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Book excerpt: A Decade of Delusions

AT ITS most rudimentary level, the featured financial story for 2000 was about speculation in certain favored industries, escalating through the process of contagion to preposterous and ultimately self-defeating extremes.

It’s a phenomenon that has repeated itself throughout of human history and necessarily has been examined in these pages in the past. If ever-iconoclastic rationalism and uncompromising intellectual independence were called for, the year just past was the time for it. Only you can be the judge as to whether we kept our heads when many about us were losing theirs.

In the midst of all the wealth-destroying “gore” for which 2000 will be remembered by a horde of sheep shorn naked, we trust that you never lost a night’s sleep (or even got “bushed”) worrying about the safety and security of your portfolio, about the possibility of a crack that threatens to become a chasm in your nest egg.

Wealth management, the markets in their own perverse way occasionally remind us, is not just about eating well; it’s also about sleeping well. Perhaps our profession is not unlike amateur tennis: It’s usually not the number of winners hit but rather the number of unforced errors that determines the outcome. The rather extraordinary and equally humbling absolute and relative performance of last year was in part the result of good defense – we had only one unforced error – and the concurrent but somewhat unexpected good fortune of the market choosing this particular year to recognise how undervalued some of our companies were, resulting in four outright winners as well.

To be sure, it is not our intent to make light of the breadth of financial trauma suffered in many sectors the past year but simply to remind you of its existence because, like a hurricane in the Caribbean, it rendered its devastation elsewhere. Don’t be fooled; the storms may not have passed. And the winds of destruction could reach places heretofore untouched. Though your experience may be vicarious thus far, the lessons learned from the stories that follow should be taken with the highest degree of seriousness. And the word “trauma” may well understate the magnitude of the markets’ giant sucking sound, like the enormous and indiscriminate vacuum cleaner mounted on the sleigh of the Grinch (the wonderful character in the Christmas movie starring Jim Carrey) as the town of Whoville unwittingly surrendered all its accumulated material gifts to a thief in the still of the night before Christmas. Suddenly, it seems, billionaires have shrunk like cheap cotton to millionaires, millionaires slipped into the ignominy of being merely well-to-do, and all manner of speculators – big fish and minnows alike – were rendered, for lack of a better phrase, acutely unrich.

Putting numbers to the diminution of paper profits is telling. Overall, it is estimated that the market capitalisation of U.S. equity securities fell some $2.5 trillion over the course of the year, against a start-of-year total of approximately $17.4 trillion. The value of all stocks on the New York Stock Exchange, about $12 trillion, was essentially flat for the year, while the Nasdaq lost approximately $2 trillion, compared with a start-of-year total of an incredible $5.3 trillion. From its peak on March 10 in 2000, the Nasdaq Composite fell 39.1 percent. The index itself plummeted from 5049 to 3521 in a matter of 34 days, reaching a low of 2333 on December 20, which translates to a breathtaking peak-to-trough decline of 53.8 percent.

In the euphoria of a year ago, a bear market was thought to be a decline of about 20 percent. Who, I wonder, after “tout television” picked up on the 20 percent figure, was originally responsible for suggesting such an arbitrary and foolish metric? The market capitalisation of the Dow Jones index of internet stocks fared even worse. From its peak, also on March 10, the market capitalisation declined dramatically from just over $1 trillion to $251 billion on December 21, a shocking 76 percent. The remediation of speculative excess is often as dramatic as it is devastating.

Lest we overlook it, bifurcation was as evident in 2000 as it was the year before, this time in both the equity and the debt markets, as well as between them. With regard to the equity markets, the players simply reversed their roles. While the technology-bashing was under way, there was a resurrection of interest of sorts among the old-economy industries. As for bonds, Treasuries prospered, thanks to falling interest rates, while junk simultaneously sank because of worsening credit quality.

Finally, while stock prices went down, quality bond prices went up. Not only was paper wealth greatly diminished as the bubble began to burst, what wealth remained (of which there is still plenty) was subjected to a winnowing process known as redistribution. In the relative scheme of things, discerning and prudent investors climbed a rung or two on the ladder of wealth preservation and accumulation, while those who didn’t know any better (or, if they did, those who sacrificed rationality at the altar of momentum investing or its variations) dropped a rung or two… or more. As was noted in the 1999 annual report, there are always opportunities, but they are rarely found in the obvious places.

As for those who fueled the fires of reckless speculation – the men and women of our profession – we’ll have more to say about them later.

In the words of Aristotle: “One swallow does not a summer make.” Although the decisions we made during the course of the last year led to above-average equity-investment returns, we view such decision making as but one brief segment in a long-term continuum. Who knows what tomorrow will bring? We draw some solace from the deeply held conviction that the ideological foundation upon which our security selection and portfolio management practices have been painstakingly built will, at the very least, keep you out of harm’s way. At the very best, we may surprise a few people who believe that there is always a correlation between risk assumed and return earned – and that conservative is invariably synonymous with lacklustre results. In the meantime, if we continue to adhere to our principles, we are likely to avoid many of the temptations that come in the form of folly, greed and (most critical and sometimes most troublesome) fear, which on occasion precipitate the most irrational and destructive of behaviors. Our approach served us well in the final 12 months of the second millennium AD, but 2001 will be a new odyssey, to be sure. Again, our convictions will undoubtedly be put to the test. As always, we will forsake the lure of so-called opportunity where the flip side of that coin may result in permanent loss of capital.

A Decade of Delusions: From Speculative Contagion to the Great Recession, written by Frank Martin

Published by John Wiley & Sons, 2011

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