Indexing Your Way to Investment Success

“Never bet against a stock index.” – The Lonely Realist

America’s stock markets have been on a tear for the past 15 years. The S&P 500 index, down below 700 in March 2009, now is cresting 5,300, having increased more than 7.5x. Can it continue rising to ever loftier levels?

A significant number of investment professionals say “yes.” They believe that today’s momentum-dominated investment strategies will continue to drive stock prices higher. Indexed mutual funds, stocks selected by algorithmically-dependent advisers and by the apps of millions of retail investors represent a majority of stock market capital. Employing strategies that are largely equivalent means that their aggregated buying power has a disproportionate impact on individual stock prices and on the indices that include them, levitating those that are in favor. As long as the U.S. economy generates excess cash a portion of which naturally finds its way into the stock markets, the momentum buying funded by that cash will continue driving up the prices of commonly-owned securities. With index funds having grown from an insignificant $21 billion in 1993 to a managed-fund-majority of $9 trillion today, they and their momentum-emulators are the coordinated owners and continued buyers of ever-upwards America’s highest-priced securities. The enormous flow of cash into America’s stock markets has been funded by government printing presses that have spewed out cash to avoid, first, the adverse impact of the 2008-09 Great Recession…, then the potential for economic fallout that followed during the 20-teens…, then the consequences of the COVID pandemic…, and now to fund the re-election of politicians America’s global competitiveness versus China, Russia, Iran and North Korea. Excess Federal and State spending will continue (with neither Democrats nor Republicans having an interest in deficit-reduction), funded by continuing deficits and Federal Reserve largesse, the same policies that have energized America’s economy since the Great Recession. Despite the risks, there is no sign that it will stop…, and a large portion of that spending will flow into momentum-driven stock investing.

Momentum investing, whether practiced by index funds or their algorithmic and app emulators, is a passive investment strategy. Individual stocks are not selected based on their earnings or research into their relative value. The companies in the S&P 500 and the Nasdaq Composite Index are not analyzed or evaluated based on their fundamental strengths and weaknesses or their potential for growth. Momentum is value indifferent. The higher the price of a stock, the more momentum it has and the more investment-magnetic it becomes, such that overvalued stocks are among the most attractive investments. Index funds invest in all the stocks in an index based on the relative price of each stock, making periodic adjustments to preserve the same relative balance. As a consequence, if certain stocks are increasing in value faster than others, their price momentum requires index funds and their momentum-driven brethren to buy more. Companies with higher market capitalizations accordingly will have a disproportionately greater weighting and will disproportionally attract capital…, as the Magnificent Seven have demonstrated. As long as money is flowing into the stock market, momentum leaders will be the primary beneficiaries. The continuing flow of cash into the American economy has stimulated, and will continue to stimulate, investment flows into American stocks, magnifying upward price momentum in what has been a self-perpetuating cycle.

Since publicly-traded securities today are owned mostly by passive investors, there is a mistaken belief that the remainder must be owned by active investors whose investment decisions are based on fundamental value. That is not the reality. The active investor community has been largely replaced by momentum, with those who pursue value having neither the time, the expertise, the training, nor the tools to compete. As David Einhorn has pointed out, the impact on market prices of the relatively few remaining value investors has waned to the point of irrelevance. Investors who have resisted momentum necessarily have underperformed. Those investors who, for example, resisted going all-in on the AI story performed significantly below their momentum-driven competitors.

Momentum accordingly is determining price. As long as there is cash flowing from government coffers, prices are fated to continue soaring. Since both Presidential candidates are promising Federal stimulus and/or tax incentives, there is a substantial likelihood that America’s stock markets will continue to soar to ever higher highs. Should that flow reverse, however, should America’s cash flow hose develop a crimp, momentum will reverse. Will passive investors then pivot away from bad investments, weak securities, or an unfavorable economic or market environment? Or will they stick with their momentum-driven investments?

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Finally (from a good friend)

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