La La Land

President Trump’s well received speech to Congress released the animal spirits not seen in markets for some time. The very next day, the S&P 500 ETF (SPY) had inflows of $8.2 billion – the biggest daily inflow since Dec 2014 and the second largest in 6 years. Those investors that suddenly realized during this speech that Trump was going to be a pro-business president, are in la-la land.

This monster rally, which started immediately after the election, has already been one of the strongest on record. Even before the la-la land investors decided to jump on the train, the Dow Jones Industrial Average matched its longest streak of records ever in 12 days. In the 120-year history of the Dow, this streak only happened twice.

I believe that much of this rally is justified. We are in the midst of an economic boom and money is still cheap. Regulations are getting slashed. Corporate tax rates are expected to fall, and consumer confidence is at its highest level since 2001. My main concern is that la-la land investors are now chasing passively managed index funds to save on costs, and are forgetting all about risk. There is now much more focus on the investment expense than on the value of the investment.

This week Warren Buffett suggested that the stock market is undervalued. His caveat was because interest rates are so low. I couldn’t agree with him more that the biggest risk to stocks is rising interest rates. I have remained bullish for my clients in anticipation that growth was going to pick up and that inflation would follow. I’ve continued to have clients positioned in stocks and have kept my bond allocation low, even for retirees. As the Fed raises interest rates, stocks will begin to look less appealing.

Buffett’s second point was that investors should keep investment expenses low. I also couldn’t agree with him more. I take pride in having much lower fees relative to my peers. Buffett’s argument is really against hedge funds that typically charge 2% annually and also take 20% of profits. He recommends that investors who don’t have time to analyze investments should just buy the S&P 500 index. Buffett, on the other hand, would never buy the S&P 500 index. He hired two money managers to provide him with investment advice. He cares much more about buying at the right price than paying the lowest expense. Similar to our billionaire president, you have to watch what they do, and not what they say. Warren Buffett and President Trump didn’t become the richest people on the planet by following crowds.

The record breaking year is now largely being driven by la-la land investors that are blindly buying the S&P 500 index. Just ask Vanguard Funds. Vanguard brought in $323 billion in new money in 2016. They brought in another $50 billion in January 2017. I would bet that February had even larger inflows than January. Almost all the other large mutual fund companies had negative outflows in 2016! Most are losing billions and outflows have only been getting worse.

If this trend continues, we might find ourselves in a stock market bubble caused by la-la land passive investors focused on buying the same investment regardless of the price they pay. What will happen when these low-cost Vanguard investors decide to sell the same investment just as fast as they bought?

I can assure you that Warren Buffett won’t care because he understands the value of the investment that he holds. Moreover, he will be getting advice from his two money managers. Over at Vanguard, many passive index investors might eventually be in a panic as they have focused solely on buying the lowest cost investment. In the end, La La Land didn’t win for Best Picture. The same will eventually hold true for those investors that will be in for their own big surprise when they realize too late that diversifying into the right investments matters much more than paying the lowest expense.

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