- Index investing really means buying high and selling low. The latest NASDAQ 100 inclusions and exclusions are a perfect example.
- If you invest in an index, you are bound to receive market returns which will be in line with market earnings. However, history shows that market returns won’t be that great from today onward.
- Even if index investing is still the most popular thing to do, it’s time to switch to smarter investment vehicles.
Last week, NASDAQ announced the results of the annual re-ranking of the NASDAQ-100 Index®
- Nasdaq: NDX:
- Nasdaq: CTAS:
- Nasdaq: HAS:
- Nasdaq: HOLX:
- Nasdaq: KLAC:
- Nasdaq: BBBY:
- Nasdaq: NTAP:
- Nasdaq: SRCL:
- Nasdaq: WFM:
What immediately hit me is that the index is selling low and buying high. The four additions are very close to their two-year highs and have all enjoyed a market beating ride in the last 5 years, except for KLAC. However, KLAC is 100% higher than its two-year low.
- NASDAQ 100 additions:
On the other hand, the companies removed from the NASDAQ 100 are all close to their five-year lows and have severely underperformed the index in the last 5 years.
- NASDAQ 100 removals:
From a valuation perspective, there isn’t a big difference. The four additions have an average PE ratio of 24.17, with CTAS having a PE ratio of 27.3, HAS with 20.4, HOLX with 33.4, and KLAC with 15.6. The removed companies have an average PE ratio of 22.6. BBBY with 9.9, NTAP with 33.1, SRCL with 27.0, and WFM with 20.7.
From a growth perspective, the newly included companies didn’t perform better than the excluded ones. On the contrary, the average cumulative five-year revenue growth for the newly included companies is 122%, while it is 129% for the excluded companies.
- Five-year revenue growth included companies:
- Five-year revenue growth excluded companies:
The only company with declining revenues in the past five years was NTAP, while the best performer was SRCL.
This example shows us that index investing makes you buy companies just because, for the last year or more, those companies have enjoyed a positive market sentiment, while it makes you sell companies that have recently been negatively viewed from the market, no matter the fundamentals or long term business performance.
With the exception of buying high and selling low, index investors with their long-term investing horizon are bound to receive what the market has to offer at this point in time. Index investing offers diversification and peace of mind, following the mantra promoted by the majority of financial institutions, and there is nothing wrong with that. However, I doubt that index investors know what they are investing in and the risks they are taking.
Most invest under the bias that stocks are always the best investment as in the long-term, stocks should reward you with the highest return. This is correct from an historical perspective as stocks have been the best performing asset in history with an annualized return of 6.6%, compared to 3.6% for bonds, 2.7% for treasury bills, and 0.7% for gold.
- Total real returns on U.S. stocks, bonds, bills:
However, since the beginning of this century, bonds have outperformed stocks. Since January 1, 2000, stocks on the S&P 500 have returned an aggregate of 50%, or 2.4% annually plus dividends, while bonds have returned just a bit more but with much less volatility.
- Total returns for this century.:
Of course, taking the peak of the dotcom bubble isn’t the most scientific way to compare things, but a look at PE ratios might be enough to make the point that stocks in aggregate shouldn’t be treated as the best asset to own all the time.
- CAPE ratio for the S&P 500:
Looking at the cyclically adjusted PE ratio gives a better long term perception of the market by taking 10-year average earnings.
Only two previous times in history has the CAPE ratio been higher or equal to the current one. In 1929, and during the dotcom bubble. Investing $100 in the S&P 500 in 1929 would have taken you seven years to see your investment crawl back to the initial amount, and fifteen years to make some real sustainable profit.
- $100 invested in the S&P 500 in 1929:
Investing $100 in 1998, the first year of the dotcom bubble period when the CAPE ratio was higher than what it is today, would have made a profit within the next year, but for real long term profits you would have had to wait eleven years.
- $100 invested in the S&P 500 in 1998:
Timing this bull market’s peak is impossible, but historical examples clearly tell us that long-term returns will be closely correlated to the underlying earnings stocks have.
In 1929, the CAPE ratio was 27.06, implying a 3.69% return from stocks. A $100 investment with such a rate would be $143 after 10 years and $206 after 20 years. The $206 return for the S&P 500 was reached exactly in 1949, 20 years later.
In 1998, the CAPE ratio was 32.86, implying a 3.04% return from stocks. A $100 investment in 1998 would have been worth $134 in 2007, in just under 10 years, and would have been worth $182 in 2013, thus 15 years later. Given the current CAPE ratio, I wouldn’t bet on the bull market holding.
Now, if you’re happy with returns of 4% per year for your long-term investment horizon of 10+ years, and if possible 40% declines like those seen in 2001 and in 2009 don’t bother you, index funds are a good option to invest in.
However, if you would like to protect yourself from the possible declines, or at least require much higher returns for the same risks, stay tuned to Investiv Daily for global positive asymmetric risk reward stock picks.