Is The Stock Market Broken?
David Einhorn, Bill Ackman and Michael Burry are among investors who think it is
The Index Conundrum
Have you ever found yourself lying in bed at night when, out of nowhere, a thought enters your mind - and no matter how hard you try, you just can’t shake it? That happened to me recently - this was the thought:
As investors, we know all too well that market prices and intrinsic value are rarely aligned and often diverge significantly. In fact, identifying companies trading at a discount to intrinsic value is in our DNA. So if the price of a company often fails to reflect its true value, why do index administrators rely on market capitalization weightings to construct equity indices?
I decided to dig around and do some research and it was with a great sense of relief that I discovered others had grappled with the same conundrum.
For instance, Michael Burry - the Scion Capital hedge fund manager famous for predicting the 2008 financial crisis and immortalized in movie The Big Short - has warned about the potential risks of market-cap weighted indices, arguing that the massive inflow of capital into index funds is creating a bubble and distorting market prices1.
In Greenlight Capital’s 2024 letter to its clients, David Einhorn expressed the opinion that, “the stock market is fundamentally broken.” He went on to say that most investment funds today don’t care about valuation, cannot figure out valuation, and instead care more about price than value. Index funds, he said, are now "price takers.”
As I explored further, a picture began to emerge which I found deeply disturbing. I felt duty bound to share my findings within the investment community, and to explore how an intelligent investor ought to navigate the issues so ensure favourable returns.
The Backstory
The market capitalization-weighted equity index was first formalized with the creation of the S&P 500 Index by Standard & Poor's in 1957. This method weights stocks based on their market capitalization, reflecting their relative size and strength within the market.
Its history is rooted in practicality - it is nice and easy to calculate an index on this basis.
Others index administrators followed suit and notable cap-weighted indices also include the NASDAQ Composite and FTSE 100.
The original purpose of the S&P500 was to provide a broad and representative measure of the U.S. stock market's performance. It aimed to track the value of 500 leading companies across various industries, reflecting about 90% of the U.S. market's capitalization.
Indices should help market participants assess the fair value of companies relative to each other and the broader market.
Market cap weightings worked well in an era dominated by active management, where price discovery was primarily driven by fundamental analysis and active trading decisions. The methodology effectively captured the aggregate views of active managers while providing a practical benchmark against which their performance could be measured.
However, this methodology is increasingly being questioned for its suitability in today's investment landscape.
In chemistry, incompatibility may result in a reaction between two harmless substances, leading to an unexpected and often hazardous outcome, such as explosive reactions or toxic by-products. Similarly, while market cap weighted indices are innocuous alone, when combined with passive investing and practices like share buybacks, they have introduced several hazardous, unintended and highly undesirable consequences.
Consider this: Passive funds automatically buy stocks upon index inclusion, regardless of valuation, amplifying price pressures. From November 16, 2020, when it was announced that Tesla would be included in the S&P 500, to December 18, 2020, the last trading day before its official inclusion, Tesla's share price appreciated by 57%. The index is supposed to capture the value of a business, not distort it, yet Tesla's market cap surged driven entirely by index-driven demand rather than changes in its fundamentals.
This explains why critics argue that this toxic combination of market cap weightings and passive investing contributes to market misallocations, inefficiencies and concentration risks.
The premise of index investing as proposed by Jack Boggle, the founder of Vanguard, is that passive money follows active money into the the most economically successful businesses. However, Bogle himself cautioned that if passive investing became the dominant form, then chaos would ensue.
On the basis that passively managed U.S. domiciled funds surpassed their active peers in assets for the first time in January 2024, has chaos finally arrived?
This situation is increasingly problematic and potentially dangerous for market stability. The Federal Reserve in the U.S.2 and the European Central Bank3, both responsible for ensuring markets function well, protecting consumers, and upholding market integrity, have expressed concern.
So we are left asking:
Is the index methodology still fit for purpose?
Is it a reliable performance benchmark for active fund managers?
Has it created a reflexive Ponzi style feedback loop?
What are you buying when you buy the S&P 500 on a passive tracker basis?
Do passive investors know that they are inflating a bubble and exposing themselves to huge correction risk?
Is the definition of market cap being misinterpreted, capturing legal entities in the index that were never intended to be captured?
Let's attempt to answer these questions.
Buy High, Sell Low!?!
The share of the S&P500 taken by the Magnificent Seven (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla) is tending towards 35%. Prior to the emergence of these stocks, the highest share for the top seven stocks in the last 28 years was roughly 22% in 2000, which occurred at the height of the dot-com bubble.
Michael Mauboussin, author, professor, and strategist at Morgan Stanley Investment Management, has been pondering this issue, as demonstrated by the title of his recent research titled, “Stock Market Concentration: How Much is Too Much?”
This concentration means that the performance of a supposedly diversified index increasingly depends on a handful of stocks. Historical periods of concentration usually saw dominance spread across different sectors (oil, telecommunications, industrial manufacturing). Today's concentration is heavily skewed toward technology and platform companies. This undermines both the utility of the index as a barometer for the health of the economy generally and the basic principle of index diversification from a passive investors perspective.
The top 10 stocks in the S&P 500 now account for 12% of the revenue and 26% of the free cash flow generated by all constituents, yet they represent nearly 40% of the index based on their market capitalization (see chart below). In other words, their weighting is entirely disproportionate to their unit economics.
The top 10 stocks certainly have outperformed other companies in the index but not to the extent reflected by their index weighting. Additionally, Bill Miller, the prominent mutual fund manager well-known for beating the S&P 500 Index 15 years in a row, is keen to point out that, "100% of the information you have about any business reflects the past, while 100% of the value of the business depends on the future.”
Miller’s wise words should be heeded. Take Alphabet as an example, until three years ago Google was my go-to source for information 100% of the time. However, since AI solutions have materialized I rarely, if ever, use Google any more. Past performance are not a guarantee of future returns - so why are these top stocks priced to perfection?
Rob Arnott, the founder of Research Affiliates, provides an answer. He is a vocal critic of market-cap weighting. He argues that it leads to overweighting overvalued stocks and underweighting undervalued ones, which is the opposite of what an intelligent value investor would do. This suggests that passive investors are applying money to a poorly constructed portfolio.
Bill Ackman has also sounded the alarm, stating, “…the more capital that is indexed, the more it inflates the prices of [certain] companies in the S&P and leads to poor capital allocation and maybe detrimental owner performance over time because some companies get more capital than they deserve.”
The market cap weighting combined with passive investing has, in effect, tuned the index into a skewed popularity poll rather than an accurate measure of quality. Warren Buffett reflects on this issue and warns, “Polling does not replace thinking.”
In the past, periods of market concentration - such as the 1960s which was dominated by the likes of AT&T Inc. (T), General Motors Co. (GM), Exxon Mobil Corp. (XOM), and International Business Machines Corp. (IBM) - were largely driven by fundamental business strength. These were typically mature industrial or utility companies with substantial physical assets or near-monopolistic market power. In such cases, their market capitalization accurately reflected their economic size and influence.
Today, however, the picture is starkly different.
Let us turn our attention back to Tesla. Despite producing less than 2% of all cars on the road, its market capitalization exceeds the combined value of all other automakers, who collectively manufacture the remaining 98% of global vehicle volume. Does this make sense to you?
Another example is Apple, which from FY22 to FY23 experienced declines in revenue (-2.8%), operating income (-4.3%), and free cash flow (-10.6%). Conventional wisdom suggests that with declining unit economics, the business ought to be worth less. Yet, during the same period, Apple’s market cap rose from $2 trillion to $3 trillion - a 50% increase. A year later in FY24, both revenue and free cash flow remained below their FY22 levels, yet Apple’s market cap climbed further to $3.8 trillion, nearly doubling in just two years.
Contrary to the traditional principles of economics, as the price of a security goes up so too does demand - so much for the efficient market hypothesis!
We are witnessing is a perverse momentum bias - passive funds are compelled to buy more of the companies that have already appreciated in value and to sell those that have declined. This amplifies market movements in both directions and can create bubbles in popular sectors while potentially undervaluing companies with strong fundamentals but lower market visibility. This creates a "winner-take-all" (or "winner-takes-most") market dynamic.
Market cap weightings combined with passive investing is entirely to blame.
All of this exposes fundamental flaws in the market cap weighting approach as index weightings are increasingly driven by fund flows rather than fundamental economics.
“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows... now passive investing has removed price discovery from the equity markets… [as it does] not require the security-level analysis that is required for true price discovery.”
Michael Burry
What we are witnessing is not too dissimilar to the working of a Ponzi scheme: new fund flows finance the gains of prior investors, encouraging more money to enter the system and perpetuating the cycle.
If the market valuation of a company can become entirely dislocated from its intrinsic value, weighting an index by market capitalization measures only the market’s exuberance for a select few stocks rather than the fundamental health of either that business or the segment of the economy captured in the index.
Additional Consequences
Liquidity Risk: The IMF Global Financial Stability Report suggests that the growing role of passive investing has made market liquidity more vulnerable to rapid changes in sentiment. While active investors can account for momentum and price movement when making buying and selling decisions, index funds are forced to sell indiscriminately. This results in a liquidity squeeze and the introduction of unwelcome market volatility causing issues for derivatives traders, triggering stop-losses, and generally sending the wrong signals to the market. The fundamentals of the company involved may not have changed, but once again the index has distorted the market.
Proxy Market Caps: The recent inclusion of MicroStrategy in the NASDAQ index has drawn significant criticism. MicroStrategy barely qualifies as a functioning business. Instead, it operates as a special-purpose vehicle for holding digital assets. It neither produces goods nor provides services, contributing nothing of tangible value to the economy. Arguably, it even harms the economy by sequestering capital that could be more productively deployed in debt or equity markets. Additionally, its promotion of decentralized assets as alternatives to fiat currency could be perceived as an attack on the U.S. dollar, a cornerstone of U.S. economic strength as the world’s reserve currency.
None of this seems to matter. Its inclusion in the NASDAQ index is based solely on the capital it has attracted for acquiring and holding digital assets. This capital is being treated as a proxy for the market capitalization of a legitimate business. If the index methodology had been based on corporate performance rather than market cap, this situation would never have arisen and MicroStrategy would never have been included.
Corporate Governance Issues: In a market dominated by active investors, poor management is typically penalized as capital flows elsewhere and shareholders exercise their influence. Index funds, however, accumulate large ownership stakes without evaluating or addressing the actions—or inactions—of company management. This dynamic often gives self-serving executives a free pass.
As Bill Ackman explains, “As index ownership increases, so does the voting power of index fund managers. The problem is that index fund managers lack the incentive to engage in the incredibly burdensome and nearly impossible task of shareholder activism. Instead, they are incentivized to grow their assets and earn fees.”
This issue is more significant than many realize. BlackRock and Vanguard, for example, manage a combined $20 trillion in largely passive funds. For context, the total market capitalization of U.S. listed companies stood at roughly $63 trillion as of December 2024. The crucial role in corporate governance ordinarily played by shareholder voting is increasingly absent.
Consequences Seen In Data
The valuations of the magnificent seven, which is stretched on any conventional measure, is distorting the S&P500 index.
The first chart below demonstrates how the price to earnings ratio (P/E) for the S&P500 is well above the average of the last 35 years.
This second chart splits the index out by small and large caps. It demonstrates perfectly that the large caps, not necessarily the companies with the best unit economics, are off the scale in the US in terms of valuation.
The third chart demonstrates how the top 10 stocks in the S&P500 have been responsible for the volatility that leads to booms and busts.
The question I am left pondering is whether stock market bubbles are being exacerbated by the market cap weighting methodology of the indices which amplify the valuations of a small number of companies in the index.
Eugene Fama, professor at the University of Chicago, Nobel Prize winner in economics and the father of the “efficient markets hypothesis”, always argued in favour of low-fee passive funds. It is somewhat ironic that the very thing he advocates should turn out to be one of the primary flaws in the efficient market hypothesis.
Largely as the result of the confluence of market cap weighted indices and passive investing, the S&P 500 was up 26% in 2023 against sales growth of only 10.8% and earnings growth of 13.1%. In 2024 it was up another 25% with weaker sales growth of 5% and earning growth of 9.4%. Valuations are clearly running well ahead of fundamentals or, said differently, the index is detached from economic reality. One is left asking, what is the purpose of such a dysfunctional index? It no longer seems to serve any meaningful purpose.
This is only the fifth time in the history of the S&P500 in which it enjoyed two consecutive years of being up by over 20%. The last time it happened was 1997-98, just prior to the dot-com crash. There is clearly a problem that requires attention.
What we have now is clearly an inefficient market.
Conclusion
Returning to the question in the title of this piece, we need to ask, ‘is the stock market broken?’
If the S&P500 were considered a single entity with 500 subsidiaries, it would earn a 14% return on equity, distribute most of its earnings as dividends, and achieve average yearly growth of 6% to 7%. Yet it is priced at 22x forward earnings. If this were a single company, would you consider it to be a compelling or a risky investment? Would you invest? I wouldn’t. Yet it has become the most popular investment in the market.
Over the past two years it has delivered investor returns of well over 20% annually. That dislocation could be construed as the efficiency in the market being broken. Indeed, if the market is designed to reflect the economic worth of it constituent parts, index inflation can’t be sustainable and is over due a correction. However, if the market is no longer a reliable benchmark for measuring economic worth, have we turned it into a glorified casino which operates on the basis of greater fool theory?
Stock markets do reach periods where prices move far ahead of intrinsic value, but this time appears to be different. The overvaluation seems concentrated in a small subset of companies, stemming from a systemic defect in the market rather than the irrational exuberance that inflates the entire market, as happened during the dot-com bubble.
All bull markets eventually come to an end. However, the systematic issue that has caused today’s inefficiency is likely to persist, which means that this is no ordinary boom/bust scenario. It appears to be a deeper dysfunction in the market that requires active remediation rather than expecting the market to self-correct.
Market-cap-weighted indices, in conjunction with the rise of passive investing, lie at the heart of the issue. Since, passive investing is unlikely to disappear, the focus must shift to how we measure market performance and construct indices.
Wharton professor Jeremy Siegel has advocated for fundamental indexing - weighting based on factors such as earnings - as an alternative to market cap weighting. This approach may yield better long-term results.
We need to acknowledge that replacing market-cap-weighted indices presents additional challenges. These indices provide a decades-long historical reference which is important for analysts and so establishing an index in a new format will meet inevitable resistance.
One possible solution is to develop a new and improved index that runs alongside traditional market-cap-weighted indices. This dual system could enable an orderly transition while retaining historical continuity.
What’s clear is that the flaws in the current methodology pose risks to market stability and efficiency. As the investment industry evolves, designing and adopting more sophisticated index-construction methods will be essential to maintaining healthy markets and safeguarding investor interests.
Until this problem goes away, if too much liquidity is flowing to the top 10 stocks in the index, what are active investors to do?
Leaning into Momentum: Investors could ride the wave by investing in the "Magnificent Seven," assuming these inefficiencies will continue to inflate their values. However, this approach resembles a game of Russian Roulette—fraught with significant risk.
Capitalizing on Undervaluation: Alternatively, investors could focus on quality companies within the index that are undervalued due to disproportionately low capital inflows. As the saying goes, “Every problem is an opportunity in disguise.” When looking at the broader Russell 3000 Growth index over the past year, 457 stocks have outperformed the median return of the Magnificent Seven, and 48 stocks surpassed NVIDIA’s remarkable return. For those looking for upside, there are ample opportunities to outperform the index and exceed the returns of the mega-caps.
I’d love to hear your views on this topic—what do you think is the best way forward?
https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos
https://www.federalreserve.gov/econres/feds/files/2018060r1pap.pdf
https://www.ecb.europa.eu/press/financial-stability-publications/fsr/focus/2024/html/ecb.fsrbox202411_03~87408e7fb3.en.html
Great write up. Fully agree with professor Siegel.
Not investing would be the biggest mistake.
The only thing we can do is approach the valuation with a sense of proportion; quality has its price. But not infinitely.
The bigger question would be whether to keep existing old Mag7 positions or swap them for other more promising companies....