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Part 3: Survival of the Fittest: The Jungle of the Future

Part 3: Survival of the Fittest: The Jungle of the Future

Developments that will likely influence tomorrow’s markets.

One of the most significant influences on the stock market over the past decade has been the impact of improving technology and increased information flow. From enhanced communications to better trading systems to refined analytical methods to the phenomenal growth of the Internet, these developments have enabled individuals and institutions to research, analyze, and invest in ways they could not really do before. Up until now, however, the lion’s share of the benefit—as has historically been the case—has accrued to those who manage large sums of money—either their own funds or the pooled investments of others. In fact, given the financial and academic resources at their disposal, the economy-of-scale leverage they enjoy, and the close relationships they have with the movers and shakers in the business and financial community, it would have been surprising if they had not been able to maintain at least some measure of their traditional edge over the “little guy” when it comes to identifying and capitalizing on share price disparities.

And yet, despite what appears to be a significant advantage, it seems a good bet that this situation will change in the years ahead, with the differential shrinking in favor of the small investor. Why? Much of it comes down to the disadvantages of size. For, although various parts of the equity market have had numerous inefficiencies wrung out of them—helped by sizeable doses of intellectual firepower and the aggressive efforts of a rapidly expanding hedge fund sector—the primary focus has been on large capitalization issues. This makes sense, of course, given that many modern institutional portfolios tend to be measured in the billions of dollars. Usually when these managers want to invest, what they have to play with seriously limits their options. In fact, even if they want to venture out into less crowded terrain, there is generally not much that they can really do with respect to smaller companies and other less liquid investments. Moreover, with the prospects for consolidation and convergence in the mutual fund and hedge fund industries seemingly assured in the not too distant future, it is not unreasonable to assume that there will be even greater concentrations of pooled funds in the institutional universe than there are now. As a result, what will probably happen is that issues that make the institutional cut, so to speak, will end up being sliced and diced by all sorts of ultracompetitive operators, while those that do not will remain relatively ripe for everyone else to pick over.

What this also suggests, however, is that because many of the obvious mispricings in the weightier issues will be largely arbitraged away, that segment of the market will be increasingly dominated by sector- or theme-driven flows, with stock-specific factors playing a diminishing role. Practically speaking, the emphasis will be even more narrowly focused on overall market direction than it is today, mirroring the essence of what exists in the foreign exchange or bond trading arenas. The exception will be a further escalation in program trading and other forms of mechanized buying and selling that will exploit the narrowest types of anomalies on a continuing basis. The result? More momentum-driven trading, more intraday volatility in the better-known issues, and less opportunity for investors to make money in the shares of large companies using traditional investing approaches. In contrast, those who focus on small-cap stocks could stand to realize substantial rewards from their efforts. For one thing, they will have the opportunity to employ modern tactics and finely tuned methods—and to make use of the most up-to-date knowledge and critical intelligence—to take advantage of inefficiencies that will presumably continue to exist in a diverse universe made up of less widely followed securities. In addition, it is probably fair to say that they will not have to worry about bigger, stronger, and potentially more influential operators coming along and spoiling the party.

Ironically, while these developments will tend, on balance, to eliminate even more inefficiencies than have been eradicated thus far, it is conceivable that they may also put the final nail in the coffin of the Efficient Market Theory (EMT). This proposition—which essentially argues that markets are, by definition, correctly priced and tend to be influenced almost exclusively by rational investors acting in their own best interests—has long been a source of contention between certain academic interests and experienced professionals who have actively traded shares on a real-time basis. In the hypothetical world of EMT, anomalies such as stock market bubbles cannot really exist—or if they do, they are but one of what appears to be a series of exceptions to the rule. However, like those who once believed in the emperor’s new clothes, it seems that many former adherents are starting to come around to the idea that the reality of investing is somewhat different than what they had originally thought. As it happens, what has helped to alter this perspective is another growing body of academic research known as Behavioral Finance. This theory recognizes—correctly so, as many seasoned operators would argue—that irrationality often plays a significant role in influencing when, how, and why people buy and sell. Sadly, the shift has also been—and will probably continue to be—supported by the negative experiences of those millions of investors who got caught out by the EMT crowd during the Bubble years, when the latter group essentially made the case that people should stay fully invested in stocks “for the long run,” regardless of price.

On the plus side, with this greater appreciation of the human factors that can influence share prices is likely to come an improved understanding of one of the most basic tenets of equity investing. This is one that has been fairly apparent for many years to those who have a contrarian bent, and even to those who have merely taken the time to observe what goes on around them—in nature, in business, and in everyday life. Simply put, it is the fact that markets tend to overshoot and undershoot, getting dramatically expensive in some instances and exceptionally cheap in others, because they are influenced by people with biases, emotions, and shortcomings that cause them to act in ways that often defy logic. And, then, as Figure P3.1 suggests, the markets tend to swing back, like a pendulum, and revert to their historic long-term averages. As Jeremy Grantham, Chairman of fund group Grantham, Mayo, Van Otterloo & Company, noted in January 2003, in the case of 27 different extraordinary moves—or “classic asset bubbles,” as he called these once-every-40-year swings—involving a full range of instruments from stocks and bonds to currencies and commodities, “every single one retracted all of the gain [and went] all the way back to the original trend line.”[1].

Figure P3.1. Reversion to the Mean? Earnings Growth Rates: 1974–2003 (Rolling Three-Year Periods through June 30, 2003) (Source: Bernstein Investment Research and Management).

And lest some make the argument that such reactions are confined to extraordinary times or unusual macroeconomic circumstances, other research suggests that is simply not the case. As equities historian David Schwartz noted, writing in the United Kingdom’s Observer newspaper, “Periodic catastrophic declines that destroy years of accumulated profits are the norm, not the exception,” based on his analysis of two centuries of data from the UK stock market. Adds Schwartz, “History teaches [us] that virtually every major multi-year advance during the last two centuries ended with a lengthy period of underperformance.”[2] While skeptics might key in on the fact that the conclusion was not based on an analysis of U.S. share price trends, the relevance of British finance to the investing world over the course of the past 200 years would seem to suggest it is not an observation that should be taken lightly. Interestingly enough, on the back of this view, one could even make the case that the recent shift towards a more active trading approach is utterly justified, given the abnormally high returns that have been seen in the American market over the past two decades.

Perhaps more alarmingly, the inevitability of a reversion to the mean in the U.S. stock market and the long history of catastrophic declines may also lend credence to fears in some circles that there is an increased risk of a major financial “accident” taking place over the next few years—one which may ultimately affect all investors, large and small. Although there are any number of possible circumstances driving such worries—the widespread acceptance of venturesome behavior; the complexity of instruments and portfolios that depend on significant computational analysis for valuation, monitoring, and assessment; the dispersion of risk through the use of derivatives and other synthetic instruments; the speed with which markets can move and trades can be executed on all sorts of electronic exchanges; and the way that communications about potentially troubling developments can rapidly circulate around the globe—all seem to boost the odds that something may eventually go spectacularly wrong. Although there are supposedly systems and procedures in place that are meant to reduce the possibilities of a systemic reaction, it will be in investors’ interests to keep a close eye out for any warning signs that may arise on this particular front.

Finally, while there are other changes that will probably come to pass—expanded regulation on the heels of the recent scandals, increasing disintermediation as individuals and institutions begin to deal directly with one another through the same electronic exchanges, shifting geopolitical fortunes and a continuing decline in America’s once singular dominance, and a major restructuring of public and private retirement options—there is one perspective that will likely remain a steady fact of life in the stock market jungle. Just when everyone really starts to get comfortable with the way things are, that will be when circumstances will be set to change once again.

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