“Forget the past. The future will give you plenty to worry about.”
– George Allen, Sr.
“I try not to worry about the future, so I take each day just one anxiety attack at a time.”
– Tom Wilson
The middle ground can be uncomfortable. As someone now widely known as the “muddle-through guy,” I have learned this the hard way. My bullish friends call me a worrywart, and the bearish ones think I am Pollyanna incarnate.
The irony here is that I’ve never claimed to be a great trader or a short-term forecaster. I think I have a pretty good record of calling major turning points. Next week or next month is another matter. Anything can happen, and it probably will.
That said, the fact that my forecast may be wrong doesn’t prevent me from making one. So, with all the usual disclaimers, today I will review some recent analysis from my reliable sources and let you take a peek into my worry closet.
One point we all agree on: We live in unusual times.
Sell to Whom?
Last week Doug Kass sent around an e-mail comparing today’s markets to Queen’s classic “Bohemian Rhapsody.” I know that seems odd, but it was actually a good fit. The point is that, like the song says, “Nothing really matters” to whoever is buying stocks these days. They just keep buying and pushing prices higher. As Jared Dillian says, “It’s a bull market, dude!” Stock prices do go higher in a bull market; and sometimes, as the end approaches, they make value investors very uncomfortable.
Neither Doug nor I quite understand the “Nothing really matters” attitude, though we have some theories. Doug is probably more bearish than I am. He has a long list of open questions. I zeroed in on the last one, which is critical: “When ETFs sell, who will buy?”
The stratospheric ascent of passive indexing is having side effects that I suspect will make markets sick at some point. Passive investing is perverting the financial markets’ core economic function, i.e., efficient capital allocation. In terms of stimulating buying interest, a company’s fundamental business prospects are now much less important than its presence in (or absence from) popular indexes.
We’ve created this environment in which badly managed companies can still see their stock prices rise along with those of well-managed companies. The actual facts about a company don’t mean all that much in a passive-investing world. Capitalization-weighted indexes aggravate this already problematic phenomenon. Money is pouring into stocks like Apple (AAPL) and Amazon (AMZN) simply because they are big. The resulting higher prices make them bigger still, and they pull in yet more capital. Here’s a look at the five largest stocks in the S&P 500.
What about the QQQ or the NDX? The five stocks above represent 42% of the NDX and 13% of the S&P 500. That means every time you buy an index based on the Nasdaq, 42% of your money goes into just five stocks, leaving 58% for the remaining 95. By the time you get past the largest 25, you are under 1% per stock. Apple alone is 12% of the Nasdaq 100 Index and 4% of the S&P 500. That explains, in part, why the Nasdaq has outperformed the S&P 500.
For the record, Goldman Sachs researchers recently released a paper with a strong fundamental forecast for those stocks. That is, they expect them to continue to go up, absent a recession or something else that triggers a bear market. I keep scanning the horizons in every direction, and I just can’t see anything that would trigger more than a minor correction today. Of course, a minor correction could deliver outsized impacts, given the heavy weighting of a few stocks and passive index investing. Be careful out there.
