IPOs and Superior Returns

IPOs always have fascinated investors. New companies are launched with enthusiasm and hope that they can turn into the next Microsoft or Intel.

Historically,

• The large demand for IPOs means that most IPOs will "pop" in price after they are released into the secondary market, offering investors who bought the stock at the offering price immediate gains.
• For this reason, many investors seek to obtain as many shares in IPOs as possible, so underwriting firms ration the shares to brokerage firms and instituional investors.

A study by Forbes magazine of the long-term returns on IPOs from 1990 to 2000 showed that investing in IPOs at their OFFERING price beat the S&P 500 Index by 4% per year.

However, many investors forget that most IPOs utterly fail to live up to their promise after they are issued. A study by Tim Loughran and Jay Ritter followed every operating company (almost 5000) that went public between 1970 and 1990.

• Those who bought at the market price on the first day of trading and held the stock for 5 years reaped an average annual return of 11%.
• Those who invested in companies of the same size on the same days that the IPOs were purchased gave investors a 14% annual return.
• And these data do not include the IPO price collapse in 2001.

High Dividend Yields and Superior Returns

Another favourite value-based criterion for choosing stocks is dividend yields.

More recent studies by James O'Shaughnessy have shown that from the period 1951-1996, the 50 highest dividend-yielding stocks had a 1.5% higher annual return among large capitalization stocks.

In another study, a strategy based on the highest yielding stocks in the DJIA outperformed the market.

The correlation between the dividend yield and return can be explained in part by taxes. Stocks with higher dividend yields must offer higher before-tax returns to compensate shareholders for the tax differences.

It should also be noted that most current studies, like O'Shaughnessy's, exclude utility stocks, which as a group have by far the highest dividend yield but have vastly underperformed the market over the past decade.

(Another point to note: for a stock that is paying fixed dividend, the high dividend yield reflects a lower price of the stock and a low dividend yield reflects a higher price of the stock. Therefore, dividend yield fluctuates along a range. Dividend yield can be usefully employed as another tool for valuing the stock.)

Value Stocks and Superior Returns

Stocks that exhibit low P/B and low PE ratios are often called value stocks.

Those with high PE and P/B ratios are called growth stocks.

Prior to the 1980s, value stocks often were called cyclic stocks because low PE stocks often were found in industries whose profits were tied closely to the business cycle. With the growth of style investing, equity managers who specialised in these stocks were uncomfortable with the cyclic moniker and greatly preferred the term value.

• Value stocks are concentrated in oil, motor, finance and most utilities.
  
• Growth stocks are concentrated in the high-technology industries such as drugs, telecommunications, and computers.
  
• Of the 10 largest U.S. based corporations at the end of 2001, 7 can be regarded as growth stocks (GE, Microsoft, Pfizer, Wal-Mart, Intel, IBM, and Johnson & Johnson), whereas only 2 (Exxon Mobil and Citigroup) are value stocks; AIG can go either way depending on the criteria used for selection.

A study summarising the compound annual returns on stocks from 1963 through 2000 ranked on the basis of both capitalization and book-to-market ratios appear to confirm Graham and Dodd's emphasis on value-based investing.

• Historical returns on value stocks have surpassed those of growth stocks, and this outperformance is especially true among smaller stocks.
• The smallest value stocks returned 23.26% per year, the highest of any of the 25 categories analysed, whereas the smallest growth stocks returned only 6.41%, the lowest of any category.
• As firms become larger, the difference between the returns on value and growth stocks becomes much smaller.
• The largest value stocks returned 13.59% per year, whereas the largest growth stocks returned about 10.28%.

One theory about why growth stocks have underperformed value stocks is behavioural: Investors get overexcited about the growth prospects of firms with rapidly rising earnings and bid them up excessively. "Story book stocks" such as Intel or Microsoft, which in the past provided fantastic returns, capture the fancy of investors, whereas firms providing solid earnings with unexciting growth rates are neglected.

Another more economically based reason is that value stocks have higher dividends, and dividends are taxed at a higher rate than capital gains. As a result, value stocks must have higher returns to compensate for their higher taxability. However, tax factors cannot explain the wide spreads between small value and growth stocks.

The differences in the return between large growth and large value stocks appears to wax and wane over long cycles.

• Growth stocks gained in the late 1960s and peaked in December 1972, when the "nifty fifty" hit their highs.
• When investors dumped the nifty fifty, growth stocks went into a long bear market relative to value stocks. One of the reasons for this was the surge in oil stocks, which are classified as value stocks, when OPEC caused petroleum prices to soar.
• From 1982 onward, growth stocks gained relative to value stocks, soaring in the technology boom of 1990-2000, only to fall again when the euphoria subsided.
• In fact, large growth stocks have outperformed large value stocks in about half the years since 1963.

BARRA, Inc., a California-based stock research firm, has divided the firms in the S&P 500 Stock Index into two groups of growth and value stocks with equal value on the basis of the firm's market-to-book ratio. Using the ratio of the cumulative return on these two large capitalization growth and value indexes since Dec 31, 1974, when the indexes were first formulated:

• On the basis of capital appreciation alone, growth stocks, with a 11.06% annual return, beat value stocks by 0.31% over this 37-year period.
• However, these value stocks have dividend yields that are about 2 % above that of growth stocks. When dividend yields are included to find total cumulative returns, value stocks' return of 15.6% per year outperformed growth stocks by about 1.9%.
• However, for taxable investors, the difference between the cumulative returns on S&P growth and value stocks has been very slight over the past 27 years, a difference of only 0.69%.

Furthermore, the unprecedented volatility of growth stocks relative to value stocks in recent years has played havoc with historical data.

• For someone who began investing in 1975, the technology bubble of the late 1990s sent after-tax growth returns higher than after-tax value returns from September 1999 through September 2000.
• Once the bubble popped, however, growth stock returns fell back below those of value stocks very quickly.

It should be noted that beginning the growth and value series in 1975 is very favourable for value stocks.

• Large value stocks crushed large growth stocks from 1975 through 1977, when soaring oil prices sent the price of oil and resource firms (which are always ranked as value stocks) skyrocketing.
• Since August 1982, when the great bull market began, cumulative returns for growth and value investors have been almost identiacal, even after the growth stock collapse of 2000-2001.

Also read:

Nature of Growth and Value Stocks

Nature of Growth and Value Stocks

These designations are not inherent in the products the firms make or the industries they are in. The terms depend solely on the market value of the firm relative to some fundamental variable, such as earnings, book value, etc.

The stock of a producer of technology equipment, which is considered to be an industry with high growth prospects, actually could be classified as a value stock if it is out of favor with the market and sells for a low market-to-book ratio.

Alternatively, the stock of an automobile manufacturer, which is a relatively mature indsutry with limited growth potential, could be classified a growth stock if its stock is in favor.

In fact, over time, many stocks go through value and growth designations as their market price fluctuates.

The literature often showed value stocks beating growth stocks. What does this mean?

• As many stocks go through value and growth designations as their market price fluctuates, this implies that stocks become priced too high or low because of unfounded optimism or pessimism and eventually will return to true economic value.
• It definitely does not mean that industries normally designated as growth industries will underperform those designated as value industries.

There is no question that investors always should be concerned with valuation, no matter which stocks they buy.

Price-to-book ratios and Superior Returns

PE ratios are not the only value-based criterion for buying stocks. A number of academic papers, begining with Dennis Stattman's in 1980 and culminating in the paper by Eugene Fama and Ken French in 1992, have suggested that price-to-book P/B ratios may be even more significant than PE ratios in predicting future cross-sectional stock returns.

Like PE ratios, Graham and Dodd considered book value to be an important factor in determining returns. More than 60 years ago, they wrote:

We suggest rather forcibly that the book value deserves at least a fleeting glance by the public before it buys or sells shares in a business undertaking..... Let the stock buyer, if he lays any claim to intelligence, at least be able to tell himself, first, how much he is actually paying for the business, and secondly, what he is actually getting for his money in terms of tangible resources.

Low PE stocks and Superior Returns

In the late 1970s, Sanjoy Basu, building on the work of S.F. Nicholson in 1960, discovered that stocks with low PE ratios have significantly higher returns than stocks with high PE ratios.

This would not have surprised Benjamin Graham and David Dodd, who in their clasic 1934 text, Security Analysis, argued that a necessary condition for investing in common stock was a reasonable ratio of market price to average earnings. They stated:

Hence we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 16 times their averge earnings are likely to lose considerably money in the long run.

Yet even Benjamin Graham must have felt a need to be flexible on the issue of what constituted an excessive PE ratio. In their second edition, written in 1940, the same sentence appears with the number 20 substituted for 16 as the upper limit of a reasonable PE ratio.

What types of PE ratios are justified in today's economy?

Small Cap Stocks and Superior Returns

In 1981, Rolf Banz, a graduate student at the University of Chicago, investigated the returns on stocks using the database provided by the Center for Research in Security Prices (CRSP). He found that small stocks systematically outperformed large stocks, even after adjusting for risk as defined within the framework of the capital asset pricing model.

Some analysts maintain that the superior historical returns on small stocks are compensation for the higher transaction costs of acquiring or disposing of these securities. This means that there may be an extra return for illiquidity. Yet, for long-term investors who do not trade small stocks, transactions costs should not be of great importance. The reasons for the excessive returns to small stocks are difficult to explain from an efficient markets standpoint.

Although the historical return on small stocks has outpaced that of large stocks since 1926, the magnitude of the small stock premium has waxed and waned unpredictably over time.

Distressed Firms and Superior Returns

Despite the higher returns provided by value-based firms, there is one class of stocks, those of distressed firms, that has achieved some fo the highest returns of all.

Many distressed firms have negative earnings and zero or negative book value and pay no dividends.

Research has shown that as the ratio of book value/price or earnings/price declines, so does the return. However, when book value or earnings turn negative, the price of the stock becomes so depressed that the future returns soar.

This same discontinuity is also found with dividend yields. The higher the dividend yield, the higher is the subsequent return. However, firms that pay no dividend at all have among the highist subsequent returns.

Research revealed that most stocks that have negative earnings or negative book values have experienced very adverse financial developments and have become severely depressed. Many investors are quick to dump these stocks when the news get very bad. This often drives the price down below the value justified by future prospects. Few investors seem able to see the light at the end of the tunnel or cannot justify - to themselves or to their clients - the purchase of such stocks under such adverse circumstances.




(Note: Tongher)

What factors can investors use to choose individual stocks with superior returns?

What factors can investors use to choose individual stocks with superior returns?

Earnings
Dividends
Cash flows
Book values
Capitalization
Past performance

These, among others, have been suggested as important criteria to find stocks that will bear the market.


Security analysis cannot presume to lay down general rules as to the "proper value" of any given common stock.... The prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions.
Benjamin Graham and David Dodd

Stock Prices and Future Stock Returns

The PE ratio can be a very misleading indicator of future stock returns in the short run, in the long run, the PE ratio is a very useful predictor.


Current yield of a bond = interest received / price paid
(Current yield of a bond is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.)


Earnings yield of a stock = EPS / price


Since the underlying assets of a firm are real, earnings yield is a REAL, or inflation-adjusted return. Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.

This contrasts with the NOMINAL return earned from fixed-income assets (like bonds), where all the coupons and the final payment are fixed in money terms and do not rise with inflation.

The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns. The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%. This earning yield exactly matches the 6.8% real return on equities from 1871.

There are limitations to using the PE ratio to predict future short-term stock returns.

• For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.
• And in the short run, there are many other sources of market movement, such as changes in interest rates or the risk premium demanded by stockholders.

Stocks for the long run - buy the dips

Most investors claim to retain their faith in stocks as the best long-term investments. Experience showed that market sell-offs were indeed ideal times for investors to commit more to the market. The mantra of the common investor in the 1990s was "Buy the dips."

Despite the steadfast faith in the market, the bear market of 2000 - 2001 has raised doubts in many minds about the desirability of holding the overwhelming proportion of a portfolio in stocks.

• Has the continued popularity of the stock market planted seeds of its own destruction?
• Have investors sent equity prices so high that they cannot in the future possibly match their superior historical returns?

The answer to these questions must come from an understanding of how stock prices influence their future returns.

An important lesson from the October 1987 crash

A comparison of the DJIA from 1922 - 1929 and 1980 - 1987 showed an uncanny similarity between these two bull markets. On October 19, 1987, we witnesse d the greatest 1-day drop in the stock market history, exceeding the great crash of October 29, 1929. In fact, the market in 1987 continued to trade like 1929 for the remainder of the year. Many forecasters, citing the similarities between the two periods, were certain that disaster loomed and advised their clients to sell everything.

However, the similarity between 1929 and 1987 ended at year's end. The stock market recovered from its October 1987 crash and by August of 1989, hit new high ground. In contrast, 2 years after the October 1929 crash, the Dow, in the throes of the greatest bear market in U.S. history, had lost more than two-thirds of its value and was about to lose two-thirds more.

What was different? Why did the eerie similarities between these two events finally diverge so dramatically?

The simple answer is that in 1987 the central bank had the power to control the ultimate source of liquidity in the economy - the supply of money - and, in contrast to 1929, did not hesitate to use it. Heeding the painful lessons of the early 1930s, the Federal Reserve temporarily flooded the economy with money and pledged to stand by all bank deposits to ensure that all aspects of the financial system would function properly.

The public was reassured. There were no runs on banks, no contraction of the money supply, and no deflation in commodity and asset values. Indeed, the economy itself moved upwards despite the market collapse. The October 1987 stock market crash taught investors an important lesson - that a crisis can be an opportunity for profit, not a time to panic.

Volatility is the friend of the value investor

Although most investors express a strong distaste for market fluctuations, volatility must be accepted to reap the superior returns offered by stocks. Risk and volatility are the essense of above-average returns: Investors cannot make any more than the risk-free rate of return unless there is some possibility that they can make less.

While the volatility of the stock market deters many investors, it fascinates others. The ability to monitor a position on a minute-by-minute basis fulfills the need of many people to know quickly whether their judgement, which affects not only money but also ego, has been validated. For many people, the stock market is truly the world's greatest gambling casino.

Yet this ability to know exactly how much one is worth at any given moment also can provoke anxiety. Many investors do not like the instantaneous verdict of the financial market. Some retreat into investments such as real estate, for which daily quotations are not available. They believe that not knowing the current price makes an investment somehow less risky.!

As Keynes stated over 50 years ago about the investing attitudes of the endowment committee at Cambridge University:

"Some Bursars will buy without a tremor unquoted and unmarketable investment in real estate which, if they had a selling quotation for immediate cash available at each audit, would turn their hair gray. The fact that you do not know how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one."

How high is high and how low is low.

Buying when the VIX is high and selling when it is low have proved profitable in recent years. However, so has buying during market spills and selling during market peaks.

The real question is how high is high and how low is low.

For instance, an investor may have been tempted to buy into the market on Friday, October 16, 1987, when the VIX reached 40. Yet such a purchase would have proved disastrous given the record 1-day collapse that followed on Monday.

VIX: Volatility Index

In 1993, the Chicago Board Options Exchange (CBOE) introduced a volatility index, called VIX, based on actual index option prices and calculated this index back to the mid-1980s.

In the short run, there is a strong negative correlation between the VIX and the LEVEL of the market. When the market is falling, the VIX rises because investors are willing to pay more for downside protection. When the market is rising, the VIX typically goes down because investors become less willing to insure their portfolios against a loss.

When anxiety in the market is high, the VIX is high, and when complacency rules, the VIX is low. The peaks in the VIX corresponded to periods of extreme uncertainty and sharply lower stock prices.

In the early and middle 1990s, the VIX sank to between 10 and 20. With the onset of the Asian crises in 1997, however, the VIX moved up to a range of 20 to 30. Spikes between 50 and 60 in the VIX occurred on 3 occasions:

• when the Dow fell 550 points during the attack on the Hong Kong dollar in October 1987,
• in August 1998 when Long Term Capital Management needed to be bailed out, and,
• in the week following the terrorist attacks of September 11, 2001.

All these spikes in the VIX were excellent buying opportunities for investors. Peaks in the VIX also correspond to periods of extreme pessimism on the part of the investors. On the other hand, low levels of the VIX often reflect too much investor complacency.

What to expect from a unit trust fund's annual report

Annual reports: Read before you weep
Published: 2009/06/10

There is no short cut when you're dealing with investments, even if it is one of the less complicated and taxing reports, says Securities Industry Development Corp

AFTER last week's article, some of you may have already started going through unit trust fund's annual reports for your future funds.

If you somehow stopped at the pages filled with a plethora of numbers, waiting for this installment to be released, so as to get a rough idea about what those numbers represent, do not fret! Read on and we will tell you what the following pages of your annual reports are all about.

Financial Statements

Never ignore the financial statements part! For those of you who are interested in drilling down further into the financial details, what you need to scrutinise are the financial statements that have been elaborately presented before you.

Your financial statements comprise:

* Income Statement

* Balance Sheet

* Statement of Changes in Net Asset Value (NAV)

* Cash Flow Statement

What do all these mean?

* Income Statement

The income statement will provide details on the investment activities, relative to the previous financial year's activities.

This statement will provide you with a way to differentiate the net income/loss contributed by realised gain/loss versus unrealised gain/loss, which is the result of portfolio revaluation.

For example, a fund's net income is reported as RM1 million, but the realised investment loss is RM2 million, offset by an unrealised gain of RM3 million. Here, you can tell that the RM1 million net income reported does not truly reflect the actual performance of the company. It's simply a matter of accounting practice that the amount is recorded as such.

As an investor, you need to be mindful of the unrealised items, such as unrealised gain or loss on foreign exchange, which may appear in the Income Statement.

* Balance Sheet

There are a few critical pieces of financial information that you can learn from this statement:

(i) whether the fund's total asset is appreciating or depreciating as compared to the previous period.

(ii) whether the units in circulation are increasing or decreasing - a significant decrease in units in circulation shows that the cancellation of units is much greater than creation of units for sale, which also implies that the fund is losing popularity among its existing customers.

* Statement of Changes in NAV

This statement will provide the details on the changes in the NAV during the period and differentiate between the changes contributed by investment activities and transactions with unit holders.

You should be able to see the net impact of undistributed income due to investment activities versus movement due to unit creation or redemption.

From here, it will tell whether the increase or decrease in the fund's value is due to investment effort or expansion/shrinkage in the funds.

For example, if a net decrease of RM5 million in NAV is attributed to RM1 million net increase in undistributed income and RM6 million in amount paid on cancellation of units under the movement due to unit redemption, you may want to be more cautious and investigate further on the reasons behind the redemption from the unit holders.

* Cash Flow Statement

This statement tells you where cash flow for the year is being generated and spent, whether the sources of cash flows are from operating or investment activities and financing activities.

Notes to Financial Statements

Notes can be rather mind-boggling but they function as a supplement to the financial statements and help make sense of the numbers presented.


* Management Expense Ratio

As managing a fund requires a whole team of professionals, the cost incurred to run a fund is part of the cost of investing in unit trust for an investor.

The cost inherent in operating a fund includes management fees, trustee fee, audit fee, administrative expenses (printing of annual reports, distribution warrants, and postage) and other service charges incurred in the management of the fund.

Management Expense ratio is the ratio of the total of all the fees incurred for the period deducted from the fund and all the expenses recovered from and/or charged to the fund, expressed as a percentage of the average value of the fund. It can be summarised as follows:

The MER ratio should be fairly consistent over the years. If you see a significant difference from the previous year, you will need to find out the reason for the change. This is a useful ratio to compare the fund you have invested in or intend to invest with other similar funds in your fund selection process.

The higher the MER ratio, the more expenses are required to manage the fund. Therefore, when you draw up comparisons between funds within a similar range, the ones having similar performance but with lower MER will be more beneficial to you as an investor, because less money is being spent by the managers and more is available for distribution.


* Portfolio Turnover Ratio

Portfolio Turnover ratio measures the average acquisitions and disposals of securities of a fund. The calculation is as follows:

The PTR usually comes after the section on MER in an annual report's notes to financial statement. PTR indicates the rate of trading activity in a fund's portfolio of investments. If the PTR is high, it means that the fund manager is constantly changing the companies or financial instruments in the portfolio. As each and every transaction involves cost, high turnover indicates that the transaction cost incurred is high and it will in turn eat into the profit earned, which will eventually not work out to the benefit of the investors.

You should also look for any other extraordinary items stated in the notes to financial statements, especially events that can materially affect the portfolio's performance or investors' interests, such as change of fund managers and investment committee members, compliance issues, change of investment objectives or policies and major change of shareholders.

Now that you know what to expect from a unit trust fund's annual report, it is high time you get started with the actual reading! There is no short cut when you're dealing with investments, even if it is one of the less complicated and taxing reports. You need to know what you are parting your money for and to whom you will be giving it in order to manage it, so "Read Before You Weep!"

Securities Industry Development Corp (SIDC), the leading capital markets education, training and information resource provider in Asean, is the training and development arm of the Securities Commission, Malaysia. It was established in 1994 and incorporated in 2007.


http://www.btimes.com.my/Current_News/BTIMES/articles/sidc17/Article/

Bubbles: Does history guide us?

A historical perspective is an excellent place for everyone to start. It is not the only tool, but it is a beginning. History is some help if one stands back and looks at things from the standpoint of fundamentals. But if we have misinformation, or are misled by fraud or lies, then history can be outweighed and we need to add other tools to the historical perspective.

Bubbles have appeared for millennia, actually.

1. A lot of speculation occurred in the Roman economy, which included money lending and some other aspects of capitalism.

2. One of the most famous manias and bubbles of all time was the tulip mania in Holland in the early 1630s. People believed that ordinary tulip bulbs, which collectors prized, had greter and greater value;. A virus randomly made bulbs of one strain change and become more valuable, introducing an unknown into the game with a gambling or speculative element. Bulbs went up in price as people simply bid them up, and one bulb could be a lot more valuable than an expensive town house. Naturally, there came a point when the market got a bit soft, and rumors went around that there were no more buyers, and so the market crashed.

Call this crazy, if you will, but it is a great lesson in how the combination of human emotions and misinformation can mislead and fool even sophisticated people, and create powerful forces.

3. There were manias surrounding the building of railroads and canals in both England and the United States, since amazing leaps in productivity and economic advantages flowed from these developments. The reality was there and lasted for a long time - twenty years in England actually - but people just got too emotional, and their emotions led them to believe that this economic expansion would last forever. Crashes were always the way these mania-driven phenomena ended. In the United Kingdom, the famous railway mania led to the British financial crisis of 1847. October 17, 1897, was know in London as the week of terror.

Interestingly, the canals and railroads in England created a genuine and huge economic expansion, which in turn created a great deal of wealth before the situation slipped into mania territory. Thus when stocks started to come down in price, the crowd, many of whom were very sophisticated, truly believed it was only a temporary pullback in an expansion that would go on indefinitely. Most of those who got rich on the reality of the expansion were so caught up in the mania that they could not distinguish reality from wishful thinking, so they eventually lost all or most of their wealth.

Bubble lessons never go out of style

Bubble lessons never go out of style, and not only are going to help you with big bubbles, or individual stock bubbles, but will focus you on which information is real and what is perception in almost all of your investing. Learn the lessons well.

With bubbles, there is an element of mystery. To cope with that, start with the first step, knowledge, and combine that with your disiciplined buy and sell strategies, since in a bubble it is likely that the beliefs of the crowd cannot be supported by real knowledge.

A considerable number of people (but not all) in the investment community regarded a wide range of technology, communications, and internet stocks as having almost unlimited demand for their products and unlimited potential - all of which assumptions proved to be incorrect. Yet the entire crowd thought in this way about many Internet companies because of incorrect and incomplete information. Emotions temporarily filled that void. A disciplined buy and sell strategy helps you control your emotion.

The other big factor in irrational behaviour comes when the crowd is deliberately fooled, so some bubbles are either accompanied by or built upon fraud or swindles. In the 2000 Internet bubble, the atmosphere of greed it created did bring out the worst in a number of executives who engaged in what proved to be criminal behaviour, either outright stealing from their companies (as executives of Tyco International and Adelphia Communications did), or engaging in accounting and financial fraud (which is what Bernie Ebbers, WorldCom's chairman was convicted of in March 2005.)

There were 3 bubbles that burst in 2000, and they wer all related to one another.

1. The first was the most obvious: the stock market bubble, which had component bubbles in Internet, telecommunications, and various technology stocks. The excitement over those took almost all other stocks into overvaluation.
2. The second was the bubble in capital spending by corporations in the great telecommunications build-out that was going to accommodate all the new traffic, create broadband access for most businesses and consumers, and handle all the new uses of the Internet. The same beliefs that caused stocks to soar were also driving this corporate capital spending, since the new information about the potential of all sorts of technologies appeared to offer great opportunities. Ultimately, the Internet has proved to be a transforming force (just as, say, the railroads, were in the nineteenth century in Europe) and is changing business and life for many people. Thus, not everything that created the mania was false, and this fact just compounded the confusion.
3. The third bubble was the overall U.S. economy, which reached peak growth rates that wer more than twice the long-term average real growth. The other two bubbles caused that to happen, so when stocks came down, lower stock values and fear caused consumers and corporations to spend less. The biggest effect on the economy was the loss of the part of corporate spending that had been directed into telecommunications, since that was an incredibly large part of the overall picture.

Bubbles have one thing in common; they are going to burst

On March 6, 2000, Larry Summers and Alan Greenspan and many of the senior executives actually waxed poetic about the productivity gains, the technologies, the confluence of our capital markets and great new technological advances, and the fact that it meant great things for our future.

Four days after that March 6, 2000 gathering, on March 10, the bubble burst and the game was over. All had changed.

It all seemed very real at the time, and the senior people in government were getting their information from the sources that had proved the most valuable and trustworthy in the past for all of us: real economic data generated by consumers and corporations, as well as the very best information that the executives running those corporations could give them. We all had seen the same things, and we all had believed.

"Trying to understand is like straining through muddy water. Be still and allow the mud to settle." Lao-Tzu

---

The lessons from this bubble are important for 3 reasons.

1. First, there is the unlikely possibility that we may encounter another stock market bubble in our investing lifetime. One per lifetime seems the 'rule', but we cannot rule out anything completely.
2. Second, we do have small bubbles in the market (smaller than in 1929 and 2000) periodically. These include the one caused by a mania in blue chips (called the "Nifty Fifty") from the late 1960s into early 1973, a moderate technology stock bubble in 1983, and the overvaluation in the market before the 1987 stock market "crash."
3. Third and most important, bubbles occur in INDIVIDUAL STOCKS fairly frequently.

We have all heard the term bubble and also the term mania used over the past few years very, very frequently - when people have talked about possible bubbles:

• in real estate or housing,
• in financial instruments in foreign countries, and
• at times even in the Chinese economy,

which has had some startling growth numbers that are far above anything seen before.

Bubbles, like those from bubble gum or soap, come in all different sizes, but they all have one thing in common with each other, including the gum and the soap bubbles; they are going to burst. They are unsustainable because they are not built on enough real substance to support themselves. Thus, many bubbles develop from a mania. A mania is simply something that is more emotional than tangible or rational, so it can be thought of as irrationality.

The irrationality that leads to the inflating in price beyond what complete knowledge and good analysis would suggest can be the result of one thing or of two or more things in combination.

• The irrationality itself is not very easy to see at the beginning, since there would be no bubble if it were apparent.
• The causes start with beliefs that are exciting, but the crowd does not know what it does not know.
• Knowledge is incomplete or just wrong.

When something appears that is new, and seems to have unlimited potential and some mystery about it, that, to me, is "the big one". This has happened many times in history, as when electricity first came to the household; or with the advent of canals, railroads, and radio in the 1920s and so forth. Perceptions, not analysis, drove some of the stocks to ridiculous levels and then that bubble popped.

Bubble Trouble

Bubbles and bear markets are two separate and distinct things. Investors truly need to understand the differences. You need to understand which strategy to apply when, and not use a hammer when you need a screwdriver. Once you see the straightforward differences, you will know what to do.

One buys in a bear market and sells in a bubble. Those buying in bad markets made a lot of money. This approach avoids the pitfalls of market timing and uses knowledge of what you own or want to own to a maximum advantage.

A bubble results from a mania, meaning that either valuations or fundamentals are highly suspect or totally wrong, since emotions and perceptions have overwhelmed what is "real". It is better to run - meaning sell - if you recognize a bubble.

Some people wonder why the NASDAQ remained 3,000 points below its old year 2000 high for more than 5 years. They wonder why they had trouble making back their money that was lost in the year 2000 bubble. That is because they think of bubbles like bear markets and do not realize the incredible excesses of bubbles that have to be worked off. But the most important difference is the cause.

Bear markets are caused mainly by fundamental problems. The 5 main cause of a bear market are listed (see reference). It runs its course, and so does the poor market. Then things normalize. You buy into a bear market, since you get great prices on stocks; then stocks come back and you make more money.

Bubbles are not caused by fundamental events. It is investors themselves who create them. Investors come to believe some things that are not true or not rational and thus create a mania in a stock, in an industry, or in the overall market. If the mania goes on for a time, a bubble is created, and that builds until its inherent instability leads it to break.

One of the interesting differences between bubbles and bear markets is that in a bear market, there are plenty of bulls and bears. In a bubble, the few bears are drowned out by the loud and almost universal bullishness. This happened with the Internet, because a mania is normally caused by a belief in something that is supposed to be new and amazing, even though this cannot be proved.

It is natural to like momentum and money, but if investors have no disciplines and no sense of bubbles, then they are headed not for the big money, but for quite the opposite.

With bear markets, one wants to use buy and sell disciplines and buy when prices and fundamentals would dictate that.

There are market bubbles once in a great while, perhaps once in a life-time, but individual stock bubbles are more common. All bubbles have some similarities that concern how perceptions, emotions, and a lack of accurate information combine to set an investor trap.

The five possible factors that cause bear markets

While various people can legitimately pick factors that trigger bear markets, or those stock-market environments that result in declines that are long, very significant, or both, there are five factors which great investors center on. These elements of a bear market can be present individually to create falling prices, or they can appear in combination.

The five possible factors that cause bear markets are:

1. Persistent overvaluation.
2. High or rising interest rates or rising inflation that leads to them.
3. Weakness in company earnings. (By the time people know they are in a recession, normally weak earnings have been evident and if high interest rates cause economic weakness, then those rates have been present for a time.)
4. Oil shocks.
5. Wars (but not always).

The first three are, "the big three"; and those who ignored them suffered much greater losses than those who did not.

In each of the following instances: the terrible 1973-1974 market, the 1983 tech boom and bust, the 1987 stock-market crash and the 2000 Internet and technology bubble burst, there was a general disregard for valuations of individual stocks leading up to the collapses. Each collapse was related to this factor. They did not descend upon the markets out of nowhere.

Markets have a habit of discounting good and bad events in advance. This explains why a company's stock may make a big move before its earnings are made public, or why the market may hit the doldrums for three weeks prior to a rise in interest rates. The reason is anticipation. Savvy investors must take into account that reaction to future events may already be reflected in current prices.