March 10, 2005
Why The Mania Lives

Today the media talking about the lessons that have been learned following the Nasdaq crash. But what most neglect to mention is that following what was supposedly one of the biggest stock market busts in history, barely any ‘bubble believers’ have left the stock market.  To be sure, at the height of the mania 49% of U.S. households – or 51.1 million households – owned mutual funds, and the latest numbers from ICI (for 2003) say that 53.3 million households are playing the mutual fund game. Compare these numbers to 1980 when only 4.6 million U.S. households owned stocks (or 5.7% of all households).

Has the average U.S. fund investor – mutual, hedge, or other – really learned the lesson of Nasdaq 5,000? Or is the average U.S. investor still blinded by the belief that stocks are a form of savings? Time will tell.

Remembering Those Mania Days

In 1999 the U.S. Federal Reserve Board faced a quandary: on the one hand the U.S. equity markets were clearly being overrun by speculators in search of quick profits, and on the other Y2K threatened to bring the technology backed world to a standstill.  Needless to say the Fed did as it was expected to do, keeping the printing presses running and monetary policy loose.  

It is impractical to argue that the Fed was responsible for the stock market mania.  Rather, although Fed policies created excess liquidity during the late 1990s, that this liquidity ended up chasing technology stocks is not directly the fault of Greenspan.  To argue that Wall Street was responsible for the market mania is equally myopic: Wall Street is in the business of selling its products to investors and making money regardless of how the stock market performs -- it was business as usual for Wall Street in 1999/2000 just as it is today. 

No, the real reason why the U.S. stock market mania reached such fantastic heights was because - despite all of the warnings – the average investor still hypothesizes about future results by using past performance as a guide.  In other words, the Nasdaq surpassed 5,000 five years today because economic and financial market success acted as a powerful virus: Nearly everyone was infected by the idea that recent history had usurped real history, or that ‘this time’ it really was ‘different’.

Nasdaq 5,000 – Little More Than A Feeling

By early 2000 the Fed had consistently ‘proven’ that it could successfully avert financial disasters (1987, Asian crisis, LTCM, etc.), Wall Street had temporarily proven adept at forecasting mania trends, Y2K fears proved to be unfounded, and – most importantly – the U.S. dollar had proven itself as the safe haven choice for global capital flows. In short, leading into 2000 the feeling from market participants was that if any economic or financial disturbance arose the Fed would save the day, Wall Street would know what to do, and safe haven money would continue to choose America (as it did during every financial crisis in the 1990s).

Arguing that the mania was feeling or faith driven may seem absurd.  Nevertheless, when someone who has no knowledge of investing puts their savings into a stock fund no other explanation will suffice. As for the theory that the ‘dream of riches’ made the bubble possible – since your neighbor or co-worker makes money in YHOO you run out and buy the next hot IPO – this doesn’t fully explain insane stock prices. Rather, the U.S. stock bubble slowly inflated because of regulatory changes, technology changes, and successive years of economic and financial market success.

Very Little Has Changed Today

Despite the stock market crash and/or three year bear market, the average investor has not given up hope.  Rather, loose fiscal and monetary policies have ‘proven’ – at least for the moment - that severe economic recessions will never occur again, Wall Street has successfully sold the idea that all stock market declines are buying opportunities, and foreign capital has continued (this time by purchasing U.S. Treasuries) to funnel into the United States. In short, the average investor is armed with the knowledge that despite the stock bubble and bust when weeds arrive in one place (i.e. stocks) flowers blossom elsewhere (i.e. houses). Thus, the overall outlook is still that of roses.


The Promise of Profits is Infectious

Commenting on the Nasdaq’s (peak) anniversary Joseph Battipaglia, chief investment officer at Ryan Beck & Co., said yesterday that “The people involved in the whole dot-com bubble based so much of their businesses on assumptions that couldn't last”. That Mr. Battipaglia still has a job selling his financial market speculations is all of the proof anyone needs that the mania still exists. After all, one day before the Nasdaq peak Mr. Battipaglia was calling for Nasdaq 6,000 and recommended a portfolio made up “100% equities”. Anyone that is this wrong should be forced out of the business.

That being said, the business of selling stocks seems unlikely to ever die.  Rather, although technological advances over the last decade have made owning and researching individual companies easier, the average American still elects to acquire exposure to the stock market via mutual funds (blindly following Wall Street’s ‘diversified’ mantra?). There are more than 4,200 equity funds circulating today, and these funds account for more than half of total mutual fund assets ($4.2 Trillion). This despite the fact that most mutual funds underperform the S&P 500, and that the S&P 500 ETF can be purchased at lower fees than most mutual funds.

Why do so many Americans have faith in U.S. stocks?  Because like a guiding light mantras such as ‘over the long run stocks outperform bonds’ give investors the resolve to hold on.  Indeed, the same virus that made the 1990s possible - or the conclusion that the good times are here to stay - is still alive and flourishing today.

What Lessons Have Really Been Learned?

What has become perfectly, and in some cases painfully clear (for bears), is that most investors will continue to hold on to stocks unless a financial catastrophe arrives.  Ironically, that so many investors continue to hold on could be the heat source for catastrophe in the future.

Regardless, Nasdaq 5,000 may be long gone, but the participation mania still lives.  Moreover, the mania is unlikely to suffer a dramatic shakeout until the platforms that have supported investor ‘feelings’ collapse. Is Greenspan a hero or just a banker?  Is Wall Street usually right or wrong?  Will foreign capital continue to funnel into the U.S. after the next (Asian) crisis or will the heat source for the next crisis be generated in America? These questions are not easily answerable. Nevertheless, the financial markets are currently telling us that Greenspan is a hero, Wall Street is right, and no crisis will ever dampen the investor’s penchant for U.S. stocks and bonds. In fact, perhaps the only indication that everything isn’t roses is that gold is strong and the U.S. dollar is weak.

As per Buffett, the real lesson of Nasdaq 5,000 is to only be greedy when others are fearful.  Fearful is the last word that can be used to describe the markets today. Happy fifth.