Early in the 20th century a forgotten politician, Arthur Balfour, surprised England by stepping down from the leadership of his party. When asked why he had done so, a colleague replied on his behalf:
“Mr. Balfour says that there was an Ice Age once, and there will be one again.”
You may recall the quotation from Oskar Lange which graced my letter from Friday. I will repeat it, but this time with a slightly different point in mind:
“The system of free competition is rather a peculiar one. Its mechanism is one of fooling entrepreneurs. It requires the pursuit of maximum profit in order to function, but it destroys profits when they are pursued by a larger and larger number of people.”
A man makes a fortune in a dot.com business. Soon, a lot of men and women are trying to make their fortunes with dot.coms. Whatever profit margin might have been enjoyed by the first is soon competed away – regressing to the mean. Once it has reached its mean, a simple, rational market would stop. Why should the dot.com business produce any lower – or higher – profits than any other business?
But the world is neither simple, nor rational. What’s more, it is subject to epochal trends. Anyone who has ever had a teenaged daughter…or been in the same room with one…will need no further proof of this statement. Every emotion is exaggerated. Every triumph – and every setback – is amplified to the point where it is life- threatening. Ice ages come every week.
The conditions that were so fecund and flattering to dot.coms – and the rest of the stock universe – seem to be changing. Dot.com and new tech IPOs are no longer assured of a favorable reception. Recent buyers of new economy stocks – of even such mammoth, and celebrated IPOs as AWE, the wireless wonder – have lost money. In fact, anyone who bought MSFT in the last 18 months is now in a losing position. The dot.coms have reached their teenaged years.
This is not merely because free competition destroyed the profits of the TNT companies. It also destroyed the profits of investors. Over the last decade, millions of new investors came into the stock markets. Like the companies whose stock they bought, as the number of pursuers increased, the amount of profits each could catch fell.
The whole process of starting companies and funding them seems to have many of the same elements as raising children. Both require incredible faith – if not actual self-delusion, as Lange suggests. Entrepreneurs, investors and parents expend excessive amounts of time, effort and money – almost certain to be frustrated.
There are, of course, beneficiaries of these efforts. Joseph Schumpeter, famed economist and perhaps a parent too, noted that technological innovations do benefit society – by lowering prices, improving quality, and so forth. But the outsized profits expected by investors in the new innovations, like the outsized hopes they have for their children, usually fail to appear.
One contributor to the massive influx of new investors has been the idea that no special expertise is required to make money in stocks. You may recognize this as a vulgate version of the Efficient Market Hypothesis – or EMH – which holds that, over time, all investors get about the same rate of return.
This produced the notion that a completely ignorant newcomer to the stock market should do about as well as Warren Buffett or George Soros. And in the perverse way of the world, and markets, over the last few years the amateurs not only did as well – they did better.
The amateurs’ money flooded into the market. The resulting tide of cash raised all the boats. But not all alike. The heavily-laden, value-oriented “Old Economy” stocks rose grudgingly, while the hollow, helium-filled offerings of the “New Economy” positively floated on the air itself.
“The market is high,” wrote best-selling author Robert Shiller in Irrational Exuberance, “because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their emotions, random attentions and perceptions of conventional wisdom.”
The conventional wisdom has two tenets: Hold stocks for the long term. And buy the dips. Of course, the two are contradictory, but who’s going to quibble with the logic that, until recently, produced such spectacular rates of return?
And as long as the market is rising – that is, as long as the self-delusion and cash of the amateur investors holds up – these convictions pay off. Too bad they can’t last forever. Not only that, but as they reverse…the same amateurs who bid them up to absurd levels are likely to sell them down to equally absurd levels. Extraordinary profits will give way to extraordinary losses.
If only nothing ever changed! If only Maria could remain an adorable little 12-year-old forever…and stocks would rise until the end of time – or at least through the next presidential election cycle.
But that is not the way the world works. Ice Ages come. Teenagers and bear markets happen.
Your humbler and humbler correspondent,
Paris, France May 29, 2000
P.S. Today is Memorial Day. The markets are closed. I’ll have more to say about this holiday tomorrow.
*** Friday, the S&P futures opened up – as has been their habit. But the market went the other way…closing down, as has been its habit.
*** The Dow fell 24. The Nasdaq fell too – but so little it is not worth recording.
*** Advancing stocks beat declining ones – 1493 to 1351. But new lows far out-paced new highs – 98 to 38.
*** So, not much happened on Wall Street…but it is a holiday weekend. Volume was very low.
*** At the beginning of last week, Alan Abelson of Barron’s reminded us of the “Q” ratio – that is, the relationship between the value of the stock market and actual corporate net worth, or replacement cost/book value. “To cut to the chase,” writes Abelson impatiently, “…q tell us right now that, the market is more euphorically priced than at any time in history…[and] indicates that the present downside risk is that the Dow Jones Industrial Average will decline to between 4000 and 4500.” *** By the end of the week, the markets were moving in the direction Abelson and q suggested they should – with a more stocks falling than rising…many more hitting new lows than new highs…and the indices almost all down. The Dow fell 3% over the week. The S&P dropped 2%. And the Nasdaq was down 5.7%.
*** The Nasdaq decline may be explained, and further anticipated, simply by the increase in supply coming to the market. Bradley Alford, who provides a service called IPO Lockup.com, reports that 2.8 billion shares, worth about $121 billion, came onto the market in May. In June, the total is expected to be 1.3 billion shares, with a market value of about $40 billion. These are shares that were previously held off the market – restricted, or “locked up,” for a period following the IPO. These are shares that owners may have gotten for pennies on the dollar. Many of them will almost certainly be sold – even at much lower levels.
*** The euro looks a bit healthier – having risen slightly on Friday. Perhaps this is not so much a comment on the euro as on the dollar. If faith in America’s miracle economy and its levitating stocks disappears – so does the value of the dollar.
*** Higher interest rates are “hurting the rest of the world more than [the U.S.]” said Ed Yardeni. He believes capital will continue to flow to the US and its currency – thanks to Fed tightening.
*** As we know, raising the cost of capital – point has no effect on investors who expect to earn 20% per year on their money. And it has no effect on companies whose sales are negligible and whose own cost of capital is zero. But even a quarter of a point has a significant impact on the rest of the world.
*** Homes sales, for instance, are off 6.2% March to April, and down 6.9% from the same period a year ago. And there are a few anecdotal references to real estate prices topping out in the S.F. Bay area.
*** A few points make a difference to institutions with a lot of debt. The US Federal government, for example. Thanks to the ‘ledgerdemain,’ to coin a word, of the clerks and the mendacity, to use an old one, of the politicians, it is widely believed that the US will be a debt-free nation in 2013. Actually, total debt will increase by 21% by that time, but the debt holders will change. There will be fewer private holders of public debt, and a lot more debt in the hands of the Social Security administration.
*** “The operating surplus in the US federal budget was $450 billion,” according to H. Erich Heinemann, reporting in Barron’s. The trouble with that is… “A spike in the federal operating surplus has preceded every US recession since World War II.”
*** And I see Barron’s has picked up on a theme I’ve talked about here frequently. Remember the “Esperanto currency?” Barron’s labels it the goulash currency (taken from our own contributing editor, Rick Ackerman): “…blending so many politically and culturally disparate elements makes for an unappetizing stew prepared by too many cooks.”
*** Tolstoy said that all happy families are the same. But I can’t imagine that there is another one like ours. In fact, our family is not even like itself. That is, the family one week seems completely different from what it was the week before. It is always like a screw–ball farce of the 30s and 40s…with the actors coming on stage in some state of desperation, panic, or madness. But the plot changes from day to day – and so do the characters.
*** Maria, who used to be such a darling – and had me wrapped around her little finger – has changed her role. What is it about teenaged girls that causes them to lose their sense of humor – at least while they are in the company of their parents? Everything is a crisis. Every event is a cause for despair. Every comment is either stupid or insulting.
*** Well, she probably still has me wrapped around her little finger – but the position is not as comfortable as it used to be.