A vicious circle of investor gloom and mistrust
By Philip Coggan
Published: February 16 2003 17:17 | Last Updated: February 16 2003 17:17
Just three years ago, investors were being urged to day-trade their way to millionaire status; now shareholders are reluctant even to open their brokers' statements, for fear of the bad news that lies within.
This disillusionment with equities is not confined to private investors. Institutions such as pension funds and insurance companies are desperately reducing their exposure to equities as falling share prices undermine their financial position.
The change of attitude is complete. In bull markets, investors focus on reward; in bear markets, they concentrate on risk. In other words, bull markets are about the accumulation of capital; bear markets are about its preservation.
During equity bear markets, investor psychology changes. They opt for safe assets such as government bonds and gold and readily believe scare stories.
They also extrapolate the trend to infinity. Just as, during the bull market, authors fell over themselves with aggressive targets for the US market (Dow 36,000, Dow 100,000), Robert Prechter, a technical analyst, now tells us* that "the stock market is embarking upon its biggest bear market assuredly since that of 1929-32 and possibly since that of 1720-84". This will not end, he says, until the Dow is in triple digits (that is, below 1,000).
The apocalypse is predicted in many forms. Some, including Mr Prechter, invoke a 1930s-style deflation in which asset prices tumble; others, citing the power of central banks to create money, predict an inflationary surge that will prompt consumers to lose faith in paper money and will result in a return to the gold standard.
In a way, it does not matter whether investors believe the deflationary or inflationary cases. Their response either way will be to shun the equity market.
Investors with this long-term view will be subject to what academics dub "confirmation bias", whereby they seek out facts that support their view. During a bull run, almost any news can be given an optimistic twist. Good economic data mean that corporate profits will rise rapidly; bad data mean the central bank will cut interest rates. Either way, investors are urged to buy equities.
In a bear market, the reverse applies. Weak data mean that profits will fall and send the market lower. Even when a central bank cuts rates, as the Bank of England did on February 6, that is simply seen as a sign of desperation, and sends rates lower still. Either way, it is a reason to sell.
The same effect can be seen at the individual stock level. During a bear market, when a company reports figures that are even slightly worse than expected, the effect can be savage, with the share price falling 30-50 per cent on the day.
In part, of course, these declines are caused by the ridiculous ratings on which some companies traded in the late 1990s - ratings that assumed double-digit annual profit growth far into the future. The sharp declines are simply bringing ratings back to normal. In part, also, the declines are due to the feeling that, just as there is never only one cockroach in a kitchen, one profit warning is normally followed by others.
But the savage market reaction may also be the result of the increased market presence of hedge funds, which thrive on momentum. They circle the markets, rather like lions round a herd of wildebeest; when they spot a sick or injured animal, they pounce. The ability of hedge funds to go short (sell stock they do not own) means that share prices can adjust to reality very quickly.
In many respects, the markets have become a mirror image of the late 1990s. Back then, momentum investors chased "hot stocks", usually in the telecommunications and technology sectors. Institutional investors, fearful of underperforming the indices of which hot stocks were usually constituents, were forced to own them as well. With such shares in short supply, valuations were pushed up to ridiculous levels.
When the bull market was at its height, competitive forces ensured that both pension funds and insurance companies became increasingly committed to the equity market. If they did not, their performance would lag behind that of their peers.
For the insurance sector, that would have meant the loss of business to more aggressive competitors that could promise larger payouts. The competitive pressures on individual pension funds were not so obvious; employees could hardly shift to another company's fund. However, higher returns translated into lower contributions from the company sponsor and indeed into contribution holidays for many.
Accordingly, a poor investment return would often prompt a pension fund's trustees to fire the fund management group involved or the consultant who advised on asset allocation.
These pressures were strongest in the UK, where pension funds and insurance companies have traditionally had a greater exposure to equities than institutions in the US or continental Europe.
This bet on equities has, however, always been risky. Actuaries are now coming to accept that pension fund liabilities are bond-like in character (the payment of regular income to pension beneficiaries) so a focus on equities represents a mismatch. When share prices fall and liabilities rise (thanks to increased longevity and lower bond yields) as they have in recent years, pension funds can slide into deficit. If these deficits are sufficiently large, they can threaten the solvency of the sponsoring company. At best, they will require finance directors to stump up more cash to plug the hole - cash that might otherwise have been used to invest in plant and equipment or pay dividends.
Furthermore, many commentators are questioning whether it is appropriate for companies to act as a kind of hedge fund, taking a leveraged bet on equities. The business of a company is to make widgets, not to play the markets. Thus bonds are a more appropriate asset for pension funds to hold.
All this has led UK pension funds to reduce their equity exposure. While some selling of shares has occurred, the main influence has been market movements that seem to have pushed down the weighting of equities within a typical pension fund from 80 per cent to 55-60 per cent.
If there is any good news, it is that history shows sentiment towards equities has been just as gloomy at the bottom of most bear markets. In some countries, notably the UK, shares now look attractively valued relative to cash and bonds. With insurance companies, pension funds and private investors all reluctant to buy equities, it is difficult to see who will step in to turn round the market. But fortunes have been made in such unpromising circumstances.
* Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression, published by Wiley |
