How Investors Can Become Divorced From Reality: The Stock Market School of Hard Knocks

by | Feb 3, 2000

I’ve worked as an equity analyst and portfolio manager for about eight years now, focusing on international markets. The question that I and most others in my profession are constantly asking ourselves is, “is the market wrong about this?” As a general rule, I think that markets are “efficient,” in that market prices reflect all […]

I’ve worked as an equity analyst and portfolio manager for about eight years now, focusing on international markets. The question that I and most others in my profession are constantly asking ourselves is, “is the market wrong about this?”

As a general rule, I think that markets are “efficient,” in that market prices reflect all of the knowledge and opinions about the future that are acted upon by market participants, weighted by the size and urgency of these participants’ actions. Yet, I believe that for limited times and degrees, entire stock markets can be affected by participants who (at least in retrospect) acted on the wrong ideas. In particular, the period of 1996 and 1997 provided three examples of how investors can become divorced from reality. Each of these scenarios provided me with a valuable lesson in the mechanics of the market.

The first market event occurred in 1996, when the stock of Iomega was recommended by a couple of investment groups that catered to inexperienced investors. The company had an interesting story of a new product, the “Zip” drive, which some said would eventually become the next floppy disk. The stock performed well, and as it went higher, more and more people were attracted to it. For awhile, the faster the stock moved up, the more investors rushed to get “in on the action”, and the stock price rise attracted increased analyst coverage from traditional brokerages. At its peak in mid-1996, Iomega’s stock was valued at about $6 billion. By the time that Zip production got really going, however, anticipated pricing and volumes began to disappoint earlier expectations, and by the end of the year, the stock had fallen significantly. Since then, the value of the company has gradually slid down to under $1 billion (about an 85% decline).

A similar phenomenon happened in Canada around the same time. A little-known gold exploration company from Vancouver named Bre-X announced a major gold/nickel deposit discovery in Indonesia. At first, investors were skeptical, as Vancouver-based exploration companies were notorious for scams. But the stock price continued to rise on further detailed and positive announcements, and more people became interested in the company. A few Canadian brokerages picked up coverage, and the early gold-bug type investors started to make impressive money, in the thousands of percents. Multinational mining companies started seeking relationships with Bre-X. Global brokerages, smelling investment banking opportunities, began initiating research coverage, and in general there was a flurry of excitement around the company and its prospects.

As more investors became attracted to its stock, Bre-X’s value soared to over $4 billion. In 1997, however, a little over a year after the discovery announcement, the company’s chief geologist fell from a helicopter in an apparent suicide. Shortly thereafter, it was discovered that there was in fact no significant gold deposit on the property, and the stock was suspended, worthless.

My third and largest lesson in market mechanics occurred between mid ’96 and mid ’97, when Hong Kong saw the “Red Chip” phenomenon lead its entire stock market upwards. Red Chips were Hong-Kong listed holding companies that had “strong connections” with Chinese Communist Party (CCP) officials. The idea was that the CCP would inject choice Chinese businesses into Red Chip companies, at attractive prices. Red Chips started moving up rapidly, and investor enthusiasm grew in proportion. Rising prices and market valuations helped to legitimize the concept of the Red Chip, so stocks which at $1 were timidly rated “speculative buy” by second-rank Hong Kong brokerages, were at $10 rated “strong buy” by the “blue-chip” American and global brokerages.

When the Asian crash hit and China took over Hong Kong in mid-1997, investment banking inflows dried up, and most Red Chips were struck by cash shortages as their PRC operations generated negative cash flow. Three years later most Red Chips are trading at well below half their previous levels, and many are bankrupt.

***

Am I the only one who sees a similarity between the episodes above and what’s happening to the U.S. stock market? One key similarity is that there seems to be a growing number of new investors attracted to stocks by their high past returns. In each case, even I have to admit feeling a pang of regret for not “following the momentum”, particularly when returns were exceptional for those who did. In each case, it ended badly, teaching us that investors who believe that past high returns indicate high future returns are basing their investment decisions on a false premise.

I will say this about the U.S. market: current valuations imply that investors are expecting unusually good economic conditions to last for an unusually long time. Some industries’ valuations suggest that investors expect growth of intensity and duration that would surpass any in financial history. Perhaps these investors’ expectations will be right, and perhaps they will be wrong. Examine the expectations, the motivations, and methods of analysis of those who are acting in the market. I don’t accept “bubble” theory, but I do think that some investors can make mistakes and later change their minds

An even bigger concern is that if current valuations begin to bother the Fed or the Treasury enough, Greenspan and his gang will aggressively act to prove these investors’ expectations wrong by reacting with bad economic policy and forcing the market down. For example, the Treasury and the Fed could start following advice from the IMF, and hike interest rates while simultaneously devaluing the dollar. Such actions would nearly ensure that the future didn’t live up to shareholders’ expectations.

Andrew West is a Contributing Economics Editor for Capitalism Magazine. In 1997 he received the Chartered Financial Analyst designation from the Association for Investment Management and Research.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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