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S&P 500: Index Investing Is Done

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More than a year ago, I wrote an article about how the next decade will be very different from the previous one: “A Decade Of Outperformance Will Be Followed By A Decade Of Underperformance.”

A recession seems inevitable, and for the sake of the Fed’s credibility, I think the Fed will stay on its path and raise interest rates until inflation is tamed. In his Jackson Hole speech, Jerome Powell clarified that there would be no pivot to another policy stance.

Investors must prepare for a few tough years ahead. Index investing is at a clear disadvantage against stock selection in this environment, especially when investing in US indices like the Dow Jones (DIA) or the S&P 500 (SPY).

Effective Federal Funds Rate data by YCharts

Especially risky and growth stocks will be negatively affected by the Fed’s policy stance. In my last article, I discussed that we could see a shift from growth (more cash flow in the future) to value (more cash flow in the present).

The US is a service-intensive economy

The US exported most of its manufacturing base overseas and has little capabilities to manufacture cheap items domestically. This trend has been prevalent in the last two decades since China entered the World Trade Organization in 2001.

All Employees – Manufacturing vs Service-Providing (Fred)

That’s important because the developed world enjoyed a prosperous time of low inflation for the following reasons, cheap immigrant labor in the service industry; affordable products from China; cheap gas in Europe, especially Germany, powering the industry.

Russia and China are decoupling from this system which creates structural inflation – not just cyclical inflation – which the Fed is primarily showcasing to fight.

In his book “The Changing World Order,” Ray Dalio describes the different types of war we can have nowadays.

  • A Trade War
  • A Technology War
  • A Geopolitical Influence War
  • A Capital War
  • A Military War

The war landscape got much more complex, and the chances for another military world war are slim because almost everyone anticipates that the next military world war will probably be the last one.

We’re currently in a complex economic situation amidst China rising global economic power and Russia as an energy and military superpower. China has the largest share of international trade. It’s growing its economic prowess through Asia and large parts of Africa.

China and US share of global trade (The Economist)

So the inflation that the US is fighting is the result of the printing of trillions of dollars during the pandemic and much deeper structural and global problems.

Looking at the energy crisis in Europe and Germany, can we say that inflation has already peaked in June at 9.1%?

My base case is that even though the Fed can decrease demand, it won’t be able to limit the geopolitical tensions and problems that lead to structurally higher prices in the future.

The Best Time for Stock-picking

My base case for the market indices is generally bearish or flat for the next years. Many growth names already suffered immensely after the pandemic-stimulus-induced stock market speculation.

During the pandemic, I shifted my portfolio towards value, commodity, energy, and emerging market stocks. This shift helped me to withstand the general market downturn and generate positive returns.

My low-volatility portfolio (you can check out my model portfolio in Google sheets) outperformed the market by nearly 14%. Still, the timeframe is too short to form an opinion as to its investment performance.

Keyanoush’s Low-Volatility Portfolio vs. S&P 500 (Keyanoush – The Value Bull)

Index investing had a great decade, but I think prudent investors can outperform the market as we advance by building a globally diversified portfolio of value stocks that can sustain economic hardship.

The ratio of the Wilshire 5000 Total Market Index to GDP retracted but remained elevated compared to its historical average. The US stock market remains financialized.

The Buffett Indicator: Market Cap to GDP (Longtermtrends)

As the market continues to retract, more and more investment opportunities show themselves. I wrote about a few value stocks in the past weeks that have the potential to perform well over the next 2-3 years.

These are cash flow generating businesses trading below intrinsic value or profit from long-term tailwinds in their respective markets.

I’ll continue showing more companies that I consider deals in the upcoming weeks!

Conclusion

There’s no way around a recession that will lead to the definancialization of the US stock market. The market indices like the S&P 500 could suffer from the definancialization.

Inflation is not only cyclical but structural. The Fed will probably keep its foot on the brakes until inflation is tamed. Higher interest rates might not lead to higher unemployment in a service-intensive economy like the US. The labor market in the US is tighter than ever, similar to the oil and gas market. A recession might not even be enough; if it’s not, we’re headed for stagflation.

Stock pickers that invest in value stocks or companies that benefit from strong industry tailwinds, like in the commodities or energy sector, are at an advantage.

I invest conservatively and unconventional, and I caution investors that fall victim to the widely held belief that companies like Facebook (META), Amazon (AMZN), Google (GOOGL), or Microsoft (MSFT) are conservative investments because they’re conventional.

Too many people on Twitter mistake conventional for conservative. A quote from Warren Buffett applies well:

It is unquestionably true that the investment companies have their money more conventionally invested than we do. To many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach, per se, is conservative.

Warren Buffett – 1965

Good luck out there; let’s keep in touch!

I always welcome constructive criticism and open discussions. Please feel free to comment or PM me about my calculations and/or sources that I use in my articles.