Poor values and volatile prices Risk without wealth

Exit, pursued by a bear.

Shakespeare

A Winter’s Tale, III-3/57

At the time of writing, the North American stock markets are plumbing new depths in the sustained selloff of stocks that began in March of 2000.

Er, scratch that. At the time of writing, the North American stock markets are rallying from recent lows that some are identifying as the final stages of capitulation in equities and the beginning of a new bull market.

Er, cancel that. At the time of writing, the North American stock markets are in free fall, leading some to believe that equities may be poised to deliver low returns for years to come.

That is the kind of week it’s been. Daily and intra-day market moves have taken away 5% of market value, then given it back just as quickly. At the same time, the trend has been inexorably downward.

The bearish tone is no wonder. Although the market has fallen drastically, by conventional valuation measures like price-to-earnings and price-to-book ratios, it is still expensive. Piled atop the poor value is the fear that many businesses may have mis-stated earnings or presented faulty books — that bad as the appearance of value may be, reality may be even worse. Real market bears still predict a descent to early-1990s prices before market values are fair again.

But a pairing of poor values with volatile prices makes equity markets doubly unattractive. In traditional models of the market, share price motion created opportunity; in the classic formulation of securities analyst Benjamin Graham, there was a mythical “Mr. Market,” who would show up at your door each day with a buy and a sell price for your stock. If he was wrong, you prospered.

It is significant, but rarely remarked on, that the kind of volatility that now prevails in the markets is not the investor’s friend. The Grahamite interpretation of market volatility as a departure from rational valuation, which the astute investor could recognize, is of little use in a market that still seems to offer little of value. Graham’s Mr. Market now phones constantly, and his prices are no bargain.

Rather than creating opportunities to exploit mispricing, the volatile market creates pure risk for the investor with a shorter time horizon and opportunity costs for the investor with a longer one. If markets fluctuate 4% over the course of a day, as they often have in recent weeks, then a 5% annualized return over the next five years could be effectively cut to 4% if your buy order was executed at the wrong time.

Combine volatility with low or negative returns, and it becomes clear that the present market offers the opposite of what the book promises: risk without wealth. If there really is an efficient frontier, the present market can’t even see it with a telescope. The effect that too much of that sort of thing will have on the investing public is obvious; even the buyers of lottery tickets insist that somebody should win on occasion, and will walk away from the counter if there is never any payoff.

It would be pleasant to report that the mining sector had sailed through this silliness, but it hasn’t. One reason may be that investors are uncertain about economic growth, which old-economy companies will need to sustain revenues. Another is the simple in-and-out-of-equities dance that large institutional money is doing.

But another reason may be that the idea of the “new” economy is proving hard to kill. Dot-coms may be a laughingstock and investors may be shunning telecommunications utilities in fear of the next massive writedown or earnings restatement, but let a little sunlight into the computing or communications sectors and just watch the money jump in.

It may be that some professional money managers are hoping to make some big scores quickly, to balance their consistent losses over the past two years; or it may be that they fear being left behind if the newest new low really is the market bottom. Either way, the siphoning effect when market sentiment moves in favour of the new-economy sectors means money flows out of other sectors.

There is no quick fix in store for the present stock market, and until valuations become more reasonable and volatility calms, we are likely to see more and more individual and institutional investors getting out of equities.

“I’ll go see if the bear be gone from the gentleman and how much he hath eaten: they are never curst but when they are hungry: if there be any of him left, I’ll bury it.”

Shakespeare

A Winter’s Tale, III-3/132