To My Clients, Friends, & Observers
First, the good news. In my January commentary I noted that the market needed S&P 500 earnings of $105 in 2017 to justify its price of 26 times earnings. Corporate earnings momentum has strengthened and I expect that earnings of $105 will be reported for the 2nd quarter ending June 30th. That would be a 21% increase over 2nd quarter earnings in 2016. Furthermore, the senior index analyst at S&P forecasts full-year earnings of $118. Accepting that implies another 10% upside at a P/E ratio of 25, i.e. S&P 500 circa 2650. The market appears quite comfortable at this valuation, incrementally edging to new highs week after week.
The lack of market volatility has raised concerns in some quarters and not without reasons. The last 10% market correction was from November ’15 to February ’16 (actually 11%). Since then we’ve seen two brief 5% reversals, June of ’16 and August to November ’16. Money continues to flow from actively managed mutual funds to passive indexes and exchange-traded funds (ETFs). While that is a contributing factor it is secondary to secular earnings growth.
And what of the post-election bump? Any new administrative/legislative accomplishments would probably require two years or more to ignite an economy that has been growing so slowly. And the political parties are engaged in a Pyrrhic war that is delaying or denying any significant progress on corporate and personal taxation, infrastructure, and structural unemployment, let alone healthcare and immigration reforms. The nation appears unbalanced and ungovernable.
Indexing and Passive Investing
It would be my advice to anyone who has the slightest suspicion about Wall Street to take the counsel of a professional who is intensely knowledgeable of Wall Street.
Years ago I collected the covers of several Money magazine special editions featuring “the best” mutual funds – “the funds you must own now.” Over a four year period not one mutual fund ever repeated – a perfect demonstration of investing in hindsight, or “rear-view mirror” investing, the practice of which most individual investors find themselves susceptible. Most magazines make most of their money from advertising and public relations, not subscriptions. PR firms provide publications with popular articles written at the behest of the parties promoted therein who pay for its publication. There is nothing illegal or even unethical about this. The press has the right to publish whatever it chooses. But caveat emptor, let the buyer beware.
The venerable John Bogle is quoted often in the financial press, relentlessly promoting low-cost index funds. He founded Vanguard Funds which sponsors the very same low-cost index funds he promotes. Vanguard is also one of the largest advertisers for mutual funds.
An index is not an investment. An index is a valuation model of an underlying basket of securities. It bears no costs of administration, selling, or trading. Because of this an index fund can never match the performance of its index. An index fund is invested virtually 100% in its underlying securities 100% of the time, without consideration of market risk. The best argument against passively investing in an index fund can be illustrated by a chart of the S&P 500 Index for the 10 years from March 1, 2000 (closing price 1498) through March 1, 2009 (closing price 667). A 65 year-old retiree would have lost 55% of principal over that time period - without allowing for periodic withdrawals for living expenses. And he or she would be 10 years older.
Exchange traded funds (ETFs) are baskets of stocks or bonds which value is the weighted average price of its components. This value is called the Indicated Value (IV). The ETF price can trade above or below the IV. Market makers for ETFs are charged with maintaining an orderly market in the securities they trade. They are termed Authorized Participants (APs). Market makers make their profits by keeping the spread between the bid and the ask prices. If demand for an ETF exceeds supply, the AP will create new shares by buying the underlying stocks and selling new ETF shares. If sellers exceed buyers the opposite occurs. APs are mostly affiliated with the same brokerages, wirehouses and firms that sponsor the ETFs they make markets for. Trading creates revenue.
ETFs were not created to save the investing public money, or to reduce expenses, or be more efficient. ETF products are sold to make money for their producers. And that they do. Count the advertisements and promotions for the funds, the sponsors, the sectors and the brokerages which profit from ETFs.
When some or all of the underlying stocks trade wildly in times of volatility, or worse, if they stop trading, the value of the ETF cannot be accurately determined. That value is determined, arbitrarily, by the AP who sets the bid and ask prices. In volatile markets – or halted markets – when buyers and sellers can’t be matched up, those spreads get very wide. The market is then whatever the AP says it is. It is common during volatile periods for an ETF to trade down double digits, while the IV of the underlying stocks is only down single digits.
According to Rodney Johnson, posting on David Stockman’s Contra Corner blog on 8/26/15: “This morning the Wall Street Journal reported how the Vanguard Consumer Staples ETF fell 32% Monday morning, while the actual IV fell a mere 9%.” That is not an “orderly market.”
In the April 15, 2017 Wall Street Journal, Jason Zweig’s column, “The Intelligent Investor” is headlined The Expensive Element Of Trading Cheap ETFs. He addresses the accumulated trading costs of balancing ETFs and their underlying securities. Citing a study published in the Financial Analysts Journal by portfolio manager Antti Petajisto he states, “Market prices exceeded net asset values by an average of 0.18% among precious-metal funds, 0.29% in short-term bond funds, 0.31% in corporate, high-yield and emerging-market bond funds, and as much as 0.37% in foreign funds investing in small stocks. At individual funds they can be much wider.
“ ‘I was surprised both by how large and how common these differences are,’ says Mr. Petajisto. Even if you trade only a few times a year, ‘your ETF portfolio could easily be costing you 1% or 2%, and you might not even know it.’”
Assets invested in ETFs have surpassed $2.7 trillion. As investment in indexes instead of individual securities grows, there is risk that fundamental security analysis is overlooked or ignored. The financial performance of individual corporations is valued less than their capitalization-weight in an index. This transfers power from the financial analysts to the persons who determine the components of the index.
This can be dangerous and has led many analysts, and me, to consider ETFs potential “weapons of mass destruction.”
When I want exposure to a particular index, I use open-ended index mutual funds, priced daily at the Net Asset Value (NAV) of their components, and I buy them at NAV. There are only two that I position – one for technology and one for small caps.
A Couple of Reviews
I finally got around to reading Charles Murray’s Coming Apart which has sat on my night table for over a year. Mr. Murray was the guest speaker who was assaulted by students at Middlebury College last spring. I did my fair share of protesting and demonstrating during my undergraduate years. I can’t fathom why any open-minded person would object to letting Charles Murray speak.
Coming Apart is a comprehensive statistical analysis that explains in charts and graphs how America has produced an elite and increasingly insular “knowledge class.” It documents the growing disparity of incomes between the upwardly mobile elite and near-elite and the falling middle and lower economic classes. It’s a compelling work and it’s been generally well- received from left to right in academia. It is a 21st century, data-based update to C. Wright Mills’ classic book The Power Elite, which examined American social stratification in 1956. Mills was a maverick Columbia University sociology professor. A couple of his quotes:
“People with advantages are loath to believe that they just happen to be people with advantages.”
“In the world of the celebrity, the hierarchy of publicity has replaced the hierarchy of descent and even of great wealth.”
And isn’t that the truth. Speaking of which I saw a very entertaining play Saturday evening which rang quite true: 4000 Miles by Amy Herzog. It is a poignant, thought provoking mirror of contemporary America. Off-broadway for a couple of years, it’s being picked up by regional troupes around the country. We saw it at Shakespeare & Co., in Lenox, Massachusetts.
Dennis M. O’Connor
PS: At the acropolis at Lindos on the island of Rhodes, April 2017
Eudemus, one of Aristotle’s most brilliant students, founded a school of philosophy here.