There’s been a lot of words thrown around lately saying that indexing has been leading to overvaluation of the US stock market. I’m here to tell you that is wrong. I have two reasons for that:

1) Active managers have been pseudo-indexing for a long time.  The moment they get benchmarked to an index they do one of two things:

a) accept it, gain funds for mandates that are like the index, and then they constrain their investing so that they are never too different from the index, and hopefully not in the fourth quartile of performance, so they don’t lose assets. This is the action of the majority.

b) Ignore it, get less fund flows, and don’t let the index affect your investment decisions. The assets should be stickier over time if you explain to clients what you are doing, and why. Only a minority do this.

This has been my opinion since my days of writing for RealMoney. All of the active managers out there add up to something close to a passive benchmark, less fees. It can’t be otherwise.

The one exception of any size would be stocks excluded from indexes because they don’t have enough free float available for non-insiders to own/trade. Even that is not very big — it might be 5% of the total stock market, though this is just a wild guess.

2) If you want to talk about valuation issues, you really want to talk about the trade-off between stocks and bonds, or stocks and cash. Stock valuations are never absolute — it is always a question of the other assets you are measuring the stocks against, and how you desirable those other assets will be in the future, and how sustainable the profitability of stocks will be over time. I broke apart some of these issues in my piece The Dead Model. Desirability of stock investing can be broken into three components: maturity risk, credit risk and business risk.  At present, the first two are getting thinner. The last one is thicker, and at least at present, there is no great rush to encourage people to trade slack cash for newly issued shares of stock. If anything, stock is getting retired on net.  (Just a guess.)