One of the most important concepts in the realm of finance and economics is succinctly set forth in Goodhart’s Law: “When a measure becomes a target, it ceases to be a good measure.” One way to think about this is as soon as we begin to base our decisions not on the merits of the evidence at hand but on a shorthand symbol of that evidence, that symbol becomes less effective at representing the actual evidence.
The most popular example of this is probably “The Cobra Effect.” From Wikipedia: “The British government, concerned about the number of venomous cobras in Delhi, offered a bounty for every dead cobra. Initially, this was a successful strategy; large numbers of snakes were killed for the reward. Eventually, however, enterprising people began to breed cobras for the income.” There is a financial parallel here in the recent proliferation of ESG funds of dubious design; they’re Wall Street’s version of cobras bred in captivity.
More broadly, though, think about how investors largely use a stock price as a shorthand symbol of a company’s value and per share metrics (such as net income or free cash flow) as a shorthand symbol for what it has earned over a period of time. Many corporate leaders and employees are rewarded entirely on the performance of these sorts of shorthand metrics and, as dividends have become less meaningful over time, they have become the end-all be-all to investors, as well. Thus we have made them targets.
In the process, we have created huge incentives to inflate both of these symbols by any means possible, both legal and illegal. Some of the legal means that have become popular in recent years include leveraging the balance sheet by taking on cheap debt and using the proceeds to buy back stock. All else being equal, per share metrics rise, as a function of fewer shares outstanding, as does the share price, as a result of increased demand for the shares.
Of course, this rise in the share price occurs even as the company’s finances become more fragile as, again all else being equal, the liability side of the balance sheet grows and the asset side shrinks. The gains in the stock price also fail to reflect the diminished future of the business itself, depending on how much investment in people, property and research and development was sacrificed in the process of “investing” in the shares.
Another popular legal method for inflating perceived economic value is the use of non-traditional or non-GAAP earnings metrics. “Adjusted EBITDA” has become a very common way for companies to demonstrate their propitious profitability even if it is mostly make believe. One of the most common adjustments made to EBITDA is adding back stock based compensation, as if paying employees weren’t a real cost of doing business. Valuing a company on non-GAAP metrics like this obviously inflates the stock price more than valuing it on traditional metrics would allow.
In addition, we have seen an extraordinary level of creativity employed in the many illegal means of inflating stock prices. Whether it is the fraudulent misrepresentation of what product is capable of (see: Nikola, Theranos, etc.) or the fraudulent misrepresentation of its future prospects (see: Tesla, SPACs, etc.) or even the outright manipulation of the share price itself (see: Archegos, call options frenzy, etc.) matters very little. What matters is merely that it has occurred and in a major way.
So this process of targeting the stock price has resulted in it ceasing to be a good measure of the company’s true value, in many cases, as the former has indisputably risen much faster than the latter. At the same time, a similar dynamic has been happening in the broad stock market. More than just individual stock prices, we have also made their aggregate a target, too. To most, the S&P 500 Index represents the value of Corporate America. When it rises, it is a reflection of the rising value of American enterprise and vice versa.
However, once we decided to make the S&P 500 an actual target for passive investment purposes we undermined its ability to accurately represent that value. To wit, the only way the S&P 500 Index can accurately reflect the value of business in aggregate is if the market is truly efficient. And the market can only be truly efficient if investors, in large part, are making rational investment decisions based on their collective assessment of equity valuations relative to the fundamentals of the business.
When investors invest in an index fund they bypass this investment process instead using the S&P 500 Index a shorthand symbol for the economic value of American business. The more investors make the same decision, the more their blind buying begins to outweigh the investors making rational decisions, undermining the efficiency of the market. Because passive investing has become the single most popular strategy in use, markets have become less and less efficient, undermining its most basic assumption.
Like everything else in the world of finance, the best time to be a passive investor was way back when the idea was most contrarian and the market was therefore more efficient. Now that passive investing has become the de facto most crowded trade in the world, however, it’s hard to argue that its perceived merits still persist. Sure it is still low-cost, but the true cost of passively participating in a market that has potentially become less efficient than ever before could far outweigh the relatively meager savings in management fees.
Finally, the Federal Reserve adopted a clear policy of targeting the S&P 500 Index just over a decade ago. Quantitative Easing was first introduced during the Great Financial Crisis with the primary purpose of creating a “wealth effect” by inflating the value of financial assets. Since then, the central bank has spent roughly $8 trillion in this effort, more than half of that coming over just the past two years. While this may be the most significant of all of these examples it’s important to recognize that it is merely representative of a much larger trend that has now become pervasive.
And by making stock prices, both individually and in aggregate, the most important targets in the world of finance and economics, we have rendered them of little use in determining the value of business. In fact, I would go so far as to say that this process has created the largest disconnect between stock prices and the intrinsic value of equities in history. At some point, these two will have to reconnect. They always do. Perhaps the weakness in equities so far this year represents the beginning of that process.