Passive/Robo/Indexers presume markets go up forever, While active managers know…that just isn’t so.

 In Strategy Updates

We hope you are enjoying the profitability that stock ownership can provide as global stock indexes continue to reach new highs. Year-to-date most indexes have reached double digit returns, with global indexes providing the most upside. As you can imagine, this is welcome news to our team, given our exposure to both domestic and foreign companies.

As we have mentioned before, we believe that the last bear market occurred in 2015-16 when global indexes fell 20% and corporate profits experienced a very mild recession.Over the past year we have been witness to a significant global corporate profit and business cycle recovery. Though many have called this a “Trump Bump,” it should be obvious at this point that the improving global economy and corporate profits cycle has little to do with the US President and more to do with how the business cycle works. The best part of our message today is that we believe that this new bull market has a brighter and longer future than most investors believe.

Corporate profit cycles last years – not months – and this one is in its infancy. Though many investors are in awe that the Dow Jones Industrial Average is over 22,000, they should try to remember that it is simply a number – it was 800 when I started my career! What is more important is the price of the market related to its underlying profitability or “price-to-earnings ratio.” In statistical terms the market is nowhere near overvalued. In fact, there are sectors of the market that still trade at ridiculously inexpensive multiples to earnings – not at all a symptom of a market that is overvalued.

There are many investors who question the future longevity of this market strength – which is another indication that we are far from a market top. However, there is a much larger crowd who seem immune to the old adage, “what goes up must (at some point) come down.” Though we believe that the recent market strength is well justified and has “legs,” we would not advise investing without some tools to manage the risk of this thesis being wrong and to protect your portfolio from catastrophic loss. As you know, we employ our Active Risk Management process specifically for this reason – this includes actively managing your asset allocation, your sector exposure and the careful placement of stop loss orders – the combination of which we call our “plan B.”

We find it hard to believe that today’s investors would invest aggressively without some sort of “plan B” should it all come to a crashing halt. Surely investors must recall the recessions and corresponding stock market declines of 35-55% that have occurred several times in the past two decades?  Or the time it took for stocks to recoup those losses – on average six to seven years?  We find the short term memory of the average investor just plain astonishing. However, with the media’s attention on passive/robo/index investing, perhaps we can’t blame these naïve investors for getting sucked in! Let’s face it – while markets are going up the tide lifts all ships and your average index fund will participate in market returns. However this view is extremely shortsighted, particularly when it comes to the bulk of an investor’s wealth as they approach important timelines, such as retirement. They say that stock market history is riddled with investors repeating the same mistakes. The lack of some sort of “plan B” risk management appears to be the most obvious.

The increasing popularity of passive/robo/index investing should be a warning to all investors to employ risk management tools and a plan for avoiding catastrophic loss, for the next inevitable and eventual market decline may just be much bigger than expected. In the meantime, our team will continue to invest with an eye towards growth and be well prepared with our decades of risk management experience should things go awry.

We hope this update finds you well. If you have experienced any significant changes in your financial situation or would like to discuss your portfolio please let us know. As always, if you have any friends or colleagues who you feel may benefit from our services, we would be happy to introduce ourselves to them with a no-obligation introductory meeting. Thanks again for your confidence.

Your Team at Main Street Research