Rogue Missives - Thursday, February 13, 1997

Rogue Missives

ROGUE ARCHIVES

Thursday, February 13, 1997

To Index or Not to Index
By Jim Surowiecki (Surowiecki)
In the first edition of his classic A Random Walk Down Wall Street, published in 1973, Burton Malkiel suggested that the ideal investment vehicle for the individual investor would be a "minimum-fee, no-load" mutual fund that would own shares in all of the companies that made up a given stock market index. This would not only allow investors to diversify their portfolios, but it would allow them to reap the benefits of what Malkiel saw as the inevitable upward rise of the market over an extended period of time. If you kept your money in the fund for the long term, this would be as close to a risk-free investment as could be imagined.
At the time of A Random Walk's publication, no such investment vehicle existed. The individual investor looking to duplicate the market's performance was out of luck. Within three years, though, everything had changed, and one of the more momentous changes in stock market investing was introduced. In 1976, Vanguard created the Vanguard Index 500, which fit Malkiel's prescriptions exactly. Investors in the fund were able to own every stock in the S&P 500. If the market as a whole did well, so too would they. And since the S&P 500 had, at the time, returned better than 7% annually, these investors seem to have found a sure thing.
There are, of course, a number of ironies involved both in Malkiel's advocacy of index funds and in Vanguard's decision to create one. Malkiel believed an index fund was the best vehicle for the individual investor because he believed that the price movements of individual stocks over time were random and therefore not predictable. Although Malkiel was never an advocate of what's called the strong version of efficient-markets theory (which holds that at all times a stock's price reflects all the relevant available information about it), he was skeptical of claims that it was possible to, in Peter Lynch's phrase, beat the market. And since it wasn't possible to beat the market, it made much more sense to join it.
Vanguard, meanwhile, was offering the index fund in the wake of the most devastating market crash since the Great Depression. In the 1973-1974 period, the value of equities in U.S. companies dropped nearly 50 percent. The pre-crash highs the market reached in 1973 would not appear again until 1982. From one perspective, Vanguard's decision was canny. For many, the crash had seemed to demonstrate that picking stocks was a futile pursuit, and that it inevitably led to speculative excesses. In particular, the fate of the Nifty Fifty -- of which we'll have more to say later -- seemed to indicate that the stock prices of even the most solid companies could prove to be built on air. Investing in the market as a whole required no work, and provided greater protection at a time of economic insecurity.
From another perspective, though, Vanguard's decision had something daring about it. It wasn't, after all, just the Nifty Fifty that investors had become leery of. On the contrary, they had become skeptical about the market as a whole. Although stock prices rebounded after 1974, the sense of certainty that animates investors today was absent from the equity markets of the 1970s. And in that sense, investing in an index fund could easily have been seen as setting sail on a ship without lifeboats. Whereas today we understand that even if some stocks struggle, most will flourish, the opposite seemed to be true then. Diversifying your portfolio was maximizing risk, not necessarily reward.
In any case, investors did not take to index funds like the proverbial ducks to water. Although they did grow steadily in popularity over the next ten years, and although institutional investors increasingly began to turn to these funds in the 1980s, it was not until after the crash of 1987 that individual investors began to flood into these funds, and in fact it's only in the last few years that these funds have grown to the point that observers are raising cautionary questions about their impact on the market as a whole.
The Vanguard Index Fund now contains $30.3 billion, and it returned 55% over the last two years. Combined, the largest funds now manage (so to speak) $65 billion, and have grown in terms of assets a hundredfold over the last decade. Fidelity, which built its reputation on value investing and stock picking, is ready to introduce a whole new line of index funds. Furthermore, the most important institutional investors in the country, including the California Public Employees pension fund (CALpers), now index the vast majority of their assets.
Not coincidentally -- though which way the lines of causation run remains in question -- the S&P 500 has enjoyed enormous success in recent years. For 1997, for instance, the S&P is up 8.37%, which makes it the best of all large indexes. The Russell 2000, which includes many more small-cap stocks, has risen just 0.04%.
The steady rise of the S&P index has led to concerns about a new Nifty Fifty phenomenon. During the late 1960s and early 1970s, investors flocked to hot large-cap stocks that seemed guaranteed grow forever and forever. These companies were, almost uniformly, solid, well-managed companies of a substantial size competing in markets they had the potential to dominate. They were, in other words, smart investments at fair valuations. But the obsession with the Nifty Fifty drove valuations beyond the bounds of all reason. Polaroid found itself trading at a P/E ratio of more than 70, while McDonald's passed 60. Investors thought they had discovered the secret of printing money. Once the fervor wore off, and people found themselves with shares of companies which could not justify, in earnings terms, their prices, panic set in, and the Nifty Fifty quickly raced to the bottom.
Some worry, then, that index funds are laying the groundwork for a similar crash. Since mutual funds in general are so flush, and redemptions show no sign of being on the rise, index funds are seen as exacerbating the dangers of overvaluation. And since other investors know that the indexes are going to be buying S&P stocks, investing in them becomes a smart play. It's not simply, in other words, that the indexes themselves are inflating prices with their purchases, but that the commitment of these funds to those stocks almost certainly provides a floor below which they will not drop.
Indeed, according to Business Week, the P/E ratio of the S&P 500 reached 21.6 last week. Bears tend to estimate that ratio as higher, with one analyst from the Leuthold Group saying it's at 23.94, while bulls try to provide a more contextual analysis. Abby Cohen of Goldman Sachs, for instance, told The New York Times that the P/E ratio was just 16.7, and that that was not significantly higher than the market's average of 16.2 during periods of low inflation. Standard and Poor's itself says that the historical average is 14.4. Just like our old modems.
Interestingly, even the highest estimates of the current valuation place it below the market in 1991, during its recovery from the flat year of 1990. The ratio in 1991 peaked at 26.1. (The lowest it's been is 6.64, in 1948.) That's not surprising, given the fact that American business is much better off today than it was five years ago. The strength of the stock market does reflect an underlying strength in the performance of corporate America.
At least, it reflects an underlying strength in the performance of part of corporate America. Magnifying the impact of the S&P index funds is the fact that large corporations generally did better and earned more in 1996 than their smaller competitors. Earnings for the biggest American corporations last year were almost uniformly impressive, with companies like Intel and Boeing crushing estimates. Though many predicted that the fourth quarter would be slower for many large companies, that prediction proved to be a miserable one. After all the rhetoric about how small, nimble companies would be better able to adapt to the new global economy, we seem to be facing the reality that a well-managed multinational is able to leverage global markets -- of which there are now so many more -- better than anyone else.
Stock prices should, after all, follow earnings, and in that sense the relative steep rise in the proportionate value of the S&P 500 is simply what should be expected. And to connect that rise with index funds themselves is confused, since there are now a multiplicity of such funds available, with indexes of almost every imaginable stripe.
Still, the fact that index funds have become one of the primary vehicles of choice for new investors does say something important about the way mutual fund investors see the market, namely, as the source of near-guaranteed returns. It's difficult to find even a single survey of mutual fund investors that suggests differently, and most such surveys indicate that investors believe that the market will return something like 15% annually for the next ten years, a rate that until this bull market was unimaginable.
In that sense, something like a Nifty 500 may be in the process of being established, whereby investors come to take the S&P index as a proxy for the market as a whole, and in doing so inflate the prices of the stocks in that index. Until their recent tumbles, for instance, Intel and Microsoft accounted for nearly all of the rise in the Nasdaq this year. And the lack of interest in small caps reflects not only weaker earnings, but also the authority that index funds have come to exercise.
The fear, of course, is that a couple of quarters of slower economic growth or weak earnings numbers could lead to a sharp rise in redemptions, and that in turn would crash the entire index. This doesn't seem completely unreasonable, but the reality of the last six months is that we have been in the midst of a very jumpy market, and yet there is no indication that mutual fund investors have begun to panic. More than that, it's not exactly clear how real the impact of index funds on the index is. Consider one fact: less than a tenth of the S&P stocks last year accounted for nearly 40% of its rise. Intel and Microsoft are owned by many more funds than the indexes, and the latter reap the benefits of the former.
The irony of Burton Malkiel's recommendation is that index funds would be taken up and advocated by value investors in the decades that followed. The simplicity and safety of index funds made even those who believe that it *is* possible to beat the market advocate them for investors who were unwilling to do the kind of research one needs to do in order to be a successful investor. And the great virtue of the index fund, from the perspective of value investors, is that it keeps people aware of one simple fact: over the long term, the market rises. And in a universe of mutual funds, 70% of which don't beat the market averages, being at the market average is nothing to dismiss.

-- Jim Surowiecki (Surowiecki)

(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

Main
Page

Fool
Wire

Hall of
Portfolios

Fool's
School

Daily
News

Fool
Mart

Foolish
Games

Copyright©1997, The Motley Fool, All Rights Reserved.
This material is for personal use only. Republication and redissemination, including posting to
news groups, is expressly prohibited without the prior written consent of The Motley Fool, Inc.
Legal Disclaimer, in fine print of course! Questions or Comments?
Please contact
Ted Verrill at
[email protected]

ROGUE ARCHIVES

Thursday, February 13, 1997
To Index or Not to Index By Jim Surowiecki (Surowiecki) In the first edition of his classic A Random Walk Down Wall Street, published in 1973, Burton Malkiel suggested that the ideal investment vehicle for the individual investor would be a "minimum-fee, no-load" mutual fund that would own shares in all of the companies that made up a given stock market index. This would not only allow investors to diversify their portfolios, but it would allow them to reap the benefits of what Malkiel saw as the inevitable upward rise of the market over an extended period of time. If you kept your money in the fund for the long term, this would be as close to a risk-free investment as could be imagined. At the time of A Random Walk's publication, no such investment vehicle existed. The individual investor looking to duplicate the market's performance was out of luck. Within three years, though, everything had changed, and one of the more momentous changes in stock market investing was introduced. In 1976, Vanguard created the Vanguard Index 500, which fit Malkiel's prescriptions exactly. Investors in the fund were able to own every stock in the S&P 500. If the market as a whole did well, so too would they. And since the S&P 500 had, at the time, returned better than 7% annually, these investors seem to have found a sure thing. There are, of course, a number of ironies involved both in Malkiel's advocacy of index funds and in Vanguard's decision to create one. Malkiel believed an index fund was the best vehicle for the individual investor because he believed that the price movements of individual stocks over time were random and therefore not predictable. Although Malkiel was never an advocate of what's called the strong version of efficient-markets theory (which holds that at all times a stock's price reflects all the relevant available information about it), he was skeptical of claims that it was possible to, in Peter Lynch's phrase, beat the market. And since it wasn't possible to beat the market, it made much more sense to join it. Vanguard, meanwhile, was offering the index fund in the wake of the most devastating market crash since the Great Depression. In the 1973-1974 period, the value of equities in U.S. companies dropped nearly 50 percent. The pre-crash highs the market reached in 1973 would not appear again until 1982. From one perspective, Vanguard's decision was canny. For many, the crash had seemed to demonstrate that picking stocks was a futile pursuit, and that it inevitably led to speculative excesses. In particular, the fate of the Nifty Fifty -- of which we'll have more to say later -- seemed to indicate that the stock prices of even the most solid companies could prove to be built on air. Investing in the market as a whole required no work, and provided greater protection at a time of economic insecurity. From another perspective, though, Vanguard's decision had something daring about it. It wasn't, after all, just the Nifty Fifty that investors had become leery of. On the contrary, they had become skeptical about the market as a whole. Although stock prices rebounded after 1974, the sense of certainty that animates investors today was absent from the equity markets of the 1970s. And in that sense, investing in an index fund could easily have been seen as setting sail on a ship without lifeboats. Whereas today we understand that even if some stocks struggle, most will flourish, the opposite seemed to be true then. Diversifying your portfolio was maximizing risk, not necessarily reward. In any case, investors did not take to index funds like the proverbial ducks to water. Although they did grow steadily in popularity over the next ten years, and although institutional investors increasingly began to turn to these funds in the 1980s, it was not until after the crash of 1987 that individual investors began to flood into these funds, and in fact it's only in the last few years that these funds have grown to the point that observers are raising cautionary questions about their impact on the market as a whole. The Vanguard Index Fund now contains $30.3 billion, and it returned 55% over the last two years. Combined, the largest funds now manage (so to speak) $65 billion, and have grown in terms of assets a hundredfold over the last decade. Fidelity, which built its reputation on value investing and stock picking, is ready to introduce a whole new line of index funds. Furthermore, the most important institutional investors in the country, including the California Public Employees pension fund (CALpers), now index the vast majority of their assets. Not coincidentally -- though which way the lines of causation run remains in question -- the S&P 500 has enjoyed enormous success in recent years. For 1997, for instance, the S&P is up 8.37%, which makes it the best of all large indexes. The Russell 2000, which includes many more small-cap stocks, has risen just 0.04%. The steady rise of the S&P index has led to concerns about a new Nifty Fifty phenomenon. During the late 1960s and early 1970s, investors flocked to hot large-cap stocks that seemed guaranteed grow forever and forever. These companies were, almost uniformly, solid, well-managed companies of a substantial size competing in markets they had the potential to dominate. They were, in other words, smart investments at fair valuations. But the obsession with the Nifty Fifty drove valuations beyond the bounds of all reason. Polaroid found itself trading at a P/E ratio of more than 70, while McDonald's passed 60. Investors thought they had discovered the secret of printing money. Once the fervor wore off, and people found themselves with shares of companies which could not justify, in earnings terms, their prices, panic set in, and the Nifty Fifty quickly raced to the bottom. Some worry, then, that index funds are laying the groundwork for a similar crash. Since mutual funds in general are so flush, and redemptions show no sign of being on the rise, index funds are seen as exacerbating the dangers of overvaluation. And since other investors know that the indexes are going to be buying S&P stocks, investing in them becomes a smart play. It's not simply, in other words, that the indexes themselves are inflating prices with their purchases, but that the commitment of these funds to those stocks almost certainly provides a floor below which they will not drop. Indeed, according to Business Week, the P/E ratio of the S&P 500 reached 21.6 last week. Bears tend to estimate that ratio as higher, with one analyst from the Leuthold Group saying it's at 23.94, while bulls try to provide a more contextual analysis. Abby Cohen of Goldman Sachs, for instance, told The New York Times that the P/E ratio was just 16.7, and that that was not significantly higher than the market's average of 16.2 during periods of low inflation. Standard and Poor's itself says that the historical average is 14.4. Just like our old modems. Interestingly, even the highest estimates of the current valuation place it below the market in 1991, during its recovery from the flat year of 1990. The ratio in 1991 peaked at 26.1. (The lowest it's been is 6.64, in 1948.) That's not surprising, given the fact that American business is much better off today than it was five years ago. The strength of the stock market does reflect an underlying strength in the performance of corporate America. At least, it reflects an underlying strength in the performance of part of corporate America. Magnifying the impact of the S&P index funds is the fact that large corporations generally did better and earned more in 1996 than their smaller competitors. Earnings for the biggest American corporations last year were almost uniformly impressive, with companies like Intel and Boeing crushing estimates. Though many predicted that the fourth quarter would be slower for many large companies, that prediction proved to be a miserable one. After all the rhetoric about how small, nimble companies would be better able to adapt to the new global economy, we seem to be facing the reality that a well-managed multinational is able to leverage global markets -- of which there are now so many more -- better than anyone else. Stock prices should, after all, follow earnings, and in that sense the relative steep rise in the proportionate value of the S&P 500 is simply what should be expected. And to connect that rise with index funds themselves is confused, since there are now a multiplicity of such funds available, with indexes of almost every imaginable stripe. Still, the fact that index funds have become one of the primary vehicles of choice for new investors does say something important about the way mutual fund investors see the market, namely, as the source of near-guaranteed returns. It's difficult to find even a single survey of mutual fund investors that suggests differently, and most such surveys indicate that investors believe that the market will return something like 15% annually for the next ten years, a rate that until this bull market was unimaginable. In that sense, something like a Nifty 500 may be in the process of being established, whereby investors come to take the S&P index as a proxy for the market as a whole, and in doing so inflate the prices of the stocks in that index. Until their recent tumbles, for instance, Intel and Microsoft accounted for nearly all of the rise in the Nasdaq this year. And the lack of interest in small caps reflects not only weaker earnings, but also the authority that index funds have come to exercise. The fear, of course, is that a couple of quarters of slower economic growth or weak earnings numbers could lead to a sharp rise in redemptions, and that in turn would crash the entire index. This doesn't seem completely unreasonable, but the reality of the last six months is that we have been in the midst of a very jumpy market, and yet there is no indication that mutual fund investors have begun to panic. More than that, it's not exactly clear how real the impact of index funds on the index is. Consider one fact: less than a tenth of the S&P stocks last year accounted for nearly 40% of its rise. Intel and Microsoft are owned by many more funds than the indexes, and the latter reap the benefits of the former. The irony of Burton Malkiel's recommendation is that index funds would be taken up and advocated by value investors in the decades that followed. The simplicity and safety of index funds made even those who believe that it is possible to beat the market advocate them for investors who were unwilling to do the kind of research one needs to do in order to be a successful investor. And the great virtue of the index fund, from the perspective of value investors, is that it keeps people aware of one simple fact: over the long term, the market rises. And in a universe of mutual funds, 70% of which don't beat the market averages, being at the market average is nothing to dismiss. -- Jim Surowiecki (Surowiecki) (c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.