A New Era for a Benchmark Index
Washington Post Staff Writer
Sunday, January 10, 1999; Page H03
John Bogle pioneered the creation of mutual funds that track a major stock index at the Vanguard Group, but he never imagined this.
The builder of America's second-largest family of mutual funds could never have foreseen a Standard & Poor's 500-stock index with a price-to-earnings ratio of 33, roughly twice the historical norm. And he would have been hard pressed to imagine an S&P 500 that includes highflying technology stocks with P/Es of 60, 80 or 100.
Last month America Online Inc. -- with a P/E of 617 -- joined the S&P 500. It bolsters the ranks of richly priced technology firms on the S&P 500 that already include 3Com Corp., Cisco Systems Inc., Intel Corp. and Microsoft Corp. At the end of 1998, technology stocks made up 19 percent of the S&P 500 weighting. In 1992, they made up just 7 percent. Both the health care and financial sectors have doubled their weightings in the index since 1980. The proportions held by energy and basic materials have plunged.
Bogle, senior chairman of Vanguard, who wrote his senior thesis at Princeton University about the mutual fund business, took time this week to share his thoughts on the latest changes in the benchmark index, which Vanguard's biggest fund seeks to mirror.
Q: How has the influx of expensive technology stocks changed the S&P 500 index and has that damaged its usefulness as a benchmark of the broad stock market?
A: This is not the S&P index of the old days. This is not your father's or grandfather's S&P index. At the end of 1964, 40 percent of the value of that index was in 10 stocks. They were really hard business companies. There was a real business there. AT&T, General Motors, Exxon, IBM, Texaco, DuPont, Sears, General Electric, Kodak, Gulf Oil. AT&T alone was 9 percent of the index.
Just consider that list being the basic industries of America. Oil, a computer company with what looked like a monopoly, autos, telephone -- everything you needed to live.
Today what are the stocks that make up the S&P? It is heavily populated with high technology: Microsoft, Intel is the third largest, Cisco is the 10th largest, and Dell and Lucent are going to be right there. That's a different list. Technology oriented. . . .
The interesting thing to me is the concentration of the index is so much less. Now the top 10 stocks are only 20 percent of the [value of] the index.
Q: Isn't that a good thing? Doesn't that mean the index is a broader reflection of American businesses?
A: Yes, but . . . you get those large stocks selling at extremely high prices. . . . The 10 largest companies in 1964 probably . . . [would have had] a P/E of about 16. The ones today are selling for 35 or maybe higher.
Q: What does that mean for investors?
A: When you get a high P/E market, it is more susceptible to earnings [disappointments].
The market return is earnings growth plus dividend yields and a speculative return, which is how much people are willing to pay for a dollar of earnings. With a dividend yield of 1.25 percent and prospective earnings growth -- let's say for argument's sake that you get 10 percent, far higher than is likely -- that would be an 11 percent return on stocks. That would be your return if the P/E remains what it is, about 20.
If at the end of 10 years the P/E is still at 30, your return will be 11 percent a year. To get a really big future return out of the market, you have to get a higher P/E. It is unwise to count on very high returns on stocks looking out over the next three, five or 10 years.
Having said that, you could have said the same thing at the beginning of this bull market. But at the beginning of the bull market you had plenty of room for P/E to go. At the beginning of 1982 when the bull market began, stocks were selling at eight times earnings. At the end of 1998, they were selling for 28 times earnings. For the same thing to happen in the next 10 years, that 28 P/E will have to go to 90 times.
Q: So you don't believe that we are in a new era of valuations for earnings because of changes in technology or the increase in retirement savings?
A: Maybe we're in a new era, but there have been an awful lot more new eras predicted than have come to pass.
Q: So does the influx of high-tech and highly valued companies into the S&P 500 make index funds less useful vehicles for investors?
A: These changes in the S&P 500 have made it what it is today. Thank God the index put some new stocks in. You have to understand that the S&P index is just a giant subset of the market. If Microsoft is the biggest in the index, it is also the most widely held by other investors. The index isn't different from anybody else. The index may be exposed [to these companies], but so is every equity program in America.
Q: So what does the investor do?
A: My rule has always been to do nothing. We say stay the course. But before you stay the course, make sure you're on the right course. If you think the market has increased your allocation to stocks radically, it would not be ridiculous to cut back. It's not by guessing the market. It's saying that instead of 70 percent stocks, I now have 85 percent.
Q: What have you done with your own holdings?
A: I'm close to 70 years old. My retirement fund is my wife's main asset. So I'm leaning against the wind. I've reduced my stock holdings from maybe 72 percent to maybe 60 percent of my assets.
I can shift from Vanguard Index 500 to Vanguard's total bond market index. I do it very gradually. That's another important rule for investors. Don't do it all at once.
I have investors who write to me and say they sold everything two years ago, now what should they do? I say you should be back in, but do what you should have done before. Do it gradually.
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