Equities

In October 2000 I wrote a newsletter called "The End of the Bull Market for Equities." Equities seem only now to be recovering from an extended vacation.

The economy did quite well in the 1990's. Buyers of equities anticipated that those profit gains would continue. The P/E for the S&P 500 was in the low 20's in the early 1990's. It increased to a record 39 in January of 2000. In general, the bull market that we have been in has been justified by the continued healthy performance of the economy. The built-in presumption was that the performance would continue.

"New" Economy

In 2000 it seemed at if the attention of all of Wall Street was devoted to Yahoo's earnings report. While Yahoo! was indeed be a bellwether of the Internet business I was genuinely concerned that something is amiss if this company's earnings report were guiding the markets.

The phrase "new economy" is something that I find interesting. I am not exactly sure what it means. Sometimes it is used to describe the fact that the economy in the 1990's was booming with very low unemployment and little inflation. This used not to happen. It was accepted, for decades, that low unemployment caused inflation. If the "old" rules do not work then this must be a "new economy". The phrase "new economy" is more often used to describe tech stocks. In this sense, the "new economy" is the Internet, the PC business in general and all tech stocks.

Somewhere along the line, someone got everyone to believe that these stocks needed a new method of establishing valuation. As it turned out this was almost entirely Wall Street hogwash. Hype cause folks to buy but it could not sustain the dot-com thing. In essence the "new economy" was a Wall Street scam.

Why are stocks worth what they are worth? Stocks are sold in an open market. Stock prices rise because there are more buyers than sellers. Stock prices fall because there are more sellers than buyers.

In the "old" economy stock prices reacted to news that was perceived to affect earnings. For some strange reason, I think that stocks in the "new economy" have been governed by what I will politely describe as "the bigger jerk" theory. It made sense to buy Red Hat at $100 is some "bigger jerk" is willing to pay $150 next week.

Let' take a step back. What is the purpose of the stock market? To my simple mind it has only two purposes. 1) When a company wants to make a public offering (either an IPO or a secondary offering) the stock market is where this happens. The companies get the capital. People buy shares of stock and own a part of the company and are thus entitled to a share of the future profits. 2) The market provides an instant way for shareholders to sell their stock. This makes stock extremely liquid and increases the value of the shares somewhat.

The aftermarket for stock shares is not the heart of capitalism. Raising capital is. The constant reporting of the fluctuating prices of equities increases their perception as speculations and diminishes their perception as investments. An aftermarket for shares helps but 3.3 billion shares traded on the NYSE and NASDAQ today. The extent to which trading represents speculation rather
that investment translates into volatility and risk.

Cash Infusion

Whatever the numbers may say, to a certain extent, stock prices rose in the 1990's because more and more money was poured into the markets. In fact, the rationalization behind "new economy" stocks may have been based on the mere fact that there was a market and the product did not exist. Product (IPO's of tech companies) was rushed to market, rationalization (don't worry that these companies don't make money) was offered and the Red Hat Linux's of the world soared to multi-billion dollar market caps.

Funds managers and investors were faced with a strange situation vis-à-vis the "new economy" stocks. Funds managers were reticent to not climb aboard the tech rocket. The fact is: these stocks were soaring. The fact that the flight was unjustified made no difference. A fund manager who did not play would wind up looking like a yutz.

The IPO Market

The healthy runup in equities had an effect on the way that businesses were built. To a greater extent than ever, corporations strategize IPO's in order to grow. In the past, businesses went to banks for loans. Banks have become more risk-adverse and IPO money easier. Business people turned to VC's for capital. IPO's offered obscene rewards for executives who could pull them off. But VC's depend on IPO's as an exit strategy. They do not want to get their capital tied up in companies. They want to recycle it. There existed a complex relationship between the VC side of business and going public with hype.

On-line Trading

I am speculating here and open to comments but in 1998 I started on-line trading. I am by no means a sophisticated investor.
People in the office that I worked in saw what I was doing and though that it was cool. Online trading. That is cool. I watched what some of them were doing. It seemed that no one knew the difference between a market order and an order a specific price. They did not even know that a difference existed. I started to think about this. If there are buy orders for a few hundred thousand shares "at market" made overnight what is going to happen the next morning. The point here is that the lack of sophistication of these investors increased the volatility of the market.

What is the Effect of "Day Trading"?

Day trading is the purest form of speculation. If you buy a stock in the morning with no intention of owning it at day's end I dare say that that qualifies as speculation. Speculation is the purchasing of something today just because you think the price of it will be higher tomorrow (or this afternoon). It pays no heed to the inherent value of the asset. This happens in real estate markets and fine arts markets. The Hunts did it in the silver market around 1980. Day trading, increased margin debt, Internet stocks and Index funds have all added to speculative investing. Index funds make for a "bandwagon" approach to investing. As the value of the encompassed stocks increases the index rises. That attracts more money and that money is used to runup the value of the stocks and another cycle starts. The increase in speculative investing during this boom has driven market beyond where it would have otherwise have gone. More volatility.

What Caused the Bull Market?

The decade long bull market of the 1990's was not based entirely on hype. It was based on a combination of things - the main one being higher corporate profits. If one does a regression analysis of the S&P 500 and examines what causes equities to move the fact is that there are three things. The first is corporate earnings as measured by the Bureau of Economic Analysis. The second is the yield on the 10-year Treasury. The third, strangely enough, is demographic. It is the percentage of the population in their 40's and 50's. These folks are in their prime time with regards to earnings and have lower risk aversion.

If one runs the model the conclusion is that 80% of the gain in the S&P 500 was explained by these three factors. The other 20% may be hype or speculation and may well represent the extent of the market overvaluation.

The Other Type of Bull Market

In the past several years we have seen numerous examples of improper accounting designed to inflate stock prices. Enron might be the most obvious case. The present issue with option backdating is interesting because it may not be illegal but it hardly represents a situation where the company is looking out for the best interests of the stockholders.

I find the present situation at Apple to be interesting because Apple has long been a company that depends on perception to justify the prices of its products.