The months preceding the stock market’s peak during the second week of March were an interesting time for observers of the New Era financial scene. The NASDAQ Composite average had risen over 100% in just the previous twelve months. The Internet craze was in full bloom and optimism filled the financial media. Although we normally shy away from such trendy manifestations of popular culture, we got a taste of the excitement while attending a meeting for business entrepreneurs held at the Massachusetts Institute of Technology. The focus was on e-business, of course (it was MIT, after all), and the keynote speaker was a casual, recent graduate who had gotten rich selling his Internet-related company to the public. He regaled the audience (mostly students, with a smattering of venture capital types) with his story. At each stage of its development, he explained, from initial to additional financings and finally public ownership, the value of his company multiplied exponentially. His wide-eyed listeners were awed by the message: you can do it, too; all you need is a good idea and lots of hard work. Few (except perhaps the venture capitalists) seemed to be aware that what was also required was a receptive stock market willing to pay any price for this kind of stuff.
In an environment such as this, all sorts of things that would, in more skeptical times, be scoffed at gain a fleeting respectability. You want to sell truck tires on-line – no sweat. Even Day Traders seemed to gain in status. One of that group was quoted as saying that trading in and out of stocks dozens of times a day had become a “real profession.” Really? What kind of business loses money overall and creates no lasting value except the commissions paid to the hucksters who promote it (who, if they are smart, do not engage in the activity themselves)? Perhaps they do serve a useful function, akin to that of the so-called “locals” trading in the commodity pits in Chicago: small traders for their own accounts who take on risk and provide liquidity, enabling the markets to function smoothly. Somehow “providing liquidity” to permit operators with far greater resources to move their positions more easily does not seem like an attractive business to us.
In any case, the enthusiasm began to subside around the Ides of March as Federal Reserve interest rate moves started to have an effect and the excitement over dot-coms seemed to exhaust itself. There commenced a general migration away from risk, making it more difficult for the bolder technology ventures (meaning those with no realistic prospects for earnings) to raise capital. Debt issuance slowed, especially the high yield “junk” obligations that had been in great demand the year before. The stock market averages declined sharply during April, with the NASDAQ Composite down almost 40% from its highs at one point. The first half of the year ended with all of the major U.S. indexes showing year-to-date losses. Most stocks had been declining for two years. Now the popular few that had held up the indexes began to weaken as well.
Looking back, the period during February and early March was extraordinary -- and not just for Internet enthusiasts. As more and more “investors” were drawn to the circus sideshow involving the tech sector, the long slide in the broader market that had already brought many stocks low seemed to gain force. Money was being sucked out of virtually every other market segment. In some cases, individual issues reached valuations more depressed than they had been in the past decade -- among them leading companies in their industries. This is the process by which the public markets create opportunities that the observant and the prepared can use to profitable advantage. Paradoxically, it was the furious chase after high flyers--ultimately a losing proposition for most who attempt it--that helped to create these bargains. But how many were independent-minded enough to doubt the accepted wisdom at the time that the Internet would subsume everything else?
Risk in The New Era
We have long been amused, puzzled, and concerned by the “What, me worry?” attitude toward investment risk found among large segments of the public in recent years. But it is not just among new mutual fund owners that one finds misconceptions about what the markets are capable of doing to the foolhardy. In a television interview, a Nobel prize-winning finance professor stated that expected future stock returns should be lower because stocks are now less risky than in the past. Gasping, we wondered: does this mean that stocks in the early 1980s had high expected returns because they were somehow riskier then, at a time when their prices (including those of the most entrenched companies) discounted economic catastrophe? In a similar vein the Federal Reserve chairman has spoken of unexplained declines in the “equity risk premium,” that extra return expected from equities due to their higher risk. Others have even argued that stocks carry no extra risk, that they are, in fact, no riskier that treasury securities, and should carry high prices.
To us it is absurd to associate the current period of high stock valuations with reduced risk (although such times are, indeed, often followed by extended periods of meagre returns). Furthermore, risk premia should be interpreted in the same fashion as credit spreads (the yield that a risky debt instrument must offer above that of a risk-free treasury security of similar maturity). Narrow spreads (indicating that risk-free and risky asset prices are relatively close) are red flags as they usually indicate loose money conditions and less heed of and reward for taking risk (especially when junk credits carry relatively narrow spreads). For example, spreads were quite narrow shortly before the Asian crisis began and Russia defaulted on its debts.
But one does not need to get into such financial esoterica to recognize that investors face significant perils today, some of which are readily apparent: stock prices that—unlike those of 1982—discount all good news between now and kingdom come, record high corporate and household debt levels (including margin debt), rampant speculation in real estate, record trade deficits, and so on.
Yet, risk comes in more subtle forms as well. For example, the aforementioned chase after the most popular issues has seduced many market participants, including some who should have known better. Here is a story often heard in investment circles lately: a money manager who had shunned technology investments because the companies were “difficult to understand” or their shares too expensive, suddenly becomes a convert and loads up (too late, as some have recently discovered). Why? “Technology is the growth engine for the American economy and will be into the foreseeable future,” or something like that. Reading between the lines, what this really means is that “technology stocks are the only ones going up right now and since I manage money I have to own them or else I won’t have any clients.” Note that this line of thinking has little to do with investment considerations. Such is the impact of competition on the dynamics of the investment business.
This story reveals how the modern financial world too often views “risk” as the danger of underperforming an index or your peers each month or, heaven forbid, “style drift” --buying stocks you are not supposed to buy because they do not fit into such neat pigeon holes as “value” or “growth”. To our way of thinking, these non investment-related matters, and their concrete expression in investment policies throughout the industry, represent yet another stratum of risk that could magnify the impact on client portfolios of the real investment-related concerns enumerated above.
Investors should expect lower returns in the future because the risk-reward picture currently just isn’t that attractive. Perhaps the turmoil we have experienced lately--should it continue--will change the situation and make interesting opportunities available. Until that happens, a “What, me pay?” attitude is advised. Sometimes, in this business, you just have to sit back and let others have all the fun for a while.
Dennis Butler, MBA, CFA