I read the Alchemy of Finance - and
didn't like it. Soros seems to believe that everyone is irrational except
himself; that only he can see the light. Buffett, on the other hand,
believes everyone is rational given the information they possess... Buffett
just believes he adds value by doing more homework than the next guy.
I guess I'm not quick to believe that either index or tech bubbles exist.
The author seems to believe that the growth in index funds has caused stock
prices in the index to shoot over some undefined level of "normal"
valuation. First, I would remind the author that for all the press
indexing receives, only about 5% of all capital invested in the market it
tied to index funds. Furthermore, not all index funds are SP500 index
funds. Check out Vanguard, you can index your investment to small cap
stocks, foreign markets, and to different industry sectors. Latest
estimates put funds indexed to the SP500 at about 4% (read that in Business
Week recently). So with all the trillions of dollars out there, one would
have to give undue influence to the very small amount of purchases made
through index funds to believe that they can determine market direction.
Therefore, I think its extremely unlikely that purchases through index
funds are controlling the level of the SP500.
I believe there are rational reasons for the current valuations of the
SP500 relative to small cap stocks. Obviously lots of investors (mostly
non-indexers!!) are buying large cap stocks. Why? Well one reason is that
interest rates in the 1990's have been dropping to their extremely low
current levels. Low interest rates help large cap firms more than small
cap firms.
During periods of falling interest rates, large cap firms are typically
more effective at lowering their cost of capital, by renegotiating debt
contracts (just like individuals can refinance their mortgages). Unlike
large cap firms, small cap firms typically do not have the steady earning
streams that banks (and the bond market) love when pricing loans...
therefore, small cap firms typically can not get the same percentage
reductions in rates that large cap firms can. And lowering the cost of
capital lowers the discount rate that investors use to discount those
future cash flows. Therefore, a larger percentage drop in large cap
discount rates implies a larger percentage rise in large cap stock prices
relative small cap stock prices. So there is a rational reason for the
differences in relative valuations. This effect has occurred before in the
past, but since its a "boring" answer - the press typically likes to focus
on "bubble" stories, or people who promote bubble stories. Bubbles stories
sell.
I think its more likely that bubbles could exist (and quickly expire - as
they should) within the market for a single stock, or a small sector of
stocks. Within a single stock (like Yahoo) it doesn't take much capital to
move the stock to new highs (relative to the huge amount necessary to move
market indicies). However, I think there are also rational explanations
for the current valuations of internet stocks.
Just remember that large and violent price swings, per se, DO NOT
constitute evidence of bubbles. Large and violent price swings can (and
do) occur when new information is revealed that causes all investors to
simultaneously and rationally agree that a stock price should be higher or
lower.
So what do I think about the direction of the market? I think its going to
bounce around in the 7400-9000 range while both good and bad news about
domestic and international market continue to hit the airwaves this fall. |
