The Mental Error underpinning the Equity ‘Index-Bubble’ Today
If every household in a neighborhood invests the majority of their savings in the equities of the same set of 500 companies, can any single household truly claim to have a diversified investment portfolio? The answer is ‘yes,’ but only in the event the stocks are held ‘individually,’ so the positions can be unwound in a ‘piecemeal’ fashion. By contrast, the same level of portfolio diversification does not exist in exchange-traded funds (ETFs) directly invested in the Standard & Poor’s 500 Index (‘S&P 500 Index’) that provide diversified cash flows from 500 companies in a single tradeable unit. The difference stems from the fact that these ETF investors must sell their stake in its entirety, to ‘diversify-away’ from cyclical industries, such as the (now) troubled retail and energy sectors, or increase exposure to single-stock names like Amazon, which would have to be ‘sold’ before a bigger stake can be ‘bought.’ This perverse arrangement creates (at best) added volatility and (at worst) extreme downside risk in a sell-off scenario. Sound familiar?
While the distinction between portfolio and cash flow diversification is seemingly trivial, this illustrative example details a ‘real world’ problem that has manifested itself in hitherto unknown levels of volatility in the S&P 500 Index, including four +7% drops that triggered automatic circuit breakers at the New York Stock Exchange, and a +30% monthly drop, marking the fastest ‘Bear-Market’ on record. Known in psychology circles as the Fallacy of Composition, the ‘mistaken belief in diversification,’ occurs when one, incorrectly, infers ‘something is true of the whole, because it is true in some part of the whole.’ It is a common error among investors in speculative asset bubbles, and noteworthy in the field of economics because, when committed on a massive scale, it forms the basis for the Paradox of Thrift that, narrowly-speaking, says ‘total savings in an economy can fall because of the collective attempts of individual households to increase their wealth.’ Like all paradoxes, the notion runs contrary to intuition, which means people will make the mistake, unless they are made aware of it in advance. The same logic applies to the Müller-Lyer illusion, where the lines (see Exhibit A) appear to be of different lengths. They’re not.
Popularized by John Maynard Keynes, the Paradox of Thrift borrows directly from the notion put forth by Adam Smith that: “What is prudence in the conduct of every private family can scarce be folly in that of a great Kingdom.” In other words, while it may be financially prudent for a household to invest the majority of their savings in the S&P 500 Index, the same truth does not hold if the entire neighborhood has opted for the same portfolio strategy. As the Paradox makes clear, the problem is not necessarily the investment vehicle, but the simple fact that ‘everyone else is doing it,’ and, to quote General George S. Patton, “if everyone is thinking alike, then someone isn’t thinking.” After all, whether it be single-family homes or ‘dotcom’ stocks, speculative pricing bubbles have traditionally developed when investors are overly-concentrated in asset classes that have surged in value, attributes on full-display in the S&P 500 Index today, which has morphed into the world’s biggest equity investment during the last decade, with $3.4 trillion in ‘directly-indexed’ ETF assets. Should 55% of all ETF assets that totaled $6.2 trillion in 2019, according to Statistica, be invested in just 500 U.S. companies? Sadly, the math does not add up, particularly when five companies in the S&P 500 represent 20% of its value.
Given the parallels at hand, one must not only question the underlying logic of ‘diversifying’ into the S&P 500 Index, but also ask whether the quantitative easing program of the U.S. Federal Reserve has fostered an ‘index-induced’ asset bubble in U.S. equities that, as a percentage of GDP, are at the highest level on record. That is the message here, which holds the coronavirus pandemic is merely the ‘tipping point’ of a much larger downturn in the S&P 500 Index that, if history is a judge, is likely to suffer (at least) two additional downdrafts (see Exhibits B-D) before a new bottom is made next year. To that end, we can expect delinquencies and furloughs to give way to bankruptcies and foreclosures in the months ahead, causing a shortfall in corporate earnings and, in turn, a precipitous decline in the price of the S&P 500 Index, which can no longer rely on corporate buybacks (see Exhibit E-F) as its only source of net share demand. From that vantage, the period today may very well resemble that which followed the collapse of Bear Stearns in March 2008. In the interim, investors should remember the words of Mark Twain, when he said: “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”
Source: Historical data from S&P Global, based on closing price as of May 20, 2020. Index up/down adjustments in Leg-2 and Leg-3 based on the average of Exhibit B and Exhibit C. Forecast period EPS is illustrative and based on prior downturns.
Source: Goldman Sachs Investment Research (October 21, 2019).
Source: Historical data from Standard & Poor’s; forecast from J.P. Morgan Research.
