In 2000, we had a significant pricing bubble. Stocks of technology, media, medical, and telecom companies composed more than half of the total value of the U.S. stock market. Most of us, with the blessings of hindsight, branded this situation a “bubble”; indeed, many of us labeled it as such even as it was happening. What is a bubble? It’s a market in which valuations—for a company, a sector, or the broad market—rise beyond levels that any reasonable scenario would justify. The reciprocal, for which we suggest the expression “anti-bubble,” is a market in which valuations fall below levels that any reasonable scenario would justify.
A Fundamental Index™ portfolio weights companies according to their economic scale as defined by fundamental measures of company size. This approach gives the index a value tilt (as opposed to a growth tilt) relative to the capitalization-weighted market portfolio. Such a tilt is the exact mirror image of the market’s bets on companies relative to their economic scale. So, the Fundamental Index portfolio benefits relative to a cap-weighted portfolio whenever the market weights for companies converge on their weights in the macro economy. Conversely, the Fundamental Index portfolio is penalized when market prices move sharply away from a company’s stature in the economy, when markets are paying an ever-larger premium for growth stocks or are assessing an ever-larger discount for value stocks.
What we are now seeing is a “downside disconnect,” or anti-bubble, in financials and certain other debt-dependent industries. If it evaporates, as we expect it will, that will have significant performance ramifications for followers of Fundamental Index strategies. Because the market has punished these stocks with lower and lower valuation levels, one of two things must happen: Either they will collectively outperform, or the financial measures of their economic scale will shrink to match their cap weights.
In our view, the financial services sector has been in an anti-bubble. Consider the following facts. For the past few years, financial services companies have represented about one-fourth of the publicly traded part of the U.S. economy, as measured by profits, book values, or dividends. Fewer than two years ago, the combined market capitalization of financial stocks reflected this economic footprint by equating to about 24%—by far the largest sector in the S&P 500 Index. Indeed, on June 30, 2008, four of the top ten stocks in the U.S. stock market, as measured by total market capitalization, were financial services companies: Citigroup, Bank of America, AIG (American International Group), and JP Morgan/Chase.
By early July 2008, not a single financial services firm—not one—ranked in the top 10 stocks in the market. It is remarkable that of the single largest sector, by far, of the publicly traded U.S. economy, only one stock is in the top 20 stocks, and only the lowest reaches of the top 20, of the stock market. And in reflection of this slide, by July 2008, the financial sector had dipped to slightly more than 14% of the S&P 500, placing it third behind energy and information technology.
Obviously, a massive stock price decline in financial stocks is behind these changing capitalization weights. In the trailing four quarters ending June 30, 2008, the financial sector has shed 42% of its market value, the worst such period of absolute performance of financials since Standard & Poor’s began publishing sector returns in 1989. Furthermore, as Table 1 shows, only the popping of the tech/telecom bubble earlier this decade can come close to such a dreadful stretch of nominal returns from any sector. In other words, 7 of the 10 S&P 500 sectors have never experienced a four-quarter stretch like the most recent one for financials, although most have seen a similar relative performance downturn.