When investing in stocks today, the common advice is to stick your money in the S&P 500 Index and forget about it.

The benefits of this are:

• Near-zero risk of losing all your money
• Requires no special skills
• Easily accessible to everyone
• Can get 7-10% pa returns, beating most fund managers

This is all true, and I agree the indexing strategy is sound for most people.

However, as more and more money piles into the index, the trade starts to become crowded.

You may even have heard recent commentary that the S&P500 is becoming overvalued.

Here are the current PE ratios for the major US indices:

Let’s add some context.

Generally, I don’t bother looking at a stock unless it has a PE ratio around 12 (after normalizing profit figures).

Anything more expensive is difficult to justify, because it would require very high growth forecasts to make the investment worthwhile, and growth forecasts are almost impossible to make accurately anyway.

The S&P 500 is currently at a PE of 23, and the Nasdaq almost 31.

This is more than double what I usually consider paying for an individual stock.

However, my criteria for stocks isn’t relevant here. I look for value, but not everyone does.

A more useful data point is how this measures up historically.

We can find out by looking at the S&P 500’s historical PE ratio, dating back to 1926:

As you can see, the index has spent most of its life with a PE under 20.

It was only in 1996 that it finally climbed above 20 and stayed there for a sustained period.

An interesting side note – the grey bars represent recessions. We can see there is no real pattern here when it comes to the PE ratio. In some recessions it spikes heavily, in others, it drops heavily.

Here’s another way to look at it:

The red line shows the current PE ratio for the S&P 500.

Has the index spent more time above this line, or below this line?

It’s crystal clear that historically, the index has traded at a PE below the current level for almost all of its lifetime.

The only time it traded higher than today were short spikes in 2000, 2009, and 2020 (which all investors should know as the dates of famous market crashes).

This tells me the index trade is crowded right now.

People want to invest, but 99% of investors do not have the skills, time or temperament to invest in individual stocks. Therefore, the majority of people resort to indexing.

There are endless personal finance books, influencers and blogs telling people anyone can be a good investor – just invest in the index and “set and forget”. This is what people are doing. Almost all retirement funds like Aussie Super and Kiwisaver and 401ks are invested in the index. This is billions of dollars and growing every day.

That’s great – people investing in stocks is a good thing.

But like all markets, there is such thing as too much.

If all investors are piling money into the index thinking they can’t lose money and it’s 100% safe, what happens?

Well, let’s go back to how indexes work.

The S&P500 is just a collection of 500 US large companies. They are household names – Nike, McDonalds, Apple, Starbucks and so on.

When people buy the index, what they are doing in reality is buying a tiny amount of stock of every one of these companies.

Technically, they are still investing in individual stocks, but doing it in a blind and diversified manner.

If enough people follow this strategy, the end result is millions of mom-and-dad investors around the world putting a few dollars into Nike stock, McDonalds stock, Starbucks etc every month.

So in effect, people are buying individual stocks. But only S&P 500 stocks.

So what happens to the stock of these 500 companies? Do they go up and up forever?

Well, not really. At some point, they become overvalued and smarter investors will start looking for returns elsewhere. For example, as the stock prices climb, the dividend yield might drop from 3% to 2%. This might cause people to look for better returns elsewhere. If money keeps piling in, the yield will drop from 2% to 1%, which encourages even more investors to leave. Also as the index climbs, people will start to take profits.

If money is flooding into the index, that means these 500 companies are going to form a bubble of sorts. This also means much less money is going into the smaller companies not in the index. These companies will look comparatively cheap, and at some point, they will get too cheap to ignore and the smart money has to move.

For example, would you rather invest in the index at 25x earnings, or a small company like Briscoes at 8x earnings.

What about the index at 30x earnings versus Briscoes at 4x earnings?

What about the index at 40x earnings versus Briscoes at 2x earnings?

You get the point.

I think we have gotten to this stage already and small caps are already showing great value.

For example, Briscoes, Sky TV, Myer and Arvida have all been small-cap value investments that I’ve publicly shared on the @moneybren Insta page and have worked out well simply because they were trading so cheaply.

From memory, we picked up Sky and Myer at about 4x earnings, Briscoes about 7x and Arvida at 0.6x book value.

The NZ market is interesting because the popularity of the S&P 500 means a lot of New Zealand investment money goes into the US market, meaning the NZ index gets less attention than it should, and the NZ small caps even less still. That presents a great opportunity for those with the knowledge to analyze individual stocks.

What do I see as we move forward?

I think indexing will become even more crowded over the next few years, with apps like Robinhood and Sharesies opening the door to many new investors who wouldn’t have been in the markets otherwise. Retirement money continues to pour in through Kiwisaver and overseas equivalents. More people are learning about investing, and indexing is becoming more popular each year.

This means the returns from indexing will potentially fall in the coming years – historically the index has returned 10% per year, but I wouldn’t be surprised if we see this come down to the 5% to 7% range.

This likely presents a big opportunity in the small-cap space, where people will get the chance to invest in under-analyzed stocks trading at very cheap valuations.

My guess (and it’s just a wild guess) is Buffett’s massive stockpiling of cash and his selling of AAPL and BAC has something to do with this. All indexed companies have had too much capital inflow, driving up their prices, and they’re at a point where they’re simply too expensive.

When Buffett starts taking profits, that’s always a good time to pay attention!

So, what does this mean for you?

Should you stop putting money into the index?

No! If your plan is to invest in the index on autopilot, there’s nothing wrong with sticking to it and continuing to build your portfolio. Over the long term, you still have a high percentage change of making a good return.

However, don’t be surprised (or alarmed) if the index pulls back or your returns are less than the historical averages.

I think a good approach to max your returns is to have a strong allocation to the index, but also some stock picks you believe in that will give your portfolio the potential to generate superior returns.

If you’d like to start analyzing your own stock picks and searching for gems outside the index, it’s never too late to begin! My course Simple Stocks is the perfect place to start and has helped hundreds of Kiwis get safely into stock investing. Click here to join us!