Economic Trends
By Gene Koretz
Index Funds and Inefficiency
What's the safest, most reliable way for people to make money in the stock market? Most economists would probably advise investing in an index fund such as those whose portfolios mirror the Standard & Poor's 500-stock index. Indeed, Burton G. Malkiel of Princeton University notes that the index has outpaced the annual return of the median mutual fund over the past 10, 15, and 20 years by about two percentage points.
The usual explanation for this performance edge, note Randall Morck and Fan Yang of the University of Alberta in a recent study, is that the market is highly efficient in determining a stock's appropriate value. And because prices at any particular time tend to reflect all of the available information about a company's prospects, predicting their course is a mug's game. Better to invest in a widely diversified index fund with low fees and transaction costs.
What intrigues Morck and Fang, however, is that the superior relative performance of index funds seems to have also been enhanced by a growing market inefficiency--a price effect related not to economic fundamentals but simply to a stock's membership in the S&P 500 club. As a result, beating the S&P 500 may have been even harder than efficient-markets theory suggests.
It's common knowledge that a company's stock tends to jump on the news that it will be added to the S&P 500 index--presumably because of a surge in demand as index funds add the stock to their portfolios. If the market is efficient, the effect should be temporary. Yet several studies find that it persists.
Morck and Yang throw light on this debate by using a common valuation measure dubbed "Tobin's q ratio," which is a company's stock market value relative to its book value defined as the replacement costs of corporate assets. They find that both relatively recent and longtime S&P stocks have higher valuations by this measure than comparable stocks not in the index.
Further, the price edge enjoyed by S&P stocks widened over time in line with the growth of S&P 500 index funds. From 1994 to 1999, for example, as index fund assets soared from $21.3 billion to over $235 billion, the average S&P 500 stock's premium grew from 18% to 100% of per-share book value.
The authors conclude that the increasing popularity of index funds ironically has created a market inefficiency that has artificially raised S&P 500 prices above the levels dictated by economic fundamentals. In so doing, it threatens to interfere with the key function of financial markets--getting investors to put their cash into the most economically promising investments.
From this perspective, notes Morck, today's bear market may be contributing to market efficiency. As investors have found that owning an index fund doesn't exempt them from risk, money has begun to flow out of index funds, and the S&P premium has started to decline. "If fund outflows accelerate," he says, "it could shrink a lot more."
Where Are the E-Bargains?
The dampening impact of the Internet on retail prices has diminished, reports economist Joseph T. Abate of Lehman Brothers Inc. In recent years, he notes, more than 100 of the smaller, more aggressive dot-com discounters have bitten the dust, leaving the field to larger, well-capitalized e-tailers.
The reduced competitive climate is reflected in Lehman's annual August e-tailing survey. This compares online prices (including shipping costs) of more than 100 items ranging from toothpaste to hardware with the prices of identical items in New York City area stores.
The survey shows that online prices over the past year have risen faster than overall inflation, with the average discount for nonapparel items down to just 2.6%. Big discounts showed up in only three merchandise categories: clothing (56% cheaper), prescription drugs (20.5%), and toys (12.2%).
In the case of apparel, Lehman concludes that the Net may be evolving into an inventory-clearing mechanism. For other products, the shrinking price advantage may reflect the value households place on the convenience and selection of Net shopping. But even if discounts are declining, says Abate, the ease of comparing prices via the Net has an ultimately deflationary effect.
The U.S. Finally Pays the Piper
It's an intriguing anomaly. The U.S. became a huge debtor nation during the 1990s. Yet until this year it actually received more income (interest, dividends, etc.) from its direct investments overseas and holdings of foreign financial assets than foreigners received from their U.S. investments. Indeed, although the U.S. last year owed foreigners $2.3 trillion more than they owed the U.S., it still managed to chalk up a $14 billion investment income surplus.
Why hasn't the U.S. had to pay the piper till now? One reason may be that a lot of recent direct foreign investment in the U.S. has faced big startup costs. Investment by U.S. companies overseas is older, so it earns higher returns.
This year, however, the U.S. is suffering a net-income outflow running at a $14.5 billion annual rate. That suggests that America's new deficit could widen sharply as foreign companies start to earn more from U.S. affiliates. But Harvard University economist Robert Z. Lawrence notes that much of recent foreign investment may have been in boom-inflated U.S. companies and stocks. So foreign companies may be plagued by low rates of return for some time.
Low returns for foreigners wouldn't be all good news. As economist Martin N. Baily has observed, foreigners whose recent U.S. investments have soured are less likely to be willing lenders to America in the future.
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Copyright 2002, by The McGraw-Hill Companies Inc. All rights reserved.
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