Should You Buy S&P 500 Index Funds Right Now?

I just saw the news reported in the Wall Street Journal earlier today that Vanguard has received $250 billion in net inflows so far through October, compared to $236 billion in net inflows through all of 2015. About $200 billion of those Vanguard inflows have been invested in index funds.

I understand the collection of events that have caused index funds to be fashionable. The industry of financial advisors has always been a bit slithery and morally suspect, and the net results from holding an ownership interest in the S&P 500 has a fantastic track record of late.

Post recession, the S&P 500 has returned 14.8% annually since 2009. The S&P 500 nearly doubled between 2009 and 2012, and then has returned 13% annually since 2012. Given that index funds at places like Vanguard have such low fees, these cited results are a close approximation of the results actually achieved by the S&P 500 indexer base.

But you have to pay attention to how those returns are generated. An S&P 500 Index isn’t some magic thing that delivers 10% annually forever and forever. It is a predetermined formula that gives you an investment share in the largest businesses America has to offer. By and large, these businesses are very, very, very good at earning profits.

When you invest $100 into an S&P 500, you are saying: I am going to put $3.32 into Apple, $2.53 into Microsoft, $1.90 into Exxon, $1.71 into Johnson & Johnson, $1.65 into Amazon, $1.65 into Facebook, $1.48 into Berkshire Hathaway, $1.42 into General Electric, and so on all the way down to the penny you put in Adient PLC. Your destiny is the performance of those companies, which will dictated by valuation changes, earnings per share growth, and dividend payments shipped out to shareholders.

Take a look at this table. In January 2012, the S&P 500 traded at about 15x earnings. This was about its historical average. It would have been a logical time to make an investment in the S&P 500, as you were not overpaying for your ownership position. You were getting your share of America, Inc. at a fair approximation of what it was worth.

In the four years since, the S&P 500 index investors have been rewarded with 13% annual returns. I suspect that these double-digit returns are a part of the reason why people are getting so enamored with the thought of moving their wealth into indexing out. You don’t have to think about it, and you get double-digit returns that have been demonstrated by years of recent history, what’s not to like about this premise?

The thing not to like is that the premise that existed in 2012 no longer exists today. Those 13% annual returns since 2012 weren’t the result of collecting cash dividend payments from the 500 largest businesses in America and then participating in an advancing valuation that was proportionally spurred on by earnings growth.

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Instead, about half the returns came from valuing those shares Amazon, Facebook, Adient, etc. at a 60% higher rate than we did four years ago. If the S&P 500 was approximately valued four years ago, then it means that the future returns have been sacrificed by bidding the shares of S&P 500 index components up above what they should be.

I don’t know when this will revert. More and more could keep piling in, and the P/E ratio of the S&P 500 could rise further. But I do know that the American stock markets have never gone a decade without seeing its valuation revert to the teens.

My view is that the S&P 500 Index is a collective growing at about 6% and offering a 2% dividend that is currently 25% overvalued. Those no way that the 13% annual returns of the recent past can be justified going forward on a fundamental basis. In the five years since I have been writing finance articles, this is the LEAST attractive valuation that the S&P 500 index has offered. And yet, the money is pouring in at its highest rate since I have begun writing.

This isn’t a shot at Vanguard. They are offering a useful service that, in its totality measured over generations, is a pretty good one. And I like a good chunk of their active offerings. But that does not mean that S&P 500 index funds are wise investment choices right now.

My opinions on investments are dictated in part by valuations. If Amazon traded at 30x earnings, it would be all that I’d write about. When the S&P 500 is trading in the 15-17x earnings range, I’ll tip my cap to the passive investors buying it every month. If BP were at $85 per share right now, it wouldn’t interest me. It always comes back to the Grahamian question: “At what price, and on what terms?” 24x earnings for the S&P 500 is an anti margin of safety starting point that guarantees some form of P/E compression ahead. I’d rather check out the Vanguard small-cap index than the S&P 500 index right now. The growth rates and valuation of the former is superior to the latter.