With the S&P 500 up around 90 per cent over the last five years — the so-called ‘Magnificent 7’ driving nearly 70 per cent of its gains this year — and trillions of dollars planned for artificial intelligence spending, some institutional investors have begun to question whether we are in a bubble and whether a correction is in store.
Unfortunately, bubbles bursting, market corrections and the end of cycles are a fact of life for investors: segments of the market regularly reach highs, fall significantly in value, and sometimes take a long time to regain their highs. For example, take gold in 1980 or equity markets in the 1987 ‘Black Monday’ crash, Japanese equities and real estate in 1989, equity markets again in the 2000 dot-com bubble and oil in 2008.
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Correctly predicting when bubbles will burst and the timing of corrections is nearly impossible, even with access to some of the best minds and data. Reflecting on the dot-com crash, former Federal Reserve Chair Alan Greenspan said, “I’d come to realize that we’d never be able to identify irrational exuberance with certainty, much less act on it, until after the fact.”
Nobel prize winning economist Robert Shiller compares big market pivots to the unpredictability of avalanches: “It may never be possible to say why an actual avalanche occurred at the precise moment that it did. It is the same with the stock market and other speculative markets.”
But that doesn’t mean there’s nothing investors can do to minimize the worst effects of these events. Diversification is the best defense. While each bubble, correction or cycle end is different, investors can reduce their risk by avoiding outsized exposure to any single company, asset, country, currency, market segment or asset class — and by ensuring their portfolio includes multiple potential safe harbours.
While diversification may allow investors to minimize the impact of bubbles in narrow segments of the market, there may be no way for most investors to completely avoid the impact of corrections that lead to broad-based market declines — like the dot-com crash or the 2008/09 global financial crisis. But, in those cases, diversification in addition to a range of safe harbours can reduce the risk of longer-term weak investment performance.
Most broad market declines are associated with one or more market segments that suffer from more lasting underperformance, like technology after the dot-com crash or European banks after the 2008/09 global financial crisis — both of which underperformed the broader markets for years after corrections. Being overweight in such sectors can turn stressful shorter-term market events for all investors into something worse for investors with the wrong big bet: longer-lasting weak overall investment performance, even after broader markets recover.
The challenge today is that closely tracking conventional public market indexes can pull investors into concentrated positions. U.S. and U.S. dollar-denominated companies now represent about 65 per cent of the all-country world index, up from about 40 per cent in 2010, and the top 10 companies in the S&P 500 now represent more than 40 per cent of that index, up from less than 20 per cent in 2014.
Investors should recognize conventional index exposure comes with increased risk today, including the risk of weak longer-term investment performance if the market segments that dominate the index today suffer from lasting underperformance after the next correction. Closely tracking indexes today comes with some big bets.
Building a well-diversified portfolio requires deliberate effort, especially today. Instead of drifting into concentrated index exposures, investors will need to swim against the tide of recent market dynamics and the make-up of conventional indexes.
Bert Clark is the president and chief executive officer of the Investment Management Corporation of Ontario.