Unexpected Inflection Points

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.


The yanked rug… [PT]


Where the stock market is 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 is 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 Index, 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 one’s brain.


When multiples expand into the blue yonder, it is easy to make a mint in the stock market (although almost no-one wanted to buy stocks at the 2009 lows as we recall). But you know what they say: easy come, easy go. [PT]


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.


It certainly appears as though everybody is indexing at this point – and this chart is actually slightly dated by now (via EWI – we have shown it before). This vast move toward passive investing has by now produced numerous presumably unintended side effects. [PT]


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.


This chart shows one of the unintended consequences alluded to above: stocks that are heavily weighted in investable index funds trade at far higher valuations than their non-indexed brethren. It seems obvious that their valuations are distorted by mindless, passive investment activity. Many investors are probably not aware that this effect cuts both ways – on the way down, the “index darlings” will lose a lot more value than other stocks. In fact, this is precisely what has happened in the recent market swoon. [PT]


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 is 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 larger than most people 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.


And of course, “everybody is doing it” – in size. Institutional holdings of ETFs swelled to almost $125 billion by the end of 2017. Our guess is that this isn’t going to end well. [PT]


Charts by: BigCharts, multpl.com, EWI, Bloomberg, Deutsche Bank / Factset


Chart annotations, image captions and edits by PT


MN Gordon is President and Founder of Direct Expressions LLC, an independent publishing company. He is the Editorial Director and Publisher of the Economic Prism – an E-Newsletter that tries to bring clarity to the muddy waters of economic policy and discusses interesting investment opportunities.




Emigrate While You Can... Learn More




Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.


Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA


Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • The Triumph of Madness
      Historic Misjudgments in Hindsight Viewing the past through the lens of history is unfair to the participants.  Missteps are too obvious.  Failures are too abundant.  Vanities are too absurd.  The benefit of hindsight often renders the participants mere imbeciles on parade.   The moment Custer realized things were not going exactly as planned. [PT]   Was George Armstrong Custer really just an arrogant Lieutenant Colonel who led his men to massacre at Little...
  • The Secret to Fun and Easy Stock Market Riches
      Post Hoc Fallacy On Tuesday, at the precise moment Federal Reserve Chairman Jay Powell commenced delivering his semiannual monetary policy report to the House Financial Services Committee, something unpleasant happened. The Dow Jones Industrial Average (DJIA) didn't go up. Rather, it went down.   The Fed chair and His Magnificence, God Emperor, Field Marshall & Stable Genius, POTUS Donald J. Trump: a complicated relationship. [PT]   Were the DJIA...
  • The Constitution IS the Crisis
      A Review of Murray N. Rothbard’s Conceived in Liberty, Vol. 5 Holy Writ The posthumous release of Murray Rothbard’s fifth volume of his early American history series, Conceived in Liberty, is a cause of celebration not only for those interested in the country’s constitutional period, but also for the present day as the nation is faced with acute social, economic, and political crises.   Murray Rothbard, the foremost representative of the “American branch” of the...
  • A Pharmaceutical Stock That Is Often Particularly Strong At This Time Of The Year
      An Example of Strong Single Stock Seasonality Many individual stocks exhibits phases of seasonal strength. Being invested in these phases is therefore an especially promising strategy.   Danish drug company Novo Nordisk   Today I want to introduce you to a stock that tends to advance particularly strongly at this time of the year: Novo Nordisk. The Danish pharmaceutical group supplies a broad range of products and is a global market leader in diabetes...

Support Acting Man

Austrian Theory and Investment


The Review Insider


Dog Blow

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts


Gold in USD:

[Most Recent Quotes from www.kitco.com]



Gold in EUR:

[Most Recent Quotes from www.kitco.com]



Silver in USD:

[Most Recent Quotes from www.kitco.com]



Platinum in USD:

[Most Recent Quotes from www.kitco.com]



USD - Index:

[Most Recent USD from www.kitco.com]


Mish Talk

    Buy Silver Now!
    Buy Gold Now!