comparisons between 2003 and 1973 show certain similarities ' including war in the middle east and the stock market halving
What does the bottom of the worst bear market in living memory feel like? 2003 is much like 1973 ' a Labour government in the UK, war in the Middle East, oil price soars, the stock market halves and gold shares double.
Is it deja vu? My investment career started in one crisis of capitalism and continues into the next one. As a survivor of that previous crisis, there is much that I have learned, but even more that I wish I had learned.
Setting the scene
Then as now, it started as a normal cyclical bear market. Consumers enjoyed a boom and house prices soared, so the authorities raised interest rates on both sides of the Atlantic and the stock market began falling. On Wall Street there was a bubble in growth stocks. Then it was thought that the Nifty Fifty could grow ad infinitum. This time it was thought technology stocks could do the same.
Then as now, some experts warned of the bubble, others called the top correctly and a few managed to switch horses from one sector to another, to prolong the winning streak for themselves, despite the onset of the bear market.
Then as now, nobody appreciated that it would grow into a crisis of capitalism.
Private investors did not sell because they had been told that equities were long-term investments. They did not know how long. The experts did not sell due to capital gains tax. They did not know it would be cheaper to pay the tax than suffer the loss. The professionals did not sell, but hid behind their benchmarks, claiming their job was stockpicking, not macro-betting. They could not see the wood for the trees.
Then as now, shares suffered a massive de-rating. The problem for stock market analysts in unchartered waters is that there is no statistical basis on which to make comparisons. How far should the de-rating go?
What is the right P/E ratio for the market at the bottom? Statistically the P/E ratio moves in a reciprocal manner to bond yields, which in turn reflect the rate of inflation. What happens if inflation soars towards an unprecedented 25%?
As 1974 began, the market was already considered to be extraordinarily cheap, because the P/E had just fallen into single figures for the first time since the ratio was first calculated back in 1964.
Could valuation halve, when the market was already undervalued by a record amount? Yes, and it did. By new year 1974, the market had already fallen a third. During the year it halved, even from that depressed starting point.
To work out the fair P/E ratio, take 25% inflation, add three percentage points for risk premium and 2% more for panic, then the earnings yield could well be 30%. As the reciprocal of that, the P/E ratio could well fall to 3.3. In fact it fell to 3.4 in November.
The same problem exists today ' only it appears in another part of the equation. The problem now is the relationship between bond yield and P/E ratio, alias earnings yield. Until the millennium, on average bonds yielded 2% more than shares. Since then, bonds have yielded less than shares.
As there is no mathematical way to calculate how much cheaper shares can become, attempts to fine-tune the turning point degenerate into an examination of esoterica. Here are some examples I remember from the depth of the last crisis of capitalism.
The firm ran an annual stock-picking contest open to all staff and partners. The winner was feted as a guru. However, in 1974 the contest was cancelled because it was thought there would be no winner.
Lesson One: When professional optimists throw in the towel, that is a sure sign of capitulation by market insiders.
The firm's chartist pencilled daily movements in long-term point and figure chart pinned on the Dealing Room wall that was two yards wide. As the market fell into uncharted territory, so she added first one small sheet at the bottom, then another small sheet, then a large sheet, which extended the vertical axis down to zero. The market dipped into the third one briefly, before embarking on the biggest bull market in history.
Lesson Two: Beware of chartists who rescale their charts to zero. That is a sure sign of capitulation by market gurus.
Bemused clients called to demand an explanation for their collapsing portfolios. In response brokers described the Doomsday Machine. Yes, company profits were rising, but unfortunately these were meaningless. In that case it was because companies were being taxed for inflationary gains on their stocks and were not permitted to depreciate assets at replacement cost.
As a result, cash flow was negative and so companies were going bankrupt, while appearing to be profitable. This process was considered to be an inevitable consequence of inflation and spelled the death of capitalism. Therefore share prices were headed towards zero.
Lesson Three: Beware of intellectual justifications which project present trends towards infinity at the top and towards zero at the bottom.
Lessons for the industry
Professionals in the City of London are now better qualified. Then I was the first graduate allowed to talk to institutional investors in the blue-blooded stockbroking firm that I had just joined. Unlike me, my colleagues were named after well-known public companies and had studied at Eton or Harrow but not Oxbridge. Now one can't get such jobs without a good degree from a good university.
Contacts count. I had joined Rowe and Pitman, who brokered stocks to blue bloods and blue chips, while Philips and Drew personified the graduate and grammar school culture.
Quarter of a century and several incarnations later, R&P slaughtered P&D when the two firms met under one Swiss bank's roof. P&D may have given better advice, but R&P had better contacts.
Consequently the business of advising investors has changed for the worse. Then I was a rookie stockbroker who was paid commission for selling investment advice in a single capacity firm. The better the advice we sold, the more repeat business we generated. Quarter of a century later, when I last sat in the dealing room of an integrated investment bank, the salesmen peddled high-priced new issues because the commissions on picking under-priced stocks had been driven down to vanishing point.
I learned that investors need single capacity firms, so I set up one that only provides investment advice. I wish I had also learned how reluctant investors are to pay to satisfy this need, despite the fact that free advice has never been so expensive ' when measured in terms of capital destruction since the millennium. It seems the richer the investor, the greater their appreciation of fee-based services, which is perhaps why they are richer.
Politicians are to blame, but it is messengers who are shot. Financial intermediaries are those messengers.
In 2002 investment analysts stand accused of conflicts of interest. 1974 stockbrokers were the class enemy. In 1923 Jewish bankers were blamed for Germany's hyperinflation.
What else should one expect if regulators create integrated investment banks nowadays, governments engage in Socialist experiments in 1974 or print money to pay their debts in 1923?
Even if a boom starts in the stock market tomorrow, there will not be a boom in stockbrokers or other financial intermediaries for years.
City employers have dug deep into their pockets to finance the jobs of their workers. They will first have to restore their bank balances before they embark on another hiring spree. Last time that took six years until Margaret Thatcher's election victory restored confidence in 1979.
Disasters on the front-line hurt the entire food chain in time ' from accountants and architects to lawyers and life-style gurus and to a lesser extent indeed everyone in the UK's home counties. All who service this country's greatest wealth-creation machine will suffer in due course after it goes into reverse. The Hampstead flat this young broker bought in 1972 appreciated 10% in a month and 50% in a year, but fell back to its purchase cost a year later. Once again, the ripples of a peaking property market are spreading out from the City.
US interest rates peaked in August 1974. In September Wall Street hit its low and in December successfully re-tested that low. At home, Labour secured its position with a landslide victory in the October general election based on extreme left-wing policies. The next month, the Chancellor soaked the rich, as promised, while simultaneously introducing a couple of technical changes to company taxation. Over the new year, Burmah Oil went bankrupt and was forced to sell its large stake in BP.
The catalyst for the turnaround was government policy.
• On the monetary front, the Bank of England? had in fact been reducing interest rates modestly for a year. As inflation was soaring, this meant that it was pursuing a massively expansionist monetary policy.
• The technical changes to company taxation were stock profit relief and replacement cost depreciation, which effectively stopped the Doomsday Machine.
• The solution for Burmah's problem was for the Bank to step in as buyer of the BP stake on behalf of the government.
Once again, there is a Labour government and the authorities are changing policies to help the stock market.
• The Bank of England has been reducing interest rates for more than two years already.
• The FSA has lifted the solvency requirement for insurance companies, which was responsible for a vicious circle that forced them to sell equities into a falling market.
None of this enables one to pin-point the bottom, for the good news started emerging several months before the stock market took note in 1974, and again it has been accumulating while the market hits new lows.
Indeed, there was little point in trying to pin-point the bottom, because when the market started recovering, it doubled within six months. Asked to explain their under-performance, one fund manager said they made the mistake of going out for a cup of coffee. So far this time the market is up 16% in two weeks.
So what did I learn? If one is going to panic, panic early, otherwise sweat it out until the investment community comes back to its senses. What do I wish I had learned? There are few niche markets, few magician fund managers, and little chance of finding them.
In 1974 capitalism itself was at stake. Three decades later the question is only what price capitalism. I placed my bets when I thought it was cheap enough, so now I have to sweat it out.
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