No Matter How Crazy The Trend It, Don’t Fight It

July 18, 2017

No Matter How Crazy The Trend It, Don’t Fight It

  • The economy has only grown 18% in the last 9 years while the stock market’s growth is measured in three digits.
  • Such imbalances can only last as long as the factors creating them persist.
  • A massive drop in stocks awaits us, but it won’t happen all that soon as the flow of funds is too strong.

Introduction

The S&P 500 (NYSEARCA: SPY) is up 259% since March 2009, and is showing no intention of stopping.


Figure 1: The S&P 500 index since March 2009. Source: Yahoo Finance.

The Nasdaq (NYSEARCA: QQQ) index has performed even better and is up 387% in the same period.


Figure 2: The Nasdaq (blue) index since March 2009 vs. the S&P 500 (green). Source: Yahoo Finance.

It’s important to understand why the Nasdaq outperformed the S&P 500 so significantly and why stocks keep going up in order to see what can be expected in the near future and whether those owning index funds can sleep well in the short term, medium term, and long term future.

Now, the rational explanation behind stocks growing that much in the last 8 years would be that the economy has grown at the same or similar pace. If this isn’t the case, then there is an imbalance between the fundamentals and asset values.


Figure 3: Comparison between economic growth and the S&P 500. Source: FRED.

The economy has grown consistently for the past 8 years, but not 200%. It has grown just 18% in the last 8 years.

As the economy hasn’t grown as fast as the stock market, it’s a clear indication that there is something else creating such an imbalance. Thus to see what will probably happen with stocks, we have to find out what’s causing the imbalance and analyze how long it will persist because imbalances can’t last forever.

Factors Creating Stock Market Imbalances

The first and most obvious reason behind inflated asset prices is the FED’s monetary easing policy and huge increase in monetary liquidity.


Figure 4: The FED’s balance sheet and the S&P 500 have been closely correlated in the past. Source: FRED.

We know that the FED will slowly start to trim its balance sheet, but that hasn’t yet had an effect on stocks. Thus the effect will be seen when the FED actually starts to pull money out from the system. However, the trimming of the FED’s $4.5 trillion balance sheet will take a long time with monthly decreases starting at $6 billion and perhaps increasing to $30 billion per month in the future.

What’s related to the FED effect that allows for high levels of liquidity is the flow of funds into passive funds and buybacks.

Since the last recession, the most popular thing to do has been to invest in passively managed investment funds.


Figure 5: Flow of funds is totally oriented towards passive funds. Source: MarketWatch.

Passive funds simply track an index and the weighting of an individual stock depends on its market capitalization. As a passive fund simply buys index stocks, it has to buy more of them with higher market capitalizations.


Figure 6: The top 10 holdings of the S&P 500 make 19.1% of the index. Source: iShares.

Therefore, as the flow of funds toward passive funds is extremely positive, there is higher demand for larger stocks which further pushes their stock prices creating a self-reinforcing cycle. Out of the top five S&P 500 holdings, only Apple (NASDAQ: AAPL) hasn’t outperformed the S&P 500 while others largely outperformed.


Figure 7: Top 5 S&P 500 holdings and S&P 500 performance in the last 5 years. Source: Yahoo Finance.

On top of all of the above, corporations continue to indulge in huge buybacks, further increasing the upward pressure on stock prices, spending about $130 billion per quarter to buy back shares. Per year, the buybacks easily surpass $500 billion or more than 2.5% of market capitalization. Given that the float is significantly smaller than the market cap, it’s clear how the buyback pressure positively distorts stock prices.

Just as an example, Apple has spent $34 billion on buybacks in the last 12 months. Without the buyback, Apple’s stock would be much lower.

Conclusion

With so much capital going after stocks, the one thing I’m sure of is that it isn’t safe to bet against the S&P 500, despite the obvious overvaluation and detachment from fundamentals.

It’s highly probable that stocks, especially those being bought by passive funds with large buybacks, will simply continue on their growth path until a recession cuts corporate earnings and disables buybacks while all those mindless investors investing in passive funds get scared and start pulling their money out in panic. However, until that happens, we will probably see the S&P 500 just continue to climb.

Should you then just invest in the S&P 500 like everybody else does? What I’ve learned from reading hundreds of books on how the greatest investors operate is that they first focus on risk, and only then on reward. Therefore, when the flow of funds towards the S&P 500 actually stops, the decline will be sharp and unstoppable. Similar, if not even sharper than the declines we experienced in 2001 and 2008.


Figure 8: The S&P 500 in the last 20 years. Source: Yahoo Finance.

Therefore, the S&P 500 remains a high risk, low reward investment. Fortunately, there are plenty other investments that offer better returns for less risk and it isn’t wise to invest in the S&P 500 now on the hope of another 5% or 10% increase in the next year or two.

I know that at some point the party will stop as the rally isn’t based on fundamentals, but rather on simple mindless capital flows. This makes me very sad because the majority of people depend on the S&P 500 for their retirement, future college tuitions, and who knows what else. It all looks good now, but it looked even better in 1999 and 2007 because the FED’s balance sheet and government debts were much smaller.

What To Do

If you don’t feel like selecting individual stocks that offer both protection and a higher upside than the S&P 500, I would suggest at least buying some protection from the potential negative scenario that might come. This protection might be in the form of gold or gold miners, commodity stocks—especially food commodities,—and some exposure to emerging markets. Such exposure doesn’t cost much at all at this point in time, but would be extremely beneficial to any portfolio when the current flow of funds directed toward the S&P 500 eventually turns.