Excess baggage

This time it’s different” are the four most expensive words in the investing language. This quote from Sir John Templeton, which opens Sandy Nairn’s book Engines that Move Markets, epitomises the fever that spread through the City and among retail investors at the height of the technology, media and telecoms bubble in 1999 and 2000. The relentless rise in share prices was justified by the argument that the internet had created a new paradigm, known as the “new economy”.

The internet has undoubtedly transformed our lives, but valuations during the TMT bubble went beyond all reason. That share prices reached ridiculous levels is shown by how technology funds have struggled over the past five years. If someone had invested £7,000 in the average technology fund in February 2000, it would be worth £1,806 today.

A few voices warned investors against believing the hype, including Federal Reserve chairman Alan Green-span, but this did not stop investors, small and large, piling in. Indeed, Greenspan suggested there was irrational exuberance as early as December 5, 1996, in a speech at a dinner of the American Enterprise Institute in Washington DC: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?

“We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability. Indeed, the sharp stockmarket break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

Of course, it was to be another three years before the long bull market that began in 1982 came to a dramatic end. On March 6, 2000, Greenspan, with Arthur Levitt, head of America’s Securities & Exchange Commission, warned that new economy stocks had reached unsustainable prices. Just four days later, the centre of this irrational exuberance, the Nasdaq, reached its peak of 5,048 points. This marked the end of the bubble.

“When historians look back at the latter half of the 1990s a decade or two hence, I suspect they will conclude we are now living through a pivotal period in American economic history,” said Greenspan at a speech at Boston College. “New technologies that evolved Tfrom the cumulative innovations of the past half-century have now begun to bring about dramatic changes in the way goods and services are produced, and in the way they are distributed to final users.

“Those innovations have brought a flood of start-up firms, many of which claim to offer the chance to revolutionise and dominate large shares of the nation’s production and distribution system. And participants in capital markets, not comfortable dealing with discontinuous shifts in economic structure, are groping for the appropriate valuations for these companies. The exceptional stock price volatility of these newer firms and, in the view of some, their outsized valuations indicates the difficulty of divining the particular technologies and business models that will prevail in the decades ahead.”

Levitt went further in his comments: “These times of unprecedented opportunity and change also demand greater vigilance from investors. A new, heightened optimism is fuelling an almost unbridled culture of entrepreneurship, innovation and investing. But history has taught us that the greatest threat to continued prosperity is a loss of perspective.

“There is still much we don’t know about what drives today’s economy and even less about where it’s heading. During these formative times, all market participants must recommit themselves – above all else – to adding value and serving the investor interest. And, more than ever, investors must remain focused on what makes sound investing sense for their families, for themselves and for a more financially stable future.

“These days, what a company is worth may be the hardest question of all. Valuing a company has never been an exact science. But in today’s market, does it even make sense anymore to look at a P/E ratio? Are some of today’s companies really worth 1,000 times nothing?” Even for those who lived through the TMT bubble, it is still staggering to look back at the returns from this period just five years after it burst. Between March 1995 and March 2000, for example, according to Standard & Poor’s, the global information technology sector rose in value by 561.8%. The global telecoms sector returned 332.5%, while media and entertainment delivered a return of 232%. This was in contrast with a return of just 41.9% by the global utilities sector, demonstrating that not all sectors experienced irrational exuberance. In the same period, the Nasdaq returned 492.3%.

Stockmarkets generally enjoyed strong returns over this five-year period. The S&P 500 returned 207.3% against 138% by the MSCI World and 137.8% by the FTSE All-Share. The average UK All Companies fund trailed slightly with a return of 135.8%.

Why did investors not listen to warnings from Greenspan and Levitt, as well as from fund managers such as Tony Dye of Phillips & Drew? And it was not only investors who failed to listen. Many fund managers came under pressure from employers and some felt their jobs were at risk. It has been said that Neil Woodford at Perpetual felt this pressure, and Dye and Phillips & Drew parted just before the peak of the bubble.

The reason is partly that there was some foundation to the hype, in the form of the development of the internet and the fact that more than £150bn was spent on technology products to prevent them being disabled by the millennium bug. This was supported by a booming economic and business environment. Global economies were growing rapidly, led by America, and there were breathtaking corporate acquisitions, including AOL’s takeover of TimeWarner and Vodafone’s acquisition of Mannesmann.

So why did the bull market run out of control? It is safe to say it was the result of a number of events. The catalyst was undoubtedly the development of the internet and the opportunities this presented in terms of productivity gains, higher margins and increased distribution potential. There was the strong economic growth of the late 1990s, the substantial liquidity being produced by falling interest rates and the massive spending on the millennium bug as well as developments in the way people invested in stockmarkets.

The first of these developments was the rise of index-tracking funds and the trend of active fund managers to stick more closely to the benchmark than today. An increasing number of fund managers became closet index trackers as they did not want to risk suffering relative underperformance. With growing amounts of money flowing into shares based on their stockmarket capitalisation, the rise in prices became self-sustaining. As share prices of the largest companies rose, so index trackers had to devote more money to them and so they increased in value further. Not all fund managers, however, attribute such a significant role to index-tracking funds.

It also became easier for retail investors to speculate on the stockmarket, spurred by friends and families making fabulous returns from their share portfolios. Discussions about the previous day’s share price movements were as common as the weekend’s football results. You could not turn on the television or open a newspaper without seeing talk of the latest technology flotation. It was similar to today’s fascination with the property market.

Ironically, retail investors were gaining greater access to stockmarkets through the development of technology, notably online trading and websites devoted to financial news, access to pricing information, corporate results and announcements, and lower trading costs. This created a new breed of investor who was more informed, more inquisitive and more in touch with financial activity than ever before. As a result, investors became more directly involved in managing their stockmarket investments.

Alan Torry of SG Asset Management, however, says the internet was the main driver behind the bubble. He argues that there were sound fundamentals behind the bull market, but that valuations reached unrealistic levels: “Capital spending on technology increased dramatically. According to US data, spending on technology rose by about 16 times from the mid-1990s to 1999. Technology spending increased for the first time again in 2004 when it rose 9%, yet it is still 80% off its peak levels. As a proportion of total capital spending, technology expenditure in America grew from about 20% to 25% up to 47% in 1999.”

It was not just the internet that drove this spending, but also the perceived need to prepare for Y2K, says Torry: “The spending did not get out of control but the momentum behind share buying became self-fulfilling. This was reflected in the proliferation of technology funds. In 1998, when we launched our technology fund at SG, there were five other unit trusts. This grew to 30 within two years.

“It was hard not to get caught up in the momentum. We all looked at quarterly performance tables and no-one wanted to be left behind. We had liquidity three months before the peak because of where valuations had reached, but we felt we had to put this money into the market because we did not know how long the momentum would run on for.”

One consequence of the TMT bubble is that technology is still out of favour as far as retail investors are concerned. Torry says this has led to the sector losing much of its previous volatility.

If technology fund managers felt under pressure, it was even worse for managers who did not fully participate in the bubble. Alex Tarver, an analyst at Fidelity Investments, says such was the momentum behind the TMT bubble that even Anthony Bolton confessed he thought about reviewing his process of analysing stocks: “Anthony thought about whether he should change anything in his investment approach. He did wonder if he would have to revisit his style of managing money.

“He attributed his relative good performance at the time to picking up undervalued telecoms. He rode up some of the telecom bubble, and then managed to sell his telecom exposure down and started buying old economy stocks before the market rolled over.”

Tarver adds that the bubble was an exciting period in which to be managing money or analysing stocks: “At meetings, companies like Tesco were considered to be dotcom stocks because it had internet shopping. There were search engines that people thought would out-search Google. There were young entrepreneurs driving around in Porsches, many of whom were spending all their seed money on advertising.

“Many people really believed the world had changed. After all, it was at this time that phrases such as business-to-business and business-to-consumer were invented. Ironically, firewalls and encryption had not been launched. The internet probably would have fallen over if it had continued to grow at the pace some had predicted at the time.”

It is argued that remnants of the TMT bubble are still with us in the form of excess capacity and asset bubbles. Tarver argues that the bubble has had a number of other effects: “Everyone talks about the importance of earning dividends from stocks now. But during the bubble, growth stocks often did not pay any dividends. People forgot that until the 1990s, something like 50% of market returns had come from reinvested dividends. Another impact of the bubble has been the change to the way the sell-side analysts operate.”

There has also been greater focus over the past five years on absolute returns and nimble, actively managed funds. It is almost as if relative performance has become a dirty phrase to be whispered in the shadows. Undoubtedly, this is at least partly a hangover from the TMT bubble.

Fund managers seem to agree that there will be further bubbles. Not only does history often repeat itself, but the next generation frequently forgets what the previous one has learned. It may not even take as long as the next generation. It is argued by some fund managers and economists that we are still living with asset bubbles; it is just that they have moved on to property and bonds.

If you are skilled or lucky, you can ride the wave of a bubble and then sell before it comes crashing down. The unskilled or unlucky are still nursing the losses they suffered from the bursting of the TMT bubble. Does anyone want a buy-to-let property?

“The ship is still sinking”
Paul Thursby, a bond fund manager at Thames River Capital, picks up the theme of liquidity by saying it is one of the main reasons behind the sustained bull market: “Investors went with the flow because they believed they could make strong returns out of the new technology. It gained a self-fulfilling momentum. This was helped by the fact that the investment community was very index-driven at the time. People invested as it became a larger part of the index.”

The excess liquidity that contributed to the TMT bubble is still with us, says Thursby, but is now in a different form: “Since the bursting of the TMT bubble, investors have moved on to other assets.” He says it has reappeared in the corporate bond market, where spreads are at historically tight margins. “Real yields are very low. This is a hangover from previous liquidity excesses by central banks over the past 20 years. Every time there has been a major problem, such as the Asian crisis, Long-Term Capital Management and the TMT bubble, central banks, including the American Federal Reserve, have responded by increasing liquidity.

“The effects of this have not appeared in retail price inflation but in increases in asset prices. The Federal Reserve is tightening interest rates and the question now is how will this play out. It may lead to investors withdrawing from bonds, spreads widening and those remaining suffering capital losses. It is like the Titanic. Investors may shift to the other side of the ship, but the ship is still sinking. This has not come to grief yet, but it could do.”

In response, Thursby has been moving into short-dated and Asian bonds. In theory, longer-dated bonds are more sensitive to movements in interest rates: “We believe Asian currencies are relatively cheap and will appreciate over time. Therefore, moving into Asian bonds is a currency play. Investors have been buying euros, but we think they will move on to Asian currencies. There are other opportunities, such as Mexican bonds offering a 9% yield at the moment.”

“There will be other bubbles”
John Chatfeild Roberts, head of multi-manager at Jupiter, reduced his exposure to the technology sector just before the TMT bubble burst. He says the bull market of the 1990s started on the basis of all bubbles – a good investment idea: “The problem is the investment idea is so good that lots of investors rush into it. In the early 1990s, most technology companies were on single-digit price/earning ratios, but they started heading towards ridiculous valuations after the successful IPO of Netscape.”

He says the listing and subsequent rise in the share price of Netscape seemed to spark greater interest in technology shares. The process was aided by loose monetary policy and then gained a momentum as investors believed the growth potential of the sector. Chatfeild Roberts says it was the same phenomenon as occurred with other bubbles such as the tulip mania of the 1630s and the South Sea bubble of the 18th century.

As a fund of funds manager, Chatfeild Roberts saw at first hand how other fund managers reacted to the TMT bubble: “It depended on which type of manager you were. It was exciting if you were the right side of it. Many managers believed they could ride up the bubble and someone else would be left holding the baby. Others loudly protested about the stupid valuations being paid for technology companies, many of which were not making any profits. It could be argued that Tony Dye was too early in his protestations as he began in about 1996. He lost his job in 2000 just as the bubble was coming to an end.

“It was a difficult period to analyse companies and demand and supply factors. At the time, it appeared there was a shortage of semiconductors, for example, but it was only later that we realised companies were ordering the same supplies from three different companies because they were worried about a shortage. A few fund managers who did not participate in the TMT bubble invested in technology stocks in the autumn of 2000 after they had come back in value because they missed the run in the late 1990s.”

He says fund managers came under internal pressure for not participating in the TMT bubble. But it was also difficult, says Chatfeild Roberts, for multi-managers to analyse fund managers as traditional measures became warped by the bull market: “We looked at a North American equity manager who said he had a Garp [growth at a reasonable price] approach. We ran his portfolio through the Barra system, which said he was a deep value manager. This is because the system had become corrupted by the bubble.”

Chatfeild Roberts says he does not believe the consequences of the TMT bubble have come to an end: “You could argue that there are still some ridiculous valuations of technology stocks, especially in the US. On the question of whether there is still excess capacity in the global economy, this could be answered in relation to China. There is a shortage in any raw materials that China requires, but there is excess capacity in anything China does not need. There is quite a lot of truth in this statement.”

While it is said that bubbles occur every 10 years, Chatfeild Roberts does not believe the same investment bubble can happen more than once in a generation: “I got burnt in the property boom of 1988/89. I have not forgotten that and the same is true of the TMT bubble. But there will be other bubbles.”

It’s always different this time”
Sandy Nairn, chief executive of Edinburgh Partners, says the TMT bubble followed a similar course to previous bubbles: “There are a number of characteristics that all investment bubbles have. The cost of capital is usually cheap, so bubbles rarely occur when interest rates are high. It is based on a sensible investment idea in which valuations get out of proportion. There is pressure for people to participate and then the market rolls over.

“The other characteristic is that people always say this time the dynamic is different. New technology is, therefore, usually a crucial ingredient in creating a bubble as there is a basis in something new and different. With the TMT bubble, it was that the internet had created a new paradigm. Japan in the late 1980s was also said to be different when the Nikkei went above 30,000 points. It is amazing what is said at the time of a bubble about how the world has changed. I have kept files on the rubbish that was written about Japan.” Nairn says that bubbles are also characterised by a proliferation of flotations.

He admits that as a fund manager it is difficult to resist pressure when markets experience bubbles: “Some people say there is no point in being right if you are underperforming substantially in a bubble period. There is pressure on managers to follow this momentum. Fund managers faced accusations of not understanding the new dynamics if they did not participate in the TMT boom. In the US, fund managers underperformed if they did not own 10 specific stocks. The question was how long could they afford not to own these stocks.”

Nairn says that fund managers reacted in different ways to the bubble, partly as a result of their investment approach, experience and which asset manager they worked for. Some companies were more supportive of managers than others: “The pressure was enormous and it came from both investors in funds and in some cases from within asset management firms. Some managers went with the flow against their better judgment because they felt they had to; some said they had had enough and left the industry; some kept out of TMT stocks altogether, and others might have believed the new paradigm story. There were some real battles going on at certain asset managers. I was at Templeton at the time and it was very supportive of our approach.”

A bubble is sustained, says Nairn, partly because most investors do not realise they are experiencing a bubble, and also because it is based on a good long-term investment story. Another factor in the internet bubble, says Nairn, was that Greenspan reduced interest rates after the Asian crisis in 1997 to loosen monetary policy, providing another leg-up to the stockmarket rise: “The monetary authorities in the US and UK were trying to prevent a hard landing for their economies and a recession by lowering interest rates. This resulted in credit bubbles.”