Do You Understand the Ramifications of Passive Investing?

Mish

What is Passive Investing?

Passive investing broadly refers to a buy-and-hold portfolio strategy for long-term investment horizons, with minimal trading in the market. Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a broad market index or indices.

The above explanation is from Investopedia.

Is Passive Investing Creating a Bubble?

The Long Version

My Two Cents

For starters, thanks to @TheBondFreak @GratkeWealth @DiMartinoBooth and @profplum99 and anyone else in the chain I missed.

With that out of the way, please take a look at what happened to a buy and hold strategy in the Nikkei. 

Buy and Hold Nikkei Synopsis

  • The Nikkei fell 82% in 19 years. 
  • Every rally in that time was a sucker rally.
  • Despite a 158% rally, a 140% rally, two 64% rallies, and a 63% rally the Nikkei is still 31% below where it was 30 years ago!

Initial Valuation Starting Point

The Nikkei was dirt cheap in 2009 and amazingly expensive at the peak in 1990.

Congratulations to those who got in the Nikkei in 2009. They are up 280%.

That shows the importance of using valuation as an investment starting point. 

Can Something Like That Happen in the US?

Sure, why not?

That is not a prediction, just an observation.

Shiller Smoothed PE

Shiller PE 2020-12-10

Chicken Littles

It is easy to dismiss as Chicken Littles those who continually point out valuations, Shiller PE ratios and the like, (myself included because I honestly never thought the bubble would re-expand as it has).

I do not claim the DOW is the Nikkei or that it will follow that path. But it could. 

Moreover, pensions plans will be crucified if the stock market does nothing but go sideways for 10 years.

Regardless, history shows that valuations do matter. Japan provides the best example.

Will be different this time? Forever?

Mish

Comments (88)
No. 1-32
Buzz lightyear 1
Buzz lightyear 1

You are missing the point. Earnings. in 2008 to 2019 SP earnings. In 2008 SP 500 earnings fell to $18.00 In 2019 they were at $240.00 The P/E reflects that, but it lags. It is not forward looking.

Mish
Mish

Editor

Earnings revert to the mean. That is the entire point of the Shiller PE that I referenced

Casual_Observer
Casual_Observer

The Dow isn't the Nikkei. Central banks have learned from Japan's mistakes. The Fed is doing whatever it can to support stocks because they are scared of a larger crisis in pensions and other funds. If the stock market goes higher, everyone is better off. This is why the Fed is buying all kinds of bonds in order to force money out of bonds and into stocks. Stocks have turned into a better store of value then anything else. The Fed has a better version of closed loop system Japan failed at creating.

Eddie_T
Eddie_T

Buy and hold is completely dead as a strategy, killed by the Fed.

But I expect a much higher blow-off top at some point, than where we are now....I don’t think we're there yet, because I think we will see more helicopter money and more exuberance before the falling express elevator drops start.

It might be after the “COVID recovery”...in two more years? Three ? Five? Hard to know.....but the stock bubble is bound to pop....and when it does other asset classes in bubbles will drop too. But at least tangible assets will hold some value.

I wish I had a dollar for every article I’ve seen in the last 15 years that said the Fed is out of ammunition. For empty guns, they’ve done pretty well. But there are too many reasons to expect a top...Demographics, as often pointed out, will be part of it.

The boomers will need to sell. Who will be the buyers of all the inflated paper? That is not clear.

LawrenceBird
LawrenceBird

I suspect that if you did monthly dollar cost averaging purchases on the Nikkei even starting at the peak you would be up at this point in time.

The issue with long term buy and hold is that at some point one must sell and it really does not matter how stellar your puchases have been if that time comes during a 30 or 40% drop (ie, March) that then continues to flatline or only slowly recover.

PreCambrian
PreCambrian

ETF investing treats every stock in the index as if it is equally as good (or bad) as the others. Poor companies get carried along with the good. That is why companies want to be included in an index. The more indexes the better. The only time that I use ETFs is for foreign investing where I have a difficult time buying the foreign stock through my broker.

Perhaps the stock market is having the same type of trouble adapting to ETFs as the news media is having adapting to the internet. In both cases there will be terrible ramifications before we adapt.

njbr
njbr

In a market where Tesla is only the brightest colored high-flying bird, it is clear that valuation is replaced by speculation.

It been multiple years of "this time it's different".

If profits follow the valuations, it means everyone else will have empty pockets.

Casual_Observer
Casual_Observer

I also think the other factor people are discounting is more money is entering the market because unemployed are gambling with whatever money they have. So more people are relying on the stock market for income. The stock market has an infinite amount of possibilities to replace the income of a single job. There are also more high frequency strategies than ever before. The Fed admitted they did not want more people to trade for a living but that is exactly what's happen. The other reason the market continues to levitate is it is a global growth and value index and not just US companies like a generation ago. There is also more foreign money flowing into the market. If the vaccine frees up the economy and the Fed starts exiting some assets, you will likely see the market tank but the Fed won't let that happen in any big way because of the pension funds that hold all assets.

Mandelabra
Mandelabra

Wow, an insightful article. Look forward to your TDS recovery.

Mandelabra
Mandelabra

Wow, actual substance. Congrats!

Doug78
Doug78

Sure. It means fundamentals don't count for judging stock prices. On the other hand many companies that are private can give you beautiful returns.

Johnson1
Johnson1

Ray Dalio said recently that we could hit PEs of 50. All the money the CBs are printing has to go some where. As companies become monopolies in specific industries by buying up the competition you have fewer companies in the stock indices but the supply of money keeps going up. More demand and less supply causes prices to go up. I think I read the Wilshire 5000 only has 3500 stocks in it. It used to have 5000 stocks?

Inflation is all around us. ATH in the stock markets, Housing ATH, Food prices are at ATH.

Funny how commodity prices have been flat or dropping but finished good prices go up. Has Starbucks ever dropped the price of a cup of coffee when coffee prices plunge? Sugar has been in a multi-year downtrend because people are drinking less soda. Yet when I buy a 20 oz bottle of soda at the convenience store it is now $2.29. 6 years ago it was $1.69. Yes the price of sugar is down 50%.

My local sale tax 5 years ago was 7.5 and now it is 10%. Heck....I remember sales tax at 3.5%. I am guessing in 10 years from now sales tax will be at least 12% to 14%.

Johnson1
Johnson1

A trend I have noticed is everyone is going to a reoccurring subscription based business model. You buy a Tesla and buy a yearly service subscription of $4kish? Microsoft Office and other products are subscriptions. Amazon has a yearly prime subscription. A lot of companies start offering their service for free but nothing is really free. Eventually they add a subscription. Google used to allow you to upload pictures for free. Now they will charge a monthly fee. Buy an Pelton exercise bike and you will be paying $19 a month to ride it.

Sechel
Sechel

My view is passive investing makes more sense for fixed income especially for liquid government bonds and high grade corporates. What does make me nervous is being a passive , index investor in any market where similar investors make up too much of the investor base or in other words efficient market hypothesis becomes qustionable.

Doug78
Doug78

Mish, have you looked into the new draft rule from the EU, the Digital Markets Act? It's causing a lot of concern for companies who track their clients and using that to generate ad revenues. It could be something very important. Europe missed the train when it comes to google and Facebook-like companies but that leaves them free to regulate them which can't happen in the US.

numike
numike

How Compass Became the Bane of Real Estate
The high-tech real estate startup boasts SoftBank backing, a $1.6 billion war chest, and plenty of skeptics. Now it’s cashing in on the pandemic real estate boom. https://marker.medium.com/how-compass-became-the-bane-of-real-estate-dc3738641b57

Scooot
Scooot

A PE ratio of 33.56 is saying it will take 33.56 years to double your money with current company earnings. That’s like buying a 33.5 year zero coupon bond at a price of 50, returning 100 at maturity in 33.5 years, an annual yield to maturity of about 2.31%.

Now of course earnings won’t remain the same, but unless my thinking is muddled, they need to rise by more than inflation to beat 2.31%. Alternatively the PE ratio needs to rise by more than inflation each year, or a combination of both. They need to rise by more than real inflation to improve the yield, not the CPI or PPI.

That’s quite a risk for a 2.31% return so I guess the markets gambling the PE ratio will keep rising at a faster rate than real inflation, as the prospect of earnings doing so in the near future seems quite unlikely. Maybe I’ve got something wrong.

jivefive98
jivefive98

To say that passive investing is dumb is to discount John Bogle, who is responsible for many people having million dollar retirement accounts today. I would also like to mention my sister, born in 1973, at the bottom of the birth years at 3.1 million births that year. The number of births has gone up every year since 1973, year after year. My sister turned 47 this year, the exact time the average adult spends as much as they will ever spend in their life time (per Harry Dent). More and more adults, since 1973, hitting 47, every year, spending the most they will ever spend, year after year ... I really dont know where this all goes but WAY up.

RonJ
RonJ

"Regardless, history shows that valuations do matter. Japan provides the best example.

Will be different this time? Forever?"

It is never different this time. Nothing lasts forever. Something always seems to be as if it is never going to end, until it does. There is always an inflection point. The pendulum reaches an extreme and moves the opposite direction. With Covid economic shutdowns, we are sitting at an extreme. With humongous wealth among a sliver of people and humongous debt among the rest, we are sitting at an extreme.

Klaus Schwab calls for a Great Reset.

MarkraD
MarkraD

The difference between Japan's lost decade and current U.S. equity markets is that since 2008 the market is heavily bolstered by the FED, and more recently in the COVID crisis the Treasury (Mnuchin) purchasing equities.

In the aftermath of 2008 Congress flings stimulus at the masses without consternation or delay, for those who remember what it was like in '08, Republicans were actually trying to promote austerity in the middle of it. (Paul Ryan's "Path to prosperity", remember?)

I remember when "Keynes" was a shameful word on CNBC & FOX and with any GOP talking head being interviewed on TV.

I.M.O. the Tea Party's ridiculous extremeness destroyed public credibility for conservatism in the middle of the 2nd most extreme economic crisis in history.

When the car breaks down, you can't avoid paying for the tow, and as a result of that lesson we now pay for tows even if we have the ability to change the tire instead.

shamrock
shamrock

Among the developed world i think the nikkei is the only stock market which has stagnated like that. Japan is an outlier. So the question is what is uniquely different about japan?

Johnson1
Johnson1

Looking through the 15 or so fund options in my 401k plan. I am amazed that all are for the year and some are up big time. One growth fund is up 60%. Many are up 15% to 20%. Incredible year for stocks.

I remember some friends worrying about their stock investments last April but now they are happy. People are getting conditioned to buy the dips. I have a buddy who was saving up for a car and dumped the $25k into the market instead. Now he bought the new car and has $20k in cash. Another neighbor 17 year old son dumped his $10k in saving from mowing lawns into the market in April too. He bought Tesla, Chipotle, and Amazon. The kid now has $19k and cashed out.

With the financial engineering tools available to the Central Banks will we ever such a downward crash again like Japan did in this example?

Granted....the more they print the higher prices go. My house price increased over $100k in the past 3 years. It is like free money. That being said so have all the other houses so did I really see any gains.

Tengen
Tengen

If passive investing is wrong, then society is pretty well hosed. We can't expect regular people to constantly follow and correctly interpret these markets, especially when they're this nonsensical. The main ingredient of success today (besides insider trading) is front-running the Fed. If the Fed suddenly changes course, even a lot of clever people will take a bath.

Personally I like gold and Bitcoin as safe havens, but please don't ask me what to expect from them in the next 5-10 years. Prediction has never been this difficult as it is, plus there is a possibility of social unrest ahead.

anoop
anoop

The US is not Japan.

anoop
anoop

There are all kinds of checks that would prevent a disorderly unraveling of the market. Remember when Yellen said that we probably won’t have another crisis in our lifetimes?

amigator
amigator

This is almost all Fed induced. And don't forget the banks multiply the dollars created by the fed roughly 8 times (fractional reserve system).

Rhet
Rhet

What's the return if you dollar cost averaged into a Nikkei index fund over the past 30 years?

frozeninthenorth
frozeninthenorth

There was a time (in the 1990s) when the value of the land in Tokyo was worth more than the entire US economy...if memory serves the Australian embassy's land was sold for US$ 1 billion -- and the house of Pan Am's Tokyo head was also sold for US$30 million. Now lets take Tesla...

realTeacher
realTeacher

So, if a Japanese investor could have foreseen this trajectory, was there any Japanese-focused strategy that would have paid off? Or would they have had to invest internationally?

Ray555
Ray555

Hi Mish, I know you have been in the deflation camp' for some time and think you are making a big mistake and missing the bigger risk: inflation.
The book Democracy in Deficit by James M. Buchanan and Richard E. Wagner points out that it is less politically painful for governments to print money to finance growing deficits rather than cut spending or raise taxes. This results in inflation.
Stocks are attractive relative to nominal bonds because they retain and grow wealth to a greater degree than nominal bonds during inflationary periods. History is clear, when things 'get bad' governments tend to print money above all else. A review of Credit Suisse's Global Investment Returns Yearbook (Google it) shows returns to stocks, bonds, bills, and inflation since 1900 for many nations. As you are keenly aware, the money printing solution is currently in effect throughout the Western world.
Inflation is one of the most significant risks for long term investors. Deep Risk: How History Informs Portfolio Design by William J. Bernstein clearly articulates this.
I have 100% equities and a cash emergency fund in case of unemployment. I think you are making a mistake holding so much of your wealth in long term nominal bonds.


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