Market Commentary: Trumped
US stock markets have been on a furious pace since the results of the 2016 election, with what analysts and talking heads are calling the ‘Trump Rally.’ Led by small cap stocks, we have seen a year’s worth of gains happening over a 3-month span. With stocks at or near all-time highs, investors are left wondering what’s next. Can the Trump Rally continue? Should I buy stocks at all-time highs?
Market Indexes Stretched:
Valuations on the major stock market indexes appear stretched , yet dollars continue to pour into broad market indexes products out of actively managed funds. The table below highlights money flows between active versus passive investment products during 2016. Over $500 billion went into index products last year, $310 billion of which came out of actively managed funds. While passive products offer investors a way to participate with the markets at a low cost, there are some inherent risks that investors may not fully grasp.
Source: Morningstar Direct Mutual Fund and ETF flows through 12/31/16
In the US, the major stock market indexes are market-cap weighted, which means that the largest stocks by market cap make up the largest components of the index. Market cap is essentially the number of shares outstanding (or in practice available float) multiplied by price per share. What this means is that when investors buy shares of an S&P 500 index fund or ETF, the largest companies get the biggest bids. This may lead to these companies becoming overvalued, as we saw with Tech companies in the early 2000’s. This can result in strong returns in market conditions like we have seen since 2009, but can be disastrous to a portfolio if-and-when the trend changes.
When the Tech bubble popped, the market cap weighted S&P 500 index lost nearly half of its value. What most people don’t realize, however, is that during that same time-period, more stocks went up then went down. The reason is because during the bubble, the prices of Tech stocks swelled and became a larger and larger piece of the overall index. When the bubble finally popped, it was the index investors who were left holding the bag. Index strategies were not as popular then as they are now, and if a market shock causes a rush of selling out of passive funds and ETF’s, the pain could be exacerbated as the largest stocks in these indexes will see the most selling.
At FinTrust, we try to take a balanced approach to portfolio construction. We survey the market landscape for opportunities, and use disciplined strategies to manage the portfolios along the way, helping to ensure that our clients stay on track. We don’t have our fund products like the big players, and therefore are free to choose from some of the best products in the market place – whether they be passive or active. This approach assists in creating a diversified investment strategy designed to manage volatility so that clients can be confident regardless of market conditions.
Cliff Hodge, CFA
FinTrust Investment Advisors