The Dow and the S&P 500 broke out of their complacency this week and yesterday closed with the biggest loss in several months. Was the more than 1% decline in response to escalating talk of armed conflict with North Korea, domestic political turmoil, or just the realization that valuations are stretched and it may be time to take some profit? As of today we see markets shrugging off the tweets and settling back in to a low volatility, slightly positive posture.
Here at Erickson Advisors we need to be longer term managers of wealth, and that means anticipating not just events around the corner but trends which will play out over time. One trend that I believe will reverse with the next significant correction is the love affair with Indexing. CNBC reports that more than half a trillion dollars moved to passive funds over the past twelve months. We support and embrace low fees as a primary tool in wealth management; we are concerned, however, that the inflows on this scale are pushing up the prices of the most heavily weighted stocks in the S&P 500 Index. As more money pours in, the fund buys the 500 stocks proportionally to their valuation weighting in the Index, thus pushing up the prices or valuations of the most heavily weighted stocks in the index. The investor is thus buying ever higher and higher – not a recipe for long term wealth growth. If the correction this process reverses. As valuations decrease and the relative percentage of the Index each stock holds likewise decreases or certainly changes, managers of the Index fund must adjust accordingly. If the largest percentage holdings drop by 15% to a lower relative percentage position in the Index, managers of the Index fund will have to sell to readjust those stocks to the correct weightings. Sales will further reduce, or even accelerate the reduction of the valuations of the heavily weighted stocks being sold, further reducing the relative percentage weighting in the Index. We believe this will be a painful spiral of reality for Indexers that will not be offset by lower fees.
The other trend we observe is the resurgence of strength in International equity, particularly Europe. Investor confidence in the economic growth of the Eurozone appears to be growing, and the decline in the value of the dollar relative to the Euro has certainly added to this positive trend. Another potentially positive aspect to preserving value in International positions is that there is relatively little indexing done in Europe.
The next potentially disruptive event for the stock and bond markets is right around the corner – the debt ceiling must be adjusted upward and the budget approved. Congress will have only a few days to approve both, and from all I read and hear it will be a contentious debate. Any hint that Congress may allow a technical default on our payments to all holders of Treasury bills, notes, and bonds will roil the markets. We have been raising strategic cash levels in all accounts in anticipation of a market disruptive event. Of course, we are assuming that eventually, sooner rather later, some compromise will occur and the debt ceiling will be raised in order to pay back what we owe for money the Congress already spent and borrowed to pay for it. If or when a market correction occurs, we will put some of the cash we have been building over this past year back to work. We may not know where the opportunity will lie at that time, but most disruptions have opportunity imbedded somewhere, and we intend to take advantage of the opportunity.
For a deeper dive into what trends have formed this year and what we see as the key drivers that effect your portfolios join our conference call on the first Friday of the next quarter, our Listen at Lunch. We offer visuals - slides and graphs - to illustrate the ideas and data points being discussed which you can find on the landing page of our website. Lindsay will send out both the reminder invitation and instructions for how to join the call later in September.
Wishing you a wonderful end to your summer,
Linda P. Erickson, CFP®