Opportunities for successful Strategic Index Investing are diminishing

Updated: Dec 30, 2020

Key Insight:

In the past decade central governments learned how to control any crisis on the stock market. The combination of interest rates cuts, QEs and other tools is essentially controlling the trend on the stock market. Unfortunately it is effectively destroying the lower section of stock market cycle. This is diminishing the opportunities for investor to buy cheep and sell high in the market.

The Winning Streak

Last couple of years were a real rollercoaster in the stock market. We saw S&P 500 and other global indices break record after record. This seems to be THE longest and most successful winning streak of the markets. S&P 500 reached 3600 points which is double its value from just 5 years ago. Not even the Covid-19 crisis was able to break the streak. Even if some instability occurs we see that the central authorities always react quickly with interest rate cuts, QEs or something similar and with that they are keeping the streak alive. This tendency has no end in sight. So what this means to investors?

On first glance index investors should celebrate - after all if you just buy ETFs that track the market and the market is constantly rising then you will be happy. On the other hand active investors should not be so happy, because if the market is always winning then it gets harder to beat it. Now I am going to question this logic?!?

What is Index Investing and why it is so popular

Let’s first illustrate what is index investing and how it works. Index investing is a passive type of investment where investors buy a portfolio that is replica of given index or it is designed to track it. Key thing is that they do not select stocks, do not optimize portfolio and do not rebalance it. That is why it is called passive. Invest in index and always get the same performance as the index. The easiest way to execute such a strategy is by buying ETF on the index.

Although called passive, such strategy requires some active decisions - when to enter the market, i.e. when to buy and when to sell short the index. In this setting when the expectations for the market are bullish investors have initiative to go long in the index ETF. Oppositely, if investors expect a bearish market - then they are more confident that they should go short on the ETF. Actually this is so common in today’s market that almost everyone is playing this game. They call this approach market timing. How it works? It is very simple and logical: investor tries to buy ETF on the index when the price is low and then short sells it in a bull market:

Every investor knows that the market tend to move in waves. So if you can forecast these waves you will buy in the lower phase and will sell in the higher. Therefore, when there is an opportunity for future growth investors activate buying long strategy and when there is an opportunity for future market decline investors sell short. It sounds very simple and its sounds like something that Warren Buffet would do, isn’t it? So let us now check this strategy in the US market between 2015 and 2019. Assume investor had a perfect vision and bought at the bottom in 2016 and sold the investment mid-2018:

In this near-perfect case the investor pocketed 35% difference in a span of 2.5 years which is pretty nice return or about 1.5% monthly.

Naturally, index investment is a strategy that takes far less effort than pure active investing, because you only need to know the phase of the market cycle rather than trying to gather information for every stock and analyze it.

Learn here what is active management!


Governments learned to control the trend

In order to get so impressive returns investor must define periods when the market is bearish to enter the market and then hope for high bull period. Essentially more extreme market cycle offers more opportunity to guess when to enter the market. Usually when there is an economic crisis we can observe such an extreme cycle – value of market indices drops significantly, stays long time low and then rises above pre-crisis levels. This scenario offers the investor perfect chance to buy low and later to sell high. The same is valid in opposite situation. When the market has been bearish for long time the chances of converting the trend are increasing showing that this is the time to enter the market with short strategy. This is normal economic process – the longer the market is at the bottom, the higher the expectations for growth are. And opposite when market has been on top then the expectation for market drop increase. Unfortunately we can prove that the global stock market has lost its connection to this economic processes. To do that we will take a look at the US market P/E ratio”:

After 08’ market crisis and following country-debt crisis, the P/E in US has been growing. The above chart represent each month’s P/E as % from the period’s average. As you see after mid-2014 we observe that P/E not only above its average for the past 10 years but is also keeping its growing trend. Recently the market just broke through the 2 standard deviation bound which means that P/E is no longer with normal distribution. It is a strong evident that even the recent pandemic crisis can’t stop the growth in market P/E. This is the latest evidence that the stock market is breaking its bond with economy.

So why it is happening?

Why the market is at these crazy levels of prices comparing to the companies’ earnings. Some may say that this is a part of normal stock market cycle and we are at the door of upcoming recession and bear market. It could be so. However, there is another factor which we see that plays a huge role and might allow the recession to happen – Central Governments. Since 08’ crisis governments and central banks around the world learned how to control the stock market. They realized that stock market is key barometer for the economy and they cannot let it fall. Through Quantitative Easings (QEs) or interest rate cuts the governments are keeping investors positive and assure them that if there is a crisis they will not hesitate to step in.

This has led to the winning streak that we are observing. We do not know if this is artificial push of the market or dumping government money will indeed lead to real growth. All these are macroeconomic problems and deserve additional attention. However, for us in this post is far more important to research the effect that the macroeconomic stimulus is having on index investing.

We remind you that successful index investing requires opportunities for investors to enter the market (to buy when the market is down and to sell when the market is up). However, the macroeconomic interventions sufficiently diminish these opportunities.

Nowadays the governments and central banks are controlling market trend and sustaining it positive.

This means that there is no low point in the market cycle where you could buy. For example take a look at the long term trend of S&P 500:

On the figure the orange line presents the long term growth of the market. Whenever the market is below this line we assume it creates an opportunity for investors to enter the market by buying long. At that time investors may expect return equal to the difference between the index level and the trend. This expectation motivate them to enter the market. The opposite is valid too – when the market is above the trend line we assume it is an opportunity for investors to enter the market by selling short. Investors may expect return equal to the difference between the index and the trend and this difference in fact will motivate them to go short. Note that we do not analyze the result of their investment but only if the market is at such level to motivate the investor to start investing by buying or selling. As you see, around the 08’s crisis it was perfect time to buy, because the index was far lower than this long term trend. Investors who bought stock there made quite a bit of money when the market returned back to the trend line. Therefore, there was an opportunity for the index investors. We measure this opportunity by tracking the difference between the index value for each month and this long term average. In this realm, during period till end of 2014 was perfect for buying and till end of 2017 market was according the trend. After that the expectations should be bearish and for investors there is opportunity to invest short. Here we track the absolute value of this difference:

The 08’ crisis offered opportunity for up to 80% expected return if the investor knew when to buy. More recently the Trade War and COVID-19 crisis gave more than normal opportunity. However since 2011-2012 we can say that governments and central banks started to control the markets by intervention with interest rates, money injection and so on.

Interventions have one major impact – they are controlling the trend! This is diminishing the opportunities for investor to buy cheep and sell high in the market.

Controlling the trend results in two consequences. First is that the new trend is much steeper. In other words the S&P 500 (and the entire market) is growing at much faster rate than usual. Second effect is not allowing huge deviation around the trend. Basically every time we hear that the market is in decline the FED steps in and cuts the interest rates and this gets it back on track. Here we present the new trend (estimated after 2012):

It is obvious that there is a definite shift to a steeper trend in the last half decade. Also it is notable that the deviations from this trend are not very extreme. This is diminishing the opportunities for investor to buy cheep and sell high in the market. So lets estimate the corrected opportunity for investors:

It is almost outrageous result. The opportunity for market timing and index investing strategies after the storm of market interventions is significantly lower. On average there is a 10% less opportunity to buy at low market level so you can sell it in the future somewhere on the trend. We should care most in last 2Y because between Trade War between China and US and the COVID-19 crisis that is unfolding we have very notable events for the stock market. Usually this will give us great opportunities to buy the stock indices cheaply and wait for the recovery. However you see that with this newly established trend the opportunities to buy low are a fraction of what was supposed to be. This should be extremely worrying for index investors who are depending on these opportunities to buy the market portfolio cheaply.