How asset class returns move in cycles with periods of above-average returns followed by periods of lower returns. How has the rise of passive indexing led to higher stock valuations, and what does that mean for markets?
Show Notes
The Equity Risk Premium: Nine Myths (JPM Series) by Rob Arnott—Research Affiliates
PASSIVE INVESTING AND THE RISE OF MEGA-FIRMS by Hao Jiang, Dimitri Vayanos, and Lu Zheng—NBER
Limits to Diversification: Passive Investing and Market Risk by Lily H. Fang, et al.—SSRN
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503: U.S. Stocks Have Never Been This Overhyped or Expensive
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468: Lessons from Japan’s 34 Years of Stock Market Underperformance
390: Are BlackRock and Vanguard Too Big and Powerful?
Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 504. It’s titled “Indexing Bubbles and Asset Class Returns Still Revert to the Mean.”
U.S. Stock Market
This is part three of what has turned out to be a three-part series primarily on the U.S. stock market, which is at its most expensive level relative to non-U.S. stocks of all time. We have looked at U.S. stocks back in episode 500, and last week in episode 503 we’ve pointed out how the U.S. stock market makes up 66% of the global stock market, even though the U.S.’s economic output or GDP is only 26% of the world’s economic output.
We’ve done performance attribution, where we’ve looked at the impact of valuation changes on U.S. stock market outperformance, where four percentage points of the close to 13% annualized return for U.S. stocks over the past decade is because stocks have gotten more expensive. We’ll share a paper by Rob Arnott where he uses the phrase for that called revaluation—performance that’s driven by an asset class getting more expensive or less expensive.
We’ve looked at positive elements that contributed to a stock market outperformance, such as the U.S.’s deep and attractive financial markets, the nation’s venture capital availability for startups, the higher education system that attracts top talent from around the world. We’ve looked at some macroeconomic factors that have contributed to the outperformance, such as the growing U.S. federal budget deficit with those elevated cash flows flowing into the economy, boosting corporate profitability.
We’ve also looked at the earnings overlap, how 40% of earnings of stocks that comprise the S&P 500 index come from non-U.S. countries, whereas non-U.S. listed companies, those stocks overseas get 20% of their earnings from the United States. We’ve looked at Goldman Sachs’ forecast that U.S. stocks will return only 3% annualized over the next decade, with a range between -1% and 7%.
Reversion to the Mean
Now, I have more to say about this, as I continue to think about the U.S. stock market, how incredibly successful it has been over the past 15 years, where an investor since 2009 would have earned 11 times their investment, a 1,000% return since March 2009.
There’s a phrase though, in finance and other statistical fields, called reversion to the mean. It means that extreme outcomes tend to move back toward its average, be it higher-than-average earnings growth, higher-than-average returns, higher-than-average dividend yields, or lower-than-average returns, lower-than-average earnings growth, lower-than-average dividends when it relates to stocks.
We’ll look at some examples of reversion to the mean, that yes, it does apply to asset classes. Also in this episode, we’re going to look at the impact of passive investing or indexing, which has become an ever-larger part of stock market investing, and it has had an impact on the U.S. stock market’s overvaluation. And so we’ll look at, well, how could that end?A key element of this week’s episode is an article by Robert Arnott, founder of Research Affiliates. Arnott is 70 years old now. He has been highly influential, along with Seth Klarman, the hedge fund manager, in my approach to investing. Rob Arnott wrote a blurb for my book, Money for the Rest of Us: 10 Questions to Master Successful Investing. He called it a clear roadmap for investors. He contributed a series of articles in the Journal of Portfolio Management. The Journal of Portfolio Management is my favorite financial academic journal. Back when I was in graduate school, I would just go to the library and sit and peruse finance journals. I was a finance nerd, and that journal has been very influential in how I invest.
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