The tide may be turning even sooner than I’d hoped…

It looks like investors have pushed growth stocks to historically high valuations relative to value stocks. Analysts at JPMorgan Chase say the spread between forward price-to-earnings (P/E) ratios has “become stretched.”

At an extreme value of around seven, the spread isn’t as high as early 2000 when it exceeded 10. But it’s outside the normal range, at levels we haven’t seen in more than a decade.

That’s a huge change in the stock market. And it could mean a “Golden Age of Value Investing” is starting… with value stocks outperforming growth stocks for years to come.

It could also mean the current mania is on its last legs.

Yesterday, I began sharing our list of the common traits of speculative manias and how they’re playing out right now.

Today, let’s continue with a look at two more of these traits…

4. A reasonable fundamental taken to unreasonable extremes

This trait could double as the definition of a speculative mania.

Most times, a reasonable financial or economic fundamental remains reasonable until too many investors discover it. Then purely by too many people acting on it, the fundamental deteriorates into its opposite…

At one time, it was conservative to invest in housing and mortgages. Then investors noticed that U.S. housing prices hadn’t fallen in living memory. They took that to mean housing prices would never fall. That helped create a massive bubble, ending with the S&P 500 down 58% from its October 2007 highs by March 2009.

The same thing is happening with passive investing today.

Index funds are often referred to as passive investment vehicles. Passive investing makes fundamentally good sense for most investors. You won’t always be able to beat the market, so just own the market. Index funds are how you do that. They’re one of the greatest ideas in finance.

However, experienced investors will automatically ask, “So what’s next?” They know that in financial markets, success tends to sow the seeds of its own destruction…

Wall Street research firm Bernstein Research predicts 50% of all U.S. assets under management will be passively invested by early 2018. In a report last year, it called passive investing “worse than Marxism,” and said it “threatens to fundamentally undermine the entire system of capitalism and market mechanisms that facilitate an increase in the general welfare.”

This is not as ridiculous as it sounds. Steven Bregman, co-founder of investment adviser Horizon Kinetics, says passive investing has two big problems.

First, passive funds buy baskets of stocks as new money comes in, without any reference to the fundamentals of the businesses they’re buying. When money comes into the fund, they buy. When it goes out, they sell. No due diligence required.

The second problem is that many active managers are penalized for taking contrary positions against the passive buyers. This is because over time, they command fewer and fewer assets relative to the passive herd. So their influence on the marketplace shrinks as the mindless passive herd of buyers grows… and experiences less and less pushback from more rational actors in the marketplace.

Passive and active buyers and sellers ought to balance each other out over the long term. It’s how the market tends to gravitate toward fair value for most securities, even if it takes a long time and a lot of irrational pricing to get there.

Bregman complains that the destruction of this kind of “price discovery” and the herding effect created by exiting active managers spells real trouble for financial markets.

With passive investing approaching 50% of total U.S. assets under management, it’s starting to feel like the tipping point is growing near. When nobody is left to buy the indexes, they’ll top out and start falling.

The market can go up for years more, higher than any rational person would ever expect. But passive investing has the potential to go horribly wrong, precisely because it’s so widespread and assumed to be so safe and conservative, which leads us to Trait No. 5 of speculative manias…

5. A risky scheme sold as a safe investment

The only way an asset can turn to toxic waste and wreak widespread financial havoc is if enough people accept it as safe and start piling in.

The widespread acceptance of assets as safe and conservative makes it more likely they’ll see more investor interest and wind up in more investors’ portfolios. The act of everybody buying them because they’re safe makes them unsafe, amplifying their flaws and weakening their strengths.

That’s the key: Today’s safest investments are most likely to become tomorrow’s largest pool of toxic waste.

For example, in the 1920s, publicly traded investment trusts were supposed to be diversified equity portfolios like today’s index funds. They became highly leveraged speculative vehicles. At one point, a new trust was floated on the public market every day. Many disappeared completely in the 1929 crash.

Let’s go back to our index fund example… One strength of indexing is that you can easily hold a diversified portfolio in a single fund. But how diversified are you if everybody else owns the same thing you own?

If Bernstein is right and 50% of all U.S. assets under management are in passive vehicles by early 2018, what will happen when the stock market starts heading the other way? Will index selling turn a 10% correction into a 50% bear market?

Indexing is a strategy solely based on buying. Selling is not part of the deal. When selling goes into overdrive, indexers will feel less like they’re making a safe, conservative bet and more like they’re juggling flaming chainsaws.

Of course, we can’t know exactly what will happen if indexers start selling. Maybe enough of them will hold on for the long term that we’ll have nothing to worry about.

What I do know is this: What the wise do in the beginning, fools do in the end.

Indexing was wise for decades – an easy, low-cost, efficient way to get decent long-term investment results and prepare for retirement. But now that it’s the most popular strategy in the world, with the biggest index fund provider (Vanguard) taking in $2 billion a day, I bet there are more fools than wise folks getting in today.

Good investing,

Dan Ferris


Source: Daily Wealth