Tesla is the proxy for a stock market gone mad

This article is part of Fortune‘s quarterly investment guide for Q1 2021.

According to many of the best minds in investing, including Jeremy Grantham and the experts at Research Affiliates, the investor mindset that’s driving Tesla’s stock ever higher mirrors the reckless thinking that has pushed the S&P 500 to an unsustainable speculative fever that’s soon bound to break. Since early summer, Tesla has been showing the same excesses, on an ultra-exaggerated scale, as the overall S&P. In the view of many market sages, Tesla is now the proxy for a market gone mad.

In an essay posted on Jan. 5, legendary investor Grantham asserted that the S&P 500 has recently entered bubble territory, and that the leading indicator, a symbol of “bulls gone wild,” is the explosion in Tesla’s stock. Grantham warns, “For the first 10 years of this bull market, we lacked such wild [1929- and 2000-style] speculation, but now we have it,” adding that it’s “especially Tesla” that epitomizes the market mania.

Grantham, the octogenarian cofounder and long-term investment strategist at asset management giant GMO, asserts that you know it’s a craze when share prices, after rising steadily to lofty heights, suddenly break from that gradual ascent and take a moonshot, as if propelled by a booster rocket. “It is precisely what you’d expect from a late-stage bubble: an accelerating, nearly vertical stage of unknowable length—but typically short,” he writes. For Grantham, a market vaulting faster and faster from one new peak to the next signals that we’re near the bursting point.

Exhibit A is Tesla. No enterprise in the history of equity markets has ever staged such gigantic jumps in market cap, each leap far exceeding the last, in such a brief period as the electric-car maker garnered starting last summer. As of early January, Tesla’s liftoff has made founder and CEO Elon Musk the world’s richest person, boasting a net worth of $195 billion, putting him $9 billion ahead of the previous title holder, Amazon’s Jeff Bezos. Tesla’s warning lights are also flashing that its shares are flying free of fundamentals, notably: reasonable estimates of how fast its sales and earnings can grow from here, the gravitational metrics that normally govern stock prices.

In a recent paper, Rob Arnott, Vitali Kalesnik, and Lillian Wu of Research Affiliates—a firm that oversees investment strategies for $145 billion in mutual funds and ETFs—argue that Tesla fits the two key criteria for a bubble: first, “implausible assumptions are needed to justify its valuation,” and second, that “buyer interest is based on a great narrative or story that foretells great future success” but omits detailed forecasts of how Tesla will triumph, including the gigantic share of sales in the slow-growing global auto industry it would need to get there.

Let’s start with Grantham’s warning on how a big, new spike in prices, from already high levels, presages the death throes of a bull market. Once again, Tesla’s trajectory mirrors what’s happened in big-caps, just on a much grander scale. From the start of 2020, Tesla doubled to an all-time high of $180 in mid-February, only to retreat back below $100 during the brutal March selloff. Around that time, rumors abounded that the S&P 500 planned to add the electric-car maker to the index. As it turned out, the journey toward joining the S&P greatly helped Tesla’s shares.

Getting a place in the 500 provides a big lift to the newcomer’s shares, and the rise happens in two phases, both coming before the day it’s actually added. The first boost takes place in the period when the market is buzzing that “XYZ Inc.” is up for membership. The second bump, which is usually bigger, arrives when the S&P announces that it’s admitting XYZ and gives the starting date. In its study, Research Affiliates notes that hedge fund managers and other liquidity providers stockpile XYZ’s shares before it joins the S&P, first during the rumor period, then at a faster pace when the S&P makes it official. Those intermediaries then unload their inventories of XYZ to the hedge funds, ETFs, and investment vehicles that track the S&P (and are hence obligated to sell shares in the companies that are kicked off, and purchase shares proportional to XYZ’s weight in the index).

In Tesla’s case, that pre-membership buying was epic—because the EV giant is by far the biggest new contender, measured by market cap, ever to enter the S&P. Research Affiliates estimates that $11 trillion in assets track the index. From mid-March, when the rumors started, to Nov. 16, when the S&P made the word on Wall Street official, Tesla’s stock jumped from around $90 to $408, a rise of 350% that swelled its market cap by $300 billion, to $390 billion. Then, following the S&P’s pre-Thanksgiving announcement, Tesla staged a second, even bigger blowout measured in what matters most, its total valuation. In the nine weeks from announcement day to officially joining on Dec. 21, its shares waxed another 59%, to $659, then surged again by Friday, Jan. 8, to $880, not long before this story was published. All told, from the Nov. 16 news to Jan. 8, Tesla more than doubled to $880, an explosion that raised its market cap even more than in the rumor period, by $446 billion.

Research Affiliates reckoned that index funds, ETFs, and other trackers bought $220 billion in Tesla’s shares to rebalance their holdings, mostly from those hedge funds that had been long building stockpiles, when Tesla replaced much smaller members on Dec. 21. All that buying was bound to buoy its stock. But how does that performance compare with the gains notched by other companies just before they join the S&P?

Research Affiliates estimates that between the date of the official announcement and the day it joins the index, the average new entrant’s shares beat the S&P average by 10 points. In the period from Nov. 16 to Dec. 21, the index rose just 1.9%, and Tesla soared 59%, outpacing the S&P by 57 points, almost six times the average. And in its three weeks as a member, it has gained an additional 34%. That pattern of first adding $300 billion from the March rumors to the mid-November announcement, then adding an additional nearly $450 billion in less than eight weeks, is what bothers the likes of Grantham.

The S&P 500 bubble?

In fact, Tesla’s quickening hop from summit to new summit mirrors the recent course of the S&P. After a tremendous summer surge that took the index to an all-time record, it took off again in November around the time Tesla was romping, rising from 3300 early that month to 3804 on Jan. 8, or over 15% in nine weeks. The Nasdaq fared even better, rising 20%.

Tesla’s second bubble alert is the performance required to give its current shareholders what they’re expecting: big gains in future years. That’s an absolute must if Musk is to keep investors loyal to what even he acknowledges is a risky stock. Once again, Tesla is typical of the market, only more so. The S&P 500 is so expensive that to reward investors, it needs to generate extremely rapid, if not unachievable, increases in profits going forward. As the Research Affiliates authors put it, “The first part of our definition to confirm a bubble is that using a discounted cash-flow or other valuation model, we would need implausible assumptions to justify the market’s or asset’s current price.”

Let’s assume today’s and future investors would want at least a 10% annual return as the carrot for taking a rocky ride in Tesla. Since Tesla doesn’t pay a dividend, it would need to deliver all of those gains via increases in its share price. So just over seven years from now, in early 2028, its stock price would need to double to $1,760, and its market cap reach $1.672 billion. The latter is an optimistic bet, since it’s highly possible that Tesla will float far more shares, as in the past, to fund future growth.

Let’s further posit that in 2028, Tesla’s price/earnings multiple settles at around 30. That’s a high number, signaling that investors anticipate more big growth ahead. If all this happens, Tesla would be booking $55.7 billion a year in GAAP earnings in early 2028 (the $1.672 billion market cap divided by a multiple of 30), about what Apple makes now, and rising pretty fast from there. That journey would take Tesla from an enterprise that generated $556 million in net income over the four quarters ended in October, and would have lost money without selling $1.3 billion in carbon credits, to probably reach the top five of America’s most profitable companies in seven years.

I’ll go with the informed guess that the top money-spinners in the S&P 500 grow their profits at GDP plus inflation in the same period, or by about 3.7% (2% for economic growth, 1.7% from a rising CPI). In that scenario, Apple, last year’s No. 1 (excepting Berkshire Hathaway, which jumped in the lead because of an accounting change), would post profits of $72 billion, followed by No. 2 Microsoft at $51 billion and third-ranking JPMorgan at $47 billion. If that picture plays out, Tesla would become America’s second most profitable company, beating Microsoft by $4 billion and JPMorgan by over $8 billion.

It not only won’t happen, it won’t come close to happening. At least that’s what the numbers are saying. Grantham, a philanthropist who has contributed most of his fortune to fighting climate change, likes to cite his own favorite metric for Tesla. “As a proud Model 3 owner,” he writes, “my personal favorite tidbit is that its market cap, now over $600 billion, amounts to over $1.25 million for every car sold each year versus $9,000 per car for GM.” The recent run-up, just the kind of late-bubble spike Grantham warns about, has lifted that number-per-car to an even scarier $1.7 million.

The S&P is facing its own Tesla-style overvaluation problem. As of Jan. 8, the index stood at nearly 28 times the S&P’s all-time peak: 12-month trailing GAAP earnings of $139 per share, posted at the close of 2019. That number either means that future returns on big-cap stocks in general will be extremely low, or that prices will drop sharply so that Wall Street can really provide what it’s promising—big future gains that are impossible at these premium prices. As Grantham points out, what’s unusual, and unusually disturbing, about this frenzy is that most bubbles happen when the economy’s in great shape, and this one is brewing in a terrible climate ravaged by COVID-19.

As the experts at Research Affiliates point out, Tesla fans tend to shun the numbers and fall back on atmospherics, mythology, and the cult of personality. It’s the same posture taken by zealots claiming that this euphoric market has legs that can churn forward ever faster. The bulls hold that Tesla is really a budding tech giant with the “optionality” to conquer sundry lucrative fields, that betting against Musk has ruined many a short-seller, and most of all, that Tesla’s thundering momentum has trumped the numbers for so long that it has become a law unto itself. They’re making the same case for an overall market that according to the traditional yardsticks is way overpriced. As another iconic investor, Carl Icahn, told CNBC the day before Grantham issued his warning, “Another thing [these wild rallies] have in common: It’s always said, ‘It’s different this time,’ but it never turns out to be the truth.” That wisdom applies to America’s big-caps, and nothing illustrates their vulnerability better than Tesla’s outrageous run.

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