Trouble for Index Funds?

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Once upon a time, before quantitative easing became our permanent lifeline, stock markets actually went up and down. 10 to 15% corrections were an annual event.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard, that's Lisa Shalett. She's the chief investment officer at Morgan Stanley Wealth Management, and she says The S&P 500 index is headed for a tumble soon, like before the end of the year. But she says that view does not make her bearish. We'll hear more in a moment and talk with Ed Yardeni of Yardeni Research about stocks, rates, inflation, and why babies could be the key to understanding all of them. That's right, babies. Don't let their chubby cheeks and roly-poly toesies fool you. They're powerful economic indicators. Welcome to September, which you might have heard has historically been the worst month for U.S. stock returns.

And we have been talking about how September can maybe not be the best month for markets.

That's true. But I've heard some commenters say that September on average hasn't been so bad in years like this one when the market has been on a hot streak. That's true too. Maybe September could bring more smiles. This past week, I read one Wall Street report that said it's really the last 10 trading days of September that are a problem. Those have historically averaged a 1% decline, and they've tended to be negative even in years when the stock market has had strong year-to-date performance. Now, you can safely ignore all of those observations. One month has to be in last place historically, and it happens to be September, but there's no cause-and-effect relationship between September and stock returns that I'm aware of. Anyhow, calendar months are arbitrary things. Did you know that the name September comes from the Latin word for 7, even though it's the 9th month? That's because the Romans originally had a 10-month calendar that just ignored much of winter. They eventually shimmied 2 more months into the start of the year and later renamed months after Caesars willy-nilly. So Quintilis, which means fifth, but turned into seventh, that was renamed July for Julius, and Sextilis became August for Augustus. But September stayed September only because Tiberius didn't want a month and Caligula tried but failed to get everyone to start calling the month after his father. Otherwise, we'd now be worrying about the last 10 trading days of Germanicus. It's nonsensicus. Now, I've heard some people say the stock market is headed for a decline, not because we're in September, but just because it's due. The market usually has at least one decline of 10% or more per calendar year, and we haven't had one in around a year and a half. We haven't even had a 5% decline since last November. Does that raise the chances that a decline is imminent? I don't know. If we were talking about random independent events like coin flips, the answer would be no, even though the feeling that, say, 5 heads in a row is likely to be followed by tails is so common that it has a name. It's called the gambler's fallacy. Stock trading doesn't quite seem like a random independent event to the extent that past trading influences today's valuations. But then I've never found a way to reliably predict short-term returns. This past week, I saw a remarkably specific call by a respected market strategist, and I wanted to learn more, so I reached out. Hi, Lisa.

Hi, how are you, Jack?

That's Lisa Shalett, the Chief Investment Officer at Morgan Stanley Wealth Management. In a Tuesday note to investors, she wrote that they should expect a 10% to 5% decline in the S&P 500 before the end of the year. She sees the index's 20% climb year-to-date, despite a recent rise in COVID-19 hospitalizations and a drop in consumer confidence as a result of, as she puts it, quote, "masterfully nuanced communications from the Federal Reserve." In her view, the Fed has convinced investors that tapering its stimulus programs is not the same as tightening monetary conditions, that elevated inflation will soon pass, and that the bar for raising interest rates is high. But it now must make good on those expectations without making mistakes., and stock indexes don't seem to have adequately priced in the risks. Lisa's position is nuanced in that it relates specifically to the S&P 500 and similar indexes, not to the whole of the U.S. stock market. And she's more bullish than it might seem at first glance.

We have been cautioning our clients not so much about the economy and the market in terms of the average stock, but really in terms of the S&P 500 index. The index itself has gotten excessively expensive, is very concentrated in a handful of names, all of whom are the usual suspects. Those usual suspects have seen their correlations with 10-year Treasury rates at all-time highs, and it makes for a pretty fragile combination. At the same time, owning the index today in a global context is, is a relatively defensive position, and we believe that it's time to play offense.

When Lisa says the usual suspects, she's referring to the largest companies in the S&P 500: Apple, Microsoft, Alphabet, Amazon, Facebook, and so on. These 5 companies alone combine for nearly $10 trillion of stock market value, or around one quarter of the index's value. And since the index weights companies by their size, a handful of companies have significant influence over the index's returns and valuation. Throughout the pandemic, these tech giants have been resilient growers, so investors have come to think of them as defensive. They buy these stocks when they're seeking safety, and that's what Lisa means by the high correlation between these stocks and Treasuries. But now Lisa says the divide between premium valuations of these tech giants and the cheaper parts of the market reminds her of back in 2000. Just before the dot-com stock crash. And she points out that the tech giants have underperformed during moments when interest rates have risen a bit. You'd expect interest rates to rise if you were optimistic about economic growth, like Lisa.

Now, it's our view that the U.S. economy, and quite frankly, the global economy, is going to reaccelerate. We actually think economic growth is going to be quite decent. And so, quote unquote, hiding out in the same old, same old isn't really necessary when where you're going to see upside surprises in earnings is actually going to be in things like financials, like industrials, like energies, like commodities, materials, consumer discretionary, consumer services, healthcare names. And so we're very excited about buying a lot of different stocks. We're just not super psyched about owning the index.

The overall S&P 500 index trades now at between 22 and 23 times this year's earnings forecast. Which seems a bit pricey. But a search for index members trading below, say, 18 times earnings pulls up hundreds of names. Lisa says there are plenty of good deals to be found, including for investors seeking dividend income.

You know, some of the old-timers who are used to buying things at 13, 15 times forward earnings, we've said, well, look at the dividend yields. I mean, if you look at some of these companies, and, and we're not anti-tech. I mean, look at IBM, for example. You've got more than a 4% yield. I mean, nothing for nothing. That's 3 times what you're getting on a U.S. 10-year Treasury.

I asked where it's harder to find value now, stocks or bonds. It wasn't a close call. Lisa calls the bond market ridiculous. She points out that prices are so high that even yields on many junk bonds have dipped below the latest reading on inflation. And she doesn't think the good times for bond investors will last.

We're not excited about finding value in the fixed income market. Again, I know that the deflationistas and the bears are talking about the resilience of the 10-year Treasury market. Our perspective is that a lot of what has anchored rates over the last 6 months, or really since March, has been a real imbalance in supply and demand. And so as we start to see much much higher inflation outside the United States. You're starting to see higher yields in Europe. You're starting to see better economic growth in Japan. You're starting to see some of those surprises there. We think you're going to start seeing, you know, some of the foreign flows that again have flowed defensively into the U.S. Treasury market flow back out. And that's going to happen at the same exact time the U.S. is tapering, that the ECB begins to reduce their purchases, and the U.S. Treasury starts running out of cash. Has to raise the debt ceiling and wants to spend another $3.5 trillion.

I appreciate your use of the term deflationista. I like that one. I heard the term finfluencer today. That's for someone who's influential on matters of finance on TikTok. I studied the wrong thing in college for that.

Oh my goodness.

But I want to just ask you about, and this lifts my spirits hearing about your bullish outlook for the US, but for investors, let's say a 60/40 investor out there who They know they can't get any kind of yield in bonds, but they've looked to bonds for kind of a haven in their portfolio if everything else goes wrong. What do they do to reproduce that now? It seems like bonds aren't as safe as they once were if we're talking about all these yields that are solidly below the rate of inflation.

So, you know, the strategies that we've been using with our clients require a lot of handholding and are reasonably complex because they require diversifying into maybe some non-traditional areas, not just treasuries and municipals to exactly Exactly to your point. So we are encouraging clients, given our call on the, on the index of the 10 to 15% correction, to have above average levels of cash short term. But we're complementing that with working with some active managers who know some of these more niche-like asset classes. So things like asset-backed securities, like bank lending, like preferred shares, like very high dividend paying utility stocks, real estate. We upgraded REITs and real estate. We like infrastructure assets. We're trying to protect against inflation with broad commodity exposure, so not just gold.

Lisa says the 10% to 15% S&P 500 decline she's predicting isn't unusual. It's an ordinary part of a healthy market. She says a higher long-term inflation rate than many investors are used to, say 2.5% to 3%, is healthy too, because rising prices give people a reason to spend. She says if you want a sign that higher inflation is here to stay, look at the labor market.

And this is a thing that I really don't think the Fed is being honest about. I think the economists, the Fed, know exactly what's going on in the labor market. And the labor market is in the process of restructuring in a way that is reducing the supply of labor where, you know, High-skilled white-collar workers are demanding remote work and flexibility, whereas lower-skilled frontline workers are saying, hey, I need to be compensated for the risks that I'm taking. So this is not runaway, but it is part of a structural reset, and it's a healthy structural reset.

This was great. I'm going to add you to my list of Finfluencers. I'll be watching TikTok just in case you change your mind.

Exactly. I'll get up on my dance moves before I do it. I'll make sure I'll be making a market call while, you know, to some good tune.

But that's all that the public asks of you. I spoke with Ed Yardeni about babies this past week. I mean, we started off talking about stocks and inflation and government debt and stuff like that, but babies kept coming up like this.

It's the voluntary self-extinction of the human race. In other words, if we're just going to get old and we're not having babies along the way, populations are going to stop growing as they, they have in Japan. For a long time, I used to refer to Japan as the world's largest nursing home. Well, now China is becoming the world's largest nursing home. And a lot of what's going on in China in terms of their policymaking has everything to do with their disastrous demographic policies.

Ed runs a research service for portfolio managers called Yardeni Research. Last year, he published a book called Fed Watching for Fun and Profits, and he's working on a new book called The Power of Profits. We last heard from him on this podcast just over a year ago in an episode on modern monetary theory. Here's how we got to babies. I asked Dad if he's bullish on the US stock market. He is. He predicts the S&P 500 will hit 5,000 by the end of next year or sooner. That's 11% above recent levels.

Very impressed with the strength of earnings. Profit margins are at an all-time record high. So I think the fundamentals underlying the bull market are still very much intact. The economy is slowing, but some of that is arithmetic. We definitely saw peak earnings growth in the second quarter, peak economic growth. Anything where you're comparing today's activity to a year ago is going to be at a record pace. So we are slowing down. Uh, but that's a good thing. It gives companies an opportunity to restock. Inventories are extremely lean. Buy some time for the auto industry to get some semiconductors so they can make cars again.

Ed's view rests on the stock market continuing to trade at an above-average multiple of earnings. And that would seem to depend on investors not having better choices. In other words, on bond yields and interest rates on savings accounts staying exceptionally low. So I asked Ed, when do you think we might see higher rates? Now remember, Lisa from Morgan Stanley Wealth Management pointed to labor market shortages as one sign that investors should expect higher average inflation and ultimately higher bond yields. Ed also points to labor market shortages, but he sees something a bit different.

The baby boomers kept working longer than the age of 65, but now because many of them are 75 and Maybe because the pandemic has made a lot of us baby boomers think about the meaning of life, what we really want to do for the rest of our lives, we're starting to see more and more retirements, which is fine. Live long and prosper, go travel and enjoy life. But the question is, who's going to replace the baby boomers? And we're finding that we just forgot to have babies along the way or enough babies so that the working age population isn't growing. And that's the problem they have in Japan and then some because their population has actually been shrinking since 2011. So the labor shortages are here to stay.

Labor shortages mean companies will have to raise pay and then pass the cost of that higher pay on to customers as price increases or inflation, unless companies are also getting more in return for their higher pay in the form of increased worker productivity. Now, when economists use the term productivity, they don't just mean workers working harder instead of— and I'm just thinking out loud here— reading pointless facts about calendars to pass the time during Zoom meetings. They mean companies investing more in things like technology to make their workers more efficient. During the pandemic, companies were forced to do just that when workers and customers couldn't meet face to face. And now Productivity is rising. Ed expects that to continue. He calls rising productivity the ace in the hole that will keep inflation from making a long-term comeback like it did in the 1970s.

Productivity growth has actually been on an uptrend. It bottomed at the end of 2015 at around 0.6% at an annual rate, and now it's at 2%. So that's a substantial increase in productivity. I think productivity is going to continue to make a comeback. When I tell people I think it's going to go to 4%, they said, that's impossible. That's, that's Looney Tunes. And I show them a chart showing that there were 3 or 4 cycles since World War II where we did get up to 4%. And I think there's every reason to do that again. Labor shortages, technological innovations that allow companies to augment the mental and physical productivity of their laborers. It's all out there. And so I think productivity is going to save the day. And if it does, that allows real wages to go up. It keeps inflation down. It's great for profit margins. It's a win-win scenario.

Ed says that with inflation contained, bond yields could rise a bit but not much, and that will help keep stock valuations elevated. I asked about the U.S. government debt. I'm old enough to remember a $300 billion yearly budget shortfall being noteworthy. The government ran a larger deficit than that just in the month of July. But there's no sign of worry among investors buying all of that debt that the U.S. is issuing. I asked Ed, how will we deal with the debt without elevated inflation? Ed calls near-zero interest rates and massive budget deficits a crazy combination, but he says it might make sense if we expect to come up against a powerful deflationary force in the future. And that powerful deflationary force is That's right, too little baby making. The U.S. birth rate fell last year for its 6th consecutive year to its lowest point on record. Immigration helps, but even so, the U.S. population over the past decade grew at its slowest pace since the Great Depression. The situation is even more acute overseas.

Everybody's got a problem with demography because of urbanization. Kids just are an expense in a city. And they're an economic necessity in rural areas. So urbanization is really the reason why fertility rates have collapsed below replacement. The Chinese made that much worse with the one-child policy. So, uh, the rapidly aging demographic profiles are inherently deflationary. Uh, technology is inherently deflationary.

My head is swirling. You've given me a lot to think about. So we might be— these deficits might be sustainable without runaway inflation in part because of the low birth rates around the world and that deflationary effect.

Very—

the demographics are very important. Thank you for listening. Jackson Cantrell is our producer. Jackson, what do you make of this baby deficit business? I mean, babies are the ones who are supposed to pay the debt eventually. I'm for smaller deficits and more babies. Where do you come down? Well, if we keep having fewer and fewer babies, eventually that debt's just going to fall on one baby, right? Then the baby will owe itself the money. It can decide whether it wants to pay or not. That's the idea. You're definitely going to win a Nobel Prize for that. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhoug. See you next week.

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