December 2006
As we've recently witnessed the market climb to new high after new high, you can't help but wonder what other investors are thinking about. Actually, I know that you'd be better off remaining completely independent in thought and simply ignore what others are thinking about, but obviously I just can't help myself. So, what are other investors thinking about exactly?
First off, before I attempt to answer that question, I will pose another. How much do investors' aggregate time horizons affect the market's overall behavior? I mean, if an individual investor who completely believes that her investment horizon is, say, 25 years from today, it naturally strikes her as very rational to forget about today's stock prices. Her belief is that short-term volatility doesn't matter because time will heal all wounds. In other words, if the valley represents an economic downturn, then having a super long time horizon enables her to confidently own stocks by "looking over the valley" to the better times ahead.
It is this ability to look over the valley that allows investors to make money when others are paralyzed by their worry about the nearer term future. Basically, that is what market commentators call "climbing the wall of worry". Is that all that is happening today with markets hitting highs amid the fretting about a slowing economy heading into 2007? Are investors simply peering way out over the valley ahead and buying stocks in anticipation of better times or is something else happening here?
To attempt to answer this, I would claim that the investment industry isn't that much farther seeing than it was in the past. In fact, it could be convincingly argued that it has a far shorter time horizon than before. But, regardless of that, I think there is a more robust explanation as to why the market seems willing to ignore signs of a slowdown ahead; The Great Economic Moderation! Investors are clinging to the idea that this time it truly is different.
I believe many, many professionals are passionately discussing the thought that we've entered a new and permanent state of economic moderation and it is justifying ever higher prices in most asset classes. With it, the ups and downs of the normal business cycle have dampened and are creating a low level of economic volatility across the globe. The lower the volatility, the lower the risk and the lower the ultimate returns to investors. As is always the case with new theories, there is clear evidence that this is happening. The more important question is will it stick.
Here is a basic summary of the Great Moderation theory. It is being driven by well known global forces in which the global economies are better able to weather normal cycles. It is also driven by better information systems that enable companies to better manage their inventory, speed up their supply chains, utilize their capacity more efficiently, diminish the inherent power of their labor forces through free trade policies and therefore crank out record profit margins.
Additionally, many investors are increasingly buying into the thought that the global central banks are much better at sensing the state of economic activity and are now better than ever at delivering the right monetary policy at just the right moment.
Think about it. Our own Federal Reserve deftly responded to the bursting tech bubble with 12 rate cuts over 3 1/2 years, held those rates really, really low for a long, long time and then slowly and methodically raised rates 17 straight times. They then stopped this summer and now the economy is supposed to slow only a little and then start picking up steam again by late next year. If it all unfolds just like that, then it would produce a very, very shallow valley indeed and it doesn't take a far-sighted genius to have the guts to look over it! Does this explain why the market is rising? Well, I think there is possibly more to the story.
Even beyond stock prices, the highest rated bond issuer of all, the US Treasury, is paying a very low historical interest rate of 4.4% in exchange for 10 years use of investors' money. Further, bonds issued by entities other than the US government are paying less (normally expressed as a spread over that risk-free alternative) than they usually have had to pay. This is coupled with the fact that interest rates in general are already low on an absolute level basis. This is helping spur a number of leveraged buyouts and injecting even more optimism that stocks can't fall much. Lots of investors consider this an ever present magical bid propping up the market.
All this, in the face of an economy that is slowing by most agreed upon measures. But, due to the new paradigm shift of the Great Moderation, risk is now increasingly seen as forever reduced in the minds of market participants. I would venture to guess that investment committees across the country, made up of people wearing mostly gray suits are convincing themselves to accept this new theory in order to justify buying into this rising market. After all, their "conservative" behavior up to this point likely has them trailing the market indexes and their jobs may be on the line.
On another front, money managers whose IQ has been proven to have increased overnight by about 50 points since they decided to quit their boring mutual fund job to open up their new hedge fund shop are seeing all of this in real-time and are efficiently squeezing every last ounce of return out of the market. All of this with lower risk to boot. Welcome to the new reality of the Great Moderation. I wish it ended there, but unfortunately I don't think that fully explains why the market is going up either.
So, I come to the closing thought to ponder and it starts with how I feel markets may be working today. It was once said by the famed economist and investor, John Maynard Keynes, that successful investing is about anticipating the anticipations of others. Today, you get the strong sense that the game has moved to another level of guessing what the next guy is going to guess about.
It all begs the question of who these "lead dogs" are and why investors should be following them to begin with. So, since I begged the question, my answer is that the hoard of private equity and hedge funds (that are literally getting buried in cash that's being handed to them on unbelievable terms by the investment industry) are playing a game that is packed with gargantuan financial incentives to ignore the valley, play short-term performance catch up if they have to and just ride the market momentum of the day. And, wow, does it pay!
If you could convince enough investors to trust you with say, $100 million of their money and you set up the normal hedge fund deal of taking a fee of 2% per year plus 20% of profits, what would you do? Also, understand that the normal date cutoff to judge "profits" is the pretty arbitrary date of December 31st each year. So, if you were able to be quite pedestrian and eke out a gain of 8% over one calendar year, you'd get paid around $3.5 million. And with only 4% gains, you'd get to pocket $2.8 million. Eventually, you'd get canned for such mediocrity, but then again, the money is often locked up for a couple of years. So, what is the worst that could happen?
As a result, there is a big, big incentive to push stocks higher, especially as the year nears a close. And that is my final foray as to why today's market seems to be in a new paradigm mindset. The only thing is...it doesn't look all that different to me this time, because greed has been around for a long, long time. My solace is that it doesn't tend to pay off for very long. So, in a way, this is the valley I am choosing to look over for the time being.
Jason P. Tank, CFA
jason@frontstreet.com