The State of the Market: Part 5

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 27, 2017 2:13:54 PM

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marketIn part 4 of this series, we concluded that the map was separating from the territory, along with the reasons why that was so. Today, let’s take a look at what to do about it.

Mind the gaps

The key assumption behind passive investing is that prices within an index accurately reflect relative values. This assumption is being undermined by the current rule-based investment flows, which are buying the indices regardless of individual security values. To sidestep this problem, we have to find a way to use the good parts of the map while still accounting for the gaps that are opening up.

The specific gap here is in relative pricing, which gives us a potential solution by changing the map so it relies less on pricing as a way of determining purchase decisions and more on something else. The more common indices, including the S&P 500, set relative weights based on market capitalization. So, the more a company’s price goes up, the greater weight it will have in the index. But this is not universally the case.

Other indices set weights on metrics other than market caps. Sales is a common one, as are earnings or book value. The idea is that investors should weight their investments more on fundamentals, which don’t change as much, rather than on price, which is much more variable and, in many ways, more a popularity metric than anything else. There are many investment products out there that offer these different exposures, usually under the description of fundamentally weighted indices. This is still a map, but it is one that is less distorted by current market conditions—which is just what we need.

The new map

Of course, there are concerns regarding this new map as well. A major one is that it might be more value weighted than the more common cap-weighted indices. This makes sense, in that an index weighted to sales (for example) will have larger weights in companies with high sale levels but lower stock price performance. While this is certainly true, the flip side is that cap-weighted indices can be seen as growth weighted. It all depends on how you look at it.

The point is that this is a map to the same destination: passive investing that captures the market as a whole. But this map does not have the pricing distortions that the cap-weighted index map does. It certainly has distortions of its own, mind you, but that is not the primary concern at the moment.

You can think of this as picking the right map for the journey and then switching maps as one becomes less reliable. This, again, is a human judgment effect. Waze will not switch maps due to the weather or road closings, and it may keep leading you back into the trouble you are trying to avoid. Put another way, a hiking map gives very different information than a road map of the same area. Which map you use depends on your needs.

Finding a better map

What maps are we using today that we may need to reconsider? Market capitalization indices are a good candidate. Pricing based on low interest rates may be another. Others will come up as we move forward.

Here, the entire AI, rule-based map discussion has been, at its base, an exercise in understanding our assumptions. This includes those so basic that we don’t think of them as assumptions but as facts. AI relies on built-in relationships and rules, without being able to think about the larger issues; that is, we are luckier. When something like valuations starts to look disconnected, the right course of action is to find a better map—not to look for reasons why it is different this time.

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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

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