The Downside of Mindless Investing

High inflection points in life, like high inflection points in the stock market, are both humbling and instructive.  One moment you think you’ve got the world by the tail.  The next moment the rug’s yanked right out from under you.

Where the stock market’s concerned, several critical factors are revealed following a high inflection point.  These factors are not always obvious at first.  But they become apparent over time.  Most notably, it’s revealed that the period leading up to the high inflection point was more suspect than previously understood.

The stock market, as represented by the S&P 500, became a sort of money minting machine over the last decade.  Quarter after quarter, year after year, investors opened their brokerage statements to the delight of an inflating portfolio.  Investing was fun – and easy.

Without much interruption, investors got more out of the market than they put in.  They also got more out of the market than the underlying economy warranted.  The stock market delivered an illusion of prosperity that many investors mistook for the real thing.

Yes, the economy grew and corporate earnings increased.  However, thanks to debt based corporate buybacks propagated by the Fed’s cheap credit, rising share prices greatly outpaced earnings.  Stock valuations soared.  And stocks became more and more expensive.

The close of a near decade long bull market brings a new clarity and reflection upon the abundance of mistakes that built up over the agreeable upswing.  For example, the reassurance of ever increasing stock returns, over such a lengthy duration, taught a wide spectrum of investors a very dangerous lesson.  That one can get rich without using their brain.

Chaos and Catastrophe

Over the past decade, investing was reduced to a thoughtless endeavor.  Why bother breaking down a corporate balance sheet when you can buy the market via a passive index fund?  Why sift through an extensive list of companies searching for value laden diamonds in the rough, when the whole rough performs like a diamond?

Indeed, for nearly a decade buying the market by investing in an index fund, or exchange traded fund (ETF), was a simple and successful strategy for building investment wealth.  A person who invested $100 in the S&P 500 about 10 years ago would have well over $300 today.  Not a bad return for blindly deploying investment capital into the market.

The succeeding decade, however, will likely be far different for investors than the past decade.  For one thing, decade long bull market runs are not the norm; they’re an aberration.  Over the next decade we expect a passive indexing strategy will encounter a series of problems that many index fund enthusiasts are unaware of.

In fact, John Bogle, founder of Vanguard, and architect of the world’s first index fund, now has reservations about the innovation he created nearly 40 years ago.  In mid-2017, at the Berkshire Hathaway shareholder meeting he stated:

“If everybody indexed, the only word you could use is chaos, catastrophe.  The markets would fail.”

The chaos and catastrophe Bogle warns of is a function of two things: (1) The popularity of passive index fund investing; and, (2) The volume of passive investments the market can accommodate while still functioning as a market.

Certainly, index funds and ETFs have delivered many benefits for investors.  Most importantly, they’ve successfully curtailed the outrageous fees that mutual fund managers had charged investors for what was often little more than closet indexing.  But index funds, like a second helping of chocolate cake, have approached the point where too much of a good thing becomes a bad thing.

The Downside of Mindless Investing

An economy, in theory, should reward honest and productive activities and rebuke waste and incompetence.  In practice, and largely because of government intervention, unproductive activities, like federally subsidized corn ethanol production, are often rewarded.

There are also instances where an economy rewards idiots, like the Kardashians, for shameless attention seeking or other unproductive vulgarities.  But, by and large, a free functioning economy rewards productive enterprise and ingenuity.

Similarly, the stock market, in theory, should efficiently direct capital to its best and most productive use.  In this respect, investors should be judicious and discriminant about the companies they invest in.  Yet, in practice, this is hardly the case.  People are quick to invest in fads or in last year’s winners without much other thought or rationale.

What’s more, passive index fund investing has turned investing into a mindless and mechanical undertaking.  And as a greater and greater percent of the stock market is composed of passive index investments the stock market becomes more and more distorted.  Without judicious evaluation of businesses, which results in rewarding good companies and punishing bad companies, investing, in the form of passive index funds, is cheapened to corporate charity.

As of early December, index funds control 17.2 percent of U.S. listed companies – up from 3.5 percent in 2000.  On top of that, 81 percent of all indexed assets are under management of BlackRock, State Street, and Vanguard.  In other words, these three asset managers own roughly 14 percent of all U.S. listed assets.

Within the confines of an extended bull market, where liquidity is prevalent, index fund investors could sell their holdings at any time without any issues.  How these index funds function during a sustained panic, when liquidity’s scarce, has yet to be tested at the current size and composition of the market.  This, among other reasons, is why we expect the downside of this bear market to be much further than most anticipate – the S&P 500 may even fall below 1,000.

Following the shakeout, opportunities for value investors will be immense.  After years in darkness, active managers will have another day in the sun too.

Sincerely,

MN Gordon
for Economic Prism

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