The Bubble That Is The S&P 500 Index

The boom in passive investing has led to an unintended consequence. As more and more investors buy into the S&P 500 by purchasing the exchange-traded funds or mutual funds that track this index, the index managers have to buy the underlying holdings. Given that the index is cap-weighted and that larger holdings receive a greater share of new dollars, the top stocks in the S&P 500 index continue to appreciate. This virtuous cycle has made indexing unbeatable for the past few years: nothing has been able to match the self-propagating nature of this phenomenon by which Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), and Facebook (FB) have gone nowhere but up. Their performance has been partially justified by growth, but has mostly been goosed by the inflow of new money into index funds.

Now most of these top holdings trade at multiples not justified by the growth rates. Microsoft, for example, trades at 27 times trailing earnings, a multiple only halfway justified by the three-year annualized net income growth of 24%. Revenue has grown at a lesser 11%, implying that this multiple will be hard to sustain. A more egregious example is Amazon, which trades at 73 times trailing earnings. Net income has exploded at 157% a year for the past three years, but revenue has been slowing. The hardy three-year annualized rate of 30% looks to be sliding fast, imperiling the sky-high multiples. For example, Amazon's year-over-year revenue growth has declined to approximately 17%down from the juggernaut of recent years. As Amazon gets even larger, anything approaching 30% sales growth will be difficultif not impossibleto achieve. Apple trades at a far more reasonable 17 times earnings, making it the only stock in the bunch worth buying at these levels.

Could the tide already be turning? The so-called "FAANG trade," where an investor buys shares of Facebook, Amazon, Apple, Netflix, and Google's parent company, Alphabet, has lost its momentum recently. As the Wall Street Journal pointed out in August, all these stocks except for Alphabet reached peaks last year and are still far below their record highs after the collapse in the fourth quarter of 2018. It may be too early to proclaim a change in leadership, but it seems that these tech behemoths are losing their charm. As the FAANG stocks go, so goes the S&P: given that these five stocks make up almost 20% of the value of the S&P 500, their performance looms very large. The mania for indexing could easily reverse into a vicious cycle if these tech giants lose their footing. It's sobering to remember that Amazon lost over 90% of its value during the tech collapse of 2001. Although a similar decline would be highly unlikely, anything can happen when a stock trades at a nosebleed multiple.

As the old expression goes, the top-heavy tech portion of the S&P index is pricing in not just the future, but also the hereafter. Investors need to plan accordingly.

James Berman owns shares in Apple (AAPL), both for himself and in accounts he manages for clients. In some client accounts, he also owns positions in the ProShares Short S&P 500 (SH), an inverse ETFs that hedges against declines in the S&P 500.
