If you're saying that the novices are just bad investors who always buy at the wrong time then I'd want a little more evidence of that. My base assumption is that the novices do not have predictive power and are simply "noise traders".
Note that I'm not expressing a view on the market in this comment.
This means that with less than $1000, you can own a representation of the S&P500, weighted by market cap, either through ETFs or mutual funds. Weighted by market cap means that you're putting a larger percentage of that $1000 into the bigger companies, versus the smaller companies.
When a few companies start to dominate the market, everyone can be overweight a few stocks in the same way, and not even know it.
https://www.cnbc.com/2017/05/17/four-tech-heavyweights-make-...
Of course, that's little consolation for those who lose out during the correction period - so your point stands. But AFAIK we're well below the danger zone for too much public market capital being passively indexed.
Given how the central banks act, this affects the currency markets and interest rates.
(1) https://asia.nikkei.com/Markets/Equities/Japan-s-central-ban...
(2) http://www.businessinsider.com/swiss-national-bank-owns-80-b...
If company A is worth 10x what company B is worth then I can buy 10x of company A and 1x of company B to spread my impact as evenly as possible.
The minimal impact of cap weighting is actually that you don't have to rebalance your investments to keep them tracking the same. By them going up and down, they keep the same percentage by market cap weight.
What you seem to be saying is good is diversification, which it is, but you have to make sure you are well diversified.
Can you explain how this works?
Suppose Company A is worth $100 billion and Company B is worth $10 billion. Buying $100 of Company A and buying $10 of Company B shouldn't push up the price of Company A faster than Company B. You're buying 0.0000001% of each company so you'd expect that you'd push up the price of both companies at the same rate.
> The minimal impact of cap weighting is actually that you don't have to rebalance your investments to keep them tracking the same. By them going up and down, they keep the same percentage by market cap weight.
Yes this is another benefit of cap weighting.
Sorry, you're totally right. The prices should increase in the same weighting when buying just like they go down in the same when selling.
The difference is that you're weighted by market caps, so you're increasing the P/E of the entire market (in a super small way). That is, you're not investing more in companies that are valued more "attractively" (lower P/E multiple) than those that might be "over valued" (high P/E), which is what the market typically does to determine prices.
I'm not sure I agree that low P/E means that a stock is undervalued. For example a company that is guaranteed to make $10 every year should probably have a higher P/E than a company that is expected to make $10 with $1 variance.
If we move to a more abstract notion of undervalued then I still agree with you that cap-weighting isn't guaranteed to overweight the undervalued stocks.
Not necessarily. The price could change in VERY different ways depending on the marginal supply and demand for each stock (i.e., how many more/fewer shares of the stock are other investors willing to buy/sell at different prices when the index fund goes out to buy that 0.0000001% of float). A tiny 'buyer-seller imbalance' in the stock market cause a big price adjustment.
Anyway, it seems like sound advice.
-Roughneck's Proverb
The rather dramatic multiple expansion the last few years is not debatable however, it's at historically high levels.
Microsoft's net income has not increased since 2011/2012 or so. The stock went up nearly 200% bottom to top over five years regardless of that. It's up roughly 67% over just two years, for absolutely no good reason that relates to actual growth in their sales or earnings. Plus, they've loaded up massively with debt in that time as well, their balance sheet keeps getting worse by the year.
So who are the suicidal investors paying ~30 times earnings for zero net income growth for half a decade and an epic pile of debt?
How about for Amazon's ~300 times 2017 earnings? It'll take them a minimum of ten years of 20% annual growth, to justify their present valuation, assuming they can ever manage to produce ~$20 billion in net income even with that amount of continued sales growth.
There are far more mundane examples of the extreme valuation expansion that is going on (thanks Federal Reserve for another asset party!).
ADP has hardly expanded its net income since 2011. The stock is up over 100% in that time, for absolutely no good reason. They have no growth of consequence, and there isn't likely to be any inbound. Quite the opposite if anything, they're probably on the chopping block of having their business seriously threatened by cloud competitors over the coming decade.
Priceline.com has a tremendous business, with modest 10-15% annual sales growth... trading at ~45 times earnings, meanwhile their net income hasn't increased in years. The stock is up ~67% in 14 months or so, for absolutely no good reason, their growth didn't just suddenly shoot through the roof and it isn't about to.
Why is PayPal's modest 14-15% net income growth worth 50 times earnings? A little over a year ago it was worth barely over half that. Dramatically increased future growth expectations? Yeah right.
The examples don't stop, it's practically every publicly traded stock.
Who's paying 30 times earnings for Coke (KO)?!? Its business is collapsing:
2014: $46b sales | 2015: $44.2b sales | 2016: $41.8b sales
Net income for KO has gone from $9 billion in 2012, to $6.5 billion today, with a persistent annual erosion. Why is the stock at an all-time high? McDonald's is similar, their business has contracted by 10%+ since 2012, with net income down 13% over that time - the stock is up 50% in two years for absolutely no good reason.
The damage on the way down will be immense, again.
If more people invest more (compared to the growth of companies/stocks) the value increases.
This is a technical point, but in my opinion it's also an important conceptual point. Stock market prices do not rise because dollars are flowing into them.
That's incorrect. New capital flows into or out of the market constantly. Very frequently the market sees immense net cash flow in, for example typically toward the end of an expansion and just before the next recession or crash. Joe & Jane investor tend to be very late to the party, especially after getting burned badly by the last two asset bubble parties, they joined this one quite late into the expansion.
Large amounts of capital - trillions of dollars in the US alone - are essentially always sitting on sidelines, sometimes more of it moves into the market, sometimes more of it moves to 'safety' and out of the market. You can track these capital in and out flows, it's mostly public information.
For example, this huge burst after the election:
"A whopping $63 billion has poured into U.S. stock funds since Donald Trump won the presidential election, according to the latest tally by Bank of America Merrill Lynch. ... Investors have yanked $37 billion from bond funds since the election. Most of that money rotated right into stock funds. This "great rotation" could be a major story in 2017."
http://money.cnn.com/2016/12/19/investing/investors-pour-63-...
To make this more concrete, let's imagine how this actually happens. Joe & Jane send $10 to a stock fund. The fund places a market order to buy stock. The market matches the buy order with the lowest sell offer. The fund sends the money to the seller, and the seller sends the stock to the buyer. At the end of the transaction, both the amount of money is conserved (J&J are down $10, but the seller is up $10) and the amount of stock is conserved (J&J have one additional share and the seller is down one share). Money did not move "into" the market. On the opposite side of every buy, there is a sell. For every dollar that J&J sink into the market, sellers are pulling exactly that many dollars out.
As the article you link says, there can be net inflows into stock funds. But that's only possible because there are entities besides stock funds that have equal and opposite outflows. In aggregate, buying stock cannot put money into the market because every purchase is also a sale.
Buy bids/orders being matched with sell orders/bids would imply zero net cash flows only if prices were constant.
In this scenario, the price of the stock increased from $10 to $11. But still, there was no net cash flow into the market. Bob put $11 in and simultaneously Sally took $11 out.
Even when stock prices change, net cash flows are zero. Every buyer is always matched with a seller. Every dollar that goes into a trade comes out on the other side.
Markets aren't just a pipe or a screen where stuff goes through, at least in economics. The market isn't just the market mechanism, but rather that mechanism plus the collection of all possible buyers and sellers at any given time. If all we have is Sally and Bob talking over the phone with their portfolios in stocks and cash, that's the market.
Now, you're right that no money entered the market when Bob bought that share. But if someone who had no interest in either buying or selling stock handed either Bob or Sally $11, that would be $11 going into the market. If Bob took those $11 as a loan from Chad while Chad himself had no interest whatsoever in what Bob would do with it as long as he paid them back, that would be money going into the market.
Also, I reckon I changed my initial position. But I'm also rather drowsy right now.
> If more people invest more [...] the value increases
If you have just Bob, price goes to 11$.
If you have Bob, Charlie, and Darrel willing to pay, wouldn't the price possibly go to 12$?
In this situation, there were 3 buys and 3 sells. $11+$12+$13 flowed into the market while at the same time $11+$12+$13 flowed out of the market. At the end of the day, even though the share price rose, there were an equal number of buys and sells, with equal inflows and outflows.
A higher stock price does not mean the company has more dollar bills in its vault and investors have less. A higher stock price means that stock traders in aggregate now think the company is worth more.
Cash flows through markets, it doesn't flow into markets.
(Technically what this means is dollars are not 'invested in the stock market.' People are not investing 'more.' Prices going up does not mean more money is being invested in the stock market.)
And, my personal opinion, more "less-skilled" people entering the market = even easier to raise prices (exactly like in street markets with tourists vs locals).
I'm not sure why you pointed that out. Of course my data speaks about the companies, the future potential earnings of said companies is mostly what is being (over) paid for.
If you assume the number of companies and shares is constant, then the value increases. Why some companies and not others? Maybe their ability to attract these money.
(The amount of companies/stocks isn't constant, I agree, that's why I was comparing relative growth.)
It isn't some companies, it's most of the public companies containing substantial invested capital. The S&P 500 earnings multiple has gone up ~60% since 2011. Currently near 25 times, it's at roughly the second highest non-recessionary level in US history.
I think the rest of my argument still holds, more availability of cash = increase value. (I actually just noticed that the top comment says basically the same.)
Who knows when this outlandish mass multiple expansion party will end. It will though, they always do; and they always end badly.
Curious historical fact regarding the present context in terms of liquidity / loose money: 5 of the 6 times the Fed has contracted its balance sheet in US history, it has occurred immediately prior to a recession. [1] That's interesting because we're facing a potential double liquidity tightening, with rising interest rates and a contracting Fed balance sheet (supposedly, we'll see if they ever get around to serious balance sheet reduction before the shit hits the fan, I'd wager it's a very slow moving feint meant to restrain asset prices, similar to them threatening to raise rates for years prior to actually doing so).
[1] https://www.cnbc.com/2017/08/02/fed-balance-sheet-reduction-...