In 2013 and 2014, a big theme for retail investors was indexing. Many personal finance pundits and bloggers pounded the table about the value of low-cost index funds, arguing that active management cannot and will not sustainably outperform in the long run.
The backdrop of this shift is quantitative easing, the Federal Reserve monetary policy that was designed to promote investment in higher-risk assets, including common stocks. In such a monetary environment, the S&P 500 (SPY) will see a strong performance, as money floods in search of yield when Treasuries (TLT) offer no above-inflation return.
The problem with this trend is that it creates tremendous market inefficiencies, in which speculative stocks see a large inflow of capital as the tide rises for all boats. The end result is stock price appreciation that is not married to fundamentals, creating high overvaluation in many stocks. Janet Yellen herself noted this trend last year, pointing to bubbly valuations in social media stocks (a comment that many criticized as inappropriate market analysis from the Fed Reserve chairperson).
This is easy to see when looking at the 2013 and 2014 performance of a basket of high-beta stocks: P, FUEL, TSLA, FEYE:
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In 2013, simply picking a stock at random and putting money in it was profitable—even stocks that were not profitable provided massive returns.
In 2014, that party ended:
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Here we see the risks involved in these stocks beginning to get priced in; the value of these stocks’ opportunity was overvalued when money was cheap and liquidity was high. As that liquidity fell, so too did the price investors were willing to pay for future returns in these high-risk equities.
There is an opportunity here that speaks to the dangers of faith in indexing. When money flows into passive funds and everyone expects the market to provide its own efficiencies, the market will become more inefficient. This then becomes an opportunity for analysts to anticipate when the equities will get reset to their appropriate risk-adjusted price.
Surprisingly, few financial analysts are developing models that take into account how the pricing of equities will be impacted by index investing; the assumption is that this is a market-neutral flow of funds that rises the tide of all boats. The trend of these stocks indicates that, in fact, indexing can produce its own irrational exuberance that then becomes an opportunity for investors to bet against.