I try to invest rationally, not emotionally. That means that while I never participate fully in a bull market, I also manage to avoid bear markets.
What I have consistently done in my 40 years in this business is keep my clients out of trouble – but in manias like the one we are in (and have been in for some time), the label “perma bear” to describe people like me is used en masse.
I don’t believe that we have “new eras” or “new paradigms” but rather that we have inflection points around trendlines. Wars, pandemics, elections and technological advances come and go and can affect the trajectories of markets. But the basic math behind rational investment decisions never changes and never goes out of style, despite what the hucksters tell you. I don’t believe the business cycle is dead, either.
What I also believe in are (a) capital preservation, (b) the preservation of cash flows alongside that (dividend yield and growth), (c) diversification across asset classes and regions, (d) portfolio rebalancing (booking profits) when it makes sense, and (e) having respect for the present-value cash-flow discounting mathematics embedded in the discount rate, which is a concept that has been thrown into the dustbin this cycle.
But one of the things keeping me awake at night is that we are in a bull market that has been built on the general public investing blindly. This is also a demographic problem because the aging and aged throng of baby boomers are behaving as though they are in their 30s, as opposed to their 60s and 70s.
We have a situation where well over 70 per cent of the U.S. household sector’s financial assets are concentrated in the equity market (just 8 per cent are in bonds). Few have chosen to take profits or rebalance their portfolio in what is among the top 10 per cent most expensive U.S. markets of all time, with a forward P/E multiple north of 21 times (whereas the “fair value” is closer to 16 times under the current 4 per cent to 5 per cent interest rate backdrop).
The U.S. market is more than 30 per cent overvalued, and while not a timing device, it is a warning sign about expected returns, nonetheless. All new entrants to the equity market are now chasing nickels in front of the steamroller. And existing equity owners, who must feel they have won a lottery ticket with the S&P 500 market cap growing by 25 per cent in just these past 12 months, have not bothered to make any adjustments to their asset mix.
Accelerating technology and the continuing wave of financial products have not changed basic human nature, which involves those two extreme emotions of greed and fear. These never go away. “Peak greed” at historically high valuations should be repelled at this time with money market funds, Treasury securities, and even A-rated corporate paper paying you decent yields to wait.
It is the structure of today’s market that is the elephant in the room: The most highly overvalued and bifurcated equity market since the late 1990s is occurring at the same time that households have exposed themselves to concentration risk to a degree that they don’t remotely appreciate, or even understand. Over half (53 per cent) of the market today is owned by passive index funds.
You read that right – there is more money in passive index fund investments than in actively managed accounts. It is a new era, indeed: the necessity of doing research on individual company income statements and balance sheets no longer exists.
One small slip-up, especially given the intense concentration in this market, and the selling will accelerate sharply with no buyer on the other side. This is when we get into a liquidity crisis – and the winners will be today’s alleged losers who are on the sidelines sitting on 5-per-cent-plus yielding cash. That is the thing with passive index investing – these funds track the entire market; they have no choice but to take the inflows they receive and invest in the stock market based solely on index allocation, with no regard to fundamentals, valuation, or technical analysis.
Index funds have come to dominate the composition of most retirement accounts – ETFs now make up 23 per cent of self-directed assets, for example, nearly doubling in the past decade. And what is even more problematic is that when the inevitable turn comes, is that these passive index funds are stuffed in baby boomer 401(k) plans (the RRSPs of the U.S.). Roughly 60 per cent of U.S. families with the head of the household aged between 55 to 74 own equities, and their median stock market allocation in terms of share of the asset mix is also nearly 60 per cent (a quarter-century ago, both these numbers were closer to 30 per cent).
An ever-rising share of 401(k) plans stuffed with these passive indexed funds will make the situation more difficult for them once the bull market ends, which it most assuredly will at some point. What people tend to forget is that bull markets are escalators going up while bear markets are elevators going down. Time is not on your side once the next bear market rears its ugly head.
Something tells me we are going to see one boom take hold: a surge in these currently retired boomers applying for cashier jobs at the local grocery store once the tide goes out. Not in the 1929 crash, nor the Nifty Fifty bubble-bust, nor the dotcom fiasco, nor the housing crisis, have we seen folks in their 60s and 70s so exposed to equities to the degree they are today – and at or near the peak of a gigantic bubble not just evident in prices but also in sentiment and extreme concentration.
The next bear market will carry with it a retirement crisis that nobody is willing to discuss. Should we not be considering, right at this moment, what could happen to the price of the S&P 500 if outflows replace the inflows and this maniacal trading activity in high-flying AI-related concept stocks begins to subside?
I never get asked that question, which is why I pose it.
We are in a huge mania, especially when it comes to mega-cap tech stocks. The growing dominance of passive index investing has compounded the bubble. And the fact that people in their 60s and 70s, who used to have a 30 per cent allocation to the equity market in their asset mix but now have double that, have either unwittingly or deliberately exposed themselves to the ravaging effects a bear market brings.
This will become a huge societal problem once the masses realize that they will not come close to affording the retirement lifestyle they either aspire to or currently enjoy.
In a bear market, the buying dries up because even potential bargain-hunters with liquidity are hesitant to come in and support the market as prices deflate. This is why every bear market ends with valuations at stupid-low levels, just as the bubble peak ends at crazy-high multiples.
Cycles exist and human nature never changes. Never. Like the fibre optic, router, and telecom equipment craze of two decades ago, generative AI chips today and in the future do not change the fact that, at extremes, sentiment becomes a primary driver of the market. Human nature, the complacency of the current investing environment, the stories that you hear the pundits come up to try and fit the narrative to the parabolic valuations, and the willingness of the huge baby boomer cohort to invest blindly – jeopardizing financial future – are all the things that keep me up at night.
Bottom Line: By definition, passive investing does not involve what you learn in the CFA courses, which provide you with the tools for making prudent decisions: the ability to separate the winners and losers, to rebalance the asset mix, or to allocate capital efficiently. In other words, what the passive investing mania ultimately lacks is flexibility, which the unsuspecting souls in these funds will discover when they try to sell into a market dominated by hesitant buyers once the turn begins. This future imbalance then reinforces the downward momentum in the overall market as it replaces the current imbalance between buyers and sellers, with all the index buying that has particularly dominated the last leg of this mania over the past few years (and especially these past 12 months).
But nobody believes we will ever see a bear market again and nobody believes that the economy will ever slip into recession, even though these things happen. Markets and the economy move in cycles. No one can time the turn, and the race to the bottom hasn’t happened yet.
Yet it will. And when it does, it will be wonderful if you do have liquidity, but devastating if you are “all in.”
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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