The debate over the inclusion of the $1.8 trillion SpaceX IPO in the basis for index funds has drawn a split result – the Nasdaq 100 Index will include it after 15 days, whereas the Standard and Poor’s 500 Index has said it must wait for a year, like other new companies. The two indices will thus diverge; either one or the other will fail as a representation of the market. Since OpenAI and Anthropic are also due to do IPOs soon, I would suggest that with such huge speculative IPOs the fad for index funds may have been taken too far, and that retail investors will eventually lose their money.
Index funds currently own about 20% of the U.S. stock market and “passive” fund managers who track stock indices currently own about another 15% — most of these fund managers adjust their holdings at the end of each day to reflect the index they track, so are effectively also index trackers. (You may well ask why anyone would pay for that service – well, institutional investors are a fairly dopey lot!) We are therefore reaching the point where the index funds themselves affect the overall level of stock prices. In such a case, the index fund can become detached from the stocks it supposedly covers and index fund buying can itself affect the price of the underlying stocks, thus creating an upward price spiral that is fun for all concerned – until it isn’t.
To illustrate what I mean, suppose the world had already invented index funds in 1720, and one had been constructed on 1st January of that year to cover the major European Stock Exchanges in London, Paris and Amsterdam. The dominant holdings in that fund would have been the South Sea Company, with a market capitalization of £7 million at its share price of 125, the Bank of England with a market capitalization of £8 million at its share price of 150, the East India Company with a market capitalization of £7.5 million at its share price of 200, the Dutch East India Company, with a market capitalization of about 60 million guilders (£6 million) and the French Mississippi Company, which had reached a peak value of 10,000 livres per share and had a capitalization of 6 billion livres (about £240 million – three times France’s GDP.)
Thus, an index fund across the stock exchanges of London, Paris and Amsterdam at that date would have had some percentage, perhaps 10% of the total market capitalization of the three markets of £280 million, or £30 million of which £24 million would have been Mississippi Company, £800,000 Bank of England, £700,000 South Sea Company, £750,000 East India Company, £600,000 Dutch East India Company and about £3.15 million a combination of all other shares in the London, Paris and Amsterdam markets. With 80% of the fund in the Mississippi Company, the portfolio would have been thoroughly unbalanced.
On July 1, 1720 Bank of England shares were trading at 230, for a market capitalization of about £13 million, East India Company shares were at 420, for a market capitalization of about £16 million while South Sea Company had exploded to 760 and in addition increased its capitalization massively by issuing new shares and by swapping its shares for public debt; its market capitalization was about £300 million – it reached a peak of £420 million in late July. The Dutch East India Company peaked in July 1720 at about £7.5 million. The Mississippi Company, on the other hand was trading at 4,800 livres and the livre had halved in value, so had a market capitalization of £58 million. Add in perhaps £5 million for the bull market value 10% of all the other shares in London, Paris and Amsterdam, and you have a total fund value of £44.5 million, up from £30 million in January. A very satisfactory performance, it would appear, but now the South Sea Company represents just over two thirds of the fund.
However, go forward another 6 months and the picture is very different. The Bank of England’s share price is 140, so market capitalization is £7.5 million. East India Company is at 150, so market capitalization about £5.5 million, and Dutch East India Company is down to about £5 million. South Sea Company has collapsed to 150, so a market capitalization of £50 million, though most of that represents about £30 million of government bonds the company now owns. As for Mississippi Company, its shares were now trading at 1,000 livres and the livre had halved again, so its market capitalization was £6 million. Add £2.5 million for all the other shares in the three markets, and you have a total value of £9.9 million – one third of its value a year earlier and 22.5% of its peak. The South Sea Company still represents more than half of the fund, but three fifths of the South Sea Company (roughly 30% of the fund) is represented by government bond holdings.
That value would decline further in 1721, bottoming out around £6 million and would then remain around that level for more than a century, with mild fluctuations, as the 1720 Bubble Act prohibited further company flotations in Britain and the Dutch East India Company lost ground to its English rival. In other words, an index fund constructed in early 1720 would, because of its holdings in the South Sea and Mississippi bubble companies, lose about 80% of its value within two years and would then stay depressed, although it would pay out dividends of a fluctuating 4%-5% on its lower capital from its Bank of England, South Sea Company, East India Company and Dutch East India Company holdings. By indexing a bubble, index-tracking investors in 1720 would have done far worse than more selective investors, even though Sir Isaac Newton is reputed to have lost £20,000 in the crash, presumably without indexing, since constructing an index required mere arithmetic, not his fancy fluxions.
If indexed investors would have lost money in 1720 by being forced to buy overpriced bubbles, the same must be true of index fund investors today. The three forthcoming trillion-dollar IPOs for SpaceX, Anthropic and OpenAI have all the South Sea Company characteristics, which were also shared by the dot-com promotions of 1999-2000, although none of them dared come to market at these kinds of valuations.
Anthropic for example, is a perfectly fine company, whose product Claude I sometimes use, but there is very little in the way of a “moat” to stop other companies, especially Chinese ones, from producing a better product, the cost of which is more than can be financed from a garage, but no more than about $10 billion (excluding the data centers, which in the long run are a commodity that can be rented). In other words, Anthropic (and OpenAI) are like the pioneering search engine AskJeeves in 1996, a brilliant new tool that at any time can be made obsolete by a couple of greedy Googlers.
As for SpaceX, part of it is another Anthropic; the rest is an attempt to send humankind to Mars, probably not a profitable endeavor in the first century or so since there is nobody on Mars to sell stuff to – it’s not like the Venetian merchant Marco Polo discovering China! If we were heading to C.S. Lewis’s Malacandra instead of boring old Mars, there would clearly be a market among the eldils for our AI technology, but alas as always, the dull rock-strewn reality snuffs out the charming Art Deco fantasy. Interstellar exploration would be a different story, but not even SpaceX’s $1.8 trillion will get us that.
For index fund investors, the lesson is that indices that accept bubble companies too quickly risk severe underperformance in future years as the bubbles burst or merely deflate. The Standard & Poor’s 500 Index has the right approach, making the trillion-dollar wonders wait a year before entering, though bubbles often last much longer than that before reality returns.
Indeed, I would suggest an attractive investment alternative would be a new index the “Economic Solidity Index” that made new companies doing IPOs wait for five years before joining, thus weeding out bubbles and preventing insiders from selling their rubbishy stock into an index fund that is forced to buy after the IPO. A fund linked to such an index would have a great deal of attraction for investors who wish to profit steadily from the long-term growth of the U.S. or international economy, without losing sleep over fashionable ephemera. It would almost certainly outperform conventional index funds over the long run, because the new issues market is inevitably a cauldron of lies, dishonesty and hype, inflated by financial used-car salesmen.
Investing in bubbles is dangerous, which is why John Bogle gave us index funds. Putting all your money in index funds that invest in bubbles is however just as dangerous, and without the thrill of buying Elon Musk’s brainstorms directly.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
The post The Bear’s Lair: Bubbles Break Index Funds appeared first on True Blue Will Never Stain.