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2017-04-06 05:52:45
Japan dominated the index in the late 1980s. That didn t end well
Apr 4th 2017
THE aims of a stockmarket index are threefold. First, to reflect what is
actually going on in the market; second, to create a benchmark against which
professional fund managers can be judged; and third, to allow investors to
assemble well-diversified, low-cost portfolios. On all three counts, there are
reasons to worry about the MSCI All Country World Index, one of the most widely
used gauges of the global stockmarket.
That is because the American market has a weighting of 54% in the index, as
high as it has ever been (it reached the same level in 2002). In other words,
anyone using the index to monitor the market is seeing a picture heavily
distorted by Wall Street. The relative performance of international fund
managers against the index will largely depend on how much exposure to America
they are willing to take on. And anyone buying a tracking fund is making a big
bet on the American market. Things are even worse if investors track the MSCI
World Index, which covers only developed markets. In that benchmark, America s
weight is 60.5%.
There is nothing wrong with the way that MSCI calculates its indices; the
weights reflect how America dominates global markets. With world index funds
having fees as low as 0.3% a year, they look a tempting option. But there are
worrying parallels with the way that Japan dominated the index in the late
1980s.
At its peak, the Japanese market was 44% of the MSCI index. That was far more
than double the Asian economy s share of global GDP at the time (see chart).
Investors were enthusiastic about all-conquering Japanese multinationals like
Toyota and Sony; the talk then was of the rest of the world needing to learn
from the Japanese model. Japan s companies were free from the threat of
takeover and able to pursue long-term expansion plans without worrying about
short-term profits.
The American stockmarket s index weight is also more than double the country s
share of global GDP. The gap has widened since the start of the millennium,
because America s share of world GDP has been on a downward trend. Today s
investors are wildly enthusiastic about America s all-conquering technology
groups, such as Google, Facebook and Amazon. They, too, are either shielded
from the threat of takeover by special shareholder structures, or in the case
of Amazon, have persuaded investors that long-term growth is more important
than short-term profits. Other countries only wish they could create technology
giants with the same reach as one of America s titans.
Do such parallels mean that America is doomed to follow the same path as Japan,
whose stockmarket weight steadily dwindled until it fell back in line with its
contribution to global GDP? Not necessarily. A country s stockmarket is less
likely to be an exact replica of its domestic economy; only around a half of
the profits made by S&P 500 companies are earned at home. The weight of
American firms in the global index has been given an extra boost by the recent
strength of the dollar.
Still, investors may grant a higher valuation to a country s stockmarket
because they perceive it to have attractive fundamentals. The American market
is nothing like as highly valued as Japan s was in the late 1980s, when
sceptics were told that Western valuation methods did not work in Tokyo. Still
American companies trade on a multiple of 21 times last year s earnings,
compared with 18 for Europe, 17 for Japan and 14 for emerging markets. On a
cyclically adjusted basis (averaging profits over ten years), the ratio of the
American market to earnings is as high as it was in the bubble periods of the
late 1920s and 1990s. And it is worth remembering that those corporate profits
are still very high, relative to GDP, by historical standards.
Perhaps all these things can be justified. America may have better prospects
for economic growth than the rest of the developed world, not least because of
its favourable demography. Its technology giants may be less vulnerable to
competition than the Japanese multinationals of the late 1980s because they
benefit from network effects , or natural monopolies. And profits may have
shifted to a higher level in a world where trade unions are weak, the cost of
capital is low and business is very mobile.
Nevertheless, an investment in the MSCI indices is an implicit bet on three
things: the importance of the American stockmarket; the valuation placed on
American companies; and the robustness of profits as a proportion of American
GDP. This is not the kind of lower-risk option which those buying an
index-tracker probably have in mind.