The Index Bubble

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In the last two quarters we’ve examined the growing divergence between US Megacaps (S&P 500) and everything else. We concluded that this divergence was driven by non-sustainable sources of return and began to discuss the potential sources of divergence. While it’s tempting to point to the recent AI hype, this trend goes back a lot further and is better explained by a more subtle force: The rise of ETFs and other index trackers. By far the most tracked index in the world is the S&P 500 index. As investors have pulled money from other funds and invested them in S&P 500 trackers, there has been a wave of indiscriminate buying of the US Megacap stocks that comprise this index at the expense of everything else. This is evidenced by the fact that almost half of the S&P 500’s total return over the last decade has come from non-sustainable return, whereas US Midcaps, emerging markets and other developed markets have just kept pace with their sustainable return.

Passively managed funds now account for more than half of US assets under management, up from 20% in 2009. There is a lurking danger in this that probably won’t be exposed until the next major bear market. There is an old saying that ‘the bull goes up the stairs, but the bear goes out the window.’ The idea is that bull markets climb gradually, while bear markets fall very suddenly. As long as money continues to flow into equity markets in an orderly fashion, the dislocation being created by the dominance of index funds is likely to go relatively unnoticed. But what happens in the next bear market, when investors panic and decide they want to pull their money out of stocks?

With every redemption from an index fund, the exact same group of stocks that has been bought indiscriminately over time is likely to be sold indiscriminately in a much shorter space of time. And with the market dominated by index funds all facing the same wave of redemptions and all selling the same group of stocks, where is the liquidity going to come from on the buy side? Bear markets have always been characterized by a liquidity crunch where desperate sellers overwhelm reluctant buyers. If this has been the case in markets dominated by active investors with different portfolios/strategies and the ability to trade at their discretion, what will happen in a market dominated by passive investors all trying to sell the same stocks without the ability to exercise discretion? Might we see some breathtaking plunges in the prices of the most popular index constituents? Might we see a failure to meet redemption requests from some of these funds? Time will tell, but the risk is real and growing as indexation increasingly dominates the investment industry.

We believe there’s far more potential for good long-term returns in those neglected areas of the market that have often been indiscriminately sold in favor of the S&P 500 Index. We also believe there’s a lot less risk of the bottom falling out.

Bigger is Better… Or is it?

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Last quarter we discussed the divergent performances between the US stock market, emerging markets and other developed markets. In particular, we noted how the gap between the US and emerging markets is now at its widest since 1988, per the below graph. Importantly, we also noted how this gap has inverted several times in the past, suggesting the possibility that it may do so again.

This quarter we’re going to build on this and consider a second source of divergent performance, even within the US: Market capitalization, or company size. The biggest corporations in America have outperformed the rest. Consider the following graph comparing the performance of the S&P 500 (500 biggest companies in America – megacaps) and the Russel 2000 (a broader index of corporate America, excluding the 1000 biggest companies – midcaps).

While the divergence isn’t as extreme in this instance, it is nevertheless notable since a) these two indices generally track one another quite closely, and b) there appears to be a correlation between megacaps outperforming midcaps, and the US outperforming the rest of the world: We saw the same phenomenon between 1998 and 2003 during the Tech Bubble.

Both the relative performance figures and the prevailing narratives of the last decade would suggest that US Megacaps are the only game in town. Bigger is better, everything else is a waste of time. But is this true? Should we simply abandon everything else and pile into the S&P 500? Afterall, that’s what’s worked for the last decade. The above graphs suggest that caution is warranted – we’ve seen this trend reverse in the past. Might it happen again, or is this time different?

What’s been driving US Megacap performance?

To understand whether this time is likely to be different, we need to understand what drives return over different time periods. Total return can be expressed as the sum its constituents as follows:

Importantly, these constituents can be grouped together into either sustainable drivers of return, or non-sustainable drivers of return. Sustainable drivers of return are those which are expected to persist and compound over time. These would include dividend yield and revenue growth. Non-sustainable drivers of return are those which do not persist over time. They tend to fluctuate rather than compound. These include change in profit margin, revaluation and currency fluctuation.

Over very long periods of time (20+ years), total return tends towards sustainable return. Over very short periods of time however, total return tends to be dominated by fluctuations in the non-sustainable drivers of return. For example: Over the last 20 years, sustainable return has accounted for 70%-85% of total return on most stock markets. Over the last year though, non-sustainable return has accounted for between 80% and 120% of total return in those same markets. This is exactly what we’d expect to see.

Why is this important? Because over the last 10 years during which US Megacaps have outperformed everything else, that outperformance has been driven almost exclusively by non-sustainable drivers of return. US Midcaps have actually done slightly better in terms of underlying sustainable return. This observation is consistent with our analysis from last quarter – that the S&P 500 is very overvalued relative to everything else.

While we cannot predict the future, we can look at what happened the last time this scenario played out by examining the decade which followed from 2000 to 2010 (see the graph below): Even though US Megacaps delivered a fair sustainable return in that decade, it was outweighed by negative non-sustainable return, resulting in a negative total return (the black dash represents total return). Emerging markets won the race that time. This doesn’t mean the future will play out exactly the same. History doesn’t always repeat itself, but it does rhyme and we’d do well to learn from the past.

Is this a Bubble?

The last time we saw a divergence of this magnitude was during the Tech Bubble in 2000. This begs the question: Are we seeing a similar bubble in US Megacaps today? And if so, what is it? There has certainly been a lot of hype in the AI space, particularly with Nvidia, but this is a fairly recent development and doesn’t fully explain the phenomenon we’ve observed in recent years. There is another more subtle force at play which may better explain what we’ve been observing in the last few years: The rise of ETFs and other index trackers. Index trackers now account for more than half of assets under management in the US, up from 20% in 2009. By far the most tracked index in the world is the S&P 500. Could this supply/demand dynamic be driving the relative outperformance of the S&P 500 vs everything else? The fact that almost half of the total return of the S&P 500 over the last decade has come from non-sustainable return drivers lends support to this idea. We’ll likely discuss this in more detail next quarter and consider some of the hidden risks this trend has introduced to financial markets.

What does all this mean for us practically? We’ve positioned our portfolios to take advantage of a normalization in the trend between US Megacaps and the rest of the global stock market. As uncomfortable as it is to sit on the sidelines of this US Megacap boom, the only thing less comfortable for us is to take the risk associated with jumping on the bandwagon. A globally diversified portfolio of high-quality businesses trading at attractive valuations is more likely to deliver good long-term returns than the current hype, as it has in past cycles. It also carries far less risk of the bottom falling out. But it does require patience and discipline. As Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.”

The Good, the Bad and the Emerging Markets

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Recent years have seen global markets split more or less into a 3-horse race. In first place, you have the US – ‘the good.’ The S&P 500 has returned 38% in the last 3 years. In distant second place, you have the rest of the developed markets – ‘the bad.’ The SPDR Developed World (ex-US) ETF has returned 10.9% in USD in the last 3 years. Finally we have ‘the emerging markets.’ This horse seems to have bolted out the back of the gate, returning negative 17.4% in USD over the last 3 years. The following graph provides a better picture of how this race has developed.

The performance gap between the US and emerging markets is now the largest it has ever been since the MSCI Emerging Markets Index was established in 1988, per the below graph. Note however how this gap has fluctuated over the years. It hasn’t simply been an ever-widening gap, rather a mean-reverting series.

The Big Question…

The big question for investors then is: Will this gap revert again, or will it persist indefinitely? If we consider the prevailing narrative today, the US seems to be the only game in town. But we quickly forget that the reverse was true in 2007 and 2011 when the emerging markets narrative was all the rage. In 2007, emerging markets traded at a PE of 19.7x and Price/Revenue of 2.3x. The S&P 500 then traded at a PE of 16.8x and Price/Revenue of 1.7x. In other words, emerging markets traded at a valuation premium of between 17% and 35% (depending how you measure) relative to the US. That would be unthinkable today. Now, those same figures are 15.1x/1.3x for emerging markets and 24.5x/2.8x for the S&P 500 – a premium of between 60% and 115% in favour of the US. Is that really reasonable/sustainable?

Valuations and narratives go hand-in-hand, therefore the most extreme valuations seldom look that extreme given the prevailing narrative. Your mind can play some strange tricks on you to justify the way things are in the present… What looks obvious in hindsight is seldom that obvious at the time. This was true for the housing bubble and the emerging markets rage in 2007, not to mention the tech bubble in 2000. Even for those who can spot the unsustainable extremes, timing is often a great frustration. The few years that look like a blip on a graph can feel like an eternity in the present. That being said, might we look back at the US market in years to come and say that 2024 was an obvious extreme?

Isn’t there a Third Option?

This article started with a discussion of 3 horses. So far we’ve focused on the winner and the non-starter, but what about the other horse? Developed markets outside of the US have a lot to recommend them – think Canada, Europe, Japan. They don’t have the same political risks associated with most emerging market countries, yet they trade at a very similar valuation – a PE of 15.7x and Price/Revenue of 1.3x. You might stretch to justify the current US/emerging markets premium, but is it really reasonable to have the same extreme premium relative to other developed markets? Japan in particular is offering up some attractive investment opportunities at present, particularly considering the Yen is at its lowest in 40 years.

We’ve generally been overweight emerging markets and underweight the US, which hasn’t helped us recently. (We tend to underperform when things go from extreme to more extreme, but we outperform when extremes begin to normalize.) We’re now also considerably overweight developed markets outside of the US, having used most of our available cash to make new investments in this space – primarily in Japan.

Macro Themes or Micro Fundamentals?

As you reach the end of this article you might begin to think that we’re making our investment decisions based on macro/geographic considerations. But this really isn’t the case. We concentrate on company-specific micro fundamentals which ultimately drive returns over the long term: Profitability, financial strength and valuation. But we’re aware that in the medium term macro trends often dominate the return landscape, as they have in the last few years. These macro trends help us to understand why certain extremes have occurred, presenting opportunities to find businesses with good micro fundamentals in specific geographies/industries where these trends have led them to be undervalued. It remains the combination of favourable micro considerations that ultimately drive our investment decisions and therefore also our geographic/industry exposures.

If we look at our portfolios, our largest regional exposure is currently in developed markets (ex-US) at 40%. The median PE of our holdings in this region is 15.3x (vs 15.7x for the developed markets index). Our US exposure is 37% with a median PE of 16.9x (vs 24.5x for the S&P 500). Our emerging markets exposure is 20% with a median PE of 13.8x (vs 15.1x for the MSCI EM Index). The underlying businesses, regardless of geography/industry have consistent profitability and very little debt. The unpredictable macro trends that produce divergent results in various parts of the world will come and go, but it’s these micro fundamentals that produce winning results in the end.

What can we learn from a Century of Stock Market Returns?

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Legendary investor Charlie Munger, famed for his role at the helm of Berkshire Hathaway alongside Warren Buffet, died at the age of 99 on 28 November 2023. He would’ve been 100 years old on New Year’s day.

The stock market experienced 5 major crashes during his lifetime, the Great Depression being by far the worst, during which the S&P 500 lost 80% of its value. He also lived through World War II and the Cold War, inflation and high interest rates in the 70s, the internet bubble, the housing bubble, numerous recessions, COVID-19, and so on. Think of some of the major events and crises that have taken place over the last century. Think of the newspapers, headlines, breaking stories, predictions, etc. Think of the advances made in technology, medicine and other fields. Think of how much has changed, even things we regard as being constant, like national borders… And that’s just the last 100 years. What might happen in the next 100?

The Lasting Impact

The investment world, especially the media, places a great deal of importance around daily happenings. Every day there’s a story important enough to make the front page, significant enough to cause many people to make major long-term investment decisions. These stories drive a lot of volatility in the stock market, which in the short-term is all we see. But over the long-term these stories come and go, and so does the volatility.

What really matters is profitability compounded year after year. $100 invested in the stock market (S&P 500) on Charlie Munger’s birthday – 1 January 1924 – would’ve grown to nearly $2.2 million dollars over his lifetime. A return of 10.5% per annum, despite all the craziness of world events during that time. That’s the lasting impact of the stock market over the last century.

The Next Century

It seems unlikely that the next century will be any less chaotic or more predictable than the last. The stories that dominate our thinking today will likely fade with the passage of time. But the discipline of investing in good businesses at good prices for the long-term is likely to leave a tangible impact that outlasts any of these stories. There will be plenty of volatility along the way, even a crash or two, but don’t let these things deter you from consistently doing the basics well. Don’t let the news sway you from your long-term investment plan.

“If you’re going to invest in stocks for the long term or real estate, of course there are going to be periods when there’s a lot of agony and other periods when there’s a boom. And I think you just have to learn to live through them. As Kipling said, treat those two imposters just the same. You have to deal with daylight and night. Does that bother you very much? No. Sometimes it’s night and sometimes it’s daylight. Sometimes it’s a boom. Sometimes it’s a bust. I believe in doing as well as you can and keep going as long as they let you.” — Charlie Munger (2021)