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A "V" or a "W"?

Is the much-talked about "V"-shaped stock market recovery happening? Sure it is. Just take a look at the chart of the S&P 500 below. The "V" is obvious and has a long tail heading off to the right. Kind of like someone wrote a "V" on a piece of paper and then kind of dozed off and her pen kept going to the edge of the page.

Have investors dozed off also? Maybe. We're in midst of the largest shift in the political landscape since the 1930s. Not since then has government become so involved in the private sector, whether it's healthcare or financials or automobiles. We can argue about whether that's a good thing or bad thing, but this shift is going to result in massive wealth redistributions and economic dislocations and the stock market doesn't tend to like that. Which is why I'd argue for a "W" versus a "V". Is now still a good time to own stocks? Probably. But I'd be wary.

Down market?

A colleague of mine said of another company's stock performance yesterday, "Not bad in a down market." A down market? The S&P 500 is up 62% from its low on March 9. Hardly a down market, but interesting how that perception lingers. Which means it is still a good time to buy stocks.

Happy 9th Anniversary

Nine years ago yesterday - March 10, 2000 - the Nasdaq peaked at 5,048. I remember it fairly well - I was on a road show selling stock in a company, called meVC, that was slated to bring venture capital investing to the masses in the form of a publicly-traded fund. The management team and bankers were in Orange County visiting with investors that day. I recall walking outside to make phone calls and check stock tickers on my StarTac phone (yes, I still had one in 2000) and once again my stock portfolio was up a bunch. In just over a year I was up 700%.

The Southern California sun beamed down. It seemed a bit too good to be true.

Stocks peak

Oops. It was. Back at the office later that week my page of stock tickers on Yahoo! Finance was awash in a sea of red. No green tickers to be found. And stocks fell fast - by April 14, roughly a month later, the Nasdaq was at 3,321 - a 34% drop.

All the headlines touting venture funds began to diminish, replaced with ones like, "Is it over?" The people who had left their day jobs to become traders began to question the wisdom of their decisions. And those who had been shorting stocks for months were finally vindicated.

Should we have been so surprised that things were suddenly heading south? The value of the Nasdaq index was roughly 2,500 in August 1999 and by March had doubled. Doubled. We're not talking about a single stock here - that's more than 3,000 stocks that all went up enough so that the index comprised of them rose by 100% in well under a year.

It's easy to say "I told you" so now but people thought the sky was the limit. Do you remember the book called Dow 36,000? It was published in 1999, just ahead of the market's peak. Just last week Jim Glassman, the author, took some heat in an interview with a Washington Post reporter for his now seemingly silly prediction.

The way down

It took a long while for people to really get their heads around the fact that it was over. Lots of people, including myself, bought lots of stock on the way down. I recall that, while trading online, warning messages would appear that said, "Fast market conditions exist for this security" before allowing you to click Buy or Sell. But many of us traded anyway, sometimes on margin, sometimes using derivatives. The cowboy mentality prevailed long after the Nasdaq topped out.

The resilience of the S&P 500 didn't help matters. It peaked just above 1,500 on March 24, 2000 and then re-tested that peak on September 1, 2000. The continuing blue chip leadership meant investors remained wild-eyed about the future and companies continued to command significant valuations. And if the S&P could reach its peak again the Nasdaq could too, right? Except it didn't, only making it back to 4,234, 16% below its high.

(meVC made it out to the public markets, by the way, in late March 2000. The company raised $330 million, well short of its $500 million goal. (What a difference 2 weeks can make.) It conducted its IPO at $20.00/share and has never seen that price since; the remnants of meVC are now part of a company called MVC Capital, a shadow of its former self.)

Stocks bottom

From there, as we all know, things got much uglier. For the next two years the market would fall, save for a sucker's rally here and there. Corporate and accounting scandals graced the headlines. Throngs of tech companies went out of business. Funding dried up. When the market reached its nadir in October 2002 the Nasdaq had fallen to 1,140, or 77%. The S&P joined the funeral, making it down to about 800 or so. Venture funds had dominated the headlines at the peak; hedge funds dominated the headlines in the trough. Equity investing became taboo.

The aftermath

Just to scare people once more, the market re-tested its lows in March 2003, forming a not-too-common triple bottom (July and October 2002 were the others). And just when nobody wanted to touch stocks with a 10-foot pole they started to go up.

As stocks rose the tech bubble morphed into what became known as the real estate bubble. Money got cheap. Lending standards became lax. LBO funds enjoyed a spotlight they had not witnessed since the 1980s.

But in the summer of 2007 the market ran out of steam again. I remember this well too - I was working to help an Internet company (one that you would know well) raise $5 billion of debt and the capital markets suddenly wanted none of it. As the debt markets crumbled and LBO deals fell apart, the equity markets followed behind.

Interestingly the S&P 500 formed a double-peak that was a mirror image of its 2002 double-trough, stretching just above 1,550 in both July and October. (The Nasdaq didn't bother to peak in July and rose 100 points higher to more than 2,800 in October.) The other interesting piece is that the S&P 500 reached almost exactly the same highs it had reached in 2000. I'm no technical analyst but I believe they might call this a giant "cup and saucer" pattern.

Lessons learned

The rest of the story is recent enough that I needn't go through it. The index levels today? The S&P recently closed at 720 (below its 2002 low) and the Nasdaq at 1,358.

What wisdom have we come away with? My answer would be: very little.

Investors as a group are remarkably myopic. All the pain everyone is feeling now has been felt many times before - not just during the 2000-2002 bear market but in 1987, 1980-1982, 1973-1974 and so on, back to the Great Depression of the 1930s and even before then. But people react each time as if it's the first time.

And people make the same mistakes over and over. They assume the recent past is the road map for the future and follow the crowd unwittingly. That works fine if you're long and the market keeps going up, or if you're short and the market keeps going down, but not when things reverse.

Investors buy high and sell low. Right now we're in a recession. People are clamoring to find deals on everything from toothpaste to furniture. But despite the fact that the stock market has a big "Sale" sign posted in its window, nobody wants to buy stocks. Investors would prefer to wait until the market is more expensive when, ironically, they are more comfortable buying. And unfortunately the point at which some people get most comfortable is exactly the time when they'll get burned.

The media will continue to get it wrong. Long after the market bottoms and starts rising the headlines will continue to proclaim doom and gloom. The talking heads will continue to dramatize the negatives of economic events to keep you tuning in each night. And down the road, after stocks have risen a bunch, they'll all switch gears to pontificate about whether stocks will go higher still.

Economist stock market forecasts will continue to flounder as well. (They call it the dismal science for a reason.) The stock market will bottom months before the economy does which means what these forecasters do is exactly backward. Forecasting the economy to predict stock market performance is futile; forecasting the stock market and lagging that forecast to make an educated guess about the economy is better. But that won't change their ways.

And people will expect mediocre returns, even as the market rises, and even if the evidence would suggest anything but. Mid- to high-single digits is a popular forecast, for example. But returns near the beginning of bull markets tend to be materially better. And returns in any given year are typically much higher or lower than the 10% average so many have come to expect.

On a less skeptical note, investors and lenders and regulators will be more prudent, at least for awhile. It's kind of like a firm that is restructuring - the organization is realigned with certain objectives in mind with the goal of making it better. But flawed incentives and other unforeseen issues will cause that that new organization to mutate and become a variant of what it was before. And then restructuring has to occur all over again. The same is true of the stock market and macro economy - the restructuring taking place now will create new problems that will need to be addressed down the road.

But that's down the road. In the meantime, Happy 9th Anniversary.

Anecdotes

Quick - what's the level of the S&P and Nasdaq indices? Don't know? Okay, within 20 points, plus or minus. No? Okay, I'll make it simpler - is the S&P higher or lower than its low last year? Lower? Hmmm. Okay, simpler yet - what's the level of the Dow? The Dow's not a real index, you say? You're right.

The S&P closed today at 907, the Nasdaq at 1,599. The low for the S&P last year occurred on November 20 when the S&P hit 752; that was the lowest level since 1997, even below the lows of 2002 if only for a very short while. But to listen to the headlines is to think the stock market has caved further the past few months when it fact it has traded sideways.

Now that I've bored all but a few of you with stock market stats I'm going to throw some economic stats your way. No, on second thought I'm not. I majored in Economics and know how dreadfully dull that would be. I would like to point out some anecdotal economic items that are interesting though:

• As I pointed out above, the S&P is up 21% from its 2008 low. That's nothing to sneeze at.

• On a recent business trip on a chartered plane, some business colleagues pointed out that the airport ran out of jet fuel because it was dealing with so many travelers.  

• Traffic to Colorado ski areas, where it costs as much as $97 for a day pass not to mention gas and incidentals including that $15 burger at the mountain lodge, is as heavy as it's ever been.

• E-commerce continues to shine, with Amazon reporting record holiday sales this year.

• Consumers, who represent two-thirds of the economy, have done a good job paying down debt. And they aren't levered to the hilt like financial institutions.

• In general, corporations have relatively healthy balance sheets which is far different from recessions of the past.

• VC investment in clean energy technologies hit record levels in 2008, totaling $8.4 billion in North America, Europe, China and India.

• Other promising VC-funded companies have received huge investments recently, including one called HomeAway which got $250 million in a single round. HomeAway purports to be the world's largest consumer marketplace for vacation homes, and attracting this kind of funding means consumers continue to travel and spend money.

• Last, recent surveys suggest roughly 80% of people believe the media has played a major role in talking us into this recession. Perhaps things aren't as bad as they seem?

P.S. - For those wondering, the Dow isn't a real index because it's price-weighted (versus market-cap-weighted). It's a media prop more than anything else.

Ticker turmoil

Watching the stock market right now feels like watching a train wreck happen in slow motion. It's not much fun. Yesterday the S&P 500 broke through 2002 lows. Where lies the bottom? Nobody knows. I'd say we're not far away, but that's neither here nor there. Unless you're making big bets with the hope of making big money tomorrow, you're fine. You have a long investment horizon.

Try this - don't watch the ticker. Don't pull up Google Finance or Yahoo! Finance when you get to work in the morning. Shred your brokerage statements when they arrive in the mail before you even open them. Focus on where you think stocks will be down the road, say, a year or two from now. The daily movement of the ticker can drive people crazy.

Everything fluctuates in value - real estate, cars, collectibles, etc. It is fortunate for all of us that when we get in our cars each morning there isn't a ticker on the dash telling us how much the value has dropped from the prior day. Most of us don't even think about that. But it did drop for sure - cars are a depreciating asset. Compare that to the stock market which rises 2/3 of the time. The real estate market has been a wild ride lately as well, but somehow it's different. Sure - it has been a real drag, but you can deal. You don't have a screen in front of your face each day telling you what the market thinks of your home's value.

The key to more happiness right now: don't watch the ticker.

When will you get back in?

Boy, I wish I had a crystal ball. Or maybe a time machine. Either one would allow me to pinpoint, to the moment, the lowest point of the stock market, and then I could margin my account to the hilt and make millions. That would be fun.

But we don't have crystal balls and we don't have time machines, at least not yet. For now we have to deal with these awkward things called forecasts, which are based on existing data and past experience, and which are tainted with biases, assumptions and uncertainty. Pity the poor investor who has to work with such blunt tools, let alone the poor souls who just shoot from the hip. It all puts into perspective how hard it is to understand the capital markets and how much we have yet to learn.

Such is the state of affairs, however, which begs the question - when will you get back into the market and on what will you base the decision to do so? Will you wait until stocks are on the up and up, or when there is more "certainty" in the air? Will you wait for good economic data? This is what you're likely to do, and waiting until then would feel easier, for sure. Your state of mental health would remain (more) sound. You wouldn't feel like you're throwing your life savings onto a roulette table hoping for lucky number 35.

Why might you feel this way, you might ask? Here's an analogy to help you. Think about something you love - maybe it is hang gliding. Hang gliding gives you more pleasure than anything else in the world. And then think about something you hate - maybe it is big, hairy Amazon-like spiders. Spiders scare the crap out of me and maybe they do the same to you. Compare how much you love the first thing with how much you hate the second thing - put them on a scale next to each other, if you will. You probably hate the latter thing with much more intensity than you love the former thing. Try it.

This applies to stocks too - you feel the way you do about investing now because you hate the thought of losing money. In fact you hate that thought with a lot more intensity than you like the thought of making money. (If you ask a behavioral finance student the intensity is about 2.5 times greater, in fact.) So it causes you to wait and avoid making the choice to invest - to wait until the market is higher, until the economy is better, until the sun is shining outside.

Today one headline says, "Stocks stuck in a rut." Another says, "Here for the holidays: Slow sales and layoffs." These headlines will keep coming until... they don't. Some time from now one will say, "Stocks headed higher on positive economic data," or something like that. Will that be the telltale sign to get back in? Well, you won't really know. You'll just decide one day to do so when it feels right, and when the market is much higher. And you'll have missed the opportunity to buy stocks when they are down, when they are cheap, and when most of the world is telling you to wait.

Airlines and telecom - same destiny?

Warren Buffet once said that airlines were one of the best inventions of the 20th century but one of the worst investments. The airline industry has constantly had to fight fickle consumers who only want the cheapest tickets available, high fixed costs and tough government regulations. The industry has been plagued with bankruptcies, has had to consolidate to survive, and has had to fight start-up airlines that are continually shaking things up for the incumbents.

I think there is (or will be) a parallel in the 21st century in communications. The advent of broadband and high-speed IP networks have given all of us the ability to enjoy high-bandwidth applications over the Internet. What a great invention that has made our daily lives so much better! But what are consumers and enterprises willing to pay for it? Increasingly less. Traffic levels are skyrocketing yet prices are compressing significantly. Think about the parallels to airlines. Highly competitive on price? Yes. High fixed costs? Definitely. Very regulated? Probably too much so. Bankruptcies? Does a bear sh*t in the woods?

Sure - in the 20th century you could make money in telecom. For much of the century AT&T was a monopoly, after all, and in order to have a phone you had to rent it from them. Who wouldn't want to own AT&T stock during that time? And then there was the tech bubble. But I think we are in a different time now. Will network companies be a good investment in the 21st century? I'm skeptical. If I'm around in 2100 I'll let you know for sure.

The myth about certainty

If you stop someone on the street and ask them if we are living in more uncertain times, most will say yes. The economy is a mess, the stock market is down, terrorism remains a threat, we have a big election coming up, and so on. There's a lot on our collective plate to worry about. But despite what the the media, stock pundits and even company executives are saying over and over about more uncertainty now versus in other periods, it's just not true.

What's true then? The truth is that there is never any more or any less certainty, whether times are good or bad. There is just uncertainty. Period.

Do you think there was more certainty in 1999 when the economy was booming and stocks seemed like they had forever to run? Nope. Sure felt like it, but that was just an illusion because people felt good about where things were headed. I can tell you that stocks had a lot better chance of heading down instead of up at that point in time but people were confident about the opposite. Psychology associates this cognitive error with something called the representativeness heuristic - people thought a "new paradigm" had arrived which meant the primary behavior for stocks was "up, up, up" when that wasn't the case at all.

Today, the stock market has a much better chance of moving up versus down. Folks don't feel that way either, but it's true. Might not happen today or tomorrow, but the odds favor it. You can place some certainty on that.

Backward bend

Conventional wisdom says that for any product, service or resource, people will buy more as the price declines and buy less as the price increases. On a graph this means a demand curve slopes downward from left to right. This "law of demand" applies in many real-life situations, but can you think of any cases in which this wouldn't be true?

Luxury goods is one example. Think about Louis Vuitton purses and the audience that buys them. Would the people who buy such purses do so if they cost a mere $100? Doubtful. This crowd derives much of its value in owning such things from the high price they pay for it. 800? Great. $1,000? Even better. Translating this into the traditional law-of-demand model doesn't quite work - there may be a "middle" section of the curve the slopes traditionally downward for the range of Louis Vuitton purse offerings targeted to a range of customers, but at higher price points the curve seems to bend "backward" and turn the other way. Same goes for lower price points where, below some threshold, demand starts to shrink. The curve bends backward here too, forming an "s-shaped" demand curve.

Another "good" where this phenomenon holds true is stocks. Think about it - the higher prices get, the more of them people seem to want. Conversely, the lower prices get the less they want. Look at what is occuring now. The stock market has been in a free fall lately. Not too many people, except for maybe Warren Buffet, are talking about buying stocks. Most people don't want to touch them with a 10-foot pole! The quantity being demanded is shrinking as prices get lower.

Now look back to 1999 and early 2000. People were piling into stocks as fast as they possibly could. The Nasdaq went from 2,500 to 5,000 in less than 9 months! The quantity of stocks being demanded was exploding as prices rose. Once again, you get the backward-bending curve near the ends.

Of course, in the case of stocks, as prices get high, supply goes through the roof as well (think lots of IPOs) which eventually sends prices straight down to the floor again (2001). And, when stocks are cheaper, as they have been lately, supply stagnates or shrinks (there have been few IPOs and lots of share buybacks the last few years), providing support for prices or pushing them upward.

If there is a takeaway it might be this: when it comes to stocks, be greedy when others are fearful (and vice versa), as Warren Buffet said recently, because fear and greed is what creates this somewhat odd phenomenon and if you recognize it you can create opportunity.

Why SNL is an indicator that stocks will go up

Do you think the stock market will go even lower? Pay attention to signs from the media and you may start to think otherwise. This past Saturday night the cast did one of its spoof commericals about an online brokerage that allows you to sell just about anything from stocks to your grandmother. Think eTrade, but you only have to click one button: Sell. Most people probably got a laugh out of it and then directed their attention to the next skit.

Why should you pay more attention to things like this? Because SNL is inadvertently broadcasting a signal that the stock market is at, or at least near, bottom. The media is a classic contrary indicator around market tops and bottoms that things are about to head in the opposite direction.

Recall the the headlines in 1999 and 2000. They were dominated by talk of venture funds, portrayed VCs as rulers of the universe, and profiled housewives making millions as daytraders. Which way did the market go? Down. Fast forward to 2002. The headlines were pushing hedge funds as the way to protect money in a falling market (at a cost of 2% and 20% of profits, of course). Hedge funds were the talk of the town. Which way did the market go? Up!

Right now the headlines are full of doom and gloom. One article I found particularly amusing was one that says the 2002 bottom, scary as it was, was a false bottom and that the market was buyoed by the then-relatively-nascent housing bubble. Nonsense. The market will be volatile but it is ultimately heading higher from here - maybe not this week or next, but down the road things will look much better.

The media is a contrary indicator. Time to buy stocks!