A Mother Bubble - Investors Beware?

Authored by: James Rickards

The Dow Jones Industrial Average (DJIA) was 36,800 on Jan. 4, 2022, an all-time high. It’s about 35,450 today. That’s down 3.8% over the past 18 months. That decline is nominal. But if you adjust for inflation, the DJIA was down 6.42% over those 18 months.

The same applies to the S&P 500 index. The S&P was 4,794 on Jan. 4, 2022, also an all-time high. It’s about 4,559 today. That’s down about 5% over the past 18 months. That decline is also nominal. If you adjust for inflation, the S&P 500 was down 8.25% over those 18 months.

The Nasdaq Composite Index was 16,057 on Nov. 19, 2021, another all-time high. It’s about 14,065 as of today. That’s down about 14% over the past 20 months. Again, that’s a nominal return. Adjusted for inflation, the Nasdaq Composite was down about 17.5% in the past 20 months.

Are we having fun yet?

The thing is, investors have trouble internalizing these steady declines. Haven’t stocks been on a tear lately? Yes.

Aren’t we hearing soft-landing scenarios, Goldilocks narratives, and “no recession” forecasts from Wall Street analysts and financial TV talking heads? Yes.

Aren’t more companies achieving previously unheard-of trillion-dollar market capitalizations? Again, yes, and it’s not just Apple.

So, the market has been down over the past 18–20 months and down even more adjusted for inflation. Most people don’t focus on that. But the numbers don’t lie. Down is down.

Weighted Stocks Makes All the Difference

Some nuance is required in this analysis. While all major indexes are down since late 2021 or early 2022, certain stocks are up significantly. Apple is at an all-time high today. So is Nvidia, fueled by the AI craze.

Tesla is not in the all-time-high club, but it is up something like 160% on a year-to-date basis. And that kind of performance is precisely what’s blinding investors to the state of the real economy.

The first analytical difficulty is that the S&P 500 and Nasdaq Composite are both cap-weighted indexes. That means gains in stocks contribute to the index in proportion to their market capitalization as a percentage of the total market cap of all the stocks in the index.

In plain English, gains in more extensive stocks impact the index more.

This creates a positive feedback loop. A mega-cap stock goes up, and the index goes up with it. More money is poured into the mega-cap, which increases the index, draws in more money, and so on.

Buying the index is equivalent to purchasing the mega-cap stocks outright since the ETF manager has to spread new investments on a weighted basis. The money ends up in the same few stocks.

For the Nasdaq, market-cap weighting means you get Apple, Microsoft, Alphabet, Amazon, Nvidia, and Tesla. Those six stocks comprise a dangerously high 50% of the total Nasdaq Composite.

The other 94 stocks are mostly trivial by comparison. The same extreme concentration exists on the S&P 500, where five stocks are over 40% of the index, and the other 495 are of little significance in index performance.

The actions of institutional investors, including pension funds and endowments, amplify this feedback loop dynamic and a high degree of concentration.

The result is that you have too many eggs in one basket. That makes the market vulnerable to sudden reverses.

The Two Fallacies of Passive Investing

Over 80% of stock trading is automated in either index funds (over 60%) or quantitative models (under 20%). This means that “active investing,” where you pick the allocation and the timing, is down to less than 20% of the market.

In all, the amount of human “market making” in the traditional sense is about 5% of total trading. This trend is the result of two intellectual fallacies.

The first is that “You can’t beat the market.” This drives investors to index funds that match the market. You can beat the market with good models, but it isn’t straightforward.

The second fallacy is that the future will resemble the past over a long horizon, so “traditional” allocations of 60% stocks, 30% bonds, and 10% cash (with fewer stocks as you get older) will serve you well.

But Wall Street doesn’t tell you that a 50% or greater stock market crash — as happened in 1929, 2000, and 2008 — just before your retirement date will wipe you out.

In a bull market, passive investing amplifies the upside as indexers pile into hot stocks like Nvidia and Apple. But a slight sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock.

The market crash will be like a runaway train with no brakes. There’s a short name for this combination of the feedback loop, market concentration, and tagalong asset management — a bubble. Or, in this case, a super-bubble.

Bubbles Are Easy to Spot

Most Wall Street analysts (and famously Alan Greenspan) claim that bubbles are difficult to identify and should not be popped by policymakers. That’s false on both counts. Bubbles are incredibly easy to spot.

Just look at a chart of the Dow Jones in 1929, the Nikkei in 1989, the Nasdaq in 1999, or Bitcoin in November 2021, and you’ll see what I mean.

Regulators should pop bubbles when they see them. The trouble is they don’t see them. They prefer to wait until the bubble pops and then ride to the rescue.

That’s far more costly than preemptive action, but regulators (especially central banks) prefer to be seen as “white knights” rather than the bad guy who takes away the proverbial punch bowl.

So yes, bubbles are easy to spot. The difficulty is knowing when they will pop. That’s extremely difficult to predict.

The fact is, bubbles can go on far longer than almost anyone expects. One sign of a bubble top is when a respected analyst who has been warning about a bubble the entire time throws in the towel and joins the crowd. That happens; look for it. I do.

But trying to time the bubble’s demise is a fool’s errand. Rather than try to time it, you should prepare for it.

The Ideal Investors Portfolio

You can’t short the index bubble. That’s an excellent way to lose money because of the timing issue.

If you wait until the bubble pops, there will be plenty of time to make money on the way down as everyone else panics and sells at fire sale prices.

Of course, you can short individual stocks and some sectors that lag the leaders and may already have begun their crash. Still, that’s challenging because even bad stocks can get carried higher in the bubble tsunami.

But don’t be overly long, either. Again, individual sectors such as energy, mining, agriculture, and defense may be good bets, but don’t try to wring the last tick out of a bubble. Your portfolio may go entirely down the drain.

The best strategy is a blend of cash, gold, private equity, land (not commercial real estate), Treasury notes and selected stocks.

Keep away from the index mania. It will wipe you out when you least expect it.

This article was printed from TradingSig.com

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