Crisis and opportunity in global investment markets

Investment markets are deep pools in which the twin emotions of fear and greed reside. In observing several cycles of fear and greed that have played out over the past years we have noticed an interesting pattern. When markets are on an upwards roll, when bubble fever is pandemic and greed is the order of the day we often hear a chorus of Pollyanna cheerleaders pronouncing that “this time it’s different!” Presumably they mean that whatever “this time” is just happens to be the one thing that will change the world forever and so stock prices will never, ever come down. Such were the atmospherics that in the late 1990s allowed online pet food to be of such world-changing proportions so as fetch stratospheric price-to-sales multiples without a dime of profits as far as the eye could see.

When the bubble bursts and fear takes over we hear a different refrain, from seemingly more sober-minded types than the bubbleheads of the greed cycle: It’s not different this time. That is meant to be a reassurance to the folks whose equity portfolios have just been eviscerated. Yes, you are down 40% now, but the world isn’t going to end, people are still going to buy stuff, and there’s still a reason to stay invested in the market. Stocks do well over the long term, so just stay put – the sun will come out tomorrow, night is darkest before the dawn, light is at the end of the tunnel – comforting catch-phrases like so many cups of chamomile tea.

“It’s not different this time” is a useful thing to say insofar as, yes, we still have a functioning economy, the everyday humdrum of life continues for the vast majority of us and stocks do indeed tend to outperform bonds over the long term. But there is a tendency to take that notion one step further: “it’s not different this time” as shorthand for surmising that the market will shortly resume its inevitable upward course. For the vast majority of professionals toiling away in the salt mines of Wall Street or the City of London that is a perfectly reasonable assumption based on their own professional experience – they came into the profession sometime after the commencement of the Great Bull Market of 1982–2000. Despite a handful of well-known debacles like Black Monday in 1987 or the Icarus-like flameout of hedge fund Long Term Credit Management in 1998, for that entire 18 year period there was only one calendar year (1990) when the S&P 500 stock index showed a negative annual return. Brokers and money managers became accustomed to dips that were sometimes quite intense (over 20% on that one famous Monday in 1987) but nonetheless short-lived. This begat a confidence that gave rise to “it’s not different this time” with a whole supporting phraseology: “bump in the road”, “soft landing” and “time-out for the market” being a particular favorite for those with young children at home.

This confidence has been rather shaken up in the decade to date. Since 2000 we have already experienced three consecutive negative years for the S&P 500 (2000-2003) and barring some direct intercession from angelic hosts we are firmly on track for a fourth in 2008. Both the Dow Jones Industrial Average and the S&P 500 reached their 2000 highs in the past couple years, which technically is supposed to signify the affirmation of a bull market – but they have subsequently fallen way off those levels and so if the decade to 2007 was really a continuation of the ’82-00 bull market (which already by that time had achieved fame as the longest bull market of the 20th century) then it is sort of a bull market with an asterisk – a Barry Bonds bull market for the sports fans. The economy, which as we write has just formally tipped into negative territory with a -0.3% 3rd quarter GDP reading, shows very little in the way of positive signs of life. Real household income is in decline, consumer debt is at record levels and heading higher still, and the banking system is moribund. Structural problems such as these take more than just one or two business cycles to work themselves out, so we may be in for some more years of anemic economic and stock market performance. If so, then “it’s not different this time” will take on an entirely different meaning: not different than 1906-22, or 1929-54, or 1966-82 – those being the three macro bear markets of the past century.

So that’s the crisis at hand. What about the opportunity?

In any given macro economic cycle the overall markets, represented by broader indexes like the S&P 500 or the Nasdaq Composite, are usually driven by a small number of industry sectors that grow much faster than others and provide forward momentum to the economy. For most of the duration of the last bull market, the one that started in 1982, the twin engines of growth were the financial sector and consumer-related goods and services. Financial institutions as a sector comprised approximately 5% of the S&P 500 market capitalization in 1980; by 2007 that had grown to over 23%. In the consumer sector entire new sub-industries came into being, driven by the proliferation of choice (think of the 70-odd varieties of shower gels and exfoliants at the Body Shop), the micro-segmentation of consumer demographics (Prius-driving suburban 28-37 year-old female office professionals in the $85-110K salary range with a taste for gingerbread-spiced lattes), and the 24/7 availability of the consumer experience for customers and suppliers alike through the Internet.

In fact growth in the financial and consumer sectors was quite closely correlated – banks came up with new ways to give more consumers more credit to spend on more stuff, and the consumer goods and services supply chain rose to meet the challenge with lots of new stuff for them to spend their credit dollars on.

Those twin engines of growth are currently in a vertical downward spiral, and even when they regain their footing they are unlikely to be the engines of growth in the next economic cycle. In terms of the broad economy it is rather hard to predict which industry sector is going to be the next to accelerate from 5% to 25% of broader market capitalization. Here are two that offer better than even odds, though, in our opinion: innovative solutions in healthcare on the one hand and alternative energy on the other. Both presidential candidates have focused heavily on these two areas in their campaign platforms. If Barack Obama indeed becomes the 44th President on January 20th, 2009 then we have two clear mandates in this direction: effective universal healthcare and a pathway to energy independence within the next 10 years. That is not to say that either of these sectors will be profitable overnight. Biotechnology innovations leading to revolutionary healthcare solutions are risky, long-term efforts fraught with high probabilities for commercial failure at critical junctures along the discovery, trial and implementation phases. Alternative energy solutions may present themselves as scientifically viable but economic non-starters.

The opportunities in these two areas and their position in the klieg lights where business ventures and government policies intersect are likely to drive a renaissance in the venture capital market. In a world where many risk-based assets (publicly traded stocks, commodities, currencies, speculative-grade debt etc.) appear systematically unattractive on a risk-return basis, venture capital, though generally considered one of the riskiest asset markets, may look relatively attractive. VC tends to have a very low correlation with other financial assets, so for example if stock markets and real estate markets trend down over a long period investors will want to obtain exposure to assets that exhibit low correlation properties with them – and that enhances the appeal of VC. VC anticipates future, not present-day liquidity, so the idea of taking early stakes in companies with the potential to be leaders in exceptionally high growth markets will, in our opinion, drive private investor money into early stage opportunities in these sectors. There is a lot of investor cash sitting in US Treasury securities today, and that cash is ultimately looking for much higher potential returns. As the dust settles amid the aftershock tremors in global capital markets we will be paying close attention to this funds flow and the opportunities they may help unleash.