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Weekend Edition

Porter Stansberry: Why indexing is a fraud
Saturday, January 14, 2012

 Every once in a while, I try to pull back the veil on how our business operates and how finance works in general. As I'm sure you realize, the financial industry doesn't exist to help you get rich. It's the other way around. Likewise, frankly, with the financial newsletter business.
 
Most of the advice you're likely to get from mainstream financial service providers is simply wrong and designed to enrich the providers of the services. Similarly, most newsletter publishers couldn't care less about the quality of the advice they're offering – they only care if it sells.
 
So today, I'm turning the tables on the way these businesses normally operate by simply telling you what I would want to know if our positions were reversed.
 
 In the past, I've written extensively about the exceptional risk-to-reward properties of corporate bonds trading at a discount to face value. I would bet a lot of money that your broker will never explain how this situation works. You should also review my writing about selling options (rather than buying them, as most individual investors do). Today, I'm going to take on the mutual fund industry's most sacred cow – "indexing."
 
 Many people in the mainstream financial world like to hide behind the public's acceptance of so-called "indexing." Indexing means buying the stocks in the Standard & Poor's (S&P) 500 Index, holding them, and buying more on a regular basis. Sometimes, you buy at the right time. Sometimes, you buy at the wrong time. But over many years, you'll get a good return... or at least, that's the assumption.
 
Of course... that's not what actually happens for most people, as I'll explain. But before I tell you why indexing doesn't actually work for most people, I want you to understand why it's so popular with financial institutions.
 
 Indexing takes all of the responsibility for your investment performance out of the hands of financial institutions. If your investment account doesn't do well, it's not your brokerage's fault – it's the economy or the stock market that caused the problem. Meanwhile, indexing requires that you stay with a firm like Vanguard (the leading index firm) for a long, long time. These firms get your fees for decades whether or not your account grows. And to make sure that there's never a bad time for you to send them your money, they sponsor all kinds of academic research that "proves" you can't time the market, which is another way of saying value doesn't matter.
 
 It's complete nonsense. Clearly, some times are better than others to buy stocks. Isn't it obvious that in 1982 – when you could have bought the Standard & Poor's (S&P) 500 for less than eight times earnings(!) – your future returns were going to be better than buying the index in 2000 at close to 50 times earnings? Yes. That's why all the good research on the topic shows that the price you pay for stocks – the valuation – is the ultimate determinate factor in your future returns.
 
 Just look over the last decade. Imagine that on the first day of the year every year since 2002, you put $10,000 into stocks, corporate bonds, or gold. You would have made 23% – total return – in stocks. You would have made 44% in corporate bonds. And you would have made 190% in gold.
 
Why? Ten years ago, stocks were very expensive relative to earnings... and gold was only beginning to emerge from a 22-year bear market. But indexers would tell you there's never a bad time to buy stocks. It's hogwash.
 
 And here's the final nail... have you ever considered how these index funds actually work? Almost all of them are based on the S&P 500. This is simply a list of the 500 largest American companies that trade freely on our stock exchanges. That makes some sense – you want to own the leading companies, assuming you can buy them at a reasonable price.
 
But here's the incredibly stupid part. S&P organizes its index by giving the biggest, most expensive stocks more "weight" in the index. Thus, the companies least likely to perform well for investors (because they are already big and expensive) end up collecting the largest amount of investment capital from index funds. Said another way, index funds guarantee your money will mostly go into stocks that are a lock to do poorly relative to other smaller and cheaper companies.
 
 What do I suggest you do with your investment capital? Simple: Allocate to value. I see tremendous value today in real estate, where I'm buying cheap apartments with gross yields (before expenses and taxes) in excess of 20%.
 
Likewise, I see value in gold mining shares and certain areas of the oilfield-services complex. When you can't find value in stocks, bonds, or real estate, don't be afraid to simply sit on cash (and high-quality bonds) and wait. The institutions don't ever want you to be out of the stock market because they don't get paid when you hold cash. But there are plenty of times when it will pay off – for you – to be out of stocks.
 
Regards,
 
Porter Stansberry




This Week's Winners
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MEMC Electronic Materials WFR +19.8%
First Solar FSLR +17.2%
Netflix NFLX +16.2%

Countries Symbol Change
Chile CH +6.7%
Turkey TKF +5.2%
Brazil EWZ +5.1%

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Infrastructure PKB +4.9%

S&P 500 Symbol Change
First Solar FSLR +17.2%
Netflix NFLX +16.2%
Eastman Chemical EMN +14.9%
Countries Symbol Change
Chile CH +6.7%
Turkey TKF +5.2%
Brazil EWZ +5.1%

Sectors Symbol Change
Clean Energy PBW +11.6%
Homebuilding ITB +5.6%
Infrastructure PKB +4.9%

Commodities Change
Copper +6.5%
Feeder Cattle +6.1%
Zinc +6.0%

Date Range:1/5/2012 to 1/12/2012
This Week's Losers
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Cabot Oil & Gas COG -18.8%
Equity EQT -12.4%
Urban Outfitters URBN -12.3%

Countries Symbol Change
Ireland IRL -1.0%
Japan EWJ -0.4%
United Kingdom EWU -0.4%

Sectors Symbol Change
Oil Services PXJ -1.1%
Big Oil IXC -0.9%
Utilities XLU -0.9%

S&P 500 Symbol Change
Cabot Oil & Gas COG -18.8%
Equity EQT -12.4%
Urban Outfitters URBN -12.3%
Countries Symbol Change
Ireland IRL -1.0%
Japan EWJ -0.4%
United Kingdom EWU -0.4%

Sectors Symbol Change
Oil Services PXJ -1.1%
Big Oil IXC -0.9%
Utilities XLU -0.9%

Commodities Change
Natural Gas -7.2%
Corn -5.0%
Wheat -4.1%

Date Range:1/5/2012 to 1/12/2012
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