After beginning the year's final quarter in headlong retreat, the end of December found the U.S. equity markets once again at record levels, helped by a Federal Reserve Board which finally seemed to realize that strategies used in fighting the last war (against inflation) were no longer valid in the face of world-wide financial chaos. A rapid 0.75% reduction in U.S. short-term interest rates, in conjunction with foreign central bank easing and measures taken by international financial agencies, seemed to do the trick: confidence rebounded and the world was safe anew for speculators who drove security prices back to the flush valuations prevailing before the late-summer panic.
1998 proved to be quite a year for new records. In addition to record high stock prices and low interest rates (at least for this generation), energy prices, adjusted for inflation, have not been so low for many decades, in part a reflection of the fact that average temperatures around the globe reached their highest level in the history of such measurements. Bailouts achieved a new level of notoriety, if not of Savings and Loan debacle magnitude, as a large hedge fund in the U.S. and Japan's entire banking system had to be thrown life preservers.
Trading volume also hit a new high last year. On a couple of occasions during the crisis, the New York Stock Exchange reported that about 1.2 billion shares of corporate ownership interest had changed hands during the trading session (when we entered the business over 16 years ago, 30 million shares was a good day on Wall Street). Interestingly, a survey of millionaires done a couple of years ago found that fully 42% of these wealthy individuals had executed no trades at all in their equity accounts during the previous year. Is it fair to inquire who is making money from all of this hyperactivity on Wall Street?
“Speculation in the pursuit of performance is no vice; prudence in the preservation of capital is no virtue,” to borrow an idea from the political realm, could very well serve as the battle cry of modern fund managers who, in their zeal to “beat the market,” seem prepared to go to almost any length to put the assets under their care at risk. How else can we characterize the trend found in funds of all kinds to “bulk up” on the shares of the largest and most popular companies (companies which happen to sell at the highest valuations of all stocks in the marketplace) if not as a strategy to simply own the stocks that are “going up”? How, otherwise, are we to explain the appearance in some funds (including ones of a supposedly more conservative bent) of “hot” Internet stocks, if not as an attempt to “goose” returns by surfing waves of enthusiasm in high-flying shares? Wall Street fads like the Internet are usually relegated to speculative fringe areas of the market. Participants in this business are very open about the rationalization process behind such moves -- said one analyst: underperformance by money managers has “forced” them to purchase Internet stocks. A money manager, explaining the purchase of stocks in companies often with scant revenues, non-existent earnings, and huge stock market capitalizations, claimed that the failure to participate in these new industries would mean that “you're dog meat three or four years from now.” Such reasoning has a perverse logic all its own, but from the standpoint of prudent investment, the policies it attempts to justify are entirely reckless.
Money management is a highly competitive business in which decision-makers and clients constantly compare their results to market returns and those of other investment managers. Market returns are measured by various indexes representing artificial groupings of stocks, the most important of which are “capitalization-weighted;” hence, the price behavior of the stocks of the largest companies has the greatest impact on the indexes. The growing domination of the markets by the activities of huge investment institutions, especially “index” funds, has brought a focus on the large capitalization issues, which are the easiest to buy in large quantities. A vicious cycle has been created in which demand for the large issues drives up their prices which, in turn, drives up the indexes, creating still more demand for the big stocks. Finally, in a futile attempt to keep up with the indexes and keep clients happy, there has occurred a general migration to large capitalization issues (or an occasional foray into hot market sectors) because, people think “it's the only thing that works.”
Futile because it doesn't work. Over 90% of money managers do not beat the market averages and the ones who do are usually fortunate to own the current favorites or specialize in a sector that happens to be doing well. Some data will help to explain why this happens. On July 27, 1998, the Dow Jones Industrial Average rose 91 points, or about 1%; the S&P 500 gained 0.6%. On the New York Stock Exchange, 946 issues rose in price that day while 2076 stocks lost value. Later, in mid-December, when the year-to-date return on the S&P 500 was 24%, the median gain for the stocks making up the index was only 2.0% (The median is the return above and below which lie the returns of an equal number of stocks. It is less susceptible to distortion than an average.). Ten stocks accounted for nearly half of the S&P's gains. The Russell 2000, an index of smaller capitalization issues, was actually down about 10% for the year. Furthermore, as many of the market averages recovered and reached new highs during the month, generally more stocks fell in price on a given day than rose. Despite the recovery, the typical stock in the marketplace had lost about 20% of its value since the beginning of the year. Clearly, unless the bulk of one's assets were placed in the biggest dozen or so issues in the market, it was very, very unlikely that an investment manager could achieve results approaching that of the major indexes. Even the most aggressively managed funds have difficulty achieving such concentration. More conservative investors simply will not consider such shares due to their speculative prices.
None of these matters are new to observers of the investment scene; in fact, they are frequently mentioned in the financial press and find their way into chatter by market “technicians” about “bad breadth.” What seems to be lacking, however, is any sort of critical commentary questioning whether or not this state of affairs represents an appropriate business model for the investment industry. Also absent is any serious discussion of the potential impact of these competitive practices on the industry's customers who, assuming their financial affairs are in the hands of well-trained professionals, may be unaware of the risks that are being taken with their funds. If, as we would argue, the returns achieved by the major indexes (the focus of the competitive struggle) no longer represent the kinds of results that a prudent investor can expect from his or her investments, at least on a short-term basis, why bother paying attention to them? More importantly, why expend so much talent and energy trying to out-do the averages when the achievement of such goal is unlikely without taking on excessive amounts of risk?
The answer, of course, is that because everyone else does, you have to play the game if you want to keep your business. But it is dangerous to ignore time-tested investment principles for the sake of short-term results. While we all attempt to find investments with the greatest potential, not all of them are realized within discrete periods of time. It is also not safe to do what everyone else on Wall Street is doing -- usually, that means the price is too high. Large stocks are now popular, as are the funds that have benefitted most from their impressive gains of recent years. At some point the large stocks may fall, as they have risen, further and faster than everything else.
Dennis Butler, MBA, CFA