You know how products that are bad for you come with warning labels. Well, the same needs to be done for some investment products. Now, the most ubiquitous investment product of all, the S&P500 index fund, needs a warning label.
First, this is because the index is now the most expensive it has ever been by a number of valuation metrics. This includes going back to the internet bubble of 1999 and the equivalent pricing back in 1929.
Second, this is because one of the world's most expensive and bubbly stocks is about to enter the index - Tesla. Tesla's meteoric rise in 2020 has been incredible. Somehow a company that generated only $28 billion in revenue, just turned cash flow positive a year ago, has a lot of debt, is in a highly capital intensive business, and facing mounting competition became the nation's sixth most valuable company at $659 billion (as of 12/18/2020).
Right before it turned cash flow positive in Q2 2019, it was one of the most shorted stocks due to smart investors betting it was on a path to bankruptcy. In May 2019, the stock was $37 (post split). As of 12/18/20, it was $695, an increase of over 18x in a period of 19 months.
A lot of this valuation hangs on the promising story of the company and the bold and innovative founder, Elon Musk. He seems to have struck the right chord with enthusiasts and investors who have an unwavering belief in a huge and prosperous future for the company. This was then accelerated with a Joe Biden win which will likely trigger a global coordinated effort on combating climate change.
The issue is at today's valuation, Tesla would not only need to become the dominant player in auto manufacturing, solar production, power storage, and other businesses that the company is in, but it also needs to make those businesses profitable. Each of those businesses is notoriously capital intensive and also requires continued R&D and innovation which then makes the products you just made obsolete. This is an impossible feat for Tesla to generate the future profits needed to justify today's stock price.
It would be one thing if this was one isolated company, but the problem is this is now the sixth most valued company. As a result, it will now need to be bought by the trillion dollar index industry. Never before has a company been added at this scale. This new source of demand may continue to push the price of Tesla higher (as everyone is betting on), but at some point the buying stops and the selling takes over from everyone realizing the valuation upside of Tesla has hit its peak.
This selling which will start small will slowly create a massive feedback loop that will create more selling and lower prices and so more selling and then lower prices still. You see, by their very nature, index funds do not care about the fundamentals of the company. All they care about is the valuation of the company. The higher the valuation goes, the more they need to buy. They lower the valuation goes, the more they need to sell.
Index funds will be buying Tesla at all time highs and will then be forced to become sellers if/as Tesla's stock retreats from its all time highs due to the very nature that there are no longer any buyers to support its price.
And being the sixth largest company, its declining price and value will result in the index fund itself losing value even though the other companies in the index may be holding or increasing in value. This may trigger holders of the index funds themselves to realize that it no longer makes sense to hold the index so they become sellers. What this then does is trigger even more selling by the index funds in order to provide those investors with their money back. This selling would then need to be done across all stocks, not just Tesla, which would cause all stocks to drop.
Index funds are one of the reasons we are at all time high valuations in the market. As people wanted to hold more of their savings in the stock market, index funds received this money and would need to buy stocks no matter the price. This continued and continued over the last two decades until we are now past the prior valuation peak from 1999.
Now with Tesla being added, this may lead to the undoing of the virtuous index-buying feedback loop that has supported stock market prices and turn it into a massive negative feedback loop that could result in untold destruction of wealth.
This is the time to be very careful with your investments, particularly if you hold one of these index funds that have become so popular, including inside most employer 401Ks. I've even shared two index ETFs in this blog that I like and use, Vanguard's VTI (U.S. only) and VT (Total World including U.S.), that would need to buy Tesla.
I checked Vanguard's website on 12/20/2020 and Tesla is now the #7 stock in VTI and #9 stock in VT. I have a feeling this is not going to go well and I am looking at my portfolio myself to see if now is the time to sell some of these index funds and wait for better valuations that will certainly come, hopefully when Tesla's stock itself is priced according to realistic expectations for the company.
And if I had to make a prediction, I am sure when this cycle ends, Tesla will fall out of the Top 100 valued stocks (let alone Top 10). And given it is a capital intensive business and much of its revenue relies on government subsidies that may shift or come to an end, Tesla may even reduce substantially in value and bankruptcy may still be a potential risk, proving those early smart investors right all along.
No one could have predicted 2020 both with respect to the pandemic and the stock market. When the year started, I knew it would be interesting and that somehow the phrase "Hindsight will be 2020" was going to apply to the year. I have a funny feeling that in hindsight, everyone will have wished they sold their stocks and investments this year. It will become clear that these valuations are not supportable and that Tesla's addition will have marked the very top.