Passive investing has become the new popular retail strategy. It involves buying an index fund without picking individual stocks or trying to time the market. It is in vogue because mom and pop workers, who are saving for big life events such as retirement, are waking up to the fact that the high fees mutual funds charge can cause them to underperform the S&P 500. With the poor performance many mutual funds had in 2008, it appears having an experienced money manager in charge of your assets during uncertain times doesn’t improve performance. Just because an investor is ‘seasoned’, doesn’t mean he or she will be able to avoid losses in the next bear market.
While the many index funds have much lower fees than having someone manage your money, they aren’t without faults. Those promoting passive strategies proclaim it’s always a good time to get started, but that hasn’t always been true. With the Shiller PE at 33, which is the highest point in history besides the 1990s bull market, it’s possible real returns in the next 5 years are negative. Firstly, you need to determine when you need the money before investing in passive funds that supposedly always go up. If you need the money in the next 5 years, it may not be the best idea to invest exclusively in stocks.
Bear Market Repossesses Bull Gains
Secondly, if you are squeamish about the risk of big losses (who isn’t), a much safer strategy is necessary since valuations are high and the business cycle is near its end. Bear markets often repossess more than half the gains from the bull market. If you sell after stocks crash while attempting a passive strategy, you will destroy your long-term performance. While stocks are riding high, it’s easy to say you’d buy the dip, but it’s not easy to stay the course when the economy is crashing and the media is constantly running negative stories. With retail optimism about stocks in January 2017 at a record high, it’s very likely many passive investors are taking out more risk than they can handle.
Timing Economic Growth
To be clear, the economy isn’t exhibiting any signs of a recession in the next year. The expression of caution about the next 5 years of returns is aimed to tell passive investors, who are putting all their money in the stock market, to check their allocation. It feels great to be in only US stocks in a bull market where US markets outperforms, but in the long term, being exclusively in the most expensive market probably is a terrible idea. With those long term caveats in place, let’s look at where the U.S. economy is headed in the next 12 months.
The ECRI weekly leading index shows that the economy will probably slow down in the first half of 2018, but then accelerate in the 2nd half of the year. This weakness isn’t signifying a recession. However, it goes against what many economists believe. Expectations are high for the first half of 2018 because of the tax cut and fiscal spending boost. However, cyclical headwinds will prevent sharp growth from occurring in the beginning of the year. This indicator has a great track record as it went negative in 2015, meaning it correctly forecasted the economic weakness in 2016.
Yield Curve Signals Late Cycle Economy
The yield curve is one of the best indicators of where the economy is in the business cycle. With the difference between the 10 year yield and the 2 year yield at 67 basis points, it appears an inversion will occur in the next 18 months. Usually recessions occur about a year after the inversion, meaning the economy has about 2-3 years before the next recession. With the yield curve relatively flat, a hawkish Fed could easily invert it. Currently, the expectation is for 3 hikes in 2018. With the balance sheet unwind added in, the Fed will be moving from dovish to hawkish in the next 12 months, further flattening the yield curve as investors see the writing on the wall for the next recession. The inversion can occur even though the Fed is selling long term bonds because bonds don’t always move in the direction of the policy. The balance sheet unwind will cause monetary conditions to tighten.
The economy is near the end of the business cycle. If you are exclusively buying the S&P 500 index fund, re-think your allocation. While growth may continue in the next year, in the next 5 years, stocks might have negative real returns because the Shiller PE is at 33 and the yield curve is close to an inversion. Bear markets often repossess half of the bull market gains. Are you prepared to lose that much without selling? If not, take a more conservative investing route.