The Madness of Crowds
July 26, 2017
Market Summary – 2nd Quarter, 2017
“Money, again, has often been a cause of the delusion of the multitudes.”
“Following the crowd” is a well-established human behavioral pattern. One of the most celebrated works about this topic is Charles Mackay’s classic book, Extraordinary Popular Delusions and the Madness of Crowds, first published 176 years ago. Mackay retraced various examples of lemming-like behavior among the masses across history, some of them related to financial failures. What the author called “thinking in herds,” a tendency to conform to the conventional wisdom, often leads to people going “mad in herds.” The desire to go along with what’s popular too often goes too far. Perhaps the most notable example of a financial mania cited in Mackay’s book is the Dutch tulip craze of the 17th century – where people paid as much as 10 times the annual income of a skilled crafts worker for what were considered a “must-have” investment – tulip bulbs. This is one of many examples over time of people justifying their investment decisions by seeking comfort through conformity, even in the absence of judgment.
In case you believe investors today are too sophisticated to fall victim to crowd madness, the reality is that our own versions of the tulip craze have surfaced time and again. Recent examples include the “Nifty Fifty” stocks of the 1960s and 1970s (“these are ‘one decision’ stocks – you have to own them at any price”), the 1990s technology bubble (“don’t worry about high stock valuations – this time it’s different”) and the housing bubble of a decade ago (“borrow as much as you can to finance your home purchase – home prices will never go down”). While lessons should be learned, the reality is that repeatedly, investors become obsessive about being left behind if they fail to follow the herd. In their mania, thoughtfulness and judgment take a backseat to the willingness to pay any price to participate in an investment. As a result, many fail to appreciate the potential negative consequences of paying too much for a specific investment.
Perhaps the most noticeable version in today’s investment marketplace is the “madness” for passive investing. Billions of dollars have flowed into index funds and exchange traded funds (ETFs), while billions more have traded out of actively managed funds. While the trend has been underway for several years, its rate of acceleration is rapidly increasing. Based on the pace of inflows in the first five months of 2017, passive funds could take in more than $800 billion in 2017, a 60% jump from 2016’s record haul. Incredibly, today there are more indexes than there are stocks. Consider that there are approximately 6,000 market indexes, versus less than 1,000 just ten years ago. At the same time, the number of stocks in the Wilshire 5000 Index (a total market index) contains just 3,599 stocks, which is less than half of its total 20 years ago1. Many retail investors, and even some professionals, are buying into the premise that tracking the market, the approach of index funds, is the most efficient way to build and retain wealth. However, we believe that what’s going on with indexes today is no different than other excesses that we have seen in the past.
What, me worry?
The term “passive investing” is an appropriate moniker for money flowing into index funds and ETFs. All that is required of people drawn to this approach is that they simply put money into the fund, and then let the market’s whims dictate their failure or success. Little thought or understanding of the process involved is required. Yet it is being touted to investors today as a simple solution to the ongoing challenge of how to invest money effectively.
This method of investing strikes us as irrational. The idea of putting money to work with little preparation or careful consideration is comparable to running a marathon without ever having trained for it. In what other pursuit would it be considered an asset – to be neglectful – to ignore life’s experiences – to avoid serious study of the craft of investing – to disregard the benefit of judgment? This strikes us as an odd way to manage wealth that most of us have worked hard for and spent a lifetime to accumulate.
Today’s deceptive market
Promoters of passive strategies have benefited from a strong and extended bull market that has seen the S&P 500 Index increase in value by about 3.5 times since its low point in March 2009. But the perceived strength of the S&P 500 masks an unstable foundation. A mere 10 stocks were responsible for nearly half of the market’s impressive year-to-date return into mid-May2. These include eight familiar technology names – Apple, Google, Facebook, Amazon, Microsoft, Oracle, Visa, and Broadcom. This demonstrates to us that the index appears top heavy.
Index investors who believe they are diversifying their portfolios by “buying the market,” are, in reality, putting an inordinate percentage of their investment into a handful of stocks with mega market capitalizations and, in our opinion, excessive valuations. The success or failure of a narrow group of stocks will have an outsized impact on their own results, and these investors are not as diversified as they may think. Those who choose to diversify into sector ETFs face the same dilemma. For example, owning the largest energy sector ETF (XLE) includes just three stocks (Exxon Mobil, Chevron and Schlumberger) that make up nearly half of the index’s weighting2. That doesn’t amount to a great deal of diversification, and the performance of only those three stocks has a dramatic impact on investment results.
This is a particular concern today because of valuation disparities. History tells us that at some point, the market will recognize that the excessive valuations achieved by stocks at the top tier of the index are unsustainable. For example, the price-to-earnings ratio of Amazon.com is 149x based on estimated 2017 earnings. For Netflix, the P/E ratio is 139x. Facebook trades at 15x sales3. Stocks like Amazon, Netflix, and Facebook, valued at such rich levels, face a greater risk of a price decline or at least a failure to keep pace with the broader market. Yet index investors, who by definition are price insensitive, are committed to owning a larger percentage of the most expensive stocks as a significant part of their overall investment. It is the opposite of the desired practice to “buy low and sell high.”
No company, no matter how strong, should automatically be considered to be a great investment, whether in technology or any other sector. A prime example in the current millennium is General Electric & Co. (GE), one of America’s great industrial companies. GE has been the worst performing stock in the Dow Jones Industrial Average since Jeff Immelt was named CEO in September 2001. During those almost 16 years, GE’s stock is down nearly 30%, while the Dow Jones has more than doubled4. During the boom times of the 1990s, GE was a diversified industrial company that achieved “buy it and forget it” status for many portfolio managers. But great businesses do not always make for great investments, and businesses are always changing. Ultimately, the valuation became too rich, GE’s executives were ineffective managers, and the stock has been an incredible laggard.
Effort and judgment pay off
Because the mega stocks that have driven the market’s performance this year dominate the headlines, it is easy for investors to mistakenly believe that their own money MUST be in these stocks and nowhere else. What has been lost in the mania for the mega stocks is the reality that other stocks have generated strong performance as well, without the risk of excessive valuations. Savvy active managers capitalize on stocks that have generated impressive returns. Success is possible by focusing on longer-term considerations such as a company’s position in its marketplace or its ability to exploit significant secular trends in the global economy.
Most important, by paying attention to price, investors may avoid the risky position facing those who follow the herd and become willing to pay any price for a stock. Trends (like an accommodative Fed) that have benefited a select group of stocks in the S&P 500 are fading away. Going forward, it will require effort to identify stocks that offer the right opportunity – to the benefit of professional active management.
Passive funds are price insensitive buyers, as they must buy stocks in the same proportion as the indexes that they track, regardless of the stocks’ valuations. In the case of sector funds, these products must only buy stocks within the specified sector. Over time, every sector can become overvalued. These passive investment products, despite dealing with overvalued and risky securities, must continue piling money into these popular assets, often to the detriment of investors. Over a short period of time, this positive feedback cycle can result in gains. But let’s not forget that tulip bulbs kept rising in price . . . until they didn’t.
Value stocks well positioned
Growth stocks have had an advantage this year and for most of a 12-year stretch dating back to 2005. That is a long run that has only occurred once before, during the market run-up that ended in March 2000. Yet despite being out of favor so much recently, the data shows that since 1926, value stocks have enjoyed an average annualized return advantage of 4.8% over growth stocks!5 Simply stated, history is on the side of value stocks, and after an extended period of underperformance, value stocks appear to be positioned for resurgence.
It appears that many value stocks have avoided the “madness of crowds” mentality that has been so prevalent with the flow of funds into passive investments. The generally expensive growth sector of the S&P 500 Index is projected to generate earnings growth of 7.7% per share in the 2nd half of 2017. By contrast, earnings in value stocks in the S&P 500 are projected to nearly double that, growing by 14.1% over the rest of 2017.6 With nearly double the earnings growth prospects and, in many cases, appealing valuations, we believe that the future prospects for discerning value investors is highly compelling.
Source: CNBC.com, A Startling Fact Shows Why Value Stocks May Be Your Best Pick Now”, 7/5/2017
1 Kopin Tan, “Man vs. Machine: How Has Indexing Changed the Market?”, Barron’s, July 8, 2016.
2 Source: Factset, Goldman Sachs Global Investment Research, as of May 10, 2017.
3 Source: NASDAQ.com, July 6, 2017.
4 Tomi Kilgore, “GE is the worst performing Dow stock since Immelt became CEO”. www.Marketwatch.com, June 17, 2017.
5Mark Hulbert, “Value Investing is Ready to Stage a Comeback,” Barrons.com, June 28, 2017.
6Alex Roesenberg, “A startling fact show why value stocks may be your best pick now,” CNBC.com, July 5, 2017.