A Different Kind of Crash?

By Brad Thomason, CPA
 
 
The Dow Jones Industrial Average is a price-weighted index, whereas the Standard & Poor’s 500 is a market-cap weighted index.
 
If, at this minute, you are thinking to yourself, “Bradley, why on Earth would I ever care about that?,” I’m about to tell you.
 
Not all indexes (or indices, if you prefer…) are calculated the same way.  I’m not going to brutalize you with the whys and hows of the various methods.  But just know that in a market-cap weighted index, the biggest, most valuable stocks exert the most power on the value of the index.
 
Which companies are now the big ones exerting extra pressure on the S&P 500?  The big tech stocks.
 
Historically, are tech stocks more volatile or less volatile?
 
Tech stocks, for the last few decades have almost always been high-multiple stocks which are valued based on their growth potential, rather than the old-school book value/multiple-of-earnings type of process traditionally applied to companies working in the more tangible fields.  That’s a valuation basis that inherently focuses more on what a company may become, as opposed to what it already is. 
 
Which also inherently must leave the door open for the possibility that it will fail to fully attain that theoretical potential. 
 
An abiding characteristic of high-multiple stocks is that in times of malaise and panic, their prices usually get hammered worse than your average ticker.  Investors who are willing to push their shares higher in times of prosperity, seem to know that they are skating on thin ice, and usually head for the exits much more vigorously at the first little sounds of cracking.
 
A mini version of this happened just the other day, around Thanksgiving, when news about the Omicron variant started coming out.  Nothing really changed in the economy.  But the prospect of a new wave was a scary enough piece of speculation to trigger a low-grade sell-off.  High multiples and bad news do not play well together.  In that particular example the prices snapped back fairly quickly once the news was not so new.  But in actual crashes, the timescale is much longer, even when the underlying mechanics are the same.
 
So what if you had a situation where, over time, a country’s highest multiple growth stocks sustained enough success that they eventually came to be that country’s largest market cap stocks, too?  And the predominant stock market index for that country used a market-cap weighting…
 
It has been the case now for the past two or three years that the S&P 500 index has been dragged around disproportionately by the biggest components at the top of the list.  Like the top fifty; and at times the top fifteen or twenty.  The other 450 - 485 have had net behavior which was at times much different, but you wouldn’t know it just by looking at the index quote on the news.  If you weren’t watching the individual pieces, you wouldn’t necessarily notice it.
 
Since the movement over that period has been up, up, up, you probably weren’t watching the pieces.  The news from the market seemed to be unequivocally good, so why bother, right?
 
What, if anything, does all of that tell us about what the next stock market crash might look like? 
 
Well, if the market gets spooked by some sort of sustained bad news, the first and most severe casualties are likely to be the ones with the highest speculative multiples in the first place.  Since, at this moment in history, those stocks also happen to be many of the mega-caps, then they are going to have an out-sized impact on the resulting index measurements.  They have to, based on the formula they use to get the index number.

 
In other words, our responsible (but somewhat inattentive) retirement saver may have put a bunch of money into index funds or ETFs, thinking that doing so was a boringly-conservative thing to do, only to find out that doing so at the present time instead had the effect of causing them to be over-weighted to the tech sector – currently at record high valuation levels. 
 
Thought they were playing it safe and boring, but in actuality volunteered for concentrated exposure to the most highly-valued, volatile stocks in the land.  Oops.
 
And maybe Ouch, too.
 
All because of some nerd math that you didn’t even know was something you had to worry about.
 
But now you do.  So that’s at least a step in the right direction.
 
In a real crash, you really don’t want to be in stocks in the first place.  Historically, about eight out of every ten stocks typically follow the major market moves, especially the downward ones.  This next time it could go differently, though.  Because of the excess “air” that’s in the really big stuff, the mid caps and small caps could have a different time of it, and maybe even fair pretty well. 
 
But if all you have is index-denominated holdings, you may never feel that difference.  The rapidly- deflating giants will be enough to sink the whole index, and your account balance, too.