INDEX YOUR WAY TO SERFDOM (uh, uh, er something)

Capitalization-weighted indices like the S & P 500 virtually guaranteed to UNDERPERFORM Non-capitalization based indices.

That statement above is quite a mouthful. And there are several reasons that this is the case. Yet S&P 500 index funds are probably the most common investment in most 401K investment portfolios. So what’s the problem?

Most readers know that the Author is a momentum, relative-strength based investor. And most readers also know that the Author believes that we are in a Secular Bear Market[i] that began in 2001 and will run well into the second decade of this young century. So needless to say, the Author is bearish on stocks in general. That being said, within every Secular Bear Market there will be Cyclical Bull Markets of relatively short duration (often three-six months). When the market moves through these Cyclical Bull Markets, an investor must buy fast-growing equities. The most recent Cyclical Bull Market, which probably began in January of 2006[ii], most probably ended in May[iii] of this year.

WHY THE BIGGEST ISN’T BESTEST (uh, uh, er something)

In the June 16, 2006 edition of John Mauldin’s “Thoughts from the Frontline”, Mauldin addresses why capitalization-weighted indices under perform. He quotes at length from Professor Jeremy Siegel of the Wharton Business College and Rob Arnott, author and investment advisor exemplar. The Author urges the readers to check out the article[iv] on Mauldin’s website. Here the Author will attempt to explain capitalization-weighted index underperformance.

SOME STOCKS ARE OVER-PRICED, SOME ARE UNDERPRICED. (Thank you Captain Obvious.)

Markets are not instantly efficient. At any given time, some stocks are overpriced, or cost more than their “fundamentals” would otherwise indicate. And on the other hand, as all two-handed economists would note, some stocks are under priced, or are valued less than their “fundamentals” would indicate. Jeremy Siegel calls this the “Noisy Market” hypothesis:

This new paradigm claims that the prices of securities are not always the best estimate of the true underlying value of the firm. It argues that prices can be influenced by speculators and momentum traders, as well as by insiders and institutions that often buy and sell stocks for reasons unrelated to fundamental value, such as for diversification, liquidity and taxes. In other words, prices of securities are subject to temporary shocks that I call 'noise' that obscures their true value. These temporary shocks may last for days or for years, and their unpredictability makes it difficult to design a trading strategy that consistently produces superior returns. To distinguish this paradigm from the reigning efficient market hypothesis, I call it the 'noisy market hypothesis.'

"The noisy market hypothesis easily explains the size and value anomalies. If a stock price falls for reasons unrelated to the changes in the fundamental value, then it is likely - but not certain - that overweighting such a stock will yield better than normal returns. On the other hand, stocks that rise in price more than their fundamentals become 'large stocks' with high P/E ratios that are likely to underperform. [v]

This revelation of the “Noisy Market Hypothesis” is not all that groundbreaking. Even a casual market observer would note that stock prices swing wildly, at least in the short/medium term. But what is interesting is what this “market noise” does to capitalization-weighted index returns. It means that in a capitalization weighted index, where the largest stocks by market capitalization represent the biggest proportions of the index, you will be have a bigger stake in the overpriced stocks and a lower percentage of your funds in the undervalued stocks. Arnott goes on to say:

Now if every asset is trading above or below its true fair value, then any index that is capitalization-weighted (price-weighted or valuation-weighted) is automatically going to have us overexposed to every single asset that's trading above its true fair value and underexposed to every single asset that's trading below its true fair value.[vi]

COME ON, FEEL THE NOISE

Let’s look at an example, an example that is used in the Mauldin article. You buy into a capitalization-weighted index of two stocks. Each has a “fair” value of $100. One stock costs you $150, the other $50. In a few years, the $150 stock will fall to $100. You lose $50 on this stock. The $50 moves to $100. But your $200 investment is still only $200 and you have had a 0% return on your portfolio[vii].

What if the index was not capitalization-weighted? What would have happened? If your $200 was divided equally between the stocks, you would have purchased .66 of the $150 overvalued stock and 2 shares of the $50 stock and your total return on the $200 would be 33%. You would have a 100% return on the $100 you paid for the shares that went from $50 to $100. For the stock that fell from $150 to $100, you would have lost $33 dollars because you would then own .66% of a $100 stock. In sum, you would have had a return of 33% on your $200 dollar investment ($100-$33 = $66. $66 is 33% of $200)

SO WHAT DOES THIS ALL MEAN?

The next post will explore this issue in more depth. And it is likely that both of these posts will comprise the Desert of the Real Newsletter for July 2006. But the clear message is that the Noisy Market hypothesis makes capitalization-weighted market indices a non-starter. Mauldin has one answer, Seigel and Arnott have another. And guess what? The Author has a still better one!

RETURN EVERYTHING TO ITS ORIGINAL PLACE IN THE DESERT OF THE REAL!

[i] http://desertoftherealecononomicanalysis.blogspot.com/2005/10
/so-what-this-secular-bear-market.html. This post discusses the Secular Bear Market in great detail.
[ii] http://desertoftherealecononomicanalysis.blogspot.com/2006/01
/markets-to-date-so-far-and-not-very.html. This post noted the strong beginning to Januart
[iii] http://desertoftherealecononomicanalysis.blogspot.com/2005/11
/it-could-be-beginning-to-look-lot-like.html. This post noted that the stock market truism “Sell in May-Go Away”, or the general trend for the market to lose ground after May and not regain positive momentum in November has statistical support.
[iv] http://www.frontlinethoughts.com/printarticle.asp?id=mwo061606
[v] http://www.frontlinethoughts.com/printarticle.asp?id=mwo061606

[vi] http://www.frontlinethoughts.com/printarticle.asp?id=mwo061606
[vii] The Author knows that some of you smart guys are saying, well, duh, just buy the $50 stock and don’t buy the $150 stock. This is just a simple example. An index contains many stocks and you don’t know the “fair value” nor which ones are over- or under-valued. But you do know that about 50% will be overvalued and 50% undervalued.