Volatility signals investors' dilemma

Friday 7th April 2000

HORNS OF DILEMMA: While bulls are convinced the US economy has entered a a new era of limitless growth, some bears are predicting a catastrophic crash

Millions of investors in the US sharemarket are finding it difficult to sleep at night because of the wild swings. NEVILLE BENNETT looks at what's going on

It has been an extremely volatile first quarter for shares and the roller coaster ride is continuing. The Nasdaq fell about 10% in the last week of March alone. On one of those days it fell 4% or 186 points, the fifth largest points fall in one day. During the quarter, the market moved 2% more than 20 times. On Monday this week, it fell a record 349 points, or 7.6%.

This turbulence is unusual: the 10 largest points gains and nine of the 10 greatest points losses occurred in 2000. It seems the markets' psychological nerve is unraveling as traders' moods swing between euphoria and despair. And in a global age, a fall in one market evinces a sympathetic response in others.

Many funds are bailing out. One notable ship-jumper is Julian Robertson, owner of the huge Tiger hedge fund. He voiced the experience of millions when he said he could not sleep at night because of the volatility.

Investors are on the horns of a dilemma about what is happening in the economy. There are some bears who predict a catastrophic crash and bulls who are convinced the US economy has entered a new era of limitless, non-inflationary growth that will propel the Dow to 50,000 by the year 2010. Many are bearish one day and bullish another.

Volatility emphasises the riskiness of investing. An appreciation of the risk is quite general, but that indicates history has been stood on its head. Investing used to be a safe activity.

Investors in equities rarely risk losing their shirt but they can easily lose the fruit of years of saving. Many top portfolio advisers recommend reducing exposure to equities and acquiring less volatile fixed interest securities.

Unfortunately bonds are not risk free. The only guaranteed elements about government bonds are that the capital will be redeemed on maturity and interest will be paid regularly. The market will depress their price sharply if interest rates appreciate, with titillating yields, but the risk of default is high.

Credit rating agency Moody's says defaults on business bonds were higher in 1999 since 1991 and it predicts defaults will near 6%, double the historic rate of 3.25%. Actually, the risk of default has increased because many "old economy" companies have tried to kick their share price higher through buy-backs. Debts of non-financial business have increased 32% in the last year - the fastest growth since the rather weird year of 1985.

It takes some intestinal fortitude to buy junk bonds and investors are prone to rapid switching. Switching investments is another cause of volatility.

The evidence for switching is patent. There is a tremendous volume of equity transactions on the New York Stock Exchange. On average, every share in every listed company charges hands once every year. This is quite extraordinary, for in 1981 it was once every three years and in 1974 it was once every six years.

Ironically the "value" investors may be a cause of volatility. Traditionally their strategy is to buy and hold good sound stocks, but they have suffered as the market has driven down the value of blue chips (NBR, March 10).

Many fund managers have been obliged by their poor performance to purchase technology stocks. But when they falter, they switch back to the value stocks. This happened last Monday when Microsoft got rebooted and the Dow ended up 300 points while the Nasdaq plummeted.

The huge weight of index funds has a role. Managers buy shares when they are rising and sell them when they are falling to align their portfolios with market weightings. This exaggerates the rise and falls of the shares, giving quite extraordinary daily swings in individual shares.

If a share falls out of the index it is not regarded as, say, number 31 by capitalisation rather than 29 (a minor change). It is dumped. On March 31, Brierley Investments fell out of the Australian indices and its price melted from 49NZc to 39NZc.

But the real problem seems to be uncertainty about how to value shares. The old economy shares have high debt ratios and this will cause concern as interest rates rise this year, eating into profitability.

Even worse, many investors will wonder about the viability of some old economy shares in the internet era. Economists are speaking of a "nude" economy because the internet has made it more transparent and exposed, where buyers and sellers can more readily compare prices on a global scale. Already the internet has reduced many retail prices by 10%. The biggest impact, however, is going to be in business to business (B2B) transactions.

B2B will cut costs by reducing procurement costs, allowing better supply management and inventory control. Investors in old economy equities have to question how their selected firms will cope with revolutionary change.

New economy investors are also beset with uncertainty. Many will be aware their selected firms have no assured markets in a milieu where competitors are willing to pay heavy startup costs to enter potentially profitable areas. Tech stocks are volatile partly because there is a plethora of news of new listings and new breakthroughs that potentially menace the core business of even recently established firms.

Price remains the basis of tech share volatility. Until now investors could say, "I know xdot.com has limited earnings and is unlikely to be profitable in the medium term, but its price keeps increasing."

Many investors have the joyous experience of reaping huge gains from tech stock listings. So investors jump on the bandwagon for the ride, trusting their instinct to jump off at the last minute before a crash. The problem is that in the 1987 crash the exits were jammed by sellers clamouring to find buyers, who were in short supply.

There are signs the rush to get rich by subscribing to any dot.com will slow. Some new listings have burned the would be stags. Techs have taken a terrible beating in Europe, where the German Neuer index lost 13% on March 30-31. New listings are over-supplied and prices are falling.

One important feature is that over-subscription is no guarantee of a triumph, for heavily hyped stocks such as World Online and Lycos Europe slipped on opening despite being over-subscribed 30 times.

Volatility has also increased because many trades are made by speculators who buy on the margin. The New York Stock Exchange reports margin trading rose 8.9% in February to a record $US265 billion. Federal Reserve chairman Alan Greenspan, so often somewhat tolerant of easy money, has expressed grave concern about the buying of stocks with borrowed money, as have authorities in Hong Kong and London.

Volatility can also be an indicator of an impending share crash. Perhaps investors are not unsure of stocks' true value; perhaps they know they are overvalued and fear a stiff correction.

Yale's Robert Schiller has calculated the price-earnings ratio of the Standard & Poor's 500 has soared to 44, a third higher than the 1929 crash's 33. It also exceeds the other peaks of 1901 and 1966.

In short, the extraordinary contemporary turbulence could just be an augury of the last days of a wobbly bubble.

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