Nick dewhirst looks at the LAST TWO YEARS OF market 'RECOVERIEs' and asks whether this time it is for real
Another sinking spell. Previous setbacks to the Nasdaq index were widely hailed as great buying opportunities in May 2000, November 2000, March 2001 and September 2001. Each proved to be a disappointment.
Will this setback be any better for global markets? I think it will be, because the reasons for selling have changed.
The genuine bad news is now out. The internet shams, dodgy accounting and financial pyramid schemes have been exposed. Technology has been revealed as a cyclical capital goods industry. Capital spending is being cut to eliminate excess capacity. Growth has been replaced by debt reduction as the top priority of management. The economy has slowed.
Those things are no longer news. Instead, in the final act, phony rationalisations arise for selling at the bottom. Here are examples showing how that is happening again now.
The best collapse
While little consolation for the losers, it is worth first pointing this collapse now ranks in the record books among the greatest. The bubble index peak table compares collapse of the recent bubble with the most important ones in the past.
The point is worth labouring. The vast bulk of new issues and tech funds were launched near the top. Across the Atlantic I have used Nasdaq's IPO statistics to calculate that 35% of all new issues in the past decade took place in the peak years of 1999 and 2000. On the UK side of the ocean the Investment Management Association estimated that 50% of Isa sales in 2000 went into technology funds.
This means there are huge numbers of deeply disappointed investors, both amateur and professional, who can be expected to react in a psychologically predictable manner ' 'please stop the pain.'
It is not so much the emotional reaction of panic selling that is insidious, for those that do it, know they do so. It is the range of rationalisations used for selling at the bottom that typify stupidity in final act of the collapse. Here are classic examples.
1. Up to 25 of the 29 funds in the UK technology sector could be closed or merged by their management groups, because the decline in share prices means that their funds have shrunk below £50m, the estimated break-even value. An additional benefit for the management groups is that the track record then disappears from the overall performance of their stable of funds. Having launched at the top, no doubt for sound marketing reasons, they close at the bottom, again for business reasons that have nothing to do with investment prospects.
2. Thanks to the decline in share prices, the latest Footsie realignment will leave just one tech share in the index. Together technology and telecom shares now make up only 9% of its capitalisation, versus 32% at the peak in March 2000. Therefore those index funds that scrambled to increase their TMT investments at the top will now be scrambling to reduce them at the bottom.
Estimates of index-linking and closet-index linking range as high as 40% of institutional funds. While one can only make a crude guess as to the extent of hidden indexation, it is clearly very widespread when the implications of 'core/satellite' and 'portfolio risk control' strategies are included. The former effectively promises to index the core, while the latter is often used to control 'tracking error,' or divergence from benchmark.
3. The investigation into Merrill Lynch made public what had long been suspected behind closed doors ' that some brokerage analysts recommend purchase of new issued by their corporate finance colleagues, irrespective of their investment merits.
Vodfone's most notably bullish analyst finally ceased to recommend the company after the stock had collapsed this May. Investors might now be asking whether the change was based on pure research and analysis or because the company had become a less valuable client of its corporate finance department.
Equally, analysts are under pressure to be bullish about companies already quoted, which might bring in corporate finance revenues through acquisitions and secondary issues. That is confirmed by a survey of nearly 28,000 US analysts' recommendations by First Call/Thomson Financial in May 2001, which showed nearly 70% were buys while less than 1% were sells.
Among the suggestions for reform in the US is one that the stock-rating system of brokerage houses should be revised to generate equal numbers of buy and sell recommendations. As it happens that would increase the number of sell recommendations at the bottom of the market.
4. To these rationalisations should be added the genuine plight of the margin buyer who is forced to sell at depressed prices because his collateral has shrunk due to the market's collapse.
Seeking leverage, typically such investors are attracted to high beta shares. That might have meant mining shares in a previous era but recently it meant technology. Useful indications are provided by the performance of execution-only online brokerage firms, whose low dealing costs appeal especially to high turnover, high leverage traders.
Charles Schwab, the leading discount brokerage firm, can be taken as an example in the US. As the market rose, so too did the average margin balance on its customers' accounts. This increased from US$8,772 in 1998 to US$13,172 in 1999 and US$19,764 in 2000. However as the bubble collapsed, so too did margin balances, which had halved to US$9,145 by the final quarter of last year.
Europe's leading discount broker Consors AG also provides confirmation. Between 2000 and the first quarter of 2002, its assets per customer have fallen from e7,400 in 12,600, while its revenue per customer has fared even worse, declining over 90% from more than e900 to an annualised rate of e240.
5. Finally, in the UK, there is a new peculiarly British rationalisation for selling at the bottom ' FRS17. This new accounting standard requires that pension fund gains and losses be reflected in the profit and loss account of companies.
Imagine what happens when a finance director reports this loss to his colleagues on the board. As investment management is not a core activity, it will be argued that this new risk should be hedged as are exchange rates or commodity prices. In practical terms that means switching from shares to bonds, as the latter can be structured to match the pension liabilities.
Yes, hedge by all means, but do it at the right price. Faced with widespread negative news typically found at the bottom of a bear market, how many managements will have the courage to hold out for better prices?
This is not the place to repeat the arguments for a bull market made repeatedly in this column since October. Suffice it to reproduce our chart analysing stock market performance after 25 previous bubbles. While this one has been much more severe than many in terms of duration, the current melt-down is right on track. Based on past performance, technology shares may well stabilise at these levels for several years.
The bear market may be over, but will there be a bull market? Well, when previous bubbles collapsed, other investment concepts rose from the ashes. Sadly for the stale bulls, the new winners are seldom the previous disasters.
If technology shares merely cease declining, bullish developments for other sectors can be sufficient to drive the stock market averages higher. The new winners already have a head start. Of the 35 sub-sectors in the FTSE Europe index, 10 are already trading above the market's peak at the millennium.
Nick Dewhirst is chief executive officer of Investors RouteMap.co.uk
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