seems to be the narrative when your buying an index fund.

[rukawa]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

I don't agree. The transition to indexing could lead to a bubble if it occurs too quickly but indexing in and of itself does not create bubbles. Indexing leads to less trading and possibly if adopted on a very very large scale , wider bid/ask spreads. Philosophical economics has already basically beautifully explained what happens when indexing is adopted on mass:

 

http://www.philosophicaleconomics.com/2016/05/passive/

http://www.philosophicaleconomics.com/2016/05/indexville/

 

The real question is not about indexing. Its about equity allocation in investor portfolios. If investors increase their equity allocation, it will lead to higher prices. Again philosophical economics provides a great explanation:

 

http://www.philosophicaleconomics.com/2013/12/the-single-greatest-predictor-of-future-stock-market-returns/

[clutch]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

It's not so clear. Imagine a world where there are 100 people and only one person is an active market participant. The rest of 99 people follows this person's capital allocation a la "indexing". Is this equivalent to a bubble in the overall market?

 

The percentage of people participating doesn't matter, if those 99 people are indexing because they heard some billionaire tell them to do so without regard to the fundamentals is that any different than any other bubble we have had, its easy to tell people to index when we are in a bull market.

 

Bubbles will be created only in the assets with greatest capital allocations made by the sole investor. But that does not equate to the entire market being in a bubble.

 

For instance, market-cap based indexing will lead to bubbles in the highest market-cap stocks. Not all stocks will be in the bubble territory. In fact, it will lead to more neglected stocks being neglected, which actually could present more opportunities for active investors.

 

If I buy an index of cypto's that doesn't make cypto's any less of a bubble. Whether I buy a large cap cypto index or not.

 

Huh? So, you are saying that the "bubbleness" does not lie in the index but the underlying asset (in your example, crypto). This does not prove any point that indexing leads to bubbles.

 

I don't think you are getting my point about market-cap based indexing leading to bubbles in only certain assets.

 

[clutch]

If indexing were creating a bubble, should we not see SP500 companies trading at outlandish valuations compared to non-SP500 companies?

 

Or is the argument that indexing is in equities in general, not just the SP500? Then should we see equities trading at crazy valuations compared to other asset classes?

 

Or is the argument that indexing is creating a bubble in all financial assets? In that case, how is indexing the culprit?

 

All excellent points.

[Guest Cameron]

indexing does not scale well at all. it is a solution only if a relatively small number of people do it. Once it gets adopted en masse , it creates bubbles .

 

It's not so clear. Imagine a world where there are 100 people and only one person is an active market participant. The rest of 99 people follows this person's capital allocation a la "indexing". Is this equivalent to a bubble in the overall market?

 

The percentage of people participating doesn't matter, if those 99 people are indexing because they heard some billionaire tell them to do so without regard to the fundamentals is that any different than any other bubble we have had, its easy to tell people to index when we are in a bull market.

 

Bubbles will be created only in the assets with greatest capital allocations made by the sole investor. But that does not equate to the entire market being in a bubble.

 

For instance, market-cap based indexing will lead to bubbles in the highest market-cap stocks. Not all stocks will be in the bubble territory. In fact, it will lead to more neglected stocks being neglected, which actually could present more opportunities for active investors.

 

If I buy an index of cypto's that doesn't make cypto's any less of a bubble. Whether I buy a large cap cypto index or not.

 

Huh? So, you are saying that the "bubbleness" does not lie in the index but the underlying asset (in your example, crypto). This does not prove any point that indexing leads to bubbles.

 

I don't think you are getting my point about market-cap based indexing leading to bubbles in only certain assets.

 

I don't think I said index funds themselves create bubbles, I think the index funds feeds the bubbleness. I just don't see how if 99 out of 100 people buy large cap indexes that that creates a bubble but if 99 out of 100 buy the whole index that makes it a market, both aren't thinking about fundamentals.

[GregS]

I'm not sure indexing necessarily creates bubbles.  In my opinion, the problem with too many investors indexing is markets become primarily dependent on flows.  So in this sluggish but growing economy with a trend toward passive investing we've seen stocks march higher with low volatility.  As long as there is marginal capital to allocate, why would anything different happen?

 

The key question is when and why will the flows reverse?  Could be that stocks hit bubble territory and collapse under their own weight, but I suspect that's a ways off.  Something else could trigger it.  I suspect it won't reverse until we hit a recession and see incomes and profits squeezed.  Economic factors stall and reverse the flows, then investor psychology takes over. 

 

Of course, the market hasn't been a monolith.  We've seen bear markets in certain sectors like energy and retail over the last few years and for good reason, even as the indexes have been fairly steady.  So I don't want to overstate the case that passive is driving everything, but it does suggest that economic fundamentals are going to be the key factor in the markets for the near term.

 

[GregS]

Oh I almost forgot demographics as a factor.  Aging boomers and their retirement and pension needs could cause a sell off.  I think this is a longer ways off that most people suspect due to boomers undersaving and needing to stretch for returns, but it could also hasten the stampede for the exits as retirees seek to protect nest eggs in a declining market. 

[Cigarbutt]

Arguments from LC:

"All excellent points." 1+

But there is a risk of a fallacious basis in a multi-variable problem where critical variables are not clearly defined.

 

To illustrate:

 

If the S&P is not in bubble territory or in fact if stocks are cheap, then why do BRK, FFH, Klarman and other value investors have high cash levels in their portfolios and why do they not simply invest in index ETFs?

 

Or is the argument that indexing creates opportunities for value investors outside the indices, then why do BRK, FFH, Klarman and other value investors have high cash levels in their portfolios and why do they not simply invest in equities outside of the S&P?

 

The argument may not be that indexing is causing a bubble. It may be that passive investing is contributing to crowd psychology in any market (up or down).

 

 

[JRM]

The point that Howard Marks and others have made is that there is no price discovery when you index.  Indexing assumes that the market is mostly efficient, and the low cost structure results in outperformance because most active managers either track or underperform the market.  Indexes are essentially taking advantage of the efficient market provided by active managers, but they don't contribute to efficient pricing.

 

People are beating around the bush at the largest component by market of the S&P 500.  It's Apple.  Is Apple overvalued?  Not to the extreme that some other stocks are.  Has indexing caused the largest component to be overvalued?  I don't think so.  Perhaps and index selloff will create some buying opportunities.

[Cigarbutt]

"I don't agree. The transition to indexing could lead to a bubble if it occurs too quickly but indexing in and of itself does not create bubbles. Indexing leads to less trading and possibly if adopted on a very very large scale , wider bid/ask spreads. Philosophical economics has already basically beautifully explained what happens when indexing is adopted on mass:

 

http://www.philosophicaleconomics.com/2016/05/passive/

http://www.philosophicaleconomics.com/2016/05/indexville/

 

The real question is not about indexing. Its about equity allocation in investor portfolios. If investors increase their equity allocation, it will lead to higher prices. Again philosophical economics provides a great explanation:

 

http://www.philosophicaleconomics.com/2013/12/the-single-greatest-predictor-of-future-stock-market-returns/"

 

 

The first two links state that the ratio of active and passive investing does not matter in mathematical terms versus returns. This is the same type of premises which are used in quantitative investing that assume that investors are rational and that behavioral economics does not apply.

 

The 3rd and last link is based on a fundamental flaw. The author suggests that 1)the % equity allocation by investors will vary according to supply and demand factors, 2)the % equity allocation by investors will closely predict future market returns. The article, in fact, in a lengthy and convoluted fashion, goes on a detailed circular discussion about these assumptions.

 

But, simply looking at the top graph, the % equity allocation by investors simply coincidentally follows the market (price). For instance, when the market corrects by 50%, the % equity allocation will fall by close to 50%, as bond value overall changes much less and as cash, by definition, does not change value per unit. Also, when markets gradually increase, the market value of the equities held by investors will also gradually increase and that essentially explains the gradual increase in the % equity allocation. No wonder, the % equity allocation by investors can be interpreted as a predictor of future return as it constitutes a closely related coincident indicator. In fact, any significant deviation of this correlation would require a separate explanation. The reason behind this simple reasoning is that, for every investor who is a seller, there is an investor who is a buyer. Equity does not disappear when you sell it.

 

I would submit that using conclusions based on a fundamental flaw may lead in the wrong direction.

 

What is perhaps interesting is that the first two links (active versus passive investors) are based on the fact that even if individual investors change camp, the total number of investors does not change. Fair enough.

 

Well then, concerning the third link, the author seems to forget that even if individual investors % equity allocation (in terms of quantity of equity held) will change over time, the total % equity allocation (in terms of quantity of equity held) will be relatively stable in the aggregate. The essential reason explaining the variation of % equity allocation in the aggregate is because of share price change per unit of equity held.

 

So, when this philosophical explanation suggests: "If investors increase their equity allocation, it will lead to higher prices", I tend to reflect that, for my accounts, I will tend to increase the equity allocation when prices will be lower.

 

And perhaps that discussion explains why a relative infatuation with passive investing may be a contrarian signal.

 

 

 

 

 

 

[rukawa]

But, simply looking at the top graph, the % equity allocation by investors simply coincidentally follows the market (price). For instance, when the market corrects by 50%, the % equity allocation will fall by close to 50%, as bond value overall changes much less and as cash, by definition, does not change value per unit. Also, when markets gradually increase, the market value of the equities held by investors will also gradually increase and that essentially explains the gradual increase in the % equity allocation. No wonder, the % equity allocation by investors can be interpreted as a predictor of future return as it constitutes a closely related coincident indicator. In fact, any significant deviation of this correlation would require a separate explanation. The reason behind this simple reasoning is that, for every investor who is a seller, there is an investor who is a buyer. Equity does not disappear when you sell it.

 

The page appears to be taken down. But I found the graph here:

https://www.marketwatch.com/story/nasdaqs-new-high-could-be-the-bulls-last-gasp-2015-06-19

 

I don't think you are reading the graph right. The graph predicts future stock market returns for 10 years given today's equity allocation. And the correlations are negative not positive because he inverts the return axis on the right compared to the equity allocation on the left. So what he is saying is that equity allocations tend to mean revert. A high equity allocation today means lower equity allocations in the future. And as equity allocations go lower returns will be lower. Thus a high equity allocation implies lower future returns. For example, around 2000 the equity allocation is 65%, and the graph predicts future 10 year returns will be -3% cagr. On the other hand in late 2009 you have a very low equity allocation of 37.5% and the graph predicts future returns will be 14%.

 

So % equity allocation today cannot possibly considered a closely related coincident indicator of future 10 year returns since one is calculated with today's information (equity allocation) and the other concerns information that cannot possibly be known by investors since it happens in the future (the SP500 future return of the next 10 years). Basically what philosophical economics is saying is:

 

Give me today's equity allocation as a % of investor portfolios and I will tell you what the future 10 year SP500 return is.

[Cigarbutt]

OK. I see your point. But this is playing on words with a chicken and egg question.

 

-What the graph and basic deductions mean:

--)% equity allocation in the aggregate is essentially explained by change in price.

--)so we can conclude that markets are cyclical (we won't get the Nobel prize for that conclusion).

--)another consensual conclusion is that if markets are high, returns will tend to be lower going forward (no need for thousands of words here).

 

What this thread is about:

1-the level of the S&P now vs its "normalized" level

2-is indexing contributing to the divergence if any?

3-in combination, is it moronic to index now?

 

From a previous post, you mention: "If investors increase their equity allocation, it will lead to higher prices"

From the last post, you mention: "And as equity allocations go lower, returns will be lower."

 

The points of my last post:

These statements are truisms and derive form basic math.

These statements, as expressed, suggest (wrongly in my opinion) that what causes markets going up or down is the actual "participation" of investors or absence thereof in the markets.

 

From the last article: "It will undoubtedly come as a surprise to many of you that households’ equity allocations are at close to record highs, since the financial media in recent months have been serving up a steady drumbeat of stories about how the average investor, traumatized by the memory of the 2008-2009 Great Recession, is out of the stock market entirely."

 

What seems to be surprising to the author of the article and the author of the previous links that you provide is not surprising at all. It can simply be explained by basic mathematics.

 

Back to this specific thread.

 

The links that you provide tend to show that markets are overvalued and that going forward returns will be lower thereby questioning if passive investing is a wise choice.

 

The links that you provide and your own quotes  tend to support the idea of mass movements, momentum and reflexivity. These are concepts that are self-reinforcing and may contribute to deviations from intrinsic value.

 

My opinion is that price tend to correlate with intrinsic value but variations can occur. In terms of cause and effect, demand and supply factors can interact in a subjective manner to increase the divergence.

 

My opinion is that there is a significant divergence between aggregate intrinsic value and the level of the S&P index, and indexing/passive investing is a contributing factor. I submit that the data you provide support those conclusions.

 

[mattee2264]

 

  Agree that equity allocations are influenced by the level of the stock market. Humans extrapolate the recent past so believe the market will continue to go up or go down and act accordingly. So rebalancing doesn't happen to the extent it should and equity allocations are therefore cyclical.

 

  Even before indexing blue chips and growth stocks were over owned during bull markets.  So I don't think that distortion is anything particularly new. And the concentration risk is much lower with a broader index than it was for narrower de facto indices such as the Nifty Fifty or the narrower sector concentrations such as the tech and communications stocks during the dot com bubble. And active fund managers because of career risk tend to diversify widely and approximate indices and favour respectable and glamour stocks (which tend to be overrepresented in indices as well) so the market landscape hasn't changed that dramatically.

 

The S&P 500 market cap weighted has a P/E of around 25 and the S&P 500 equal weighted has a P/E of around 22. Converting to earnings yields that is 4% versus 4.5%. So not much of a difference and you can make a case that the tech giants over-weighted in a market cap weighted index have excess cash, better growth prospects, more investments going through the P+L etc.

There is after all an advantage to being big in a globalized economy and for tech stocks where winners tend to take all. It is difficult to comment on small caps as P/E ratios are distorted by the prevalence of loss making companies but the WSJ pegs forward P/E ratios (based on operating earnings) at 20 in line with the S&P 500.

 

So the picture I am seeing is more one of stocks generally being historically expensive as you'd expect in a low interest rate environment. So I don't think that it is easy to outperform the index simply by stock picking unless you have superior skill which by definition the average investor doesn't have.

 

And I don't think it is obvious to lighten up on stocks and move to cash in anticipation of cheaper markets in the future. This only makes sense if you believe you will have the opportunity to get back in at a substantially lower market level. And all the while you are fighting the upward bias to stock market prices from earnings growth and inflation which will partially offset the benefits of any eventual P/E contraction meaning time is not on your side.

 

It seems a good bet that interest rates will go up but how fast and how much is anyone's guess and the earnings yield on the S&P 500 still offers a cushion especially when you consider that S&P 500 earnings grow over time whereas the bond coupon is fixed.

 

 

 

 

 

 

 

[Cigarbutt]

Thank you for the wise words.

Conventional wisdom: what counts is time in the market not timing the market. OK.

 

Want to spend time on income statements this week (and for the next 20 years) but will add the following:

The last 30 years (despite dot-com and real estate induced volatility episodes) have been unusually "good" for investors. The "excess" return was not based on fundamentals. Animal spirits.

I'm not saying that the next period will be "bad". I'm suggesting that maintaining the same trajectory requires certain assumptions and that lower expectations may be reasonable. I'm not sure that investors who are indexing now have appropriate desired/required expectations. My understanding is that human nature has not changed.

 

For reference, go to PDF document, exhibit 5 page 8.

https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/why-investors-may-need-to-lower-their-sights

 

Going forward, there are many ways that this can play out. One of the scenarios is that "stocks are cheap now". Before going "all-in" and "adjusting" some parameters in my investment universe, need to "see" how my investments would turn out in various scenarios.

 

To conclude, one prediction (!). In 1997, Siegel and Thaler (recent Nobel for what it's worth) predicted a forward looking ERP of 3% for the next 20 years and said: "‘we are stressing long-term results and will not accept complaints for 20 years. Feel free to call us in 2017."

My prediction is that the forward looking ERP for the next 20 years will be much closer to zero and I can discuss again this issue publicly in 20 years (2037).

May we all do well. :)

[no_free_lunch]

What is forward looking ERP? 

[boilermaker75]

What is forward looking ERP?

 

Equity Risk Premium

[Cigarbutt]

When/if you enter a financial planner office, there is usually a big picture on the wall showing how equities "out-perform" over time.

A way to see the forward looking equity risk premium is to evaluate the return that you will (expect to) obtain from investing in the market, over a specific time period, above the risk-free rate.

Question for you now:

-what risk-free rate (level) should you use?

(Remember that risk-free rates are negative in many places these days)

 

Of course, it does not really matter if you rely entirely on your inner score card and have a very long term focus.