Given all the bubble talk I thought it would be interesting to share a perspective and some data from a report I read this week. Morgan Stanley’s report Who is on the other side addresses several topics including bubbles.
There have been countless bubbles throughout history. Bubbles are caused by our natural tendencies as humans and if we are still making decisions bubbles will continue to occur. The problem we face as investors is we know bubbles will occur but can’t definitively identify a bubble until after it has popped.
Famed economist Eugene Fama described this conundrum:
I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.
Fama didn’t have the data when he made that statement, but three researchers named Robin Greenwood, Andrei Shleifer and Yang You looked at what happened after periods of high returns.
A period of high returns was defined as a portfolio of shares in an industry returning 100% or more on a relative or absolute basis over two years. To eliminate the impact of a bounce off substantial lows the study authors also stipulated the industry’s absolute returns were 50% or more over the previous five years.
Between 1926 and 2014 there were 40 industries that meet their criteria in the US. Outside the US the researchers identified 107 scenarios between 1985 and 2014. Fama turned out to be right – in only half of the ‘bubbles’ a crash occurred. The researchers defined a crash as a 40% fall at some point in the two years following the period of high returns.
A normalised return index on the y-axis shows how an investment performs compared to a common starting point. As you can see the run-up average between the crash and non-crash outcomes looks similar to the overall market return index.
Talking about bubbles is one thing. Dramatically changing your portfolio is another. Incorrectly identify a bubble that doesn’t happen and it could make a dramatic difference in your investment outcomes.
New rules for a new era
Index providers have rules stipulating when new companies can join an index. For instance, the S&P 500 rules require 12 months of seasoning before a new company is included. The purpose of this seasoning is to avoid the volatility that often accompanies an IPO and to avoid hype-driven inclusion in the index.
The S&P 500 index also requires companies to be profitable on a GAAP (Generally Accepted Accounting Principles) basis. This rule is designed to only include mature and high-quality companies.
In what is shaping up to be a massive year for IPOs the S&P 500 has a problem. The first giant IPO, SpaceX, doesn’t meet the index criteria. Following a round of consultation which just ended Dow Jones S&P may let this new and wildly unprofitable company into the index.
If the S&P 500 caves they will follow the NASDAQ and FTSE indexes who have already changed their rules. And SpaceX is only the tip of the iceberg. The index providers are anticipating IPOs from Anthropic and OpenAI.
I know feigning outrage is in vogue. But I’m not a purist who thinks rules should never change. I don’t really care what the index providers do although I do own some index products tracking the S&P 500.
But I do think it is telling when the rules are changed in a hype-driven market to include companies that embody that hype.
Passive investors aren’t supposed to care about individual companies. Which is why I don’t care what happens with SpaceX in the portion of my portfolio that tracks an index.
But maybe this will make some ‘passive’ investors happy. They can say they own SpaceX and talk about the synergies between rockets, mobile broadband, Twitter and AI.
Or maybe this strange conglomeration of businesses that people are desperate to own is a product of a time which will look foolish in retrospect.
Mark LaMonica
Also in this week's edition...
The government’s tax proposal is supposed to help younger generations. Lauchlan Mackinnon explores the validity of these claims.
Shani Jayamanne sits down with Abbey John to learn the different ways you can minimise tax with a will.
Many investors are turning to AI to assist with investment decisions. Larry Swedroe doesn’t think AI can help you pick winning funds… but he does think AI can help avoid the losers.
Ashely Owen is back and turning his attention to inflation. According to Ashley Boomers got lucky and the next generations won’t be so fortunate.
The cost of financial advice continues to increase but expanded tax deductibility will increase affordability according to Sarah Abood.
Dr Joanne Earl returns with an update on her retirement.
Richard Holden argues the government has created the first ever productivity tax. He goes through the implications for young Australians.
This week's white paper is Capital Group's analysis of company dividends worldwide, as part of its broader Global Equity Study.
Curated by Mark LaMonica, Simonelle Mody and Leisa Bell
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