Life’s turning points, much like those in the stock market, serve as both sobering and enlightening experiences. One moment, everything may seem under your control; the next, unexpected changes can leave you reeling.
When analyzing the stock market, particularly around significant turning points, crucial factors emerge over time—hindsight reveals that the phase leading up to these moments was often more precarious than initially perceived.
For the past decade, the stock market, epitomized by the S&P 500, transformed into a lucrative machine. Investors regularly opened their brokerage accounts to find their portfolios growing, reinforcing the notion that investing was both enjoyable and simple.
Without significant interruptions, investors reaped rewards that far outstripped their investments, often surpassing what the underlying economy could support. This created a facade of prosperity that many investors mistakenly accepted as reality.
While the economy did see growth and corporate earnings rose, a significant portion of this was driven by debt-fueled corporate buybacks, encouraged by the Federal Reserve’s low-interest policies. This led to soaring stock valuations, pushing prices higher and higher.
As we approach the end of a nearly decade-long bull market, it’s time to reflect on the mistakes accumulated during this seemingly favorable period. The consistent rise in stock returns taught many investors a dangerous lesson: wealth could be achieved without thoughtful analysis.
Chaos and Catastrophe
During the last ten years, investing became an exercise in mindlessness. Why delve into a company’s financials when you can simply invest in a passive index fund? Why hunt for undervalued stocks when the entire market appeared to be thriving?
Indeed, for almost a decade, the strategy of investing in index funds or ETFs proved remarkably successful. An individual who committed $100 to the S&P 500 a decade ago could see that grow to over $300 today—an impressive return for relatively uncritical investing.
However, the coming decade is likely to present a very different scenario for investors. Lengthy bull markets are not the standard; they are anomalies. We anticipate that passive investing strategies will face various challenges that many enthusiasts may not recognize.
Interestingly, John Bogle, the founder of Vanguard and the creator of the first index fund, has expressed concerns regarding this investment innovation he introduced close to 40 years ago. At the Berkshire Hathaway shareholder meeting in mid-2017, he remarked:
“If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.”
Bogle’s warning about chaos and catastrophe arises from two main factors: (1) the increasing popularity of passive index fund investing and (2) the limits of passive investments that the market can sustain while still functioning effectively.
While index funds and ETFs have offered numerous benefits to investors, such as reducing the exorbitant fees charged by traditional mutual funds for often similar performance, they are nearing a point where excessive reliance becomes detrimental.
The Downside of Mindless Investing
In theory, an economy should reward productive efforts while penalizing inefficiency. However, through extensive government intervention, unproductive activities—like federally supported corn ethanol production—often receive undue rewards.
Additionally, the economy can sometimes reward less savory endeavors, such as those indulged by public figures seeking attention. Generally, though, a properly functioning economy should promote genuine enterprise and innovation.
Likewise, the stock market should ideally direct capital to its most productive applications. Investors should be careful and discerning regarding their choices. Yet, the reality often diverges; many people invest based on trends or previous winners with little critical thought.
Moreover, the rise of passive index fund investing has turned the act of investing into a mechanical process. As the share of passive investments grows, the market increasingly distorts. Without careful evaluation of individual businesses, the investment landscape devolves into something akin to corporate charity.
As of early December, index funds command 17.2 percent of U.S.-listed companies, up from just 3.5 percent in 2000. Disturbingly, 81 percent of all indexed assets are managed by BlackRock, State Street, and Vanguard, meaning these three firms hold approximately 14 percent of all U.S. listed assets.
Within a prolonged bull market, where liquidity is abundant, index fund investors experience minimal difficulties selling their holdings. However, it remains unclear how these index funds will perform during a drawn-out market panic when liquidity dries up. This uncertainty leads us to predict that the downswing in the current bear market may be greater than many anticipate; the S&P 500 could even dip below 1,000.
Following this market correction, opportunities for value-focused investors will abound, giving active managers the chance to shine once again after years of obscurity.
In conclusion, while the past decade has made investment appear straightforward, the looming changes in the market necessitate a return to thoughtful investing. As we navigate what may be a challenging future, embracing a discerning approach to investment could unlock significant opportunities.
Sincerely,
MN Gordon
for Economic Prism
Return from The Downside of Mindless Investing to Economic Prism
