Golden Age For Stock Pickers

ETFs Still Small But Growing Fast

The biggest trend when it comes to fund flows is the movement from mutual funds to ETFs which are passive investments. The trend is important because it effects markets. It’s also rare historically in the sense that the strategies that most non-professional investors use to save for retirement and other big-ticket items like college don’t change that often. This isn’t like a fund manager who is constantly changing his/her process. These processes become engrained as the average person with a 401-K doesn’t know much about investing and doesn’t apply much rigor to the decision. The fact that most mutual funds were able to underperform their benchmarks in the past decade and still maintain a stranglehold on the investment landscape shows how entrenched strategies become. If a firm’s profit growth underperformed the market and its sector for 10-years, it wouldn’t be touched by investors. A stock could lose favorability after one bad quarter, but some investors stick with mutual funds after several bad years. Therefore, the shift to ETFs is very important. Finally, the average investor said he/she was done with high mutual fund management fees for bad performance.

I have spoken to these people and you can tell they are very angry with past performance. They decided to move their funds into a Vanguard ETF and are unlikely to change their minds and switch back. It’s important to get a grasp for the scope of this situation to see the trends in place. I’ve showed previous charts of the inflows into ETFs and the outflows from mutual funds, but I haven’t showed the current scenario. As you can see from the chart below, the assets under management for mutual funds is $21.382 trillion and the assets under management for ETFS is only $2.555 trillion. The annualized growth rate for mutual funds is 0.8% and the annualized growth rate for ETFs is 21.4%. It’s amazing to see how the market has already been so effected by ETFs even though they are still a small portion of the total money in the market. If this trend continues, it will become much easier to pick stocks. It will be the golden age for stock pickers in the next few years. Only that change can reverse this trend because then people will see how easy it is to pick stocks and try to hop on that bandwagon.

This trend should affect your investment process because as ETFs become more important, there will be more opportunities to buy undervalued stocks and short overvalued stocks. You may find yourself stumbling across situations where you are overthinking the facts because it doesn’t seem like the opportunity should exist. That’s what could occur in a world of robo-advisors and ETFs. This trend might be altered by the next recession/bear market. When ETF investors lose money in that correction they might change their tune, switching back to mutual funds. Another possibility would be ETF investors pulling out during the bear market, mistiming the crash, losing money, and then putting money back into ETFs way after the bottom.

The average at-home stock trader underperforms the stock market, so it wouldn’t be surprising to see investors underperforming indexes even while being in ETFs which track the market. In this scenario, the market would have more volatility, but the trend toward staying in ETFs wouldn’t change unless there was a new product invented. It’s easier to sell out of ETFs than mutual funds and it’s easier to check the index funds’ prices making more people want to sell when stocks are falling. We haven’t gone a full cycle with ETFs being popular, so it’s impossible to see how well they will do for investors. In theory, passive investing would prevent volatility because there are so many investors staying in the market, but human nature is to get scared when you’re losing money. These passive investors don’t have much conviction in their holdings because it’s a new strategy.

Q2 Earnings

FactSet isn’t reporting the S&P 500 earnings results for the next two weeks because we’re at the end of the summer, so we’ll have to rely on the S&P Dow Jones results to review the earnings results from last week. The results now have 95% of the reports in, meaning we’re inching closer to the final reports coming in. Once the reports are finished, valuation metrics can adjust with the new information. The multiples will fall because earnings grew. Based on the latest as reported trailing twelve-month earnings, the S&P 500 P/E ratio is 23.298. This was a great quarter as 68.8% of firms beat sales estimates and 70.86% of firms beat earnings estimates. The easy comparisons and the rebound in energy were the story for first half earnings. The next two quarters will be affected by the dollar. As you can see from the chart below, the dollar has fallen since Q3 started in July. That will be a tailwind for Q3 earnings.

The economy is also on pace to grow GDP above 3% which is more good news for earnings. That’s a perfect scenario for firms which is probably unusual. I haven’t done an analysis on historic GDP growth versus the dollar, but you would think a strong economy would boost the dollar. The reason the dollar is weakening is because emerging markets and European economies are strong and because the ECB tapering is larger than the Fed’s unwind as I have discussed before.

A perfect scenario for earnings improvements isn’t the same as rising stock prices. They will always be related, but the halting of global QE could cause multiple compression. The other aspect to keep in mind is U.S. stocks are expensive compared to other markets. As you can see, U.S. multiples are higher than their 10-year median; they are relatively more expensive than most other markets. Emerging markets 10-year median P/E is 13% below where it’s at now, while the 10-year median P/E is 21% lower than the current P/E in America.

Conclusion

ETFs are still a small part of fund flows, but they are growing faster than mutual funds. S&P 500 earnings look to be in good shape because of the strong economy and weak dollar, but stocks might not go up. The Fed unwinding its balance sheet and the fact that U.S. stocks are relatively expensive may cap upside.

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