Fund trackers could be causing a bubble

Stock markets are experiencing a remarkable bull run. The global MSCI Index reached an all-time high in February, and since 2010 annual stock market returns have been 8%, after allowing for inflation, higher than bonds or real estate.

Leading the bull charge in the USA has been the performance of a small number of very large tech firms. The term ‘the Magnificent Seven’ refers to Meta, Nvidia, Apple, Alphabet, Tesla, Amazon and Microsoft. In April 2023 they had accounted for 88% of the gains on the S&P 500 Index. Collectively, they have a market capitalization of more than $13 trillion, more than the entire market capitalization of the China stock market ($11.5 trillion), according to Bloomberg.

Does this matter? There could be a distorting effect creating market instability. The procyclical dynamics of higher values draw in tracker funds, pushing valuations ever higher, which could mean a gradual dislocation from underlying company performance.? In the words of the then Governor of the Bank of France Jean-Claude Trichet at the time of the dotcom boom, the risk is that tracker funds are ‘creating rather than measuring performance’.

There is the potential, therefore, for an investment bubble, risking a precipitous crash. The US price-earnings ratio, cyclically adjusted, has reached 34.3. This compares with 44.2 in 1999 just before the dotcom crash, and 31.5 in 1929.

Comparisons have been made with the dotcom crash of 2000. There are some differences; one of which indicates lower risk, while others have more troubling features.

The first difference is that the dotcom boom featured a significant number of companies without a strong earnings record or robust business model, whereas the Magnificent Seven are thriving companies with sound fundamentals and strong prospects. During the collapse of dotcom company valuations, some commentators recalled the observation made at the time of the gold rushes of the 19th century – that the only folk who became rich were the manufacturers of picks and shovels. In a similar way, companies that helped construct the infrastructure and software for the internet revolution fared better than those seeking gold through a startup online store with a big marketing budget.

Nvidia, as a leading supplier of artificial intelligence software and hardware, has soared in value as the range of applications of AI has grown in the 2020s. It is a well established firm, a pioneer of graphics-based processing that was founded in 1993. It may be that investor confidence in the potential of AI has become over-confidence, but it is still a transformative technology.

The second difference, however, is that there are so few of the companies driving the increasing valuations in stock markets. Given that Apple and Tesla have not fared so well this year – Tesla, for example is 27% down on stock price – the number has become smaller. The fact that a tiny number of firms account for such a large proportion of stock market gains could be interpreted as a lack of investor confidence in the rest.

So, are we heading into bubble territory? There are some signs, but anticipating the duration of a bubble is never easy. Some market analysts talk more of a technical correction than an out-and-out crash. The values of bitcoin and of gold have also risen, so may not appear attractively priced as an alternative, while real estate is stagnant.

Another difference with 1999-2001 is the size of passive funds; they have overtaken active ones, so if over-valuation in equities is followed by a correction or a crash, the procyclical dynamics could accelerate the downward trend. Active managers would then be well positioned to identify the strongest prospects, but for the time being they are somewhat in the background.

The first indications of a correction have emerged in the Indian stock market. On Wednesday 13th March authorities warned of the potential for overheating and guided funds to limit purchases in small and mid-cap stocks, which fell on the Bombay Stock exchange, although rebounded to some degree on the Thursday. Since then the MSCI India Index has dipped, but not crashed.

For all the excitement about AI and Nvidia, the sober underlying reality is that a period of low interest rates and low corporation taxes has come to an end at a time of geopolitical unrest. The challenge to maintain earnings sufficiently to justify valuations is considerable.

Published in the Gulf Times 25 Mar 2024