The Globe and Mail

  The recent action in JDS Uniphase reveals market distortions by the S&P 500, our contrarians say.


Saturday, August 26, 2000

In a previous article we looked at the changing composition of the Dow Jones industrial average of 30 stocks. But for all its importance in the minds of investors, relatively little money is directly tied to the old barometer. That distinction belongs to Standard & Poor's index of 500 stocks. A trillion dollars is tied to this benchmark through investments in index funds designed to track it.

The success of index funds is usually attributed to a couple of reasons we heartily agree with: Low management fees and low turnover. The underpinnings of their triumph go deeper, to an assumption about the market known as efficient market hypothesis.

This idea holds that stocks always trade at a price that fully reflects all of the information currently available to investors. According to the theory, it is impossible to "beat" the market in the long term unless the investor has access to insider information. This being the case, the best strategy is to hold a random and varied basket of stocks, and to keep expenses to a minimum.

As contrarians, we have a few objections, but let's leave those aside and assume the theory accurately reflects the real world.

What would be the logical result if many investors agreed? Sales of index funds would increase, but at some point, it would become a self-reinforcing process. That's because as investors pile into these funds, most of the money goes toward companies like General Electric, Cisco, Intel and so on, as they are very highly weighted in the index. That pushes up the value of these stocks, making them even more heavily weighted, which pushes up the index, and the beat goes on.

The self-perpetuating success of index funds is undermining their basis on efficient markets. Too many people buying is leading to distortions that are rippling through the overall market.

Which brings us to JDS Uniphase. When the S&P announced on July 20 that the company would join the index, traders pounced. And why not, it was a no-brainer, the stock had to fly.

JDS is big, very big. Big enough to make its debut in the S&P 500 in position No. 28, in terms of its weighting in the index. That means a very substantial slice of the trillion dollars in index funds had no choice but to chase the stock. The day prior to the news JDS closed at $159 on the Toronto Stock Exchange.

In the next few days it soared to a high of $194.85. With the stock actually part of the index, the traders took their profits, and the shares closed at $172 on July 28. This activity is anything but efficient, but is inevitable because even a huge, liquid stock cannot withstand such an imbalance of demand.

The distortions caused by the S&P index funds are further exaggerated by the actions of the super-cap companies themselves. The huge premium put on their stock allows them to go on a takeover rampage, snapping up companies. Instead of paying cash or borrowing from the bank, they need do no more than fire up a laser printer and create a few billion dollars worth of share certificates.

This is a very powerful, feedback loop, but at some point these overvaluations will become so extreme that they will crack. Then the whole process will work in reverse: These glamour stocks will plummet taking the S&P 500 with it. Index funds will suddenly be the underperformers, and disappointed investors will shift money into other types of funds, forcing index managers to liquidate their holdings to meet redemptions and leading to a full-fledged meltdown.

The 1987 crash was caused by program trading -- a neat idea that worked pretty well -- as long as not too many players did it. But once it hit a saturation point, the entire system became destabilized and the automated monster turned on itself. In the wake of that catastrophe, strict trading curbs were enacted to prevent a recurrence.

We predict that when the index funds eventually cause a market implosion, bizarre anomalies like Nortel at 35 percent of the TSE 300 will be viewed as the empitome of unfettered market recklessness and similar restrictions will be placed on market cap indexes.