The S&P 500’s Bubble Trouble

The popular Standard & Poors 500 index is effectively a stock-picker for millions of investors. At the end of 2007, some $1.5 trillion was invested in S&P 500 funds, Exchange Traded Funds, and other vehicles that mimic the index's composition, and $4.85 trillion were invested in funds whose performance is benchmarked to the S&P 500. But as we noted nearly six years ago themethodology S&P employs to compile and maintain the index leaves it vulnerable to bubbles.

The composition of the index is always changing, as companies in the index merge, get bought by private equity funds, go bankrupt, or shrink to the point of irrelevancy. When the S&P Index committee evaluates potential new members, it applies certain criteria: Companies must possess a market capitalization of at least $5 billion and show four consecutive quarters of profits. The committee also uses new additions to ensure that the index remains representative of a highly dynamic economy. If the economy is becoming more dominated by information technology, as was the case in the 1990s, the committee will be more likely to replace a shoe company with a software company.

In the late 1990s, the methodology caused the S&P 500 to add lots of technology and telecom stocks at very high prices, after they had enjoyed huge run-ups. But many of these crashed to earth when the dotcom bubble popped, effectively saddling passive S&P 500 investors with active-trading losses. The index added Yahoo! on Dec. 7 1999, at an astronomical $228 (it's now at about $23). Several high-flyers were booted out within a matter of months. Broadvision lasted just 10 months. The shape of the economy is constantly shifting, one sector rising while another falls. And so too does the shape of the S&P 500. In March 2000, when the technology stock boom peaked, information technology accounted for 34.5 percent of the value of the S&P 500, and energy accounted for just 5.21 percent.

In this decade, the story of the markets has been a bubble (in housing and credit) and a half (energy and alternative energy). So did the S&P 500 repeat the 1990s trick of inducing investors and funds to buy bubble-era stocks at their highs and then ride them all the way down? The answer: yes, but it's not as bad as in the 1990s.

To start, turnover has been much lower in recent years than it was in the go-go 1990s, which means the committee has had to make fewer agonizing choices about which companies to add. In the late 1990s, there were nearly 40 changes per year, culminating in a record 58 in 2000. By contrasts, in 2004 and 2005 about 20 stocks were added each year, and in 2007, 37 were. Plenty of real estate and finance stocks were added between 2004 and 2007. Last October, when the financials peaked, they constituted 20 percent of the S&P 500's value, surpassing longtime leader information technology (16.2 percent). Some of the additions in the financial/real estate complex have been big losers. Online broker E-Trade entered the index on March 31, 2004 at $13.35 and now trades at $2.85. Sovereign Bancorp came in on June 30, 2004 at $21.61, and now goes for $7.50. Lender CIT entered in October 2004 at about $40 and now changes hands for about $7.22. In 2005, two homebuilders that had already enjoyed big runs came in. Ouch! D.R. Horton, admitted on July 1, 2005, at $37.11, has since fallen to $10. Lennar has lost 82 percent of its value since entering the index in October 2005. Two of the real estate companies added in March 2007, developers Diversified Realty and Host Hotels & Resorts, have lost more than 50 percent of their value since joining.

But since the housing/credit bubble was slower to develop and slower to deflate than the dotcom/telecom bubble of the 1990s, there have been fewer supernovas- companies that went public, and grew large enough to get on the S&P 500's radar, and then blew up all within the space of a few years. In its wisdom, the committee didn't add any of the subprime lenders that failed spectacularly. In 2001, the powers that be were content to let tech and telecom companies go down the tubes. By contrast, lenders, investors, and the Federal Reserve have been much more willing to bail out struggling large financial companies. The result: fewer total wipeouts. There's a final key difference between the two decades' bubbles that has insulated S&P 500 investors. In the 1990s, the bubbly activity was almost fully in the public stock markets. This decade, a great deal of the most frothy action happening outside of the public market - with hedge funds assuming titanic levels of risks and investors raising tons of cash to take companies private.

The S&P 500 hasn't gone overboard with the energy and alternative energy sectors, which seemed to be inflating just as housing was deflating. In 2007, only six of the 37 additions were energy firms. And most have been service companies like oil drillers--no ethanol companies or solar panel manufacturers yet. In addition, since the pace of dealmaking has slowed dramatically this year, the committee has had fewer opportunities to make subtractions and additions. More than halfway through 2008, only 10 stocks have entered the index.

The S&P 500 does show symptoms of its congenital bubble problem. It still rides bad stock all the way down. Four of the ten stocks booted out this year were financial companies, including Countrywide Financial and Bear Stearns, both of which were acquired at fire-sale prices, and Ambac, which was booted out on June 11, 2008 after its stock had completed a sickening 98 percent 12-month fall. Meanwhile, four of the ten additions have been energy companies, with three alone entering last month: Southwestern Energy, Massey Energy, and Cabot Oil & Gas Corp. Last month, for the first time since 1992, energy surpassed financials for second place among S&P 500 sectors. And as of June 30, energy was challenging IT for supremacy.