The Next Bear Market Is Coming. Here’s Where It Will Start.

April 19, 2017

The Next Bear Market Is Coming. Here’s Where It Will Start.

  • $2 billion a day flows into Vanguard to be mindlessly invested in the market through index funds.
  • When the only reason people invest is because staying on the sidelines means getting sore while others get rich, it usually spells trouble ahead.
  • When the investors plowing $2 billion per day understand what are they buying at extreme valuations, the next bear market will arrive and it will be terrible as the buying reverses to selling.

Introduction

A recent The New York Times article described how Vanguard, the $4.2 trillion mutual fund, is the fastest growing fund due to the attractiveness of passive investment vehicles and the average 0.12% fee the fund charges. The low fee is something I applaud as I strongly believe fees in the financial world should be minimal or performance related where nothing is paid if the manager doesn’t deliver.

Now, what struck me in this article was the description of the working culture at Vanguard. Let me quote the article:

The Vanguard trading floor is the epicenter of one of the great financial revolutions of modern times, yet it is a surprisingly relaxed place.

A few men and women gaze at Bloomberg terminals. There is a muted television or two and a view of verdant suburban Philadelphia. No one is barking orders to buy or sell stock. For a $4.2 trillion mutual fund giant that is still growing rapidly, it occupies a small fraction of the space of a typical Wall Street trading hub.

You can barely hear the quiet hum of money being invested — money in scarcely imaginable quantities, pouring into low-cost index mutual funds and exchange-traded funds (ETFs) that track financial markets.

Relaxed is how an asset management office should be because if you know what you are doing, you can be pretty sure that you will do well in a certain time horizon. However, the reason behind the relaxed atmosphere at Vanguard isn’t because they know what they’re doing, it’s because they do absolutely nothing. Let me elaborate, out of the $4 trillion of assets under management, about $3 trillion is invested in passive index-based strategies. Investing in passive index-based strategies means investing in a little bit of everything and letting the market decide how much you’ll buy of what as the indexes are weighted by market capitalization. So Vanguard invests around $2 billion a day of new investors’ money mostly into companies like Amazon, Apple, Microsoft, and smaller amounts into smaller companies.

As much as Vanguard has to be applauded for lowering management fees, it also has to be strongly criticized because it’s driving the $4 trillion of assets under management toward a cliff.

There’s Always A Mind Behind The Money

The $3 trillion that Vanguard has invested in index funds might indicate stability as, according to Vanguard, the best way to invest is to invest in index funds. But such a statement isn’t true at all. The positive performance Vanguard’s index funds have achieved in the last 35 years, which is now the main factor in attracting new funds, is just a result of many factors that has lead the S&P 500 to grow 23 times since 1980.

The Italian and Dutch stock market indexes are perfect examples how investing in an index isn’t always a smart thing to do, even if your investing horizon is longer than 20 years.


Figure 1: The Dutch stock market index is at the same level it was in 1998. Source: Yahoo Finance.

“If you pay peanuts, you get monkeys” is the perfect way to describe the current market. Investors are all playing the same game and reinforcing the passive investing trend by constantly plowing more money into passively managed funds. The management fee of the iShares Core S&P 500 ETF (NYSE: IVV) is just 0.04% which is extremely low and positive for investors. However the low fees, mindless investment strategies, and extremely high valuations will lead to a catastrophe when the same mindless buying reverts to panicked, mindless selling.


Figure 2: The Italian stock market index is still 20% below where it was in 1998. Source: Yahoo Finance.

The above shows how Vanguard is just lucky to operate in the U.S. where the economic growth has been a bit stronger than in the Netherlands, and it enjoys the self-reinforcing effect of $2 billion coming into the market every day. However, the bulk of Vanguard’s success was made in the 1980s and 1990s, while the returns since 2000 have been minimal.


Figure 3: From 1980 to 2000, the S&P 500 index grew 15-fold while it only has only grown 55% since January 1, 2000. Source: Yahoo Finance.

Apart from performance, another fact that will have a major impact on future returns are valuations, i.e. the ratio of corporate earnings and stock prices (price earnings ratio – P/E). The current P/E ratio of the S&P 500 is 26.14 which is higher than it was in 1929 and in 1999. At such high valuations, 10 year returns have always been negative.

A great example of what we can expect can be taken from Japan. In 1989, the Japanese stock market index (Nikkei) was at 38,916 points with a P/E ratio of 60. This is almost double the valuation of the S&P 500, but if we apply the S&P 500’s current P/E ratio of 26.14 to the Nikkei in 1989 it would be at 16,954 points. Fast forward almost 30 years and the Nikkei is at 18,331 points for an imaginary total return of 8% if equal the current S&P 500 P/E ratio.


Figure 4: Historical chart of the Nikkei with real return (red) and would-be return using the current S&P 500 valuation (blue). Source: Trading Economics.

Conclusion

As the people investing in index funds aren’t sophisticated investors, they don’t understand the risks of what they’re doing, and because of the historical success index funds have enjoyed, nobody has to explain the risks to them under the fallacy that “in the long-term, stocks are the best investment.”

What I’ve outlined above shows how stocks aren’t the best investment if overpaid, which is exactly what the people investing $2 billion a day in Vanguard funds are doing, overpaying for stocks while underpaying for investment management.

Eventually, probably when a recession comes along and crushes corporate earnings, it will become clear that earnings and the high valuations attached to them are unsustainable. When that happens, the same unsophisticated investors blindly plowing their money into the market will panic and rush to the exits similarly to what happened in 2001 and 2008/2009. Therefore, we can expect a minimum 50% drop in the S&P 500 and long term returns—I’m talking about 20 to 30 years—below 4% per year given that the S&P 500 earnings yield is 3.83%.

What Can You Do?

What to do is mechanically easy to answer but psychologically difficult. Marcus W. Brauchli, a Wall Street Journal reporter from Tokyo, wrote in 1989:

“Japan’s stock market spawns two kinds of investors: believers and skeptics. The believers are getting rich. The skeptics are getting sore.”

Later it became clear that the skeptics protected their capital while most of the believers lost all of their gains.

By staying out of this overvalued market, the only thing we can get is sore while the believers get rich. As it’s impossible to time the market, getting out now can be costly for a while, but is the smartest thing to do in the long run. Getting out of the S&P 500 will be extremely rewarding when the $2 billion daily inflows into Vanguard reverse and become outflows. With nobody buying, the drop will be huge.

There are far better opportunities out there than what the S&P 500 offers. Even in the S&P 500, there are stocks that are cheaper and will probably outperform the index in the long run.

Stocks with relatively low debt and lower P/E ratios are Corning Inc. (NYSE: GLW), Bed Bath & Beyond Inc. (NASDAQ: BBBY), American Express (NYSE: AXP), Gap Inc. (NYSE: GPS), Whirlpool Corp. (NYSE: WHR), PVH Corp. (NYSE: PVH), and CVS Corp. (NYSE: CVS). However, the average P/E ratio of this list is still at 13 which implies just a 7% long term return. For those who want more, the best thing to do is to look for special situations and emerging markets.