Transcript Understanding the Late 1990s Large

Understanding the Late 1990s
Large-Cap
Stock Market Bubble
David L. Debertin
Professor of Agricultural Economics
University of Kentucky
[email protected]
Foreword
This slide show is designed to help
better understand the conditions that
led to the bubble in large-cap stock
prices in the late 1990s, and what
happened as and after the bubble
burst…
The following graph provides a comparison of two
actively-managed mutual funds that are
representative of the performance of actively
managed funds that can be characterized as LargeCap Growth versus Small and Mid-Cap Value for a
15-year period beginning in 1990. The Large-Cap
Growth fund is Fidelity Growth Company (FDGRX)
and the Small and Mid-Cap Value fund is Fidelity
Low-Priced (FLPSX). Share prices for both have
been normalized to $1 a share for both funds at the
start of the period.
4/6/2004
4/6/2002
4/6/2000
4/6/1998
4/6/1996
4/6/1994
4/6/1992
4/6/1990
Normalized Share Price for Each Fund
14
12
10
8
FLPSX
6
FDGRX
4
2
0
Note that in the mid 1990s, FDGRX starts to
increase much more rapidly than FLPSX, and there
are instances in 1998 and 1999 where FLPSX is
nearly flat. During these periods, investors are
underinvesting in small and mid-cap value stocks to
take advantage of the boom in large cap growth
stocks
In March of 2000, The NASDAQ and FDGRX peaked, followed
by a steep sell off. Notice that FLPSX continued to rise
throughout this period as investors began to rotate some of the
proceeds from the sale of Large-Cap Growth stocks into
purchases of Small- and Mid-Cap Value stocks. There was a
secondary large cap growth peak in August of 2000, but after
that large cap growth stock prices deteriorated rapidly. However,
some of the proceeds from the sale of large-cap growth stocks
continued to be reinvested in small- and mid-cap value stocks,
and FLPSX continued to rise through most of the period. Even in
the steep overall market sell off of 2002 (22% loss in the S&P
500), FLPSX lost very little (about 6 %). Large-cap funds
focusing primarily on stocks with above market average P/E
ratios fared even worse than the S&P 500, with FDGRX Being
off over 33 percent that year. This performance is typical of
Large-Cap Growth funds with portfolios containing a lot of
above market average P/E stocks in 2002.
Consider the period from 1995 through 1999, when even
the S&P 500 was going up at 20 % per year, and funds
with larger NASDAQ 100 exposure were going up
even faster.
Given the market capitalization represented by these large
companies, it took huge amounts of new injections of cash
each year during the period to sustain these annual
percentage gains. In retrospect, it’s surprising that a large
cap rally of this magnitude was sustainable for as long as
it was. At some point investors run out of new
cash to invest.
In contrast, a 20% + rally in small and mid-cap value
stocks is much easier to sustain because the the total
market cap of the entire group of stocks is much smaller.
Far smaller annual cash inflows are needed to sustain 20%
annual appreciation rate in Small- and Mid-Cap Value
than in Large-Cap Growth.
To the extent that lots of cash flows into funds holding
primarily small and mid-cap value stocks, the major
problem fund managers face is identifying stocks
that are cheap on a P/E basis yet represent
favorable opportunities for further gains.
So we see lots of small and mid –cap value funds
closing to new investors (FLPSX, RYLPX) as soon as
these inflows start to get unmanageable.
A fund manager for a large-cap growth fund facing
inflows will not likely run into the same problem to near
the same degree.
Fortunately for investors with new money to invest, there
are now index funds concentrating on small and mid cap
value (i.e. VISVX) as well as Exchange Traded Funds
(ETF’s) that allow investors to purchase S&P/Barra and
Russell Value indices directly. Still, the underlying value
stocks need to be able to absorb the cash inflows without
too much increase in the P/E’s .
Since early 2000, we have yet to have a sustained
rally in large-cap growth stocks, although investors in
small and mid-cap value stocks (and funds with investment
objectives similar to FLPSX) have continued to
fare well through most of the period. We have had some
short periods of 1-3 months in outperformance
of Large-Cap Growth over Small-and Mid-Cap Value
but not longer time periods. This suggests that
having gotten burned by holding large cap growth stocks
after April 2000, investors are very wary of investing in
large-cap stocks that do not appear to offer good value.
Investors in 2004 appear to have shown increasing
interest in large-cap value stocks as the year progressed,
however (GARP).
In the following diagrams, assume that the
large green circle represents the total market
capitalization of all large-cap growth stocks, and the
red circle represents the total market capitalization of
the universe of small- and mid-cap value stocks at
the beginning of the run-up in large cap growth
stocks in the mid 1990s. The red circle is much
smaller because the total market capitalization of all
small- and mid-cap value stocks (those with belowmarket P/E ratios) is much smaller than for large-cap
growth.
Large-Cap Growth
Small-and
Mid-Cap Value
As we move into 1998 and 1999, Large-Cap Growth
Substantially outperformed Small and Mid-Cap Value.
Fund managers complained that no one was interested in
buying below-market P/E stocks, especially in the smalland mid-cap size range. Funds emphasizing these stocks
fared poorly, even relative to the S&P 500 (which
was increasingly dominated by small, high market cap
technology firms with few employees or earnings, but
nosebleed stock prices). Often these were technology or
Internet-related firms as investors showed little interest in
stocks of firms in sectors thought to be slower growing at
any market capitalization level large or small.
This was a period of extreme euphoria in the US. The Cold
War had been won, the federal budget was showing an increasing
surplus—something that had not happened in ages.
Business schools were talking about new theories of stock
valuation that no longer relied as much on current earnings, and
companies were stressing their pro forma profits that excluded
many expense items. Pro forma profits as reported to
Wall Street could be nearly whatever the company officers
wanted them to be, ignoring costs whenever convenient.
Sadly, many accountants went along with this “new accounting
math”.
Meanwhile you had near startup Internet-based companies with
billion dollar market caps, and officers with net worths of 10s
and even 100s of millions of dollars based on the price of the
stock in a recent public offering.
You had companies like AOL becoming an S&P 500-sized firm
based on market capitalization and having enough value to
enable it to gobble up older, established but slower-growing
traditional media firms such as Time Warner.
By early 2000 an increasing number of people including investors
started to believe that share prices could not grow to the sky
without real (and not just pro forma) earnings, and the
bubble burst, first in April of 2000 with a steep sell-off in
high-growth, high P/E technology firms, followed by a short rally
into August 2000 which was quickly followed by a
sharper and still deeper downturn.
The air was starting to go out of the large-cap Growth balloon!
Large-Cap Growth
Small-and
Mid-Cap Value
Whenever investors sell stocks, the proceeds from
The sale must be parked somewhere.
We know now that in the sell off starting in 2000,
many investors wanted to believe that the
downturn was very temporary.
Therefore they parked large amounts of cash
in money market funds and other accounts where
their principal would at least be safe.
All this cash caused interest rates on money
market funds to fall to historically low levels.
Option 1: Hold Cash with the idea of
moving back into the market soon
Large-Cap Growth
Small-and
Mid-Cap Value
Cash, MoneyMarket Funds
A second option was to park cash from the proceeds
in US Government or high-grade corporate bonds.
Investors who did this fared quite well for a period of
time, as the Federal Reserve was increasingly
worried about the threat of a recession (in part
brought on by the puncturing of the Large-Cap
balloon), rather than inflation. As interest rates begun
their slow decline, bondholders who had gotten out
early saw the value of bonds they purchased in 2000
and 2001 appreciate in value.
Option 2: Invest in Government Debt or
High-Grade Corporate bonds
Large-Cap Growth
Small-and
Mid-Cap Value
Cash, MoneyMarket Funds
Government and
Corporate Bonds
A third major option involved rotating proceeds
from the sale of Large-Cap Growth stocks and
mutual funds into another segment of the market.
Here the relative size of the large-cap growth side
of the market versus small- and mid-cap value side
is important. If only a small portion of proceeds
from the sale of large-cap growth stocks get
reinvested into small- and mid-cap value stocks
and funds, because the total market cap is so much
smaller in that segment, that will be enough to fuel
a strong up-movement in small- and mid cap
stocks and funds containing those stocks.
Option 3: Invest in Small-and Mid-Cap
Value stocks
Large-Cap Growth
Small-and
Mid-Cap Value
Cash, MoneyMarket Funds
Government and
Corporate Bonds
The period of relative outperformance of small- and
mid-cap value stocks and funds relative to large cap
growth funds continues through 2004, with only brief
largely unsustainable rallies on the large-cap growth side.
It is important to note that because of the comparative
size of the total market capitalization of stocks labeled
Large-Cap Growth versus Small- and Mid- Cap Value, it takes
far less newly invested cash to sustain this
relative overperformance on the Small- and Mid-Cap
Value side of the market. In short, the outperformance of
Small and Mid-cap Value relative to Large-Cap Growth could
continue for some time to come.
Meanwhile we still have lots of investors with
proceeds from stock sales when the large-cap
growth bubble burst still earning low rates of interest
on money market funds.
Life is about to become far more difficult for those
holding cash in bonds, as the value of more recently
purchased bonds decrease as interest rates begin
a slow but steady rise. The bond market quickly becomes
a Chinese water torture in which assets are depleted
a drop at a time, and investors will increasingly want
to find other opportunities for the money invested
in bonds as the Fed does its thing with respect to
slowly raising rates, and the full impacts of the huge
federal deficits start to hit the credit markets.
Over the next several years, barring major terrorist attacks or
another major economic downturn, more and more of the
money now parked in money market accounts and shorter-term
government bonds will likely come back into the equities
market in some form.
An interesting question is what side of the market will
that money tend to favor. Investors still clearly remember
what happened to their investments when the balloon burst in
2000, and those that simply held on still are a long
ways from having fully recovered.
Meanwhile they also observe the recent data showing
outperformance of Small- and Mid-Cap Value. Even a small
portion of new cash gets invested on this side a rally in these
stocks may very well continue.
Because of its size, the large-cap side of the stock market
has a far greater capacity to absorb huge cash inflows
than does the small and mid-cap side. Further, if we are
looking at the universe of small- and mid-cap stocks that
can be bought at below market average P/E ratios, unless
earnings rise in line with the purchases using net cash inflows,
P/E ratios could quickly rise, making the stocks no longer a
Value play. Both the indexes and actively-managed funds
no doubt have definite sell rules when a once value stock is
to be sold or dropped from an index. Otherwise a Value fund
would not remain a Value fund for long!
Meanwhile you have the effort toward privatizing a portion
of social security. The Social Security Trust fund is running
a current surplus in that current collections exceed current
payouts. Currently, that surplus is used to finance the national
debt in that it is used to purchase government bonds. The
federal government could fairly readily privatize a portion
of social security by permitting working people to place a
share of that current surplus in a privately held account with
their own individual names on it—i.e. a vested versus the
current non-vested (pay benefits as you go) plan.
One option in a vested plan would be for the individual to
invest that money in US government bonds. That is what
happens to the trust fund surplus right now, except that those
bonds are not tied to a particular worker.
But the most interesting possibility would be allowing
at least a portion of the privatized dollars to be invested
in the equities markets.
Even a small portion privatized would represent a huge sum
of cash for the equities markets to absorb, and quickly
would go beyond the amounts the small-and mid-cap side
of the market could absorb. Further, the Federal government
at least initially would likely believe that the large-cap
equity markets represent less long-term risk than
the small- and mid-cap markets, and workers may not have
alternatives that go beyond funds dominated by large-cap
stocks.
So social security privatization might lead to a mini-boom
in large-cap stocks and funds as the markets absorb the
new cash (cash currently in government debt instruments).
If workers are permitted to move privatized social security
accounts into investments other than US Government debt,
in essence they will each be selling some of the Government
bonds now represented by the current surplus in the
Social Security Trust fund. The Government will still have
to finance the debt once financed by trust fund surpluses,
and in order to do this, interest rates on government debt
will likely rise.
Meanwhile investments in equities by workers paying into
social security should lead to growth in
the private sector. Tax revenues from this growth might
to a degree offset increased expenditures by the federal
government for interest on the national debt.
The Corporation
One way of viewing a corporation is that it is simply
a mechanism for deploying capital
From a capital budgeting perspective, corporations
seek to deploy capital in such a way that will permit
them to earn above market average internal rates of
return
Were this not true the investor would do better by
simply investing in the market index
Large corporations need large capital projects for them
to have any meaningful impact on rates of return and
earnings
Many large-cap corporations appear to be running out
of ideas for deploying capital at high rates of return
Microsoft gives investors back a large dividend rather than
deploying capital in high payoff projects within the firm
AT&T deploys capital in projects earning below average
rates of return?
GE In the 90s an exception, but now?
Mid- and small-cap firms need to implement smaller projects
than large firms do in order to positively affect overall rates
of return and earnings
Smaller firms have more opportunities to increase Economic
Value Added (EVA)
Smaller not larger firms have the potential for faster year
over year growth rates
Projects with high potential payoffs can be riskier than
projects with lower payoffs
Larger firms have some advantages:
1. Less competition
2. Dominance over markets
3. Access to capital
4. Name recognition
Markowitz-Sharpe Portfolio
Theory
Nobel-prize winning economists Harry Markowitz
and Robert Sharpe developed the underlying theory
that forms the basis for the mutual fund industry.
They argued that a properly diversified portfolio of
volatile stocks would be substantially less volatile
than each individual stock in the portfolio taken alone
Their solution to diversification suggested picking
individual stocks for a portfolio that all have a
good potential for high returns over a long period of
time, but combine stocks whose returns patterns often
do not move together.
Markowitz and Sharpe would likely have suggested
that an investor diversify by putting half the original
investment in FLPSX and the other half in FDGRX.
The returns would have looked like the red line on
the following graph
Value of $1000 for each Model
$14,000.00
$12,000.00
$10,000.00
All Value
$8,000.00
All Growth
$6,000.00
Half in each
$4,000.00
$2,000.00
Date
4/6/2004
4/6/2002
4/6/2000
4/6/1998
4/6/1996
4/6/1994
4/6/1992
4/6/1990
$0.00
The Diversified (Markowitz-Sharpe) strategy which
puts half the initial investment in each fund (FLPSX
and FDGRX) appears to be better than the all-Growth
(all FDGRX) strategy but more volatile and risky
than the all-Value (all FLPSX) strategy.
Losses in 2000-2002 for the Diversified strategy
while a bit muted are still substantial, and month to
month variation in returns remains high.
The Holy Grail of Investing
The Holy Grail of investing is a model that would
tell the investor that relative gains from one fund
(or stock) are starting to increase in comparison with
another fund or stock, and then also signal when the
relative gains are beginning to narrow.
Such a model would provide the necessary signals so
that the investor could ride up a market bubble such as
that which occurred in Large-cap growth stocks and funds,
and them move into something else (perhaps a Value fund)
just after the bubble begins to burst.
I have developed such a model and that model appears
to accurately signal when an investor should be in
Large-Cap Growth (FDGRX) versus Small and Mid-Cap
Value (FLPSX).
Graphing the model results, we get the following graph from
a one-time $1,000 investment in April, 1990 to
December, 2004
All Growth= $1,000 FDGRX bought and held
All Value = $1,000 FLPSX bought and Held
Switching = $1,000 invested according to signals from the
Debertin spreadsheet Switching Model
Value of $1000 for each Model
$30,000.00
$25,000.00
$20,000.00
All Value
$15,000.00
All Growth
Switching
$10,000.00
$5,000.00
Date
4/6/2004
4/6/2002
4/6/2000
4/6/1998
4/6/1996
4/6/1994
4/6/1992
4/6/1990
$0.00
The Debertin Switching model generates an ending
value about twice as great as the buy-and-hold Value
(FLPSX) strategy, and about four times as great as
the buy-and-hold Growth strategy
$6,135 All Growth= $1,000 FDGRX bought and held
$12,055 All Value = $1,000 FLPSX bought and Held
$9,095 = Markowitz-Sharpe Diversified ($500 in FLPSX,
$500 in FDGRX)
$25,359 Switching = $1,000 invested according to signals
from the Debertin spreadsheet Switching Model
The Switching model requires only a limited number
of rotations between FDGRX and FLPSX over the
entire period, and signals when they should
occur with a high degree of accuracy
Further details about implementing the Debertin Holy Grail
Switching model can be found at
http://www.dldebertin.com/finance/grail.htm
----David L. Debertin