James Montier at GMO just penned a white paper called “The S&P 500: Just Say No” that echoes many of the same themes discussed in our recent client letter and also in my post on Overpayment Risk. I want to discuss one of his points, which is that price-insensitive investors who are investing passively in the S&P 500 Index are taking significant risks.
James Montier on Passive Price-Insensitive Investors
In the white paper, Montier says:
The decision to be passive is still an active decision – and we would suggest one with important risks that investors are not paying adequate attention to today. As more and more investors turn to passively-managed mandates, the opportunity set for active management increases. A decision to allocate to a passive S&P 500 index is to say that you are ignoring what we believe is the most important determinant of long-term returns: valuation. At this point, you are no longer entitled to refer to yourself as an investor. You may call yourself a speculator, but not an investor. Going passive eliminates the ability of an active investor to underweight the most egregiously overpriced securities in the index (we obviously prefer a valuation-based approach for stock selection as well). When faced with the third most expensive US equity market of all time, maintaining a normal weight in a passive index seems to us to be a decision that will likely be very costly. Yet despite this, it remains a popular path, with around 30% of all assets in the US equity market in the hands of passive indexers (see Exhibit 9).
According to Montier, passive investors are, importantly, ignoring price when they are buying a passive U.S. stock market index. Instead, they are making investments for reasons unrelated to the relationship between price and value. In my view, these investors are doing so to chase performance. Passively investing in the S&P 500 Index is indeed likely to be very costly for those passive investors who are crowding into an already crowded and very expensive trade.
In addition, these price-insensitive passive investors are causing an overvalued U.S. stock market to become even more overvalued. They are just pouring more fuel on the fire.
Besides passive investors, other price-insensitive investors are also worth mentioning, including corporations and central banks:
Corporations have taken advantage of the low-interest rate environment to issue debt and use the proceeds to buy back shares of their stock. In the chart below, it is clear that the primary buyers of equities since the financial crisis have been corporations. Corporate buyback activity has exceeded $100 billion per quarter over the past several years.
Management teams and boards make these buyback decisions to maximize the value of their equity grants, stock options, and other forms of equity-linked compensation. Because corporate buybacks are driven primarily by management compensation considerations, corporations, like passive investors, should generally be categorized as price-insensitive investors.
Corporations, like passive investors, are driving the S&P 500 Index far beyond intrinsic value. What happens when corporations can’t leverage further to continue buying their shares?
In recent years, certain central banks have turned to printing money and buying stocks with that newly-printed money. The Swiss National Bank, for example, owns about $80 billion in U.S. stocks. Thus far in 2017, the Swiss National Bank has invested $17 billion in U.S. stocks. You can see some of their major holdings in the chart below:
Unlike private investors, central banks like the Swiss National Bank do not make investment decisions to generate economic profits; they make investment decisions to meet monetary policy goals. Like passive investors and corporations, the relationship between price and value is not a consideration; they, too, are price-insensitive investors who have driven up U.S. stock prices.
What Happens When Price-Insensitive Buyers Turn into Sellers?
Unfortunately, price insensitive buying ultimately leads to poor capital allocation decisions. Also, just as price insensitive buying can boost the prices of stocks, price insensitive selling will do the opposite. When the next market turn occurs at some undetermined point in the future, many price-insensitive buyers will likely become sellers, potentially exacerbating the next market downturn.
In my opinion, James Montier is right. If you care about the relationship between price and value, you are better off saying no to the S&P 500 Index.
Are you currently invested passively in the S&P 500 Index? If so, why?