Avoid Predicting The Future By Extrapolating The Past

Given that the Index is market-cap weighted, the future expectations of a positive outcome for the largest holdings could, in our view, already be baked into the stock prices. Odds are that the top 10 largest holdings of today might not be the largest 10 years from now. For example, in 1989 the largest companies in the world were Japanese. Since then, Japan’s economy has been stuck in the mud. In 1999, the largest companies were tech and telecom related to dotcom and the Internet. It took 15 years post-bubble before the Nasdaq Index reached its pre-dotcom bubble peak value. Finally, go back to the end of 2009; most of the top 10 companies were all based on the future of China and its ability to sustain 10% GDP growth. Investors were banking on continued strength from the BRIC countries (Brazil, Russia, India and China). Fast forward to today, and many investors question if the Chinese economy can maintain 6% GDP growth. Lesson learned; when looking at index funds today, chances are the top 10 might not be so in 2029.

Don’t Forget Valuation

As the market value of a company goes up, so too does its valuation. Investors buying a passive index fund need to be mindful of what they are paying for. At current levels the S&P 500 is trading at 18.1x Wall Street analyst earnings estimates. This is a 20% premium to where the Index has traded over the past 10 years, and 15% over the past 20 years. Part of this is justified because interest rates are so low. If bonds are offering just 2%, and cash less than 1.5%, then investors are pushed out the risk curve into stocks because there are no alternatives. The economy is fairly healthy, inflation seems contained, and businesses are reinvesting cash and returning it to shareholders. So, despite normal day-to-day volatility, the backdrop for stocks to appreciate appears to be good. However, at current valuations, the margin of safety, or room for error, is slim. Shocks to the system will be met by a pullback in equity prices because valuation multiples are elevated.

Diversifying your assets is Investing 101. Spreading investments across various asset classes, stocks, regions, credit, investment type, is the one way investors can compensate for not having a crystal ball to predict the future. As an active manager, we have a fiduciary responsibility to diversify our clients’ assets in an appropriate way to meet a certain investment policy guideline. Investors have embraced index funds, particularly the S&P 500, to simply own the market. However, we believe given elevated valuations, individual position and sector concentration, and lack of international exposure, buying the S&P 500 Index fund today is like buying a used car without opening up the hood and taking it for a ride….do you really know what you are buying?

John Petrides is a portfolio manager at Tocqueville Asset Management.

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