Theory of Cycles Helps Put Stock Slump in Context
One of Wall Street’s oldest maxims is simply, “Don’t fight the tape.”
It means that, when a massive wave of emotion--be it panic or euphoria--hits the stock market, there’s no use going against the trend, because it is certain to sweep up everything in its path.
Amid the worst U.S. stock market decline since 1990, many Wall Street pros now are less concerned with the fundamental global economic crisis driving the sell-off than they are with the knowledge of how investment manias have come--and gone--before.
Unique as it may feel, the selling wave that has hit the market over the last seven weeks, driving the Dow Jones industrial average down more than 18% from its July 17 peak, is similar in intensity to those that have swamped stock, real-estate, junk-bond and other booms in the past.
“Every hurricane has its own name,” said Robert W. Bissell, investment chief at Wells Capital Management in Los Angeles, “but the damage is the same.”
To be sure, there is still no consensus that the great 1990s bull market, which began nearly eight years ago, has come to a close.
The U.S. market, as measured by the Wilshire 5,000 index of stocks, soared from $2.8 trillion in 1990 to a peak of $11.1 trillion in July. At $8.93 trillion on Friday, it has surrendered less than one-fifth of its value so far.
But precisely because the market’s 1990s gain has been so spectacular, the downside risks are that much higher now, should more investors seek to exit.
Just as a growing wave attracts more and more ecstatic surfers, so the market wave in the ‘90s--powered by prospering U.S. and global economies--attracted a record number of new investors. The tally of stock mutual fund accounts has mushroomed from 23 million in 1990 to more than 100 million.
And as with any mania, the success of the economy and market fueled predictions that the good times would never end.
The analogy would be for an oceanographer to assert that a particular wave on the ocean is different from all previous ones--a wave that would never break.
But history instructs otherwise, at least so far as economies and markets are concerned.
Federal Reserve Chairman Alan Greenspan, in a speech Friday, warned that “it is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress” with Asia, Russia and now Latin America in the midst of severe economic and financial problems.
Market Hitting Another Cycle
That, of course, is what the stock market has been reflecting since mid-July, when blue-chip share prices crested at historically high levels relative to companies’ underlying earnings.
“The information was always out there,” said Richard L. Babson, chairman of Babson-United, a Wellesley Hills, Mass.-based money management and economic forecasting firm. “We knew Asia was not going to turn around in two weeks. We knew Russia was a mess. It wasn’t new information. It just hadn’t set in.”
In a boom period “explanations are advanced as to why [stock] valuations are justified, but at some point, valuations outrun any earthly capacity [on the part of businesses] to deliver profits at a commensurate level,” said James Grant, editor of Grant’s Interest Rate Observer, a newsletter in New York. “That’s when the sentiment turns.”
The phenomenon is hardly confined to the stock market, noted Michael Clark, head of equity trading for brokerage CS First Boston.
“Look at the high-yield [junk bond] market in the mid-’80s. Go back to the late-’70s and early ‘80s commodities cycle,” he said. “It’s the same type of action: The market chugs along, starts to catch people’s interest, then you get a herd effect.
“There’s excessive speculation, then purging and then the penalty phase”--when the wave of euphoria turns to a wave of gloom.
The Bears Are Out There
The stock market now is decidedly in the penalty phase.
Although the blue chip Dow Jones index has fallen less than 20% from its peak, in the broader market the damage already constitutes a genuine “bear market,” meaning a decline of more than 20%. The Russell 2,000 index of smaller U.S. stocks, for example, is down 29% from its April 21 record high. The technology-dominated Nasdaq composite index has fallen 22% from its peak.
The average stock mutual fund has lost 20.3% since July 16.
On Wall Street, the most gentle term for market downturns is “correction”--because they correct excesses.
Some analysts think that market excesses result when investors stray from the fundamentals of basic value, which in the case of stocks involve weighing share prices against a company’s earnings, growth rate, management, competition and products.
A “fair” price for a stock is always a matter of debate. But an economic and market boom can make people begin to see everyday objects in a strange new light.
In Los Angeles in 1988, for example, it was easy to forget that a house was a place to live, as the overheated real-estate market made homes take on many of the characteristics of poker chips.
The same odd transformation has occurred this year with Beanie Babies plush toys and, before that, with baseball cards and high-status golf courses.
On Wall Street during the zaniest days of this bull market, a share of stock was, in Grant’s words, “no longer anything so humble as a mere claim on the discounted future earnings of a business, but rather a lottery ticket with a near-certain payoff.”
The gambling analogy is strengthened by the proliferation of ways for the public to “play the market” rather than invest.
One example: The Chicago Mercantile Exchange last year introduced a “mini” Standard & Poor’s 500 stock index future contract, to let individuals bet on the direction of the market.
The mini--one-fifth the size of the standard contract traded mainly by institutions--is valued at $50 times the index, or about $48,500 on Friday. But investors can control that large sum with a down payment, or margin, of just a few thousand dollars.
The public has responded in kind: More S&P; minis were sold last month--a record 460,348--than Ford or General Motors cars.
Officials at the futures exchanges say their business is all about managing risk. They note that the securities can be used to hedge against a market decline as well as bet on a rise.
However, the products aren’t marketed like insurance policies. TV ads on financial news channels tout them as vehicles for people who have a good “feel” for which way the market will turn.
The casino environment can make it hard for even the most confirmed long-term investor to stay the course--especially when get-rich-quick strategies seem to pay off.
Value-oriented investors, who follow the discipline of buying shares only when they can find them at bargain prices, have been outperformed for long stretches of time by “momentum” investors, who simply try to catch the fastest-moving stocks and ride them while they are hot.
Internet-oriented stocks were the darlings of the momentum crowd earlier this summer.
At its peak of $147 a share in mid-July, Amazon.com, the online bookseller, had a stock-market value of more than $7 billion--double that of U.S. Steel or B.F. Goodrich.
To give Amazon.com its due, it is probably the most admired Internet retailer, and has had explosive sales growth. But for a company that has yet to post a profit, $147 a share seemed excessive to many Wall Street veterans.
The stock has since slid 41%, to $86.25, including a one-day drop of $22.13 in near-panic selling Monday.
“When the market does correct, it tends to over-correct,” Babson warned.
But calling a broad market turn--and guessing the severity of losses--have proved impossible for even Wall Street’s best minds.
Babson is a descendant of the firm’s founder, Roger W. Babson, an economist best known for “calling” the crash of 1929 a month before it came.
Sometimes forgotten is that Babson’s earlier pessimistic forecasts had been all but ignored by Wall Street during the two boom years leading up to the crash.
But then, that’s the point: Warning signs are often visible, but at the height of euphoria they tend to be discounted or explained away.
If the pattern keeps repeating itself, one would think we could learn from our mistakes. Are we doomed forever to lurch between euphoria and gloom, boom and bust?
The short answer is yes.
“To say it’s hard-wired in us isn’t enough of an explanation, but there is a cyclical quality inherent in market-oriented societies,” said Grant, a student of market patterns.
Still, whether the tide has turned for the U.S. economy, and stock market, after nearly eight great years remains to be seen.
It is investor and consumer psychology that begin to matter most now--as Fed chief Greenspan alluded to Friday.
“We have relearned in recent weeks that, just as a bull stock market feels unending and secure as an economy and stock market move forward, so it can feel when markets contract that recovery is inconceivable,” Greenspan said.
“Both, of course, are wrong. But because of the difficulty imagining a turnaround when such emotions take hold, periods of euphoria or distress tend to feed on themselves,” he warned.
MARKET STRATEGIES: A special report examines what investors can do amid the current stock turmoil. D1
