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.
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?
Notice we are at 1999 Tech Bubble peaks in both valuation parameters.
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!
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.
Central Bank Failure
Since the Brexit vote, panicking Central Banks have flooded the world with more money in attempt to stabilize the financial system. Over thirteen trillion dollars of bonds around the world are yielding negative interest rates, which means nearly 30% of all worldwide government debt is at negative rates.
This is a historical first. I believe that the policy of the money kings of the global central banks is starting to fail. Over the last ten years, the United States has averaged 1.8% GDP growth, the worst in US history. The only success the Federal Reserve and other Central Bankers can point to is an artificially high stock market. Underneath the glow of record highs lies a ticking time bomb of over-extended consumers, decreased industrial production, European-banking problems, Brexit, a massive debt bubble in China, ISIS, deflation and a contentious US presidential election.
If there is a recession in the United States, the Federal Reserve will have a very difficult time cutting rates. It is this reason that a Fed rate hike could be in the cards. It would at least give The Fed some room to maneuver back down if recession strikes. The Fed should have raised rates over two years ago. At zero rates leading into a recession, The Fed only really has three options: fiscal spending, deregulation or currency depreciation.
Fiscal spending has been an emphasized topic from both US Presidential candidates, particularly infrastructure spending in the United States. Both candidates agree that the United States has lacked infrastructure spending and is in need of a big build-out. This will be one of the big themes in the stock market over the next couple of years. One positive aspect about potential infrastructure spending is that current record low interest rates allow for cheap borrowing. I believe we should require infrastructure bonds to be established as mortgage bonds that pay down the debt at the end. This will eliminate the open-ended borrowing where debt spirals even higher. Instead the projects will be paid off in thirty years just like a home.
The final way for a central bank to control inflation at zero interest rates is currency depreciation. I am expecting a major currency problem in the next 6-18 months that will likely lead to higher inflation. Evidence of the transition from deflation to inflation appears as central banks overplay their hand and currencies begin to fall. Over time, this will be good for gold and hard assets.
Long time readers of the MaxOut Savings Report know that I believe Stanley Fischer, the Vice Chairman of the Federal Reserve, is the most respected member of the Fed. Over the weekend, Fischer delivered an influential speech at the Aspin Institute laying out some important points on US economic standing. First, he made the case that over the last two years the United States has weathered a number of economic shocks. The events in China, a 20% rise in dollar value, and the Brexit vote have had little effect on the US economy and the labor market. I believe this could translate to a more hands off Fed. The next time the stock market falls, don’t expect the Fed to rush in and talk it up.
Regarding negative interest rates Fischer stated that it is “something that the Fed has no plans to introduce”. That was a clear statement.
Stanley Fischer also commented on the “exceptionally slow labor productivity growth….Business productivity growth is reported to have declined for the last three quarters, its worst performance since 1979”. Negative productivity is potentially a result of incorrect measurement or poor business investment. Stanley stated the key to boosting the productivity growth and long run potential of the economy is likely found in effective fiscal and “more-effective regulatory policy.” This statement hints the Federal Reserve is concerned that government regulation has become over reaching and is now negatively affecting economic growth.
Regulatory Policy is an area that the United States can make tremendous headway. The beauty of deregulating the economy is in the resulting increase in growth and hiring. Deregulation and regulation efficiency are low cost compared to big ticket deficits such as tax cuts and infrastructure spending. Remember deregulation will grow the economy at no cost!
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Jason Stapleton over at JasonStapleton.com released his long-awaited Recommended Reading List on the 4th of July. It spans fiction and non-fiction and covers libertarian philosophy, economy and culture as well.
Check out the episode below (57minutes):
The Revolution: A Manifesto by Ron Paul
Don't Hurt People and Don't Take Their Stuff: A Libertarian Manifesto by Matt Kibbe
American Contempt for Libertyby Walter E. Williams
Liberty and Tyranny: A Conservative Manifestoby Mark R. Levin
Real Dissent: A Libertarian Sets Fire to the Index Card of Allowable Opinion by Thomas E. Woods
Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economicsby Henry Hazlitt
Basic Economics 5th Editionby Thomas Sowell
Battlefield America: The War On The American Peopleby John W. Whitehead
Stonewalled: My Fight for Truth Against the Forces of Obstruction, Intimidation, and Harassment in Obama's Washington by Sharyl Attkisson
The Count of Monte Cristoby Alexandre Dumas père
Atlas Shrugged by Ayn Rand
The Richest Man in Babylonby George S. Clason
Nero Wolfe (or anything) by Rex Stout
Psychology and Markets
The Gift of Fear and Other Survival Signals that Protect Us From Violenceby Gavin de Becker
The Power of Habit: Why We Do What We Do in Life and Business by Charles Duhigg
Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisionsby Dan Ariely
Influence: The Psychology of Persuasionby Robert B. Cialdini
The 48 Laws of Power by Greene, Robert
The cliffnotes version "Summary, Key Takeaways & Analysis "is free with kindleunlimited.
Ready, Fire, Aim: Zero to $100 Million in No Time Flatby Michael Masterson
How to Get Rich: One of the World's Greatest Entrepreneurs Shares His Secrets by Felix Dennis
Reminiscences of a Stock Operator by Edwin Lefèvre
One Good Trade: Inside the Highly Competitive World of Proprietary Tradingby Mike Bellafiore
Market Wizards, Updated: Interviews With Top Tradersby Jack D. Schwager
Andrew Carnegieby David Nasaw
Titan: The Life of John D. Rockefeller, Sr.by Ron Chernow
The First Tycoon: The Epic Life of Cornelius Vanderbiltby T.J. Stiles
Anything by Joseph J Ellis specifically:
Founding Brothers: The Revolutionary Generation
His Excellency: George Washington
The Quartet: Orchestrating the Second American Revolution, 1783-1789
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