S&P's index guru David Blitzer on passive investing, market valuation and Trump-Reagan comparisons

Published Thu, Dec 1 20162:59 PM ESTUpdated Tue, Dec 6 201612:39 PM EST

David Blitzer, chairman of the Index Committee at S & P Dow Jones Indices, spoke at length with CNBC's Mike Santoli about passive investing, how to value the market and what may be ahead under President-elect Donald Trump. "One comment that's come up a few times and maybe it's looking at the individual as much as anything else, but there seems to be an interest to compare Reagan and Trump together," said Blitzer in reference to the similarities between both politicians. Despite those comparisons, the path ahead for the incumbent president may not be as rosy, according to Blitzer: "Reagan's economic policy — very different than what we have now in a sense — was very tight monetary policy. Paul Volcker was in the Fed. They just crashed down on inflation. And it was still very tight. When Reagan came into office, interest rates were probably 15 percent, 16 percent, which shocks people today. On the other hand, you know, Reagan said he was going to balance the budget. But he didn't. And I don't think Mr. Trump has said he is going to balance the budget. But it'd be very difficult for anybody to balance the budget today. So if he looks like Reagan, we're going to flip everything around," he said. In this exclusive conversation for PRO subscribers, Blitzer, who's been ranked by Smart Money magazine as one of the 30 most influential people in the world of investing, also discusses: How new index members are selected. Trends in the housing market. Inflation, valuations and his outlook for stocks. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) * MIKE SANTOLI: Doctor David Blitzer is chairman of the index committee at S & P Dow Jones Indices where he is instrumental in selecting which stocks are added to S & P's indexes. Throughout his career David has been ranked by Smart Money magazine as one of the 30 most influential people in the world of investing. He's also been named the nation's top economist, receiving the blue chip economic forecasting award for most accurately predicting the country's leading economic indicators for four years in a row back in the late '90s. He's also the author of several books including Outpacing the Pros Using Indexes to Beat Wall Street's Savviest Money Managers and Everyone's Guide to Understanding and Profiting from the Economy. He joins us here at the Nasdaq to discuss his investing approach as well as indexes and a bit of the economy. David, thanks for being here. DAVID BLITZER: My pleasure. MIKE SANTOLI: If we could just start with indexes and what indexes, sort of, work as investment vehicles in different environments. I just was struck actually recently in one of these days where the overall market was up. You had the Dow Jones Industrial average about a full percentage point higher on a given day than the S & P 500 was. Often they are more in tune than that. What can we take away from days like that or trends like that, if anything? DAVID BLITZER: Probably not very much. I mean, on an hour to hour, day to day basis, there is a huge amount of ups and downs or what some people would call statistical noise in the market and not too much short term rationality. Over a long period of time, certainly over a year or more, the 500 and the Dow are gonna track each other very, very closely. But day to day we dig into the differences between the indices. The Dow is only 30 stocks. The 500 is obviously 500 companies. The Dow has got a, sort of, traditional weighting system by price. So a high price stock has a lot of weight in the Dow even if it's actually a very small company. The 500 is weighted by the market value of the companies which probably makes a little more sense nowadays-- MIKE SANTOLI: Sure. It certainly makes a little more sense for the S & P 500's was, I guess, initially intended for which was really as a gauge of the broad market and how it's behaving, what it's doing. And then, I guess, a good deal later it became actually an instrument to own, to be invested in, right? DAVID BLITZER: Yeah. The 500 traces its predecessors all the way back to the mid-1920s. But it became 500 stocks in about 1957, you know, a little more than 55 years ago. And as you mentioned, the idea was really to track the market. Back in the late '50s the market was the New York Stock Exchange, Nasdaq was, sort of, something in the future. It wasn't quite figured out at that point. And the 500 was the dominant, you know, roughly among the largest stocks in the index. In the 1970s people began to realize that one way to invest was to track the whole market instead of tryin' to pick the hot stock of the week or the month. And I think for the average investor, the real moment that mattered was in 1976 Vanguard introduced the first index mutual fund based on or tracking the 500. And in some sense, the rest is history. That fund started out small. It's now one of the largest in the world. MIKE SANTOLI: Sure. And the adoption of indexing or passive investing has really just accelerated as you mentioned in recent years. Is that certainly justified on all the academic research, but are there any pitfalls associated with that, do you think, in terms of, you know, a lot of people would say well simply waiting, your own investments buy size of company or size of market capitalization implicitly is buying high because you're buying the stocks that have already got the biggest. I mean, how do you respond to those things? DAVID BLITZER: Well, one charge has been leveled over the last few years is, sort of, you know, a stock that's got a high price may be overpriced. For the low price, maybe undervalued. And, you know, what's the problem. If you look at our experience at the end of the 1990's, the technology boom, you had a time when the tech stocks would lead everything each month. And the next month because they had led everything the last month, they had more weight in the index. Well, on the way up it was fantastic fun. There were a couple of quarters in '98 and '99 when the 500 outperformed, like, 95 percent of all the funds out there, ridiculous. On the way down it stinks because all of a sudden the biggest ones are falling the most. Over the long haul, and, I mean, we do a lot of comparisons between indices and active management and over all the long haul, the indices do very, very well. Typically in any given year the index will beat three out of five active managers. And here is really the rub. Just because somebody was a top active manager last year says nothing about what he's gonna do this year. So any given year you've got a 40 percent chance of beating the index. Do it two years in a row, 40 times 40 is about 16 percent. And it keeps going down. So that's not very encouraging. MIKE SANTOLI: Exactly. So the persistence of the ability to beat the index is not very good-- DAVID BLITZER: Yeah. It ain't there. MIKE SANTOLI: Yeah. And so if somebody has decided, "Okay. This makes sense to me. I'll own an index." Now you can own just a tremendous variety of things that essentially are called indexes. I mean, every ETF in theory is based on an index or some, kind of, rules-based basket of stocks, right-- DAVID BLITZER: Right. MIKE SANTOLI: You inherited the Dow Jones Industrial Average, of course, at S & P. So, I mean, you can own it. You can own it along with everything else. What would be the determination to decide that. I mean, these are 30 very large, very well-known companies, very global in nature. Are there judgments that you make in deciding which way to go? DAVID BLITZER: For an investor deciding which way to go, I think if you're a long-haul investor, you know, the ultimate buy and hold, the 500 is better. It's a good reflection of the market. In fact you go one step beyond that and take a total market index, which we run and the others do as well. And there are funds on total market indexes. There is virtually no turnover in trading 'cause once the stock is there, it's gonna stay in that index unless it gets acquired by somebody in which case the price probably pops up, not a problem or it goes bankrupt, which is a problem. But that's it. The Dow is much more focused. It doesn't change very often. I think the last change we made was a year and a half ago. But it is very focused on those 30 names. MIKE SANTOLI: And in terms of determining new entrants and stocks to take out of the 500, let's say, you know, it captures a tremendous percentage of the total market value of the country, right. Was it 80 percent or 75 DAVID BLITZER: Yeah. Right around there. MIKE SANTOLI: So, I mean, obviously many of the very largest stocks are gonna be there. But in terms of on the margin, what are the determinations that you make when you want to decide whether something is gonna graduate into the index? DAVID BLITZER: There are a series of guidelines and rules. The market value has to be at least $5.5 million. The stock has to be liquid. We look for the stock to turnover once a year at least so that all the shares would turnover. We like to see half the shares in public flow. We don't want something that's very narrowly held or something like that. It should be U.S. company which gets a little difficult at times because we've got companies, you know, changing their incorporation to England or Ireland, anybody with a lower tax rate than we have in the United States. Wall Street still says they're a U.S. company. They're listed in New York and Nasdaq and they file results with the SEC. And one thing-- MIKE SANTOLI: So is that to some degree a judgment call then? DAVID BLITZER: No. The rules are about this long instead of this long. But there are rules. The last thing is we want it to be profitable. It has to have earnings over the last four quarters on a gap basis instead of, you know, "Oh, we're gonna make money next week but we didn't make money last year." We'll wait a while and see what happens. MIKE SANTOLI: Got it. Yeah. You know, I guess just turning to how the market has acted and, I guess, the outlook for the economy as well. You know, in the immediate aftermath of the election it seemed like the market was in a tremendous hurry to try to decide what this meant to the economy and sectors of the stock market, right. You had this, kind of, Trump effect where people at least are, kind of, penciling in some deficit-based fiscal stimulus, various deregulatory moves, things like that. Does that make sense to you? Does it make you adjust what you think the economy might do in the next year? DAVID BLITZER: Well, yeah, it certainly makes one think about the economy. You know, his policies will probably be different. They're not gonna change overnight. They're not even gonna start changing until January obviously. But it takes a while to change the economic policies and all the underpinnings. So we're really thinking about how is it gonna evolve over the next year or year and a half going forward compared to what we might have expected had the results been different in the election and so on. One comment that's come up a few times and maybe it's looking at the individual as much as anything else, but there seems to be an interest to compare Reagan and Trump together. And Reagan's economic policy, very different than what we have now in a sense, was very tight monetary policy. Paul Volcker was in the Fed. They just crashed down on inflation. And it was still very tight. When Reagan came into office, interest rates were probably 15%, 16%, which shocks people today. On the other hand, you know, Reagan said he was gonna balance the budget. But he didn't. And I don't think Mr. Trump has said he is gonna balance the budget. But it'd be very difficult for anybody to balance the budget today. So if he looks like Reagan, we're gonna flip everything around. MIKE SANTOLI: Right. I mean, in a sense, as you sketch it out here, what we might have if in fact Trump does what he says on the fiscal side is relatively loose monetary policy along with relatively loose fiscal policy? DAVID BLITZER: Well, then you get a big deficit. You almost guarantee you won't balance the budget MIKE SANTOLI: Yeah. Exactly. Yeah. You know, the other differences that are interesting from an investor's perspective, too, is if you look back to the very early '80s, stock market valuations were quite low, perhaps because of the interest rates and inflation levels and everything else. I mean, it doesn't necessarily fit in terms of the starting point. DAVID BLITZER: It definitely doesn't. I mean, the economy had a lot of inflation. We have none. The economy when Reagan came into office we were between a short recession and a long, almost as nasty as the so-called Great Recession and so on. Around that time, I couldn't give you the exact date, the in the 500 was around eight times. You know? And today it's around 20 times. MIKE SANTOLI: Dividend yield was maybe above five or something like that-- DAVID BLITZER: Oh, yeah. I mean, you know, I think nobody thought the dividend yield would go below two or three then. And it's, I think, 2.1 or something at this point. So it was a completely different world. And the same policies probably have a different impact today than they did 30 years ago. MIKE SANTOLI: Sure. You know, you mentioned there is basically no inflation. The Central Banks have had a hard time generating inflation across the developed world. Yet there is at least the, sort of, inklings out there if you look at what the bond market has been doing that at least we might be moving from a time where deflation seemed like a prominent risk to one where, you know, we might be able to bank on inflation picking up in certain respects. Does that make sense? DAVID BLITZER: I think it does. Well, for one thing, let's assume for a moment oil stays between 40 and 60, which is a big range. But if it stays in that range, you're not gonna have a huge inflation impact from oil. So, you know, you, sort of, take oil off the map. The underlying so-called core rate is probably one and a half, which it is. So instead of talking about a half, we're not talking about one and a half, you throw in a little extra spending. If you get trade barriers and some protection, you're gonna move a lot of buying to domestic stuff instead of foreign stuff. It's gonna reduce some of the price competition. All of that will give you a little more inflation. That doesn't mean we're going back to double-digit and 15% that we had in the '70s. But it's not gonna be a half of a percent. MIKE SANTOLI: You mentioned the potential for trade barriers. And people don't maybe think about that as an inflationary effect. But, you know, certainly one of the side effects of doing that, right? I mean, if globalization has been a deflationary force? DAVID BLITZER: Yeah. I mean, there is no question that autos in the '80s were, sort of, the classic example. But it's probably still true today. Back in the 1980's there were quotas on Japanese cars coming in. And what they did was it meant that anybody who bought a car paid a little bit more. You bought a Japanese car you paid more. Of course there was a shortage. You bought an American car, you paid more 'cause they didn't have to compete with so many Japanese cars. And the same thing could happen. It doesn't have to be cars. It could be just about anything. MIKE SANTOLI: Sure. The other piece of it that maybe isn't getting recognized as much is in theory very strict immigration enforcement in terms of wage gains could be another force for inflation? DAVID BLITZER: Well, I think it could. And I guess that two aspects, whether we like to admit it or not, a lot of immigrants and maybe more so immigrants who aren't fully documented, so to speak, end up doing very low wage jobs. In fact, you know, according to reports, sometimes below the minimum wage. Well, if there is no immigration, either Americans are gonna accept those low wage jobs or they're not gonna get done. So that's gonna have one impact. And second of all, you may actually create a shortage of labor. One thing we see in general, the unemployment rate is down at 5 or 4.9 percent. Labor force participation has been gradually declining. The last couple months it may have perked up a little bit. The country is getting older. We have, you know, aging of the population. The baby boomers are gonna start retiring. And that-- MIKE SANTOLI: They've already started, many of them. DAVID BLITZER: Yeah. Well, back when Bill Clinton was president, it was easy. He was born in '46, the first year of the baby boom. And I think he is retired. So there it is. MIKE SANTOLI: Exactly. I think his wife might be too, now, for better or worse-- DAVID BLITZER: Well, we'll let them figure it out. Not us-- MIKE SANTOLI: Yeah. Exactly. Turn a little bit to housing and specifically because you also maintain the S & P Shiller House Price Indexes. What has that series been telling us about the performance of the housing sector and, I guess, its ability to be a leading source of activity for the economy? DAVID BLITZER: The S & P Case-Shiller Home Price Indices cover existing single-family homes principally. What we see is a generally very healthy market. Home prices over the last year or more going up at about a 5 percent annual rate. There are some very hot hot spots in the country. The Pacific Northwest: Seattle and Portland, Oregon seems to be a big draw at this point. Some of that because there is a lot of job creation out there, and some of it just seems that that's considered a very nice, favorable place to live. MIKE SANTOLI: Sure. We've also heard that there have been some restrictions in terms of farm buying in Vancouver by the Canadians. And maybe, you know, there is just a lot of activity there. DAVID BLITZER: Yeah. You may be seeing some of that. You know, in the Northeast and in New York, the market is a little bit cooler, a little bit softer but still looks reasonably good. And home prices have done quite well. One thing in the background seems to be that getting a mortgage is not difficult but it's certainly not as easy as it was in 2006 when they handed them out like crazy. And it seemed to have not that many people selling their homes and trading up in part because of the mortgage. And so there was a bit of a price freeze in some spots and so on that's going on. But generally the housing market looks quite good. We are finally in the last, I guess, couple of quarters gotten housing starts back over a million units and more or less where they ought to be. It probably still has a little room to grow. MIKE SANTOLI: And just to, I guess, kind of, bridge the, sort of, focus on equity indexes as well as, you know, the economy, does the overall stock market, how it's valued, its size relative to the size of the economy is one thing a lot of people try to compare over time and see if the stock market is overdone or not. Is that something that we should be concerned about because it is near the top of the range, at least of recent times, in terms of how much equities are worth versus the annual performance of the economy? DAVID BLITZER: I think to some extent it's valued. I mean, the PE is high. You know, we're coming off a very long run from in 2009, the last recession and that, kind of, thing. But I wouldn't, sort of, madly panic by any means at this point. You know, for an investor who has been in the game for 16, 17 years since 2000, he's had to bear markets of 50 percent drops each. Fortunately those don't happen every week. The previous one was about 1973-'74. So keep your fingers crossed we're not gonna see another 50 percent drop around the corner. The debt levels in the economy are not scary at this point. And they certainly were scary in 2006 and 2007. So that's another plus and so forth. MIKE SANTOLI: So private debt levels certainly are not something. DAVID BLITZER: No. And, you know, markets never go straight up. So there will be some bumps. But, you know, I don't see the, kind of, extremes that's gonna take you down by 50 percent. And, I guess, the other thing, look over the long period of the market, timing it is probably a loser's game. You know, at almost any time, you know, probably all the way going back to the end of the second World War, you put money in the market, well, you'd certainly be ahead today from almost any time you put it in. We're close to the all-time highs. You know, so if you're gonna buy a house next month, don't put it in the market. But if you have a new child just born and you want to pay for college, the market may not be a bad bet. MIKE SANTOLI: True. And we always like to ask this in terms of lessons that you have picked up over the years aside from perhaps not trying to time the market. You know, as you put your books together and things like that, what are some of the things that you feel like you constantly want to go back to and point out in terms of lessons or pitfalls or anything like that? DAVID BLITZER: You know, one thing I've found talking to people, and this is probably more the proverbial man in the street or woman in the street than somebody who sits in Wall Street and thinks he knows everything or whatever. People listen to the arguments about investing with an index. And they say, "Yeah, that all makes a lot of sense, and so on and so forth. But, jeez, my neighbor told me about this hot stock and I really want to own it. Or what am I gonna talk about, you know, when I have a beer after work and everybody's talkin' about the market." And, yes, I believe in indexing and index investing. And I do it. But I also know it's entertainment for people. And so if you think you know a hot stock, what the heck. Go out and buy it. I mean, you know, there is nothing wrong with that. If you're saving for the infant child's education, I wouldn't do it all with the hot stock. But, you know, keep a little rationale and you can have some fun. MIKE SANTOLI: Well, it's a good point because often people discuss it as if they're mutually exclusive, right? And they clearly are not. DAVID BLITZER: They're definitely-- MIKE SANTOLI: Indexing and owning an individual stock-- DAVID BLITZER: They're definitely not. I mean, the only other thing which a long time back we used to do work looking at 401K plans. And you find somebody who was employed by a company, they have a big stake. It's where they work. It's where they get paid. And then they put all their savings in the company's stock. And it's nice to love who you work for. But again, have a little rationality or something like that-- MIKE SANTOLI: Yeah. Spread the risk a little bit. DAVID BLITZER: I mean, I work for a great company, but I don't have all my money in their stock. MIKE SANTOLI: Excellent. David, thank you very much. Appreciate it. DAVID BLITZER: My pleasure. Thank you. MIKE SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. Transcript by Transcript Associates, Inc.

"One comment that's come up a few times and maybe it's looking at the individual as much as anything else, but there seems to be an interest to compare Reagan and Trump together," said Blitzer in reference to the similarities between both politicians.

Despite those comparisons, the path ahead for the incumbent president may not be as rosy, according to Blitzer:

"Reagan's economic policy — very different than what we have now in a sense — was very tight monetary policy. Paul Volcker was in the Fed. They just crashed down on inflation. And it was still very tight. When Reagan came into office, interest rates were probably 15 percent, 16 percent, which shocks people today. On the other hand, you know, Reagan said he was going to balance the budget. But he didn't. And I don't think Mr. Trump has said he is going to balance the budget. But it'd be very difficult for anybody to balance the budget today. So if he looks like Reagan, we're going to flip everything around," he said.

In this exclusive conversation for PRO subscribers, Blitzer, who's been ranked by Smart Money magazine as one of the 30 most influential people in the world of investing, also discusses:

How new index members are selected.
Trends in the housing market.
Inflation, valuations and his outlook for stocks.

PRO subscribers can also read the entire transcript of the exclusive interview below.

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