The single-most-powerful force that is currently driving the world’s stock markets higher can be traced back to the 1950s, when Harry Markowitz, Merton Miller, and Bill Sharpe first introduced modern portfolio theory to the academic world.
By 1990, this theory and its related principles had become so popular and widely adopted — not just in academic circles, but also in the financial services industry — that Markowitz, Miller, and Sharpe were awarded a Nobel Prize in Economics.
Today, modern portfolio theory has been so widely accepted that an entire investment empire — called “indexing” — has evolved from the original principles and become the primary driver of activity in the world’s financial markets.
In a nutshell, “indexing” is simply measuring investment performance by comparing actual investment results to an index.
For example, the Dow Jones Industrial Average and the S&P 500 are the most commonly used indices for measuring the performance of U.S. stocks.
Other popular benchmarks are the MSCI ACWI and the MSCI EAFE. The MSCI ACWI is the most popular index for measuring global stock market returns. And the MSCI EAFE is the most popular index for measuring the return of stocks in the emerging markets.
|The single-most-powerful force that is currently driving the world’s stock markets higher can be traced back to the 1950s.|
From Reasonable to Nonsense in 50 Years
All of this seems reasonable and sensible. And when modern portfolio theory was first introduced, it was. The problem began when Wall Street and large institutional investors took the concept to its extreme.
While no precise figures exist, I consulted with a number of world-class investment professionals. And it’s our best estimate that indexing strategies (both direct and indirect) apply to 70 percent of the world’s investable assets. That’s up from approximately 20 percent in the 1960s.
This means that every time an index changes, more than two-thirds of the world’s investable assets are required to make a change, too.
I imagine Markowitz, Miller, and Sharpe would find it mind-boggling that their theory has been pushed to such an extreme.
Wall Street’s Stay with the Crowd Mentality
The well-known and widely respected investor Jeremy Grantham explains Wall Street’s stay with the crowd mentality perfectly:
“Never, ever be wrong on your own.”
As Grantham explains, you can be wrong on Wall Street when you have lots of company — that’s OK — but never go it alone. And that’s because no one is going to fault you if you’re part of the crowd that’s driving prices one way or another
This means buying the same things everyone else is buying, and selling the same things everyone else is selling. That way if something goes wrong, you can’t be blamed.
The Prudent Investor’s Creed
In fact the practice of indexing has become so wide-spread on Wall Street and in boardrooms around the globe that the prudent investor’s creed has become:
If we must lose the clients’ money, let us do so blamelessly and without sin so that we are above reproach and criticism.
This explains perfectly why Wall Street was so quick to embrace the concept of indexing when Markowitz, Miller, and Sharpe first introduced it. Moreover, it explains why many large pension funds and endowments are managed tightly to an index.
‘Indexed’ Mandates Dictate the Action
It also explains why the world’s financial markets have been on such a tear lately with the S&P 500 up an astounding 27.8 percent over the past year and almost 10 percent in just the past three months.
That means the managers of funds indexed to the stock markets have to keep buying stocks regardless of the price. This action alone pushes global stock markets higher, as all other “indexed” investors are required by policy mandate to buy more stocks to stick to the index.
It becomes a circular equation with the next big buyer setting the price for everyone until some outside event — such as a bank failure, a collapse in corporate earnings, or an unexpected spike in inflation — breaks the cycle.
The world’s central bankers know this too. That’s why Fed Chairman Ben Bernanke and his counterpart across the Atlantic, ECB President Mario Draghi, have been fueling the market rally with mountains of money. And recently, the Bank of Japan has joined the money printing party too.
The bankers hope rising stock market values provide the catalyst to kick start the sputtering economies in the developed world which in turn causes the private sector to create more badly needed jobs.>
What to Do … for Now
I don’t see anything on the horizon that will disrupt the upward spiral. We may see a temporary pull-back in the next month or two because the markets have moved up so far in such a short period. But if we have one, it will probably be short-lived as the global stock markets move higher and higher — riding the wave of indexing strategies — to levels that would have been unfathomable at the depth of the financial crisis.
That’s why I continue to recommend you consider purchasing the Wisdom Tree Mid-Cap Dividend Growth Fund (DON) on temporary market pull backs. DON is uniquely positioned to benefit from an expansion in the U.S. economy and is sponsored by the highly regarded investment firm Wisdom Tree. DON has returned over 18 percent so far this year.
DON’s laser-like focus on the mid-cap sector of the U.S. market provides the biggest bang for every dollar invested as the U.S. continues to be the location most favored by global investors. That’s because U.S. mid-cap stocks should perform well as more and more Fed-provided stimulus ripples through the economy and financial markets.
What’s more, Wisdom Tree has selected U.S. mid-cap stocks that have a high dividend yield. And the dividend provides a cash-in-hand payback that further boosts returns when the market goes up and cushions the fall when markets go down.
Next week, I’ll explain how the concept of Wall Street “career risk” and how it impacts your portfolio’s returns.
P.S. If you’d like more information about how to get my “buy” and “sell” signals, click here to learn about my trading service — The Park Avenue Society.