ears
ago, in 1988 and 1989, we would frequently jog in Riverside Park in New
York City, taking a route along Riverside Drive from Columbia University
down to 72nd street, and returning through the park to the
area near Riverside Church. When finished we would sometimes meet up
with other runners at a water fountain and exchange greetings, make
small talk, then go our separate ways. It is one of our more pleasant
memories of living in New York and working on Wall Street, at a time
that now seems quaint, when many small, old-line investment firms
remained in what was still mostly an analogue world. Computerized
systems were already impacting the markets, but the Internet and high
frequency trading were many years away. Business was conducted in the
traditional way, with brokers hawking stocks and analysts producing
tomes delivered in print. Our group at the fountain would never have
dreamt of staying in touch via email or social media.
We
describe this personal vignette because we often think about the period
since the beginning of our connection with Wall Street — a span of time
that has reached 35 years — and about the changes and upheavals we have
witnessed. The investment world in the early 1980s was depressed by
recession and high interest rates, but within several years we
experienced a complete market cycle — a period of exuberance, when stock
traders felt that nothing could go wrong, followed by the sudden crash
of October 1987. In the last years of the decade we were still in the
shadow of that traumatic event, but recovery was relatively swift,
leaving few ill effects (unlike the impact of the big downturn of
1973-74, which had taken nearly a decade to overcome). After a few years
public interest in the markets recovered, and stocks rose to blowout
levels in the bubble of the late 1990s.
The
revival of spirits after the 2000 collapse was similarly rapid. That
downturn was largely confined to the technology sector, while the
broader stock market rose nicely, leading to a period of exuberance
captured by the now notorious remark by a Wall Street banker, "as long
as the music is playing you've got to get up and dance." But the
recovery from the much more serious crisis of 2008-09 has been more
circumspect and hesitating, with little of the enthusiasm felt in
previous eras, in spite of a tripling of share prices since 2009. The
environment is more akin to that of the 1930s; despite a dramatic rise
in stock prices from the 1932 bottom, the public's aversion to stocks
after the Great Crash persisted for decades. There are major differences
between that era and the current one, however. The Great Crash crushed
business valuations, and they remained depressed for a long time
thereafter, whereas the rise since 2009 has brought market averages and
valuations to record levels. It is difficult to envision a long period
of expansion ahead of us, as one could have with hindsight, in, say, the
late 1940s.
So
where does 35 years of observing the markets leave us now? Above all,
these years teach us that no amount of experience can help to predict
market direction; markets just do what they do, frustrating those who
try to divine future events from their behavior. Experience helps us
evaluate risk, as well as sense opportunity. The exuberance typical of
highflying markets may now be camouflaged by the shift to "passive" investment vehicles, but the same "the market will take care of us" attitude that gives false confidence to speculators lies behind the
current popularity of indexing. At a time when valuations are
historically high and good investments scarce, experience, and history,
teaches us that risk is elevated.
Risk
The
evaluation and avoidance of risk are essential to proper investing.
Investment implies, above all, the preservation of capital. We cannot
eliminate risk, but we aim to reduce it as much as possible, and strive
to earn a suitable reward for the risks that we do accept.
In
speculation, risk plays a huge role as the source of potentially
outsized gains. A new business is fundamentally a speculative roll of
the dice on an idea for a product or service that may or may not find
favor. Fortunes can be made when such wagers are successful, as business
history in capitalist-oriented societies clearly demonstrates. Stock
market trading is also speculative and can be lucrative, especially when
carried out with borrowed money. Neither of these activities qualifies
as true investment, however, as the preservation of the capital employed
is far from assured. Note that "speculation" plays an important role in
our economy through the creation of new employment and wealth. It
requires a different skill set than investment, however, as well as
pluck and luck.
Traditionally, risk was thought of in terms of the possibility of
permanent loss of capital; most individuals think of it that way still.
Such losses are painful. Capital is irrecoverable, current and future
consumption and perhaps a comfortable retirement are impaired. But when
is a loss permanent, as opposed to merely a temporary setback? Such
questions have always been part of the investment problem: the
evaluation of the true value of a security, as opposed to its current
price.
For several decades Wall Street and academia have attempted to quantify
risk through the application of statistical methods in the analysis of
asset price fluctuations, or "volatility." According to this view, the higher
the frequency and magnitude of price fluctuations, the greater the risk.
We believe this theory is not supported by observation. In recent years,
for example, the U.S. stock market as a whole has been characterized by
unusually low volatility. Daily fluctuations of 2% or more, not uncommon
in the past, seldom occur nowadays, and significant "corrections," or
10%-20% declines, are almost things of legend. Advocates of the modern
statistical theories, therefore, would have to argue that markets are
less risky. Yet we look at markets that have been pushed by liquidity
and driven by a lack of attractive alternatives, inflating valuations to
rich levels (to records by some measures) that rival past peaks. Even
the non-professional observer using common sense can see the signs of
danger.
An
interesting aspect of risk occurs when events continue to unfold
smoothly, despite what is perceived to be clear signs of potential
calamity. Exuberant markets can go on indefinitely with no ill effects.
In a different sphere, since the world survived a cold war with no
"mutually assured destruction," it is tempting to think that our caution
was unnecessary and too costly. However, just because catastrophe was
averted it does not follow that there was no risk; decades later we
learned how close the world came to "MAD." In the markets, where only
our money — not our lives — is at stake, we have seen time and again
throughout our experience that when the music stops playing it is far
too late to worry about preserving capital. You never know for sure when
the band will pack up and go home.
In the
investment sphere we believe that risk is growing, and it comes from a
variety of sources. The rise of "passive" investing, with its
insensitivity to valuation, promises to distort capital allocation in
general. A related issue: the decline of traditional security analysis
(and the analyst community on Wall Street) has resulted in decreased
pressure on issuers to come clean with their accounts. Valuations are
extended. Finally, the very fact that the markets have been rising for
so long stores up danger as market participants become more relaxed
about making commitments, even when many are aware that circumstances
are less than favorable.
We
favor the traditional view of risk as the possibility of permanent loss,
which is less quantitative, perhaps, but more wedded to market
realities. Given current market conditions, losses may not be permanent
ultimately, but they could be painful and long lasting.
Fake News
In a
wonderful piece by Financial Times editor Lionel Barber, the author
points out that lies, distortions and misleading statements have been
used for devious purposes for millennia. What is new is technology,
which, as Barber states, has "flattened the digital plain," creating the
"illusion that all content is equal." This creates problems for public
discourse, and democracy, especially at a time when journalists — the
traditional gatekeepers of information flow — command less respect and
influence among the chaos of the Internet.
In the
world of finance, such "fake news" is familiar stuff. Where there is
money, there are liars, and the history of Wall Street is full of
colorful characters using various subterfuges to separate people from
their money. Technology now plays a big role here, too; Madoff was able
to create a plausible illusion of superior investment results through
the creation of fake trading reports and account statements.
Most of
the distortion that happens on Wall Street and in the corporate world is
perfectly legal, if ethically questionable: accounting manipulation, for
example, and giving positive slants to business developments or earnings
"guidance." The overall result of these behaviors, legal and otherwise,
is a decline of trust and a web of regulations to reign in bad actors
and enforce some transparency. In the media realm little can be done to
regulate the purveyors of fake news, and the erosion of trust in public
institutions continues. At least in finance, measures can be taken to
discourage bad conduct.
No
guts, no glory, as they say on Wall Street, or, to use the accepted
academic formula, the higher the risk, the greater the reward. Fake news
or no, market returns this year have been quite real, and substantial.
The S&P 500 index, the Dow Jones Industrials, and the Nasdaq returned
between 14% and 20% year to date through September. One can quibble
about the figures — technology has played an outsized role this year, for
example — but they are respectable, and remarkable given the risks the
world faces at this time, from Korea to political extremism. To borrow
another expression popular within the financial community, the markets
have definitely "climbed a wall of worry."
. ________________________________
.GIF){kind=small}
.JPEG)
