09/20/05 by Justice Litle
In essence, passive indexing is the equivalent of a dog chasing its own tail. Selected companies grow larger as sums of indexed money robotically swell their market caps. As valuations rise, the indexers are encouraged by the boost. The process repeats in round robin fashion, with little thought for the objective worth of the companies receiving these blind inflows. Few question this puzzling lack of logic, thanks to a triumph of circular reasoning: the Efficient Market Hypothesis assumes that all valuations are intrinsically self-justified. This academic diktat reinforces the torrent of not just dumb, but brain-dead money. Most of us know the crucial economic benefit of a stock exchange is rational and efficient capital allocation, but we forget that rationality presupposes intelligent thought. As passive indexing gains in popularity, the principle of rational capital allocation is turned on its head and thrown out the window.
Those who defend passive indexing invariably point to stocks’ historical uptrend. But like the Calling Station on a temporary winning streak, indexers overlook the cyclical tendencies of the market, putting too much emphasis on an extraordinary run of good cards.
As the Rydex chart shows, the market actually spends more time going nowhere than going up, with the typical bear cycle measured in decades. Whether things work out in the long run is a moot point for those with retirement needs close at hand. As Lord Keynes famously noted, in the long run we are all dead.
Editor’s Note: Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)
Justice Litle is also a member of an elite group that meets occasionally to debate and discuss the new trends in the financial world and investment ideas – among other things. This monthly gathering includes the cream of the crop of financial minds – and for a limited time, you can attend the Agora Financial Reserve meetings.
