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?
Is Passive Investing Creating a Bubble?
Spoiler, YES!@DiMartinoBooth @profplum99 https://t.co/AXncgceM9N— Randy Woodward (@TheBondFreak) December 11, 2020
The Long Version
The long version is actually better. Mike gives additional details that are important to understand the ramifications of passive investing. https://t.co/BrOjEDydOT
— Randy Woodward (@TheBondFreak) December 11, 2020
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
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
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.
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?
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…
What’s the return if you dollar cost averaged into a Nikkei index fund over the past 30 years?
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).
agree. 70% of the US GDP is service based. You can only buy so much starbucks, haircuts, etc. This extra liquidity money flows in to assets like homes, stocks.
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?
The powers that be get better at faking, but it is still faking and reality will catch up. We can’t just pretend that we are wealthier than we are, and get away with it forever.
I have no idea what will blow up, but something will. If the Fed can somehow keep evading a deflationary correction long enough, maybe it will be at the expense of triggering runaway inflation.
One thing is for sure: it is hopeless now for the bottom 80%.
The US is not Japan.
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.
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.
Great post. People are taking MORE risk because money is cheap. At least the people with money realize they need to get more return in order to keep up with perceived inflation. But it is always lightest at the peak of the day and darkest before dawn. This is truly a bizarre time we are living in.
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?
Very little is fundamentally different about Japan, except that they arrived at this point earlier than the rest and central banks were reacting differently at that time.
From a non-investment standpoint, Japan does a lot of things better than we do, with a much more cohesive society. I envy them for the most part.
Shamrock, you’re totally blind to history. You can look back as far is you want , thousands of years, from Greece, to Roman Empire, to British Empire, French , Dutch, Spanish , Japan Nikkei etc… there always collapses whether in stocks or other means.
Ok, I’ll let you wait 10 lifetimes for that to happen. I’ll focus on the next 10 or 20 years.
US has already lost competition to foreign firms in
a) production of many physical goods
b) semiconductor manufacturing
Literally the only thing that’s keeping US up is the reserve status of the USD and the military that’s stationed around the world.
That’s it.
Began passively investing in Au and Ag back in 2001. So far, so good. 😉
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.
“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.
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.
So,The Sky is The Limit…again ?! I heard it before,believe me though, everything that goes up will come down at one point, next time it might be more dramatical than any time before, for this rally is merely a CBs driven one ! If you think it will go on for ever, good luck then, put them ALL in , your chips, take an extra mortgage if necessary! Yet I wouldn t be surprised if one day the DOW stands at 5000 again….Never mind….I am crazy, I know ! Btw , I am heavily invested in the markets myself, so I do hope my financial nightmares won’t come through ,not in my lifetime anyway….but I wouldn t bet my ass on it …so old fashioned as I am, I got some gold, I think it might be better than Bit or any other virtual, delusive coin…
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.
I wager a future Nobel Lauriat working out a formula that proves once a minority of a populace owns too great a share of it’s wealth, a limit is set on the returns they can yield on that wealth.
But where would you invest your winnings? -:)
I did make a calculation error, I put the wrong maturity date in the calculator, the yield should be 2.1%.
Thats interesting. I think inflation personally comes from the rate of change of quantity of workers and the rate of change of wages, and before covid in the USA wage growth was at 3.5% and heading steadily up
while employee count was heading steadily down (difficult to find the rate) but boomers definitely retiring. So the fed definitely letting wages run hot presumably to compensate for the declining numbers. PE though, is entirely affected by profitability and the nature of companes not just a mechanical coupling of the numbers. High PE could easily be an increase in monopolistic structures across industries. Think facebook for advertising, Amazon for logistics.
Having said that, of course print money and valuations go up and thats the invisible hand.
You forgot the “greater fool” theory. Nobody today is buying a stock to hold for 33 years, just like nobody is buying a 30 year bond to hold to maturity. Think about it; would you allocate 50% to long-term Treasuries and 50% to SPY today and plan to hold for 30 years?
“Nobody today is buying a stock to hold for 33 years”
Plenty of 32 year olds planning to retire at 65 are.
I wasn’t suggesting they were. It was just a different way of standardising a means of valuation to compare assets and help gauge how cheap/dear they are. They are extremely expensive.
However, as@Rhet says, many people are buy and hold investors, that’s essentially what passive investing is all about. It’s true that the recent bubble has encouraged many people to “trade”, and they’ll continue to do so until it goes wrong. However the current view seems to be it can’t go wrong, it’s so easy, free money for ever. So the elastic band will probably get stretched a bit more.
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. link to marker.medium.com
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.
The Act is here: link to ec.europa.eu
Thanks
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.
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.
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%.
Soda is sweetened with high fructose corn syrup. Rarely is it sweetened with sugar any longer.
Actually HFCS production peaked awhile back. Sugar is back in several mainstream sodas thanks to mexican coke, cane pepsi and other alternatives with sugar.
Very good observation about monopoly creation. As corporations like the rest of the herd is in a mad scramble for hard assets, investing in questionable entities seems like a good bet – and monopolies of every kind is a predictable outcome.
Thank you imbeciles centrales.
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.
Wow, actual substance. Congrats!
Tell Orange Julius to concede, then we can all finally ignore him.
Wow, an insightful article. Look forward to your TDS recovery.
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.
It sure feels like gambling these days. Interesting fact but there are more ETFs and mutual funds than there are actual stocks.
How can this be a good thing?
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.
It is different this time because the Fed is doing even more. They refuse to let 2008/09 happen again. How long can this go on ? The Fed is playing with fire but it is all just digital money. There is very little printing going on. A number gets created on some computer at the Fed and assets get bought with that “money”. There is a twin money system but it has nothign to do with paper money.
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.
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.
At the starting point to now, perhaps. But the 1990 Peak or even 1985 to 2009, killed.
Exactly. It is impossible to time the market consistently. It is also important to rotate from the winners to losers on a quarterly basis.
They’d be up. But based on the calculations I did the theoretical compounded return over the 30 years was 2.02%. In practice it would be less.
The algorithm I used to get the numbers assumed a buy at the closing price of the 15th of each month. If there was no data for the 15th I used the 16th, 14th, 17th and 13th in that order (e.g., if there was also no data for the 16th I used the 14th, and so on).
While any value would do I used a regular purchase of $200/month. There were 372 purchases (to date) totaling $74,400. Shares bought each month = $200 / index level. Total shares bought = 5.070916906. The latest close stockcharts has for the Nikkei ($N225) is 26757.4 for 12/16. The total value = shares x index = $135,684.55. Growing to that from $74,400 over 30 years is a 2.02% compounded return.
This also ignores transaction costs and in reality the Nikkei cannot be bought directly. An ETF / mutual fund would have to be used and the expense ratio would eat at that return even more.
Also, how many people would stomach 18+ years of losses on all DCA’ing before finally having some positions go positive?
We know now how long it took but someone who started at 25 was underwater on every DCA purchase made by age 44 and they would have no idea how much longer this would go on. It’s one thing to look back with hindsight. Quite another to experience it in real time. The older one was when they started the scarier it looked. Getting the rather piddly return also assumes nothing came up that forced them to sell because they needed the money before the market could turn in their favor.
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.
How long can the keep it up. How do you turn risk assets into non-risk assets without throwing the whole system off balance.
This is impossible to say because the dollar has the advantage of being THE global reserve currency not just another currency. The yen was never that which is why it got devalued so much.
Not to mention the Wilshire 500o to GDP
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.
I never claimed the DOW is the Nikkei or would follow that path. Pensions plans will be crucified if the stock market does nothing byt go sideways for 10 years.
Even if it goes sideways they will be better off than doing what the Nikkei did. There would be blood in the streets if what happen there happen to the US markets. This isn’t the same stock market that values earnings. It is actually a store of value now where money HAS to go because in order to get any return. I don’t think they will ever admit it but this is what the Fed wanted all along. They can now control the pension crisis by buying more bonds of all kinds and flooding the stock market with more money. There is no going back.
Your correct in thinking pension plans will go crucified….but not most of the government pension plans. They can always tax people more (which happens every year). I have seen the local state budgets see the pension obligations over the past 20 years rise from 25% of the general budget to almost 40%. People should go look at their city and county budgets and look to see how much of the budget is to cover pension plans. It is only going to get worse. They will tell you they need to raise taxes otherwise they will need to fire police or fireman but the real cost increase in pension obligations.
Consider the political implications of pensions being crucified. And its not just pensions, its 401ks and essentially all retirement vehicles. Except one: Social Security. Who in the financial community wants the general population to only consider the government to be a true source of security? How would that view effect taxes, regulation, costs and the whole fight for neo-liberalism over the last 50 years? The Fed will do whatever it takes, and in my opinion it has the capability.
Maybe the FED is following Japan. Japan had an aging demographics slowing population growth. The Nikkei bottom was about when Japan started ZIRP. Japan interest rates dropped almost to zero in 1995 and were zero a few years later. That did not stop the market from dropping another 50%. But in 2009 they started buying ETFS and kept ZIRP going. That really made the Nikkei take off and gain almost 300% on almost zero population growthh. After all, I believe they are fighting deflation because Japan’s population is in decline as of a couple of years ago. If you have a smaller population then demand goes down as you need fewer homes, stores, land, stocks, stores, goods, services, etc. More supply than demand and in theory prices drop. So what does the Bank of Japan do….they buy assets to create fake demand.
“The Dow isn’t the Nikkei. Central banks have learned from Japan’s mistakes.”
I don’t think the Central Banks have learned anything. Bernanke said the housing problem was confined to subprime. It wasn’t. Yellen said she didn’t even see 2008 coming. Trump had to hound Powell to cut rates. In fact, Powell had the wind down of their portfolio on auto pilot, only to shortly afterward reverse course. Covid wasn’t even an issue, then.
The central banks have nothing to “learn”. They operate for the benefit of the wealthy, transferring assets from taxpayers to the rich whether bust or boom 24/7 every minute and second of the day they rig the game in favor of the rich.
There is nothing to “learn” here.
I don’t think the intention is to “rig it” in favour of the wealthy, it is just a consequence of their actions. I think they “rig it” because they believe a collapse in the financial system will be worse for everyone than allowing the market cycle to proceed naturally, at least in the short term. Maybe I’m being naive. However, I suspect they’re just kicking the can down the road but we’ll have to wait and see.
I think what you’re saying is what the FED wants a regular citizen to believe.
The consequence is to “rig it” , but the intent wasn’t. Riiiiiiiight. There are enough smart people at the FED, smarter than you and I, who know what’s going on and what the consequences are. The FED works for the big boys. If it worked for everyone the policies would be different, and there wouldn’t be easy money for 10 years.
If people knew what the FED was doing and the real consequences of their actions, they would wake up and demand accountability. FED has nice PR – aka “we’re just here to support the economy for everyone”.
“There are enough smart people at the FED, smarter than you and I, who know what’s going on and what the consequences are.”
And everywhere else, the trouble with such a theory is that everyone has to be in on it. Every politician, right wing or left, good or bad, everyone needs to want the Fed to succeed in this hidden scheme. There are lots of smart people at the the Fed, but in my opinion they and the politicians would rather let someone else deal with the problem in the future than admit they’ve been leading everyone into a black hole. A classic case of when a bird in the hand isn’t worth two in the bush.
Earnings revert to the mean. That is the entire point of the Shiller PE that I referenced
Smoothed. The Fed is doing their own smoothing and hoping to avoid a huge decline.
They do revert eventually but as Keynes said “Markets can remain irrational longer than you can remain solvent.” Aye, there’s the rub.
I think you miss an important issue in regard to MMT and the extend to which Fed will intervene. the Feb will launch itself directly into the market and buy equities and hold. they can will hold for decades if need be. Balance sheet debt does not dissuade them.
Interest rates matter too. Will those ever revert to the mean?
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.
Not missing the point at all. Earnings revert to the mean. That is the entire point of the Shiller PE that I referenced
Trend & Momentum matter. The passive index side creates the trend and the trend/momentum players jump on/off and monthly contributions keep rolling in.
Passive is ok if you overlay indicators to help with buy/sell decisions. It’s the buy and hold brigade, if they have a relatively short time frame, taking the most risk.
A passive fund with active overlay can be really neat.
Particularly neat if you diversify appropriately with multiple passive funds tracking geographic spread and asset classes. Do it properly and valuation needn’t be as critical. Only major crashes really spoil the party and that id where assets class diversification helps.
If the rate of change of price (second derivative) is scary, a blow off peak forming, get out. Same for anomalous volume changes.
That said, have been substantially scaled back on US exposure in favour of EM, Japan and UK.
I like Japan, Yen-Hedged
If you remove the overvalued high-flying names in an index such as SP500 (AAPL, MSFT, AMZN, FB, etc) then what would the forward PE of the index be? I bought both of Shiller’s books and basically says low PE stocks produce superior long term returns compared to high PE stocks. Shouldn’t passive investing be ok if you follow Shiller?