If everybody indexed, the only word you could use is chaos, catastrophe… The markets would fail. – John Bogle, May 2017
A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years… We are profoundly worried that this could be a risky allocation over the next 10. – Sanford C. Bernstein & Company Analysts (January 2017)
Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. – Sir John Templeton
My dad was a history teacher, instilling a love of history that has extended far beyond my 25-plus years actively investing and speculating. Due to this love of history and my equal infatuation with the markets, my journey toward becoming a market historian has been a natural path. This historical foundation has aided and abetted my investing and trading at times, and has hindered it at others, as having grounding in history of valuations can be helpful, or detrimental, depending on the investment climate.
Right now, at this particular juncture in the financial markets, we find ourselves embroiled in a historic euphoria, where in-favor stocks have been bid to prohibitively expensive valuations, that’s going to lead to subpar returns for buy-and-hold investors for many years.
At the opposite end of the spectrum, out-of-favor equities in shunned sectors have rarely been more loathed. Energy equities are the epitome of this discarded corner of the market, and Exxon Mobil (XOM), which has been partially shielded from relentless fund outflows via its prominent inclusion in the S&P 500 Index (SP500) and the Dow Jones Industrial Average (DIA) is now losing some of its shine. S&P Global (SPGI) made the decision to remove Exxon, the oldest member of the Dow Jones Industrial Average, from the Dow index effective Aug. 31, 2020.
On the Dow exit list with Exxon were Pfizer (PFE) and Raytheon (RTN), replaced by Salesforce.com (CRM), which had recently eclipsed Exxon Mobil in stock market capitalization, Honeywell (HON), and Amgen (AMGN). Pfizer and Raytheon are well-known industrial powerhouses. However, they lack the name recognition of Exxon, which is symbolic with the rise and fall of energy as a component of the S&P 500 Index. Building on this narrative, many investors trading the SPDR S&P 500 ETF (SPY), which debuted on Jan. 22, 1993, have never participating in the heyday of energy investing, which has come full circle the past 40 years.
In the following paragraphs, we will explore the history of Exxon in the Dow Jones Industrial Average and in the S&P 500 Index, the energy weighting in the S&P 500 Index presently compared to its historical weightings, and the problem the S&P 500 Index structure poses today for many investors.
Exxon Added To the DJIA In 1928
Exxon was added to the Dow Jones Industrial average in 1928 as the following quote from the linked NPR article earlier in the introduction illustrates.
Exxon joined the Dow Jones Industrial Average in 1928, as Standard Oil, one of companies descended from John D. Rockefeller’s world-transforming oil monopoly. Mobil was another branch of Rockefeller’s empire.
For a history on the Dow Jones Industrial Average, which was formally published in 1896, please see an excerpt from this blog post I authored on May 29th, 2015.
(Charles Dow) achieved notoriety for his famous “Leadville Letters.” I have posted pictures of Leadville, above, form the late 1800s and early 1900s. Dow’s writings from Leadville were based on an expedition Dow took to Colorado in 1879. He traveled to Leadville by train, over the course of four days, to report on the mining boom that was taking place in Colorado. Eventually Dow left his position writing for the Providence Journal, to head to New York City, where he founded the company that bears his name in 1882. On July 8th, 1889, Dow Jones & Company published the first issue of the Wall Street Journal. Market historians will probably find it interesting that Charles H. Dow ultimately sold his shares of his company in 1902 to Clarence Barron, and that’s why the Wall Street Journal and Barron’s are sister publications today.
Charles H. Dow was the featured editorial writer in the Wall Street Journal from 1889 till 1902. During this time, he popularized the Dow Jones Transportation Average, which he had originally created in 1884, at his predecessor publication titled the Customer’s Afternoon Letter. The original Dow Jones Transportation Average contained nine railroads and two industrial companies. This index was a predecessor to the Dow Jones Industrial Average, which was formally published for the first time in 1896. Charles H. Dow used these new averages to help identify bull and bear markets. If both averages made a new high, it confirmed that a bull market was underway, from his perspective. However, if there was a divergence, that was a warning sign. Additionally, if both averages made a low, that signaled a bear market.
S&P 500 Index Structure In 1980
While the Dow Jones Industrial Average was first published in 1896, and Exxon Mobil was added to the Dow Jones Industrial Average in 1928, the S&P 500 Index was not formally introduced until March 4, 1957, and it took almost 20 years for the Vanguard Group to offer the first index fund based on the S&P 500 Index, which was offered on Aug. 31, 1976.
There’s a bit of irony here, as Exxon is being exiled from the Dow Jones Industrial Average officially on Monday, Aug. 31, 2020.
Looking back through history, four years after the Vanguard S&P 500 Index Fund (VFINX) made its debut, seven of the top-ten S&P 500 companies were energy equities.
(Source: ETF Database)
Again, believe it or not, energy companies comprised seven of the top 10 market capitalization equities at the end of 1980.
The top market capitalization stocks at the end of 1980 were IBM (IBM), a technology company whose $39.6 billion market capitalization at the end of 1980 is dwarfed by Apple’s (AAPL) $2.1 trillion market capitalization at the close of trading on Thursday, Aug. 27, AT&T (T), Exxon, Standard Oil of Indiana, Schlumberger (SLB), Shell Oil (RDS.A), (RDS.B), Mobil, Standard Oil of California, which became Chevron (CVX), Atlantic Richfield, and General Electric (GE).
Thus, an S&P 500 Index investor would have been very top-heavy in energy in 1980, with this weighting slowly coming down over time.
(Source: S&P Global, Bloomberg, Horizon Kinetic)
Today, the major overweight in the S&P 500 Index is in technology, as I will examine below.
Examining The S&P 500 Index Today
Similar to its overweighting in the energy sector in 1980, today, the S&P 500 Index has a historical concentration to the information technology sector, which is actually understated, as I will illustrate below.
First, here is a breakdown of the current sector allocation in the S&P 500 Index.
(Source: S&P Global)
Representing only 2.5% of the S&P 500 Index, with only Exxon and Chevron being material components of the SPDR S&P 500 ETF, energy has never been a lower sector weighting in the venerable index.
These are the historical weightings of the S&P 500 Index from June of 2020 through year-end 2015, when the energy sector was 6.5% of the S&P 500.
(Source: Siblis Research)
Looking back further, a perspective emerges about how out-of-favor the energy sector is historically.
Looking at the chart above, which only goes through 2016, you can see that we are replicating the late 1990s with information technology now past a 27% weighting in the S&P 500 Index, and the technology weighting is actually understated.
The answer is simple. Amazon (AMZN), which has a 4.9% index weight, is classified as a “consumer discretionary” company, Alphabet (GOOGL) (GOOG), which has a 3.4% combined index weight, is classified as a “communication services” company, and Facebook (FB), which has a 2.3% weighting, is classified as a “communication services” company.
In summary, if you add the market capitalization weightings of Amazon, Alphabet, and Facebook to the information technology sector, the technology sector weighting balloons to roughly 38%, dwarfing even its late 1999/early 2000 weighting. In this environment, where these leading technology stocks are historically overpriced, as I recently showed with my public articles on Apple and Nvidia (NVDA), zigging while everyone else is zagging has never been more attractive, in my opinion.
Problems With S&P 500 Index Structure Today
Murray Stahl of Horizon Kinetics offered this persuasive take, that I happen to agree with wholeheartedly, on what’s wrong with the structure of the index today, which was presented in a question and answer format in Horizon Kinetics’ Q2 2020 investment commentary. Here is the section I want to highlight today (with emphasis added my own).
Murray Stahl: I personally think that indexation, which has really been a 20-25-year phenomenon in terms of raising assets and becoming unquestionably the dominant investment strategy, is just about ready to come to its end. And I say that because I think the index methodology is going to prove, at the end of the day, to be stenotic, narrowing to the point of failure.
There are a number of good characteristics about indexation, because, anything can be a good if you don’t take it to an extreme. But that’s a problem with investing, which is a problem in social science: People take things to extremes. They also lack patience, but the bigger problem is they take things to great extremes. No investment strategy is a strategy for all times. The indexation strategy is a good idea in the sense that, in theory, it is a diversified portfolio with exposure to basically everything that’s in the market. So, some elements in the index will do well and, obviously, some others will not, but in the fullness of time, assuming the market as a whole does well, the whole of the index should do well.
And in the last 20 years, at least the part of the index that is technology, which is now clearly its biggest element, has done outstandingly well. And it’s obvious how that happened: Because of the growth of the internet, from a handful of users to now, if I’m not mistaken, over 4.8 billion of the roughly 7.7 billion people on this planet. The growth rates, if you measure country by country, are just astonishing. And a lot of that internet activity is concentrated on the platforms of certain companies, and you know which ones they are: Amazon, and Microsoft (MSFT), and Facebook, and Apple, and Google.
So, they’ve been incredible growth companies. And I don’t believe that they are going to be unprofitable. I’m not really saying anything bad about them. I’ll only say two things, one of which is completely obvious. By definition and by simple math, there’s a clear and calculable limit to how much growth they’re going to have in the sense that if we’re at almost 4.8 billion users and there are only 7.7 billion people on the planet, well, then, the maximum cumulative growth in users can only be the 60%, that being from the current number of users to 7.7 billion, and that’s if every single human on the planet is connected. Which means you’re not going to get the returns of the past. I personally think that’s self-evident, but as I look around at sales projections, no one else seems to agree with me.
More importantly, let’s just imagine the following possibility: Let’s just say something else, some other segment of the index – of the S&P 500 – is going to do extraordinarily well at some point in the future. Well, if that’s true, the problem is that the index is now dominated by a handful of companies, meaning that it has undiversified itself and might no longer have much exposure to that other segment that will do extraordinarily well in the future. Many people don’t think about this, but that eventually happens to every index: Sooner or later, even if every stock in an index goes down, some stock is going to be the best-performing one, and that’s going to become the biggest position, and the next best performing stock is going to be the second biggest position, and eventually the index will be heavily dependent upon some particular few companies or sector.
This undiversifying happens over a very extended period of time and, because of that, this phenomenon hasn’t been studied – but in our case, that time is now. The S&P 500 is now a concentrated portfolio, and has undone the logic of its original purpose and is not diversified at all. The top five companies, out of 500 constituents, now account for 21% of the index.
The problem is not that something horrific will befall the largest investments, although that can happen, of course. In all likelihood, they will remain profitable. The problem – and perhaps the least appreciated one – is that some other group in the index will become desirable, but its exposure will have become negligible within the index as it gets crowded out. Hence, no matter how high the return of the negligible part of the index, it will have virtually no impact upon the total index.
So, imagine you were in control of the S&P 500 index, and you would like to rebalance it in order to give it exposure or greater exposure to some other sector of the economy. And let’s just make believe that sector is energy. Now, here I’m just asking you to admit the possibility. I understand it’s very controversial. I’m not making an argument that energy is going to do well. I’m just saying theoretically there’s a possibility that energy might do well, and you’re in control of the index and you want to alter the weightings such that energy, which is now not even 3% of the index, is going to be higher. How much higher? Let’s say you wanted to make it 15%. How would you actually go about doing it? Well, arithmetically it’s pretty easy. You would come up with a formula, and the computer would do the rest of the work. And once upon a time, you could even do that.
But in another way, it’s impossible. Why? Because, in practice, most of the investment world is now indexed, so this theoretical rebalancing would take place at a time when indexation is the dominant strategy – which never happened before. And it becomes more dominant with every passing day as the world divests itself of its active management community. In fact, rebalancing is impossible in two separate but completely related, ways.
Here’s the first problem: There’s no longer enough money being managed in the active investment community to accommodate such a change. All the major indexes – and it’s not just the S&P 500, because they all have so much overlap in holdings – are going to be doing the exact same thing. They’ll want to sell their leading positions to rebalance, but who in the world are you going to sell to, even if they wanted to buy them? The buyers, the active managers, don’t have enough money. So, you can’t change or rebalance the index.
And, second, why should they buy it? The terms of trade are about to change radically in favor of the active management community, small and battered though it may be.
Steven Bregman goes on to add to Murry Stahl’s commentary to illustrate an example of the precious metals sector, which I have written about recently with Barrick Gold (GOLD), notably highlighting Barrick before Berkshire Hathaway (BRK.A)(BRK.B) disclosed a position. Bregman makes the informative point that only Newmont Mining (NEM) is a component of the S&P 500 Index, and it has a miniscule weighting of 0.2% of the S&P 500 Index, so even if precious metals stocks were the cat’s meow, the most desirable place to be in the financial market, there would not be the capacity to absorb fund flows in a rebalance.
Said another way, there’s not enough available shares to accommodate demand, especially if the liquidity flows that are currently being directed at the Apples and Amazons of the world revert to something else that has a much smaller market capitalization.
Comparing Exxon, Salesforce.com, and Apple From A Valuation Perspective
Recently, I wrote about Apple, going from an extremely bullish stance in May of 2016, to a bearish stance today, after Apple shares had appreciated by more than 400%, and were trading at their most expensive valuation ratios in a decade.
Here’s an updated valuation table I used from Morningstar from that previous set of published articles that shows how lofty the valuation multiples are on Apple shares.
Somehow, Apple, which had very scant revenue growth the past three years, with $274 billion in trailing 12 months revenue vs. $266 billion in fiscal year 2018 revenue, is now trading at an 8.1 price-to-sales multiple, which dwarfs its own previous price-to-sales multiples. Adding to the narrative, every other valuation ration of AAPL is historically expensive, both to its own history, and to the broader market.
Salesforce.com is in the same position, with its absolute and relative valuation ratios off the proverbial charts.
Salesforce.com is trading at a 13.0 price-to-sales multiple, and a 110.5 price-to-earnings ratio, making Apple shares, which sport the aforementioned 8.1 price-to-sales multiple, and a mere 37.9 price-to-earnings multiple, look downright cheap.
As a reminder, and I have used this quote in my writing lately, remember what Scott McNealy, the former CEO of Sun Microsystems said about his company trading at a 10x revenue multiple at the peak of the dot-com bubble era.
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
Scott McNealy – Business Week 2002
Now, think about what Apple, the largest market capitalization stock in the world, which trades at an 8.1 price-to-sales multiple, and Salesforce.com, which trades at a 13.0 price-to-sales multiple have to do, to justify the current multiples, and then consider that Saleforce.com is laying off employees. And Apple’s revenue growth the past three years has been incremental, at best, with 2018 annual revenues not much different than the past twelve months trailing revenues.
Said another way, from a valuation perspective, these two in-favor companies today are off the charts, both on an absolute basis and on a historical basis.
In a sharp compare and contrast, look at Exxon Mobil’s valuation table, which shows a starkly different picture.
Trading at 0.8 price-to-sales multiple, and a 23.7 price-to-earnings multiple, in a year in which energy prices collapsed, Exxon is trading at a fraction of its own historical valuation multiples, and at a fraction of its much more loved technology peers. With still enormous revenues, what will happen to Exxon’s already cheap valuation ratios if energy prices recover, which they are already doing? More importantly, where will the index capital go?
Closing Thoughts – Exxon’s Exit Marks The End Of An Era and The Beginning Of A New Era
We have come a long way from when Vanguard introduced the first S&P 500 Index product on Aug. 31, 1976, which for many investors today probably feels like Aug. 31, 1776. In a bit of a bookend of an era, Exxon is going to be officially removed from the Dow Jones Industrial Average on Aug. 31, 2020. However, this inglorious end for the longest tenured Dow Jones Industrial Average member has actually been a long time coming, as the energy sector reached its peak S&P 500 sector share in 1980, when seven of the top ten S&P 500 Index components were energy companies.
When Exxon and Mobil merged in 1999, it was the biggest merger in corporate history, and Exxon was still the second-largest market capitalization firm at the end of 2013, trailing Apple with a $439 billion market capitalization to Apple’s year-end 2013 market capitalization of $481 billion.
Today, the relative valuation gap has grown enormously, with Apple commanding a $2.14 trillion market capitalization, and Exxon down to a $168 billion market capitalization.
This highlights the struggles of Exxon’s shares, which have been in a sideways trading range for much of the past decade before the sharp in 2020.
(Source: Author, StockCharts.com)
And, even though long-term returns of Exxon going back 30 years are still strong, one would have done better investing in the S&P 500 Index by about double, and the better investment by far, would have been in the parent company of the S&P 500 Index, which is S&P Global, which has risen in tandem with the popularity of index funds.
(Source: Author, StockCharts.com)
Looking at the long-term performance chart above, it should be easy to see that the real bubble is in indexing, and in the parent companies of these vaunted benchmarks. Personally, as a market historian, I have a feeling that we are going to look back in market history at S&P Global adding Salesforce.com, which is trading at a 13.0 times price-to-sales multiple, to replace Exxon, trading at a 0.8 time price-to-sales multiple, on the back of downtrodden energy prices, as a watershed event, that marked the end of a peak era of unknowing speculation, as the purveyors of index products got so popular, that they overwhelmed the function of the capital markets.
Bogle laid out the blueprint, with his quote in 2017, and all investors should take note of that quote today, specifically, “If everybody indexed, the only word you could use is chaos, catastrophe… The markets would fail.” We are there today, from my perspective, as the first hint of index selling pressure will unwind the clock, challenging the structure of the markets. Building on this narrative, investors should prepare for a sharp broader market correction, looking at historically out-of-favor sectors, including the energy sector, where Exxon Mobil is trading at historically downtrodden valuations offering shelter in a potential storm, and relative valuation potential in a continued market melt-up. Bigger picture, the relative and absolute opportunity is in historically out-of-favor stocks, some of which are already outperforming in 2020, in what should turn out to be the launching point for a historic capital rotation.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
Disclosure: I am/we are long XOM, GOLD, IBM, RDA.A, RDA.B, SLB, AND SHORT AAPL, NVDA, AND SPY IN A LONG/SHORT PORTFOLIO VIA PUT OPTIONS AND DIRECT SHORT SPY EXPOSURE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Every investor’s situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication and are subject to change without notice.