Anyone With an Ounce of Logic Saw This One Coming
Despite all the teeth gnashing and general angst over the stock market’s slump of recent weeks, the cruel truth is that investors weren’t mugged by this. They walked willingly into the gunman’s muzzle.
This may, in fact, have been the most telegraphed market plunge in history.
How so? Because anyone with any experience on Wall Street--heck, even novice investors, for that matter--knew that the party had become so wild and woolly that it couldn’t possibly be sustained. It was only a matter of time before trouble hit.
Remember Iomega? The maker of computer memory components was a $16 stock at the start of the year. By May the price had rocketed to $55, spurred in part by some rabidly bullish investment newsletter editors and by the company’s own personal cult of followers who touted it nonstop on the Internet.
Does Iomega have a hot-selling product? Apparently. Did the stock deserve to sell at 323 times annual earnings per share? Apparently not--or not for long. The share price has since crashed back to $23.75 on Nasdaq.
Iomega was just one of the more visible affronts to investor logic in May, as frenzied buying of all sorts of small, high-risk stocks drove their prices to stratospheric levels. “They’re high-growth stocks!” the bulls would trumpet. Yet one of the oldest lines on Wall Street (besides “Buddy, can you spare a dime?”) is that “Trees don’t grow to the sky.” There is a limit to what prudent investors should pay for a stock relative to the company’s underlying earnings.
Imagine what the person who paid $55 for Iomega is thinking now. How about: “I’ll never do that again!”
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Yet the speculative mania in smaller stocks was just one of the clear signs that the market was entering the danger zone. Remember these?
* Investor purchases of stock mutual funds rocketed off the charts from January through May, at a pace the fund companies themselves warned was bound to slow eventually, unless millions of Americans were going to begin robbing banks to sustain their fund habit.
* Corporate insiders were unloading shares in their own companies at a record rate in spring, strongly suggesting that they had no desire to stay invested in their shares, even as the public hungered for more. The insiders aren’t always right, but given that they ought to know best about their own companies’ prospects, more often than not when they unload wholesale, it’s a bad sign.
* Wall Street underwriters were bringing young, private companies public at a feverish pace in May and June, amid the battle cry “There’ll never be a better time to go public!” That was code for “Investors will never pay you more for your shares--so feed it to ‘em now, before they come to their senses.”
Case in point: CompuServe, the online service, went public at $30 a share April 18. The price quickly zoomed to $35.50. On Tuesday, the company announced--surprise--that a greater-than-expected number of subscribers are leaving the service, and it will post a loss in the current quarter. The stock price now: $12.50.
But if everyone understood that a mania was gripping the market--raising the risk level substantially--why did stock mutual fund managers cut their cash levels (i.e., the dollars in reserve to buy more stock) to an average of 6.7% of fund assets at the end of May, the lowest since the late 1970s? Wouldn’t it have been more prudent to raise cash to guard against a market turn that could have hit the funds with redemptions (exactly what they’re facing now) and/or simply to increase fodder that could be put to use when stocks eventually declined to more reasonable levels?
The answer, in two words, is “Jeff Vinik.” The former head of the Fidelity Magellan stock fund lost his job in spring by having too little in stocks, hurting his performance as the market raged.
Many fund managers figured Vinik was right to be cautious. They knew the market was becoming overpriced. But they bought more stock anyway. “Not too many of us could pull the trigger,” admits Hugh Johnson, veteran analyst at First Albany Corp.
“It’s a human frailty problem,” Johnson says, a desire to stay with the herd and avoid feeling isolated. To put it another way: “When the market is going up you can never own enough stocks,” Johnson notes. “But when the market is going down, you always own too many.”
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The percentage of stock mutual fund assets in readily available cash fell to 6.7% as of May 31, the lowest since the late-1970s. Cash percentages as of May of each year:
1996: 6.7%
Source: Investment Company Institute
