By Bob Wood
If you lost money in the stock market during the 2000-2002 bear cycle, you may have done some serious thinking about how it happened to you. After all, the markets provided you with positively joyous involvement for several years. How could things have gone so badly, so quickly? Of course, as time wore on, the reasons for the stock marketâ€™s hard drop became obvious. But many wondered why they didnâ€™t see it coming until it was too late. So: what are you missing now that will also look obvious in future years?
Yes, the future is uncertain, and just when we think we have things figured out, we find that we were wrong once again. Times change–but seldom how and when we may anticipate. But who would have thought in 1999 that truly bad times were just around the next bend for stock market investors? As we heard the promoters tell it then, the stock markets were on a never-ending run to heights that made the proverbial sugar plums dance in the heads of those involved in the climb.
You remember, donâ€™t you? Dow 36,000 was a popular new book, and the financial media were calling for the NASDAQ to hit 10,000 in a few short years. People were getting rich in a hurry, so taking ridiculous amounts of risk with your capital seemed like the smart thing to do. And it was–until it wasnâ€™t any more!
Remember when investor optimism helped shares of Lucent to sell for about $80; JDS Uniphase for as much as $150 (when my financial colleagues were calling it â€œthe next Ciscoâ€); shares of Ariba, for almost $800; and shares of InfoSpace for more than $1,000, at the bull market peak in early 2000?
As we know now, they later sold at much lower prices, some falling under $1/share at the lowest. But what made perfectly sane investors, many of them professional fund managers, do such dumb things with their investment money?
In the case of fund managers, we saw then much of what we see now. Performance anxiety, the fear of looking stupid and missing whichever rally develops, are powerful motivators. In this regard, I canâ€™t help but think of Bill Miller, manager of the Legg Mason Trust mutual fund. Perhaps you know that Miller is the only fund manager to beat the S&P 500 for 15 straight years.
But Millerâ€™s firm recently announced disappointing earnings, due in part to underperformance of its flagship fund managed by its star manager Miller. The fund is down for the year, while the Dow is showing a double digit return YTD. So even the manager with a strong 15-year track record will be replaced because heâ€™s having a few bad months? Apparently, that is so, and we should think about the performance pressures that lead even the best managers to make bad moves.
Perhaps the concept of â€œwindow dressingâ€ also warrants mentioning here. It occurs when fund managers buy the best performing stocks at the end of each quarter, creating the appearance to investors that their smart fund manager assured that they owned these stocks during the time they were shooting higher. It doesnâ€™t seem important to some that those stocks may have been bought with the benefit of hindsight and provided no boost to fund value at all. But the appearanceâ€“the window dressing–is what counts!
This column is meant for those who may feel pressure to take more risk with your savings, since the appearance now, as portrayed by promoters, is that stocks are in the midst of another meaningful bull market cycle. â€œJust consider the horror of missing out while everyone else is making money,â€ they plead! Itâ€™s unthinkable!
Maybe investors are doing well now, but their success comes from anything other than excessive risk taking. What doesnâ€™t seem to enter the equation for many is exactly what went missing during the bull market leading to the peak in 2000–the concept of risk, or downside potential, in investorsâ€™ portfolios. Too many saw only what they wanted to see–whatever supported their optimistic views about how fast they were getting rich.
And that euphoria seems to be missing now, and not just according to me. In a September 7, 2006 interview, former Clinton administration Treasury Secretary Robert Rubin said:
â€œMost people seem to think that the problem is somewhere down the road. I think the markets are remarkably complacent. Itâ€™s curious to me that economists, with an exception here or there, are as sanguine as they seem to be. They talk about a cooling off or a soft landing or whatever it may be, but generally seem to attach very low probabilities to really serious, adverse developments.
â€œMost of the people I know in the national security world, and there are many, seem deeply troubled about a variety of matters: nuclear proliferation, Islamic radicalism, the endgame in Iraq, instability in countries that mean a great deal to us in the Middle East, whatâ€™s going to happen in Pakistan, and many other issues as well. And the markets do not reflect this.â€
And I think Rubin is right. Itâ€™s not that bad things could happen or that nothing is risky about the economy or the stock market today. Itâ€™s just that investors do not see them–or choose not to see them. Investors seem to want to avoid spoiling the party or getting spooked out of a bull market before the party ends. But that doesnâ€™t mean that the risks arenâ€™t there.
The risks were in full view in the late stages of the bull market ending in early 2000. Three years before Alan Greenspan warned of â€œirrational exuberance,â€ Warren Buffett was pointing out how hard it was to find shares at fair prices when the S&P 500 was selling for 30 times earnings. But investors were having a grand time making money daily, or so it seemed. Back then, Bears were simply the people who were losing money and warning that the sky was falling.
But just as the risks involved in investing in what was popular with the crowd were ignored then, they are ignored again now. Professional fund managers are buying stocks because theyâ€™re going up, but they are ignoring better values because they are not moving up. Everyone is a trend follower–fundamentals be damned!
Of course, some of us skeptics fail to see the value in buying Dow stocks when the average P/E of that basket of stocks is about 23. And as much as my short positions in domestic stocks may not look so smart now, I still see more opportunities every day for making future gains when reality replaces these expectations of never-ending good times for everyone else.
Right now, Iâ€™m rewarded for holding a short position in Caterpillar. The company announced a pending slowdown in business, and its shares, reflected only in the best-case scenario, are tumbling almost 15% on the day. But as much as the crowd loved its recent performance, the skeptic in me says that it will some day be obvious that we donâ€™t pay 20 times trailing earnings for a slow grower like CAT.
Smart investors do not pay 30 times earnings for technology stocks whose businesses are subject to intense competition. Sandisk has been another investor favorite this year, since it was going up in price, and what more do you need to know before buying, right?
As of October 20, Sandisk was taking a beating worse than CAT. So another short position that was going badly is suddenly a joy to behold. If you have held shares of other popular stocks like EBay, Dell or Yahoo, looking at last yearâ€™s charts for these high flyers is disappointing, isnâ€™t it? All were at the top of aggressive managersâ€™ buy lists, but, at some point, reality catches up to investors paying 30 times earnings or more for any companyâ€™s shares.
Just a year ago, I would have been called â€œfoolishâ€ to disparage those shares. They were flying, so what more did I need to know? But there was more to be seen and considered then, which, in hindsight, seems obvious now.
What should at some point look obvious to investors wearing party hats embroidered â€˜â€™Dow 12,000â€™â€™ is a combination of the risk of buying slow-growing companies at more than 20 times earnings and the geo-political concerns mentioned by Rubin. Itâ€™s too bad that many investors who consider taking such risks will only come to realize these other effects on the markets after the damage has been done.
If youâ€™ve made money in domestic stocks this year, good for you! But how far will you press your luck, given the risks involved and the speed at which popular stocks can come falling back to earth? I am witnessing this scenario now in two short positions that are finally paying off–after months watching investors considering only the positive potential of each.
But all is not lost. There is always a bull market somewhere, in something. And there is always a bull market properly priced to warrant considering all risks involved. But I think these are not in our domestic markets, with energy and gold shares excluded.
Have a great week,
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.