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Part 1: Evolution The Modern Jungle

Part 1: Evolution The Modern Jungle

Developments that have influenced today’s stock market.

From the beginning, the language of the American stock market has included references to a colorful menagerie of creatures and critters, conjuring up vivid imagery that breathes life into a world of cold numbers and hard facts. Bulls and bears, dogs and dinosaurs, spiders and sharks[1]—all have found their way into the lexicon of equity investing, making for good copy and catchy sound bites. Almost designed, it seems, to keep audiences enthralled with the daily comings and goings of various buyers and sellers. Regrettably, these simple descriptions have sometimes fostered the illusion that coming out ahead is relatively easy—merely a matter of choosing between two extremes—or, to put it in Wall Street terms, of picking winners rather than losers. Yet, whether referring to the hard-charging optimism of bulls, trampling excitedly through fields of worry and doubt, or the grizzly pessimism of bears, chomping on high prices with super-sized incisors, investors have sometimes overlooked a key point: Because of the diverse backgrounds and complex—often irrational—interactions of various participants, making money is frequently a challenge for even the most seasoned players.

This did not always seem to be the case, especially during the stock market bubble that developed in the 1990s. Although many investors did not fully appreciate it at the time, an even more simplistic understanding of how the game was played influenced the collective consciousness during the dot-com[2] days. The battle cry then: Just “buy and hold” until the price—of the stock or mutual fund—goes up. Of course, that view proved to be foolhardy—and expensive—in the wake of the collapse that followed, and nowadays there are signs that at least some of the “irrational exuberance”[3] of the era has been slowly ebbing away. Nonetheless, the echoes of often fleeting successes during that upswing still linger, occasionally serving to hide the fact that the equity market has always been like a dense jungle, teeming with predators and dangerous traps. It is—like many areas of the business world where a potential for sizable returns exists—a place where the strongest, savviest, and most ruthless players tend to dominate the inside ranks. For the most part, they establish the ground rules and influence price action in ways that can seem baffling to a casual observer.

Figure P1.1. Portrait of a Stock Market Bubble (Source: Bloomberg LP).

To be sure, this is not just conjecture, as an assortment of qualitative and quantitative data—from tallies of block trades[4] to exchange-sponsored surveys of market activity—generally supports the view that large-scale operators have been—and will probably remain—the driving force behind daily share-trading turnover. Even at the height of the Bubble, for example, when individuals played a starring role in supporting and promoting the fortunes of countless technology, media, and telecommunications companies—or TMTs, as they where called back then—pension funds, mutual funds, investment banks, and other major institutional players generally ruled the investment roost. Of course, size in itself has never been an absolute advantage—in finance or in nature—and there are many examples of investors—and creatures—who, lacking obvious advantages in terms of resources and capabilities, have managed to thrive despite seemingly poor odds.

Indeed, the nimbleness associated with being small can sometimes give an edge to the individual investor, along with the flexibility that comes from being able to trade a broad range of instruments with little need for regulatory approval or committee endorsement. Some professional money managers, for example, cannot buy certain types of securities because of internal restrictions or contractual obligations. They also tend to avoid stocks of companies with capitalizations[5]—a measure of their size—below minimum threshold levels due to worries about liquidity and other concerns. As a consequence, the ability to invest in shares or funds that do not appear on institutional radar screens or to trade in and out of all kinds of markets can offer a useful advantage to smaller players. They can also respond more quickly than in the past to breaking news and rapidly changing developments because of significant improvements in technology and communications networks, as well as the vast information resources now available through the Internet and other channels. Taken together, these factors have made it easier for nonprofessionals to achieve investing success.

Ironically, given the mediocre results posted through the years by a significant proportion of institutional money managers in a long string of quarterly performance surveys, together with positive data on individual investor performance from at least one academic study,[6] it seems that larger share operators do not necessarily have a monopoly on investing ability. This is in spite of their size and many tactical advantages. According to the research, which analyzed the returns of 113,000 accounts at a large discount brokerage firm between January 1990 and November 1996, some 20 percent of the retail investors studied managed to consistently outperform the market throughout the near seven-year time span, while the top 10 percent beat the average by about 38 percent per year. Not a bad showing for so-called amateurs.

Nonetheless, the same forces that appear to have leveled the field for outsiders have had a far greater impact on the mechanisms and methods of the institutional marketplace. Fueled in part by the virtuous circle of investments leading to improvements that stimulate further spending, the structure of the wholesale share-trading environment has undergone a dramatic change during the past two decades. This, in turn, has altered the personal links that were once fundamental to how markets operated. For instance, with the development of electronically connected dealing and back-office systems, it is now possible for an investor to initiate, execute, and settle a trade without actually having to speak to another individual—presumably reducing the risk of human error. Yet without that interaction, today’s professionals sometimes miss out on a variety of benefits—such as picking up on unique insights about supply and demand or brainstorming alternative approaches to executing share orders—that have traditionally been available to them.

Other significant changes include the development of powerful processing and data-retrieval capabilities, available in many cases at the touch of a screen or with the click of a mouse. Whether accessed through in-house computers or systems provided by outside vendors, many institutions on the “sell side”—brokers, investment banks, and other intermediaries—and the “buy side”—mutual funds, pension funds, and other institutions that manage money—now have impressive resources at their disposal. They can instantly sift through, sort, and summarize what is going on in the market without having to leave their desks or call on Information Technology professionals for support. They are able to quickly analyze and trade vast portfolios of complex securities in ways which would have been inconceivable even two decades ago. And, in many instances, they now rely almost exclusively on order management systems (OMSs)—rather than paper blotters—to monitor trades on a real-time basis.

Communications methods and networks have also been significantly reshaped and improved in recent years. This has dramatically altered the ties that bind in equity investing. With almost limitless capacity, vastly improved quality, a variety of different avenues featuring numerous bells and whistles, and near universal access, modern communications channels have expanded the number of person-to-person exchanges taking place during—and outside of—trading hours. They have also increased the quantity and speed of interactions between various market participants. At any given time, for example, a sell-side trader might be talking on the telephone, making eye contact with a colleague, speaking on the internal squawk box, reading an email, responding to an instant message, listening to CNBC, and broadcasting informal comments to a preset group of contacts through a Bloomberg terminal—maybe even while sipping some coffee and chomping on a donut. Efficient, but no doubt a recipe for indigestion.

This explosive growth in communications traffic and the overall degree of “connectedness” has been matched by a parallel rise in the volume and quality of real-time, readily accessible data, news, analysis, and other information streams coming from numerous internal and external sources. Whether through informal channels, such as overhead public address (PA) systems, in-house “chat” programs, or mobile telephones; traditional financial media outlets or scrolling newswires; or email, proprietary information vendors, or the Internet, institutional operators are showered with absolute gushers of market intelligence. Or, on occasion, the exact opposite, depending on the nature of the source. Whatever the case, most view the data blitz as a necessary evil for staying on top of the investing game.

On another front, the rise of new technologies at both ends of the trade processing pipeline has accelerated the trend towards lower transaction fees—and related rises in turnover—that began in earnest with the elimination of fixed commissions on share trading in 1975.[7] Spurred on by extensive productivity improvements, increased competition from discount operators and wholesale agents providing execution-only services, and the far-reaching impact of a long-running bull market, banks and brokers developed systems and practices designed to provide better service and handle more trades at a lower cost. Together with the structural changes and substantially increased capacity put into place by the various U.S. exchanges in the wake of the October 1987 stock market crash, commission rates have, at both the wholesale and retail levels, fallen sharply. This has created powerful incentives for investors to boost their overall activity levels.

The rise of the Internet—along with a wide range of proprietary computer networks and user-friendly systems established by a host of modern discount brokers and other intermediaries—has also stimulated increased turnover. The reason? It has simplified and reduced the number of steps needed to buy and sell shares, mutual funds, and other financial products. Instead of following the well-worn path of telephoning a designated representative or call center, placing an order, having it processed through numerous links as it made its way to and from the relevant exchange or administrative center, and waiting—sometimes endlessly—for confirmation that the transaction was—or was not—executed, retail investors now have the option of going online. There, with a few simple clicks or keystrokes, they can usually get their business done fairly quickly and efficiently.

For institutional players, there are even more options. Driven in part by pressure from mutual funds and other large institutional money managers for more electronic “connectivity” and rapid trade reporting—in the name of increased productivity and better risk management—buy and sell orders can now be routed through third-party dealing systems; from internal client OMS programs directly to sell-side computer terminals; through alternative trading venues such as Electronic Communications Networks (ECNs) and Crossing Networks (CNs);[8] or by email, instant message, and of course, the telephone. What is more, the relatively seamless integration of desktop dealing systems with back office operations and settlement functions—which have become, in some cases, nearly “paperless”—has substantially eliminated many of the related processing bottlenecks that were common during the 1980s.

Taken together, sharply falling commission rates and more efficient trading technologies, as well as a turnover-friendly move to decimal pricing,[9] have dramatically increased share volumes and transaction totals in recent years. In many respects, the pattern has mirrored the way traffic expands to quickly jam newly widened highways before the last bit of blacktop is even laid down. The added combination of a fairly supportive macroeconomic environment—for a great deal of the last two decades, at least—intensive marketing and “educational” efforts by the financial services industry, and perhaps, the psychological appeal of hands-on control provided by new and easy-to-use interactive technologies has also helped. Considerable numbers of small and large players alike have been inspired to move away from the long-followed buy-and-hold model towards more active approaches and lower-margin, higher-volume trading methods. While index investing and other passive strategies remain a formidable presence in modern equity markets, the urge to act—and to act more frequently—has been growing.

Along with this far-reaching shift has been the phenomenal expansion in the market for derivatives—instruments, such as options and futures, which essentially “derive” their values from other securities or commodities. Options give owners the right, but not the obligation, to buy or sell an underlying asset at a preset price during an established time frame. In exchange for an initial purchase amount, or “premium,” the seller of the option, or “writer,” agrees to fulfill the commitment if called upon to do so. Futures, on the other hand, are contracts between buyers and sellers whereby they agree to execute a transaction at an agreed price on or before some specified date, with the seller typically having the right to trigger settlement during the period when “delivery” is allowed. In both cases, either party can usually close out its side of the deal by executing an offsetting trade with someone else prior to the final expiration, or “exercise,” of the agreement.

While they have existed in one form or another for centuries,[10] financial derivatives—or “synthetic” securities, as they are often called—really began to take off following innovative moves at two Midwest-based trading venues. The first was the launch of standardized equity options trading on the Chicago Board Options Exchange (CBOE) in 1973; the second was the 1982 introduction of Standard & Poor’s 500 Index futures—with a relatively novel settlement feature that allowed the two parties to the contract to close out their interests with cash rather than an exchange of securities—on the Chicago Mercantile Exchange (CME). Combining the power of leverage with increased pricing visibility and a centralized marketplace, these high-octane instruments attracted a wide assortment of private investors and speculators looking for a better-than-average bang for their buck.

Institutional interest eventually came on strongly as well, aided by several important developments. Among them was the formulation of a landmark theory on options pricing by academicians Fischer Black, Myron Scholes, and Robert Merton—referred to as the Black-Scholes model—which allowed for a more rigorous and scientific assessment of valuation and risk. In addition, substantial improvements in computer processing power enabled investors and traders to quickly analyze and manipulate increasingly complex securities and portfolios of unrelated instruments. Academic studies and industry promotional efforts touting the “insurance” benefits that derivatives could provide to managers of large and sometimes unwieldy portfolios, as well as the combination of intellectual firepower and financial market intelligence stimulated by the rise of large-scale Wall Street operators, added to the growing attractiveness of the instruments.

Like waving a lit match near gasoline, however, it took the euphoria of a breathtaking bull market, sharply falling interest rates, and a decisive change in compensation preferences away from cash towards “paper”[11] to really get the derivatives market going during the Bubble years—and beyond. Inevitably, a range of products popped up to satisfy the rapidly rising demand. Aided by a parallel acceptance of leverage and risk among an ever-widening circle of investors, derivatives have become an important fixture of the U.S. equity markets—but not without controversy. The 1998 U.S. Federal Reserve-led bailout of Long Term Capital Management, a highly-leveraged derivatives player that nearly got wiped out by unusual conditions in global fixed-income markets, as well as negative comments from knowledgeable hands such as famed investor Warren Buffet, who described these synthetic instruments as “weapons of mass financial destruction,” were not taken lightly.

Nevertheless, this speculative shift echoed another major development taking place in the marketplace. Many investors—as well as the managements of publicly listed companies—were becoming increasingly short-term oriented. For whatever reasons—the speedier pace of the Information Age, the increased volatility associated with aggressive portfolio strategies and unfamiliar macroeconomic conditions, or even a more superficial approach to life—small and large players alike began to focus on quarterly, monthly, and even daily returns and performance benchmarks. Other none-too-disinterested parties also did their part to reinforce the swing away from a long-term investing perspective. The brokerage community, for example, always eager to satisfy a budding demand for more commission-paying action, redirected its efforts accordingly. The financial mass media, increasingly striving for the business equivalent of “leads that bleed,” juiced up reports and added experienced market operators to their lineups.

Compensation arrangements, altered to reflect the modern perspective, also reinforced it. Corporations, institutional money managers, and investment banks structured deals that almost seemed tailored to capitalize on quick fixes and stepped-up speculation, while offering relatively little in the way of downside risk if circumstances did not work out as planned. Moreover, stimulated to a great extent by investors’ and managers’ unfortunate reluctance to look beyond surface facts and figures, as well as a corresponding gullibility with respect to modern performance measurement data—or “metrics,” as the trendier breed of analysts coming onto the scene called them—many beneficiaries of the generous new provisions had a strong incentive to focus on near-term results and fleeting accomplishments. In the new era, the long run was quickly becoming a has-been.

Along those same lines, another phenomenon began to take hold, especially during the roller coaster ride of the past decade: the growing importance of trading. Epitomized by the widely reported exploits of independent “day traders” during the go-go days, the professional dealer’s role has actually undergone a substantial metamorphosis in recent years, especially on the money management side of the business. Once viewed as overhead and regarded as little more than order clerks at all but the largest institutions, buy-side traders’ primary responsibility in earlier times was to execute investment strategies on behalf of portfolio managers, the “real” decision-makers. They doled out trades to counterparties on the sell side and ensured that transactions settled properly. However, with the growing complexity and variety of financial instruments that began appearing in the marketplace, and the threats posed by increasingly sophisticated competitors employing multiple investing styles, professional money managers began to rethink the situation. They recognized the advantages that could be gained—and the disasters that could be avoided—by relying on in-house traders to closely monitor news and short-term supply-and-demand imbalances.

Together with this newfound importance came the recognition that these execution specialists, by virtue of having their ears constantly to the ground, might be good at detecting anomalies that could prove valuable at the earliest stages of the investing process. They could also help uncover interesting opportunities and round out a potentially one-sided analysis with valuable color on market psychology and complicated technical issues. Reflecting a change in status and influence that was stoked in no small way by the media-driven promotion of active traders as swashbuckling buccaneers during the Bubble years, centralized dealing desks began taking on more of a “partnership” role at many traditional fund management firms. They gained a larger say in setting policy, making investment decisions, and allocating commissions. Eventually, this paved the way for a significant cross-pollination of methods and mindsets.

This combination of circumstances—an increasing emphasis on the short-term, the rise of trading, and a rapidly growing derivatives market—also laid the groundwork for another revolution. Suddenly there was a significant expansion in the number of modern operators in the marketplace, primarily hedge funds, offering alternative approaches to familiar “long-only” investing styles. Dating back to 1949, when Alfred W. Jones created the first such approach to capitalize on inefficiencies by buying undervalued stocks and selling overpriced shares “short,” hedge funds were once viewed primarily as a “rich man’s game” because of U.S. regulatory restrictions. In fact, the sector was relatively unknown before the 1990s; what little public awareness that existed was driven largely by the media-reported exploits and long-term successes of global big picture—or “macro”—players such as George Soros. Following the post-2000 collapse, however—when the realization took hold that paper gains could quickly evaporate into painful losses—a more widespread interest in the “alternative investment sector” developed, as Figure P1.2 makes clear.

Figure P1.2. Hedge Funds—Assets Under Management and Number of Funds (Source: Hennessee Group LLC).

At the same time, the increasingly unsettled economic outlook, relatively cheap credit,[12] and the widespread fallout from the bear market—which pressured financial services firms, in particular, to cut costs in the face of declining revenues—led to another shift. Considerable numbers of traditional money managers, analysts, traders, and others, lured by the rising demand for talent and a performance-based compensation structure, decided to stake their claim in the growing hedge fund sector. Relying on a variety of sometimes exotic strategies, they were welcomed into an industry that prized flexible approaches to making money. Many also had a perspective that was clearly in tune with the revolution taking place throughout the investment world. Leverage, active trading, short-selling, derivatives—all were seen as potentially lucrative sources of advantage in the new stock market jungle.

Indeed, the rapid expansion of the sector mirrored and magnified the broader trend towards a more speculative, shoot-from-the-hip style of investing that was gaining ground in the share-trading arena. With operations that were opportunistic, secretive, and lightly regulated, hedge fund players could evaluate and execute investment strategies that might not pass muster with traditional money managers. They were also not held to the consensus-oriented approach favored by conservative players, and they created flat organizational structures designed to speed up the process of converting ideas into action. The result is an industry made up of aggressive operators overseeing more than $700 billion in assets. While not all of the funds are linked to equity markets, the numbers are substantial any way you look at it. The ripples from their expanding influence began poking holes in such long-held institutional safety nets as broad diversification requirements, minimum liquidity preferences, well-defined risk parameters, and portfolio turnover restrictions.

Accelerating demand for the modern approaches, along with the numerous professionals and support teams required to make them tick, had interesting consequences—though not necessarily what conventional wisdom might have indicated. For example, many of the newer arrivals to the hedge fund sector, despite their sometimes considerable talents, seemed to lack the maturity, experience, and temperament needed to comfortably operate in free-wheeling and unfamiliar working surroundings. This was especially true given the unsettled market conditions of the past few years. Moreover, because scores of them were formerly specialists of one sort or another, a significant proportion did not appear to have the hybrid skills necessary to analyze and implement often complex strategies in a real-time trading environment. Some also brought with them lots of unwelcome biases and emotional baggage. The learning curve for these relative novices—as well as the subsequent impact their missteps and mistakes have had on the markets—has been steep—and often expensive.[13]

In contrast, those who did come from the small and close-knit core of long-established operators, while not exactly clones of one another, frequently relied on familiar investing strategies and proven tactics borrowed from their former employers to generate outsized returns. This has contributed to repeated instances of “overcrowding” that have often had a disruptive impact on share prices. Many also continued to depend upon regular daily contact with—and the ongoing support of—a fairly closed network of colleagues-turned-competitors to ensure their long-term success as they moved on to other firms or set up shop on their own. The result has been the emergence of “virtual” communities within the investing world, rife with catty gossip and rumors, arrogance and narrow-mindedness, and the secretive paranoia associated with a small-town mentality.

Interestingly, given the recent widespread academic and professional fascination with Behavioral Finance, which explores the irrational factors that can influence investor actions and approaches, there does not seem to have been much interest in analyzing the psychological and emotional elements churned up by the rapid expansion of the hedge fund segment—which, by some estimates, now accounts for up to 50 percent of daily share-trading activity.[14] These sophisticated operators are not necessarily the voice of reason, either. According to one recent study, rather than exerting a correcting force on stock prices during the Bubble, many of them actually went along for the ride.[15] Aside from that, little attention appears to have been paid to the host of relatively alien attitudes about money and investing that have been brought to the surface in the post-Bubble share-trading environment, especially given the rapidly evolving dynamics of the market. For instance, fear, rather than greed, seems to be the dominant emotion currently influencing individual attitudes. That has helped to boost the daily quota of jerky moves and panicky reactions, which few had been accustomed to during the seemingly never-ending bull run.

Similarly, the pressure-cooker environment stirred up by intense information overload,[16] the need to make rapid-fire decisions under occasionally extreme duress, and aggressive competition from sharp and well-funded rivals has had a negative effect on the state of mind of countless investors—especially those with little experience operating in such hostile surroundings. Many of the hedge fund newcomers—as well as the broader range of individuals and institutions swept up by the tide of a more active investing approach—have sometimes found themselves unwittingly seduced by dark forces. Some have been overwhelmed by the emotional sway of the speculative crowd, while others have been drawn in by the siren song of overtrading that has sunk many dealers in years gone by. Likewise, intoxicated by feelings of empowerment, the allure of instant gratification, and the childish pleasure that comes from being able to act on nearly every whim, more than a few had to learn the hard way that the market is very efficient at doling out punishment to the self-absorbed, the foolish, and the unwary.

Certainly the challenge of performing even routine tasks in an atmosphere of chaos and confusion can be overwhelming. In an energetic trading environment, where mistakes and bad decisions can have particularly nasty bottom-line consequences, the stakes are high and the pressures are that much greater. Various studies have shown, too, that there is a downside risk—in terms of physical well-being and mental sharpness—to operating in a continuously stressful working environment. In sum, not everyone is inherently capable of successfully employing intensive multi-tasking skills under severe time constraints or facing the unique strains of wheeling and dealing for a living. Unfortunately, it seems that few of those who jumped on board the quick-response, high-turnover train looked to see whether they had what it takes to complete the journey.

Numerous investors have been caught out by the asymmetric price action and vicious “spikes” that are fairly common during choppy or down markets. Many have been affected as well by the unsettling lopsidedness of leverage, which seems to work wonders on the way up, but which strikes fear into the hearts of even the most battle-hardened speculators on the way down—especially when there are derivatives or other complex securities involved. Some money managers, particularly those who had achieved success at traditional firms—where performance is usually measured in “relative” rather than “absolute” terms—have been intimidated by the ever-present need to generate continuous positive returns under widely varying circumstances. No doubt, a few have even discovered a fear of large numbers—as when a seemingly minor 50 basis point, or half-percent, short-term swing in a $1 billion portfolio equates to a nerve-wracking $5 million. That is an effect that may not have even been on their radar screens during earlier—but smaller—investing triumphs.

While the emotional dynamics of the marketplace were being altered by evolving conditions, structures, and perspectives, other more concrete developments were also having an influence. In particular, new investment strategies cropped up that took advantage of improved technologies, revolutionary products and methods, and the infusion of considerable academic and analytical resources. They provided diversification benefits and the prospect of above-average returns that many old-line managers—and a growing minority of individual investors[17]—were looking for now that the easy-money days had passed. Some were designed to exploit discrepancies in prices or relative values. They relied on sophisticated models, specialized skills, or distinctive information-gathering networks for their success. Others incorporated big picture—or “top-down”—approaches that scrutinized sector and thematic trends, economic influences, technical conditions, or asset allocation preferences. A growing assortment depended on “black box” mathematical models, arbitrage methods, and computer-driven buying and selling to capture small but consistent gains from market inefficiencies. All were aimed at grabbing a share of the alternative investment pie.

At the same time, inspired in part by sell-side efforts to develop new sources of revenue in the wake of the deflating Bubble, as well as the hedge fund industry’s quest to cut costs and achieve a scale necessary to boost returns from high-volume, low-margin strategies, numerous intermediaries stepped in. They began offering a relatively modern form of bundled service called prime brokerage. Combining back office support, securities lending arrangements that made short-selling easier, and perhaps most importantly, lines of credit that enabled aggressive players to gear up their assets with borrowed funds and potentially magnify their winnings, these operations played a key role in increasing the already growing clout of the sector. They also opened the doors for a multitude of start-ups, providing turnkey facilities and formal introductions to potential investors looking to place bets with rising stars on the alternative investing scene.

Sensing a major moneymaking opportunity in their flagging brokerage arms, many of the multiproduct Wall Street operators brought together firm-wide resources to tap into the activities of this rapidly expanding segment of the institutional investment industry. They put dedicated hedge fund teams in place to generate specially targeted research and short-term trading ideas, brought together experienced and aggressive relationship managers, salespeople, and sales-traders[18] to service the often demanding accounts, and offered streamlined execution capabilities and plenty of market-making[19] capital to encourage the steady flow of commission-paying business. Overall, these efforts were designed to capture a substantial measure of the hefty fees these 800-pound gorillas were throwing off on a regular basis.

Undoubtedly, this new breed has driven many of the changes that have taken place in the equity market during the past few years. It is worth bearing in mind, however, that a wide range of individual and institutional investors, industry intermediaries, and others have long taken steps to avoid being stuck at the bottom of the financial food chain, even during the most euphoric moments of the last decade, when almost everyone appeared to be making money. Before the 2000 peak, for example, one especially aggressive segment of the long-only investing crowd embraced strategies that singled out companies with accelerating earnings or share price “momentum.” Once the shares were identified, the operators would leap on to the rapidly advancing uptrends and hang on for the ride. Although successful for a while, these “greater fool”[20] approaches proved to be a disaster when the Bubble burst and formerly high-flying stocks and sectors came crashing down to earth.

In the post-Bubble era of increased competition, unsettled markets, and outsized returns being registered by various segments of the alternative investment universe, it was inevitable that many traditional managers would try to follow in the footsteps of the newer operators. In numerous instances, they significantly stepped up the pace of their buying and selling activities. Occasionally, they granted centralized dealing desks the discretion to trade in and out of portfolio holdings on a short-term basis, or even to manage separate “pads.” A variety of mutual funds began offering products featuring short-selling or leverage strategies.[21] Some launched—or contemplated setting up—internal or affiliated hedge fund operations designed to compete with their modern rivals—and, ironically, even their own in-house teams. Faced with pressures from within their own ranks, many established operators also appeared to put in place a conscious policy of reducing cash cushions and increasing holdings of investments at the farthest reaches of their allowable comfort zones, potentially boosting relative performance. In general, the institutional universe seemed to be moving up the risk curve.

Similarly, many Wall Street firms, already well-versed in trading a vast array of securities in a variety of markets—with sophisticated risk management tools and structures at their disposal—went along with the shift towards a more speculative approach to making money. For instance, they granted market-makers and proprietary dealing desks increased authority to buy and sell issues unrelated to servicing clients’ immediate needs. The hope was that those activities could generate sufficient revenues to offset the overall drop in fee income that had taken place in the post-Bubble period. Small investors, meanwhile, stung by the double whammy of plunging portfolio values and a sharp decline in dividend and interest income, were under considerable pressure of their own. They, too, moved into more aggressive investment vehicles and adopted riskier trading strategies than many had been conditioned to do during the long-running upswing.

Even foreigners, who throughout the past century have played a significant role in the fortunes of the American markets, have gotten caught up in many of the same influences affecting domestic operators in recent years. Heavily invested in U.S. securities for an assortment of reasons—the nation’s standing as a global superpower, efficient trading structures and shareholder-friendly policies, relative economic vitality, and vast holdings of offshore dollars—overseas players have long viewed the American marketplace as a natural second home for long-term investment. They have also found it to be a powerful magnet for speculative “hot money” flows when things are really hopping. Because of their strong support during the past decade, domestic consumers and investors managed to reap substantial rewards in terms of cheap imports, low interest rates, and stock and bond values that were firmer than they might otherwise have been.

In recent years, though, the staggering increase in the size of overseas holdings of U.S. assets, combined with global financial strains and politically charged trade and exchange rate policies—which have become the focus of overseas attention amid a worldwide economic slowdown—have introduced an element of instability to our markets. Many domestic investors, it seems, are not even aware of the scale of foreign dependency that exists. Using the classic example from Chaos Theory[22] of a butterfly flapping its wings in Brazil influencing the weather in Texas, there are clear signs that even relatively minor events outside our borders will likely have a substantial impact on domestic equity prices and broader macroeconomic conditions in the years ahead. A Latin American politician barnstorming about the perils of Western values, a terrorist attack on an Asian tourist attraction, a magnitude 7.9 earthquake in Eastern Europe—these and countless other developments have the potential to echo, abruptly and loudly, throughout the land.

Meanwhile, the influx of foreign players with unique cultural biases has added to the ongoing “democratization” process that has taken place in the U.S. market during the past two decades. Aided in part by the rise of English as a universal business language, as well as enormous improvements in global telecommunications networks and a growing interest in international affairs, outsiders have joined the millions of small and large domestic investors who have become more actively involved in buying and selling shares. This broadening process has made the landscape somewhat less homogeneous than it used to be, and because the range of activities, attitudes, and perspectives has expanded significantly, it seems more difficult to get an accurate read on what the “average” investor is doing, saying, or thinking these days. Moreover, it appears that widely varying levels of sophistication, knowledge, and ability frequently lead to odd market moves in reaction to ordinary events. In fact, it often seems unclear exactly how participants will react after unexpected developments. In general, modern analysis now requires intense second-guessing and an increased reliance on pretzel-like twists of logic.

Finally, changes in the regulatory environment since the Bubble burst have altered the landscape as well, though the implications are not yet as apparent. As with many reactionary efforts by politicians in response to headline-grabbing crises, they frequently end up “fighting the last war” or they create unintended consequences that can sometimes cause more harm than good. For example, the implementation of rules such as Regulation FD[23]—Reg FD, for short—which is designed to prevent individuals such as brokerage analysts from gaining an advantage over others by obtaining important company information “first,” should theoretically make markets fairer. While that may or may not be true, what occasionally happens now is that unwanted volatility soars as market-moving news is abruptly, rather than slowly, assimilated into stock prices. Similarly, statutes such as Sarbanes-Oxley,[24] which was created to protect shareholders in the wake of Enron and other scandals by subjecting companies to added oversight, is probably causing managers to refrain from providing important—though potentially questionable—guidance about future prospects. Under such circumstances, investors may be denied critical intelligence they need for effective decision-making.

Whatever the case, all of these developments—changes in technology, economic circumstances, regulatory policies, investing perspectives, infrastructure, the range and variety of players, strategies, and products in the marketplace, the fallout from the boom and bust, and so on—have created a new investing climate. One that is fraught with perils for the naïve and the uniformed, but offers profitable opportunities for the knowledgeable and fleet of foot. It goes without saying, of course, that while the equity markets have been transformed in recent years, human nature has not, and successful money management will continue to depend on having the appropriate skills, emotional makeup, self-discipline, and consistent approach to capitalize on any opportunities that may arise, as well as weather the inevitable storms. Nonetheless, for most investors, understanding the forces at work in today’s investing environment—The New Laws of the Stock Market Jungle—will make it easier to achieve long-term success.



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