Three Things I Think I Think: Crazy Friday Edition

So much going on today….here’s another three things for you:

1) Apple gets added to the Dow, the investment world goes bonkers. I’ve spilled a lot of ink talking about how “passive indexing” is really much more active than you think. And if you look at the turnover within any index this becomes obvious. Today, Apple was added to the Dow Jones Index. I don’t really know why anyone cares about an index of 30 arbitrarily selected large cap stocks, but I guess it’s a legacy thing. Oh well.  The point is, these indices are obviously made up of active choices and their returns are derived from how the various components perform.  Buying a large cap mutual fund versus buying the Dow index isn’t so much the pursuit of “active” vs “passive” investing as much as it’s the pursuit of low fee and tax efficient investing (the index fund) versus high fee and tax inefficient investing (the mutual fund).

What’s more interesting here is something Michael Mauboussin tweeted this morning. He points out this paper from Pomona College which finds that you’re actually better off picking an index that is comprised of stocks that are dropped from the Dow Index instead of the Dow Index itself:

A portfolio consisting of stocks removed from the Dow Jones Industrial Average has outperformed a portfolio containing the stocks that replaced them. This finding contradicts the efficient market hypothesis since changes in the composition of the Dow are widely reported and well known. Our explanation for this anomaly is the market’s insufficient appreciation of the statistical principle of regression to the mean, an error that has previously surfaced in a variety of contexts.

In other words, the index committee isn’t all that good at “picking” the assets that comprise the Dow Index.  Not surprising given their tendency to be so focused on rear-view corporate performance.  Index funds don’t perform better because they’re necessarily less “active”. They perform better because they’re tax and fee efficient. Eugene Fama did a fabulous job convincing the investing community that discretionary intervention in a portfolio is a bad thing when the reality is that discretionary intervention is the norm – even in index funds.  Unfortunately, the terminology here has been horribly muddled and now even index fund pickers think they’re not active asset pickers. I guess Fama won in more ways than one….

2) Today’s excellent employment report is sparking Fed rate hike fears.  There are a few big takeaways from today’s employment report. First, the US economy continues to look strong on a relative basis. Second, worries about a rate hike are surging. Bond yields jumped following the announcement. The 10 year yield has been hovering around 2.24% all morning. That’s a 0.6% move from the recent lows in January. And it means that a 30 year T-Bond has lost 10% in just over a month.  This is precisely what I was worried about when I said that bonds looked “frothy” in January. That is, the deflation fears were so overdone that long duration bonds actually increased the risk of permanent loss in a portfolio. Investors who piled into that trade are feeling it big time….

 

The last important point is on average hourly earnings. This is a widely cited inflation metric, but you have to be careful relying on it too much. The Fed doesn’t like to rely on AHE and the reason why is because it doesn’t include non-production bonuses, health insurance, and payroll taxes. The Fed prefers to focus on the Employment Cost Index because it’s a more comprehensive view of wages. Something to keep in mind every time these employment report comes out and people start citing the AHE….

 

3)  Why are stocks falling if the economy looks strong?  It’s always a bit difficult to justify why the stock market does anything on any given day. After all, the stock market is just a place where irrationally emotional apes meet to exchange money for stocks – two things they don’t really understand all that well. Further, the economy isn’t the market so we shouldn’t always assume that the stock market and the economy move in tandem.

Anyway, the very awesome Joe Weisenthal has a good piece at Bloomberg asking why the stock market is tumbling today. His answer – the worry about Fed rate hikes. But here’s how irrational that would be – the stock market tends to rise before and after rate hikes.  Our friend Ben Carlson showed us the data last year.  But it’s probably best not to get too worked up over one day of performance in the stock market or any market. Unless it’s the market for beer. If something goes wrong there then we’re all in big trouble. Especially on a Friday….Enjoy your weekend.