Roughly once every decade, investors enthusiastically inflate a dangerous new bubble in the market. Each bubble has its own unique “color”, which further confuses the memory. Using the dates for the bubble peaks, here were the big ones: the commodity bubble (silver, gold & oil) in 1980; the Black Monday program trading crash in 1987; the tech/internet bubble in 2000; and the CDO/housing bubble in 2009.
Bubbles are created by massive capital flowing into a specific subset of the equity market. These flows are behavioral-based and not based on security analysis. Investors (both amateurs and experts) become convinced about the right train to take during these occasions, regardless of the price of the ticket. And as the price (and risk) keeps rising, investors seem to become increasingly comfortable taking this highly publicized and popular train.
Today, is there a train and, if so, where is it headed?
In our view, the most extreme bubble today is indexation. And as the bubble grows, investors are becoming increasingly comfortable with their investment. Not only are the fundamentals not considered relevant, it feels like a mistake to not be invested in the indexes. To us, that is the definition of a bubble.
A clear measure of this bubble buildup has been the capital flows from investors over the last few years. See Chart One below. As noted by the blue bars representing the last three years, hundreds of billions of dollars flowed out of active management and into passive. Investor flows this dramatic have an equally dramatic impact on the relative pricing in the market.
Chart One: Capital Flows to/from Active and Passive Strategies
Source: Morningstar Direct through 9/30/2019
At CornerCap, we do not have a problem with index investments; we often use them ourselves to build out certain segments of client strategies. Over time, however, the risk is that investors pursuing the most popular investments create an unavoidable mispricing opportunity. We believe that these price-insensitive investors create a significant investment opportunity, once the bubble unwinds.
An important characteristic of equity index investing is that popular indices are mostly capitalization weighted. What does this mean? When a $500 investment is made in the S&P 500, $60 (12%) goes into the largest five stocks, under current conditions today. At the other end of the index, the investment in the smallest five stocks is just 25 cents (1/2 of 1%).
In other words, most dollars invested in the index flows to a few giant stocks, with very little going to most securities in the index. The selection factor is simply size … and not price opportunities relative to the fundamentals. Absent any analysis, significant mispricing will likely occur and has occurred.
In recent years, a successful active management program would have needed to hold these mega-capitalization stocks, regardless of the fundamentals of the specific securities. And to outperform the index, the active management strategy would need to add even more weight to the largest stocks in the index—in other words, that investor would have to have above-average exposure to these narrow groups of stocks.
In the following chart, you can see the indexation/capitalization effect as we compare the cap-weighted index to the equal-weighted index. Note that over the long term the equal-weight has consistently outperformed the cap-weighted index, indicating that the markets should expect a reversal to the current trend. For reference, an annual difference of half a percent or more is meaningful and adds up over many years.
Chart Two: Comparative Returns by Index Weighting
Source: Fama-French; CIC Research
As contrarian investors, we are always monitoring the behavior of the herd(s). We must stay ahead of the big ones. The pastures are lush before being overrun by the herd. More important is avoiding the stampede when the bubble eventually pops.
To us, the indexation bubble is large and continuing to grow. We suspect the cycle will run its course. The longer it goes, we believe the bigger the bubble becomes, and the louder the pop. Like the other major bubbles noted earlier, once the flip-to-fear is triggered, there is not enough liquidity for an orderly exit for investors who have joined the herd. With a rush to sell with constrained liquidity, we would expect what generated the best returns during capital inflows will produce the worst returns during capital outflows.
For context, we provide our commentary on the Tech Bubble at its peak in March 2000 (see Appendix below).
Note: CornerCap wrote this commentary in a paper-based (not digital) newsletter in March 2000, the height of the tech bubble. It is published in full below.
The Beauty Contest
For over 20 years, we have worked to better understand the market. The current market has probably been the most difficult to understand and explain. It’s not about Value investing or Growth investing. Growth investment managers who follow a discipline are also having a difficult time. We believe that the market began a major shift on March 10, and that it is moving into the final stage of this unusual period. We want to share with you our best thoughts on why things have moved to such extremes recently and what we can expect in the future.
The best analogy that we have for the stock market over the last two years is a beauty contest. Beauty contests tend to focus more on the façade than the foundation. This beauty contest is held daily, and at the end of each day, they can count the votes of the judges and easily see who won the contest for that day. Essentially the same contestants come back the next day, parade themselves in front of the judges again, and, hopefully, convince more of the judges to vote for them.
We are one of the judges, but there are many judges. In fact, there are so many judges that any one judge is not material. We want the contestant we choose to win. We are investing real money in the contestants whom we choose. In order to choose the best contestant, we spend a lot of time studying the cash flows, ROEs, relative pricing, etc. While we believe these qualities to be important, actually essential, most other judges have recently been looking for other qualities. The primary quality that the other judges look for is hope – what is the chance that someone will pay a higher price for this stock, and quickly. So, to be successful at picking the winning contestants in recent quarters, you would have had to focus more on the judges than on the contestants, thereby accepting a preference for the superficial over any measure of substance.
An attractive lady may win that year’s contest because of her exceptional, external beauty, but the real winner will be determined by her fundamental worth on the inside. It is the same with investments. In today’s market, an attractive company can move to an astronomical valuation almost overnight. The company can capture a lot of the votes. However, the company will not be a real winner over time unless it has a sustainable, competitive advantage that will generate sufficient cash flows that can be returned to the shareholders. That essentially defines long-term investing.
We realize that terminology like “long-term investing” is not popular or relevant with many of today’s investors or judges. If their goal were to win the beauty contest every day or even every year, then, again, they would need to focus more on the judges than on the contestants. This is not long-term investing. It is really a trading strategy, and it is closer akin to gambling. Warren Buffett characterized the recent high tech run up as a Ponzi scheme. We can accept some investors wanting to gamble with some of their money, but we see this happening too often with the lion’s share of many individuals’ retirement assets.
As Peter Bernstein reminds us, “the value of an asset without cash flow is only what somebody else will pay you for it.” Stocks with positive cash flows were down last year, whereas stocks with negative cash flows were up over 50%. This seems like a risky position for an investor. However, at least until the recent dramatic sell-off in the technology sector, acceptable levels of risk were being redefined higher almost daily. There is always a downside to higher risks in the market, and it is not a question of if but rather when it will be realized.
As we said at the start, we believe that we are in a unique period in the history of the US equity market. This unique market has resulted in many of our clients’, especially our most recent clients, seeing CornerCap as being overly concerned about risk. It is true that all of our clients’ assets must be there ten years from now, so risk control will always be important. Because of the extremes that exist in today’s market, we believe that above-market returns are now available at below-market risks. Stated another way, the contestants who are receiving our votes now possess both inner and outer beauty. The other judges have been in agreement with us since March 10. Whether it is happening now or at some later date, the laws of economics, old and new, will force this change to take place.