S&P 500 Index Stomps Active Managers

By on September 15, 2006

Originally published in June 1998:

The market’s advance has weakened significantly in all but the larger cap stocks that make up the Dow and S&P 500 indexes. This may be the precursor to the correction we are anticipating as the year unfolds. The market recently moved into overvalued territory with the incredibly strong advance which took place in February and March. Using hindsight (which happens to be perfect) stocks were incredibly undervalued in 1994 with the DJIA struggling for months to top 4,000. A lot of bearish advisors were proclaiming that the top had been reached and a dreadful collapse would follow. But earnings growth exploded and the rest is history. The market is now 150 percent higher than it was in ’94, and momentum has replaced fundamentals as the main reason to own stocks. Comparisons to 1929 are now being repeated by several pundits as always after a significant advance.

It is convenient to compare ’98 with ’29, but hardly a meaningful exercise. The world is so much different now that any comparison, except for investor exuberance, is folly used by those to play at the underlying fears of the investing public. One can certainly find similarities between any two different eras, but the world is incredibly different now than it was just in 1989 (Communism in its death throes, Capitalism triumphs). You could buy $10,000 worth of stock with $1,000 in 1929, but today you need $5k to buy the same amount. Workers didn’t have funds withdrawn from paychecks and automatically invested in the market as they do now. The Fed has the benefit of historical precedent which wasn’t available in ’29.

What has not changed is the rationality of equities as an investment class. When equities are purchased the investor is counting on a certain degree of future earnings growth. The amount an investor is willing to pay for an equity is influenced by inflation and the perception of inflation (since inflation erodes the value of future earnings) coupled with projected earnings growth. We have witnessed a decoupling in the last two months of the prices of stocks with their conceivable growth of earnings in the future. As the market continues to move higher from here the risks are becoming greater for a “meltdown.” Demographics have played a big part in the boom, but that is another story. How this eventually plays out is anyone’s guess, but equities are now very expensive and even the best of all possible worlds does not make them an intrinsically good buy right now. The market will likely trade between 7000-7500 before resuming its advance. Deflation fears will likely be the catalyst for the biggest correction since 1990.

S&P 500 Index Stomps Active Managers

The Washington Post recently reported that over the past ten years there have been five mutual funds, out of 796 that existed for the entire time period, that beat the market (as measured by the S&P 500 index) over the past 3, 5, and 10 years. That leaves 791 that underperformed the market. This is a stunning statistic and good reason for investors to give serious consideration to index funds, although not necessarily those based on the S&P 500, for the bulk of their funds. Caveat: At some point this will seem like a poor decision since there have been times, although fairly protracted, when the average mutual fund has outperformed the S&P 500 index.

Trading for a Living is a Dangerous Thing

The popularity of the stock market and deflating commission schedules has infected some people with the notion that they can trade stocks for a living. This is a lot harder than it looks. I wouldn’t want to give up my day job for something that has less than a 50 percent chance of success even if I could work in my pajamas. For more see the USA Today article at http://www.usatoday.com/money/bcovfri.htm

Growth of Hedge Funds….Another Sign of a Temporary Top

Hedge funds are unregulated investment vehicles for the well-heeled investor. However, on average, they haven’t done any better than the lowly index fund (but who am I to talk). See who’s really making out with them at the recent Fortune article located at http://www.pathfinder.com/fortune/1998/980608/hed.html

Portfolio Updates

Keane (AMEX: KEA; 44 7/8) has been weak lately since some insider selling was disclosed. This is a temporary respite in its long term ascent. The company has booked substantial long term contracts for outsourcing work which will carry it well past the year 2000. Read more about it at http://biz.yahoo.com/prnews/980512/ma_keane_o_1.html

An upbeat view of Merck (NYSE: MRK; 117) is located at http://www.smartmoney.com/smt/stocks/index.cfm?story=199805202

Recommended Allocations

Aggressive portfolios: 60% equities, 40% cash.

Conservative portfolios: 40% equities, 60% cash.

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