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S&P indexing is moronic right now


LongHaul
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I have the opposite opinion of the current masses on Indexing (right now).  More than any other time in history that I can think of, almost everyone seems on one side of the boat in recommending and liking indexing.

In practice if you buy the S&P 500 it is like you are buying one massive US Company.  And if that Company is way overvalued your returns will stink until value catches up with the price.  And currently the S&P is a ripoff - especially with low GDP growth.  At something like 26x P/E you might have 7-9 years of 1% return per year while the downside could be 30-50% in the near term. 

 

Previous market bubbles saw individual and institutional investors excited over individual stocks.  Today indexes are all the rage.  I guess the koolaid tastes too great - until one's liver stops working.

 

I generally agree with indexing but at fair or undervalued levels.  Not today.

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for someone who doesn't want over exposure to individual companies through the typical s&p500 etf you can buy equal weight etfs

 

not saying the index are cheap or expensive, with equal weight etfs you get rid of the over exposure to "one/few" company problem

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I don't disagree that the S&P 500 is trading at a higher than average historical valuation. With that being said, I do think it's much better than most of the alternatives for the US large cap blend category. Valuations aren't dramatically higher today than the were in 2007...and the index still did just fine. I'm not saying the S&P 500 is the best investment option out there (it probably isn't) but it's way better than the typical mutual fund (let alone if you're paying an advisory fee on top of a mutual fund expense) if you want large cap US exposure...this is especially true once you factor in taxes.

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If the index earns 140 next year, one estimate I found, you are making 5.4% on your investment compared to 2.4% if you buy ten year treasuries.

That's a ridiculous comment. Why would you compare the index relative to bonds as opposed to other equities? And since when is it a good thing if your equities earn 3% more than treasuries?

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In the past year or two, it has become a common refrain at financial independence blogs and related fora to push a 100% allocation to VTSAX, the Vanguard Total Stock Market Index.

 

Most of these 'pushers' are Millenials who weren't even around for the crash of '08, much less the collapse of the late 1990s tech bubble or the 16 year (16 year!) S&P bear market from 1966 to 1982. The members of the 100% equities/VTSAX club believe that they will win out in the long run (they naturally decline to define "the long run") because US equities have always gone up. But as investors in 1929 and the mid 1960s discovered, the "long run" can be very long indeed.

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In the past year or two, it has become a common refrain at financial independence blogs and related fora to push a 100% allocation to VTSAX, the Vanguard Total Stock Market Index.

 

Most of these 'pushers' are Millenials who weren't even around for the crash of '08, much less the collapse of the late 1990s tech bubble or the 16 year (16 year!) S&P bear market from 1966 to 1982. The members of the 100% equities/VTSAX club believe that they will win out in the long run (they naturally decline to define "the long run") because US equities have always gone up. But as investors in 1929 and the mid 1960s discovered, the "long run" can be very long indeed.

 

Despite the overvaluation, will the returns still be better than holding cash or bonds ?

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Despite the overvaluation, will the returns still be better than holding cash or bonds ?

 

Over the next 50 to 100 years? Probably. But I suspect that most of us, lacking the genetics of Metusaleh, do not have that time horizon.

 

Many people also seem to mistakenly believe that indexing is somehow "less risky."  I don't think it's a bad strategy over a long time frame but a lot of retail investors are probably in for a nasty surprise.

 

They are, in my opinion, making the classic mistake identified by Ben Graham: Mistaking a conventional investment for a conservative one.

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I think it's always very difficult to forecast the future... If you go back in the archives of this forum, you'll see people say similar things pretty much every year since 2011. "The new normal" used to be mentioned a lot, with the permanent stagnation and such... Even Fairfax stayed hedged for many years expecting low or negative returns. And since then the SP500 has more than doubled, so it's definitely not easy to know.

 

It'll depend on what interest rates and the economy do (and not just the US economy, since so many of the SP500 companies get a meaningful amount of their sales globally--another change to take into account when comparing with historical numbers), and it's also hard to compare historical metrics for the SP500 since it's not a static thing. Decades ago a lot of it might have been industrial/manufacturing companies with low margins and low ROE/ROIC, and today more of it might be composed of asset-light, high-margin, high ROIC/ROE companies (more software, more services, more medical, more branded CPG, etc). Does the index always deserve a static multiple or does that change over time too? ¯\_(ツ)_/¯

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If the index earns 140 next year, one estimate I found, you are making 5.4% on your investment compared to 2.4% if you buy ten year treasuries.

That's a ridiculous comment. Why would you compare the index relative to bonds as opposed to other equities? And since when is it a good thing if your equities earn 3% more than treasuries?

 

Because the ten year is typically thought of as the risk free rate of return.  The current spread is probably slighter lower than average historically, but there doesn't seem to be a consensus opinion on that. I'm not saying I think this makes the index a good investment, just guessing at why its being made by people.

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IMO indexing is always moronic. But IMO most people are in fact morons; at least in terms of their ability to make investment decisions. At best, indexing is just lazy. But most people are also lazy. So maybe it's for the best...

 

I do think, for the average person, that indexing is probably the way to go if one understands its purpose and limitations (which, admittedly, few do). To paraphrase Churchill, for the man on the street, buy-and-hold indexing is probably the worst form of investing - except for all the other forms that have been tried.

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In my opinion, the problem with indexing is you are taking on huge, unknowable macro risk through what is being sold as a safe, highly diversified investment.  If rates rise suddenly, tax cuts fail, earnings slow or stall the index could get crushed.  How can you make a bet on something with so many seemingly random and highly important variables? 

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IMO indexing is always moronic. But IMO most people are in fact morons; at least in terms of their ability to make investment decisions. At best, indexing is just lazy. But most people are also lazy. So maybe it's for the best...

 

I do think, for the average person, that indexing is probably the way to go if one understands its purpose and limitations (which, admittedly, few do). To paraphrase Churchill, for the man on the street, buy-and-hold indexing is probably the worst form of investing - except for all the other forms that have been tried.

 

Indexing is brilliant. It would be a huge waste for society if everybody had to spend as much time and energy as we spend on investing. Just like not everybody should have to learn to perform surgery on themselves, know how to design sewer-systems in CAD software, file appeals at the supreme court or maximize crop yield on a multi-acre field. Specialization is a great win for humanity. And if the alternative to cheap indexing is expensive mutual funds that don't generally outperform the indexes or to not own pieces of busineses at all, then indexing is even better.

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Indexing is the best solution for most of the "no-nothing" investors portfolio & probably for the most others who do not have an edge.  It provides low cost exposure to the growing equity markets.  In terms of valuation, IMO we are not over valued as the ERP is 4.7% (see Damodaran's home page) at discount to the historical average of 6.2% (see link to Damodaran page).  At market tops (late 1960s and 2000), the ERP was closer to 3% (late 1960s) or 2% (late 1990s).  The only reason stocks appear expensive is the assumption that interest rates will revert to the historical mean of 5% versus 2.5% today.  If you chop 2.5% off 4.7% you get 2.3% which is quite low.  So the question is do you think interest rates will stay at 2.5% (market fairly valued) or will they go to 5% (market expensive)?  IMO interest rates will stay low as the forces that got us here (excess capital creation with no large capital destructive event (war, famine, epidemic)) are likely not going to change. 

 

Packer

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In my opinion, the problem with indexing is you are taking on huge, unknowable macro risk through what is being sold as a safe, highly diversified investment.  If rates rise suddenly, tax cuts fail, earnings slow or stall the index could get crushed.  How can you make a bet on something with so many seemingly random and highly important variables? 

 

This is a very salient point. S&P indexers are right when they say that over time, they will match the returns - minus fees - generated by a broad cross-section of American business. The problems arise when we start asking: (1) what those returns are likely to be; and (2) how long the "long run" is. The first is inherently unknowable and subject to dramatic secular shifts, as you point out.

 

For instance, what happens if Piketty is right and we have reached a secular turning point where returns on capital will be markedly lower going forward? What if the years of fiscal and economic mismangement in the developed world finally come home to roost and businesses find themselves in a vicious macro environment for 30 years? There are many, many more scenarios one could envision.

 

On (2), the long run: Consider the perspective of a Japanese investor in 1989 - if you bought a Nikkei index in December of that year, you would still not even be close to your nominal cost basis decades later. One can also think of Russian investors in 1917, Chinese investors in 1949, and holders of a basket of Confederate States of America bonds in 1865. The long run can be very long, and there is no guarantee that there will even be a "long run."

 

That being said, I still hold a portion of my portfolio in indices. It is a low-cost, low-effort strategy, and if I am wrong about my ability to generate alpha - which I very well may be - then I am hedged against my own arrogance and stupidity.

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In investing, a good plan you can stick to is better than a great plan you can't.

 

Indexing is an attempt to provide a good plan investors can stick to.  Few people have the time or skill to invest in individual names themselves.  Funds have proven their long term track record vs indexes is poor in general, and the average investor's return in the successful funds is terrible due to performance chasing.

 

Indexing brings more long term focus and discipline that, in theory, should allow more people to stick with it through corrections, especially when combined with dollar cost averaging.  Set and forget.  However, given how popular it is getting over the last few years, it hasn't been thoroughly tested.  Like, at all.  I doubt it ends much differently for the average person than any other strategy.

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Instructive.

 

Would add an opinion that the increasing market share of ETFs (now very significant) has had a tendency to reinforce the general upward trend and to decrease short term volatility. That's OK. A big question is how the typical investor will react when trends change. As GregS says, history offers some suggestions.

 

Would also add that the significant rise in synthetic replication ETFs has created a new potential risk, especially in the leveraged category. The risk is related to the opacity and lengthened financial intermediation process. It reminds me of the period when the market of credit default swaps on a specific underlying asset was actually much larger than the value of the underlying asset. I don't know exactly how this may play out if risk management is eventually tested but the 2008-9 period for the CDS market showed that price discovery may be a painful process when the true market value of an asset is difficult to appraise in a fire sale context even if the pool of assets is said to be over-collateralized. Ask AIG. Of course then, systemic risk was socialized. Who could have predicted that?

 

A word on ERP mentioned by Packer16 along the way. Probably not worth discussing but Damadoran has written a lot of interesting stuff on the topic. What I find particularly fascinating are not the numbers he comes up with but the actual "models" used. There is a relatively large consensus on historically realised ERP. But, I would humbly submit that, going forward (let's say for a relatively short term horizon like 10 or 15 years), you can hypothesize a number but need also to include a standard deviation that is much larger than the number.

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For the early retirement folks, they normally base their assumptions on the 4% rule. The 4% rule is successful (historically) under just about all market conditions. I believe it also worked if one retired on the eve of the Great Depression. Is it 100% fool-proof? No, but neither is stepping in your car either. However, the odds are very much in your favor. No all even assume 4%. Plenty of people assume worse and if markets get too bad they can also reduce expenses. You can live a pretty decent life on very little money (trust me on that).

 

I do find it odd that folks are so sure that future returns will be so much lower than history. I'm sure people were just as confident of their assumptions back in 1979...at least Businessweek was. Who knows, with all the technological advances things could still be cheap. That said, there will probably always be bumps along the way - some much bigger than others.

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