Saturday, January 24, 2009
End of an Era - Richard M. Ennis, CFA
Profits on the exchange are the treasures of goblins. At one time they may be carbuncle stones, then coals, then diamonds, then flint stones, then morning dew, then tears. —Félix Lope de Vega, 1562–1635 We are witnessing the end of an era. It was an era born of economic malaise: the stagflation of the 1970s and recessions of the early 1980s. At its dawning, you could pick up U.S. Treasuries yielding 13 percent and stocks at single-digit price-to-earnings ratios. Risk—not the prospect of market gains or garnering “alpha”—weighed heavily on investors’ minds in the beginning. The era got off to a rousing start, with U.S. stocks soaring 65 percent in the first year after the market bottomed out in August 1982. It was an era marked by vigorous global competition from the outset. Early on, Japan, with its manufacturing prowess, corporate wealth, and powerful banking resources, appeared poised to become the dominant economic power. The Japanese threat roused a torpid U.S. economy, and intense global competition—globalization, as it came to be known—began in earnest. It was one of the most productive periods in modern economic history. The fall of the Berlin Wall provided the fillip that enabled the economic revolution to spread to Eastern Europe, Russia, and even China. India, the sleeping giant, came to life. As Thomas Friedman observed, the world became flat. From the beginning of the era, leveraged finance was the mother’s milk of expansion. Michael Milken, “the Junk Bond King,” fueled the growth of takeovers and bankrolled early leveraged buyout specialist Kohlberg Kravis Roberts & Company. Buying on credit became the financial hallmark of the era. Stocks rose briskly through the 1980s. In October 1987, markets finally stumbled, losing nearly a quarter of their value in a single day. But investors largely took it in stride. Wealth had been amassed so quickly that few had gotten used to thinking of it as their money; rather, there was a pervasive sense among investors at the time that they had been playing with the house’s money. And it took a mere 19 months to fully recover the loss and for the market to begin establishing new highs. On the eve of the 1990s, reflecting on the extraordinary gains of the 1980s, one thoughtful observer remarked that only one thing was sure to be true of investing in the 1990s: Stock market gains, if any, would be modest in comparison with what we had witnessed in the 1980s. And then it got interesting. Stock prices continued their steady ascent through the middle of the 1990s, and then, they really took off. The dot-com–media–telecom bubble was born. The accretion of wealth, combined with foolishly easy credit, spawned a separate bubble in housing prices. Between 1997 and 2004 in the United States, housing prices rose by more than 50 percent. Even the demise of the tech frenzy did nothing to arrest the positive momentum in housing prices. It was an era in which pioneering efforts in a handful of university investment offices began to reinvent portfolio management, and the “endowment model” was born. Some investment offices produced sustained, extraordinary gains through canny diversification and astute manager selection. These investors were bona fide champions of the era. But this success story had a downside: It inspired large numbers of ordinary investors to channel great sums into anything “alternative” on the basis of little more than an encouraging historical covariance matrix. Not surprisingly, the emulators turned to the endowment model. Imitating Warren Buffett had become impractical after the mid-1990s; by then, cheap stocks were in scarce supply. So, instead of buying assets that offered old-fashioned risk premiums, many investors pinned their hopes on the wonders—and the myth—of “uncorrelated returns.” In the era just ended, hedge funds flourished in spite of their implausible compensation arrangements. Some exceptional investment talent found its way to that sector, to be sure. But more than anything else, a single, remarkable event propelled hedge funds above the trillion-dollar level of assets: Hedge funds played the bursting of the internet bubble just right, riding high-flying stocks up and bailing out near the top. Just as leverage had played a key part throughout the era, it took on a starring role at the end. By the first few years of this century, oceans of liquidity were sloshing about in world markets. Liquidity of that scale, it seems, makes anything possible. Easy credit was everywhere, and leverage seeped into every nook and cranny of the world economy and financial markets. Perhaps the greatest shortcoming of regulators, financial institutions, and investment professionals was that we couldn’t see it. We could feel it, like the ground trembling beneath our feet before an earthquake. But we couldn’t frame it properly, let alone imagine the destructive force of the eruption that was to come. With this issue of the Financial Analysts Journal, we inaugurate a series of articles that reflect on the era just ended and what might lie ahead. Titled “Global Financial Crisis,” the series will address a wide range of topics, including internationally integrated markets, market regulation, market transparency, the structure of institutions, the nature of incentives, contagion and bubbles, behavioral economics, the perils of financial modeling, and some good old Graham-and-Dodd security analysis. An overarching theme will be putting to use what we have learned because painfully reliving the past, over and over again, is a miserable way for civilization to journey through time.