Stock Market Whiplash: How Bad is the Burn?Published: April 26, 2000 in Knowledge@Wharton
The movement of stocks in the past few weeks, especially that of the NASDAQ Composite Index, has been so contorted you half expect investors to rush to their doctors complaining of whiplash. The NASDAQ declined more than 25% in five days, a fall that culminated on April 14 with the index's biggest-ever one-day point plunge and second-largest percentage decline. Then, just when it looked like Wall Street's raging bull had morphed into a vengeful bear, on April 17 and 18, the NASDAQ snapped back with its biggest two-day gain ever, in both point and percentage terms.
On Monday of this week (April 25), the NASDAQ plunged another 161 points, or 4.31%, while on Tuesday, it climbed back up with a 228.9-point, or 6.57%, gain. Even the Dow Jones Industrial Average has seen some wild swings, although they have not been as neck-wrenching as those of the tech-heavy NASDAQ. If a bear market indeed has arrived on Wall Street, it appears to be a puzzled bear, whose confusion matches that of many investors.
At the same time that stocks have been volatile, recent figures show an increase in consumer prices, and the labor market continues to be tight. To explore the reasons for the volatility and to gauge the outlook for the market and the economy, Knowledge@Wharton talked with three savvy market-watchers: Wharton finance professors Marshall Blume and Jeremy Siegel, and David Pottruck, president and co-chief executive officer of Charles Schwab.
Knowledge@Wharton: What factors have accounted for the market's recent volatility?
Siegel: The major factor causing the decline in the NASDAQ really doesn't relate to outside events directly. The major factor is investors learning that other investors will not automatically buy their stock at higher prices than what they paid. A lot of the price movement on Wall Street is really nothing more than investors learning from other investors what people will pay for stocks. That generates more movement and often is a much bigger source of instability in the market than extrinsic news events.
I'm not surprised at NASDAQ's volatility. It's very usual in any bear market to have sharp snapbacks where people buy at what they think are bargain prices. Then there's often a move back toward the low, which we may have seen with Monday's decline. Monday's fall was precipitated by Microsoft's earnings report and future earnings warning. But what the decline also did was cause a lot of people to say, 'My goodness, if Microsoft, the erstwhile king, can fall, what can happen to these other big-cap tech stocks?' Nevertheless, earnings are very good outside of a few isolated examples. If you had told analysts two months ago that earnings would be this good, they would have been very happy.
Pottruck: The strong economy, rising inflation and the Microsoft case have triggered concerns over market valuations. In addition, you have the undeniable fact that many Internet stocks are terribly overvalued. As people move from greed to fear it causes a mad rush to get out the door and hold onto profits. If you look at the last 12 monthsthe last nine months, certainlythe market has been dominated by psychology more than economic factors. There is often a psychology of general nervousness, and if something then triggers an increased level of pessimism and lack of confidence, people race for the exits.
Blume: There's a formula that investors can use to determine what the price of a share of stock should be. This theory says that the stock price is equal to the dividend paid by a company divided by a difference of two numbers. The two numbers are the required rate of return and the growth rate of earnings. This formula is really only useful for a normal type of company, the "Old Economy" type of company, where you have dividends increasing steadily. A very small change in the growth rate of earnings can create a substantial change in the value of the company.
Now we get into these New Economy stocks where they don't have dividends, or even earnings, so what do we do? You're getting earnings real far out in the future and modest changes in growth rates are going to have a very substantial change in the value of that stock. If there's good news of any kind, the price goes up a lot, and if there is bad news the price drops. The reason is that all the value of these companies is in the future. That creates uncertainty.
Knowledge@Wharton: Why did the markets rebound so quickly last week after the big decline on April 14? What is the outlook for further market declines?
Pottruck: As far as last week's bounce is concerned, traditionally the great thing about markets is that you literally have millions of buyers and sellers looking at prices and saying, 'Is this stock now a bargain? It used to be $100, now it's $50. I liked it at $100, now I love it at $50.' So you'll have people step in to buy at bargain prices.
Siegel: It's important to remember that there's only a bear market in NASDAQ stocks. There's no bear market in the [Standard & Poor's 500 or the Dow Jones Industrial Average]. We have to be focused on where there is a bear. Time will only tell if the lows reached on April 14 will hold or not. I think they have a chance of holding. However, that will depend on upcoming events. One of the myths that has really been exploded with the decline in the NASDAQ was that "New Economy" stocks could stand apart from the "Old Economy." People now realize they are critically intertwined.
Knowledge@Wharton: Can you put the recent volatility in perspective?
Blume: You could argue that the 1980s and 1990s were a period of low volatility. In the grand scheme of things, the volatility of recent weeks and months has been more in line with a long span of history. For the last 15 or 20 years, we haven't had [heavy] losses in the stock market. Normally, the market goes down once every three or four years. That hasn't been the case during the most recent bull market.
There's an issue that needs to be examined. Is the volatility normal or excessive? Excess volatility is an overshooting argument. It says the market goes up or down more than it should in any particular period. Therefore, it will reverse itself. I don't know if that's what we're seeing. If you don't have overshooting, then you have volatility dictated by the fundamentals. If things overshoot because people overreact, that's not good for the market. That's when you see extra risk all over the place.
Knowledge@Wharton: How have Schwab customers reacted in the last two weeks?
Pottruck: We've seen a lot of investment activity. Some are sellers, many are buyers. They are looking for bargains.
Knowledge@Wharton: Are you concerned about inflation?
Blume: Some of the indexes, like the Consumer Price Index, are starting to go up. Everybody recognizes that the labor market in the U.S. is very tight, which can lead to inflation. The rest of the world economy is starting to pick up. That means overseas companies will be able to raise prices when they ship goods to us, which also can contribute to inflation.
Pottruck: I am concerned about inflation. I see it in my daily life at work. I see competition for people bidding up the price for talent. I see competition for real estate bidding up the price for office buildings. We also have wonderful technology applications in our society that bring in new levels of productivity to companies. This helps reduce the pressure on costs.
Siegel: Now the focus is going to be put on the Fed and what it will do at its May 16 meeting. Earnings season will end this week and attention will turn to the Fed and to the inflation announcements that will be coming out. The recent increase in core level of the CPI was a disturbing factor but it was only one month. You usually need to see two or three months of poor showings on the core rate before you start to worry about inflation. It should cause us to be a bit on alert, but let's not overwrite the script at this point. There have been other one-month blips.
KnowledgeWharton: How should the Fed respond to recent developments?
Siegel: My feeling right now is they're on track for a quarter-point increase unless the inflation news is bad. We'll have the first announcement Thursday with figures for the employment cost index, but there will be other reports subsequently. If the economy continues to be strong and if inflation is higher than previously thought, then a 50-basis-point increase would be called for. But I think the decline in the NASDAQ has broken many investors' expectations of continuing double-digit rates of return and I think that will have a dampening effect on spending in the future. My feeling is if we get some bad inflation numbers in the next two or three weeks, that would cause the NASDAQ to break down again into lower territory. However, if the inflation news remains benign, there's a good chance that the April 14 low will hold.
Blume: One of the basic problems the Fed faces is that people's expectations about market returns are unrealistically high. I've seen surveys where investors expect 19% to 20% returns a year for the foreseeable future. That's just not sustainable. The Fed has to get people to have realistic expectations about future returns. But I don't know what the Fed will do about it. Ultimately, if the Fed raises interest rates sufficiently, consumer confidence will drop and perhaps people's expectation of equity returns will drop too.
Pottruck: The Fed has to be looking down the road and figure out 'Have we done enough [to curb a resurgence of inflation?]' Remember, the Fed has different levers that it pulls; these levers are inexact and inevitably have delayed reactions. You don't move rates and expect immediate reaction. It's usually six months before you see results. What the Fed has often done in the past is put too much pressure on and throw us into a situation where we end up with a recession.
Knowledge@Wharton: Could a declining market lead consumers to spend less, thereby helping to spark a recession?
Siegel: A recession would require a tremendous cutback in consumer spending, and I think that is unlikely. It's unlikely because if the market should really crash and take down all stocks, not just tech stocks, [Fed Chairman Alan] Greenspan would stop increasing rates and maybe contemplate a decrease. My belief is that a slowdown in the economy is certainly very possible, but an outright recession doesn't seem to be in the cards.
Pottruck: Let's put this all in perspective. We've created an enormous amount of wealth over the last two or three years. It's hard to think that the last sell-off got to the point where people will think they're poor. The market has had an annualized rate of return at or above 20% for several years, so we're having an adjustment here. We've done surveys of our investors, and people are not pessimistic.
Blume: I think some people have unreasonable expectations about the future. They've invested in some dot-com companies and seen them go up a lot, so they've taken on more debt to put an addition on their homes or what have you. If these companies fall in value, these investors are going to be in major financial difficulty. We don't have much evidence, but we do know that margin debt is at an all-time high and consumer debt is increasing dramatically. Ultimately, consumer confidence goes down and the spending slows. If the market drops and people stop spending very quickly - that could lead to a recession.
Knowledge@Wharton: Could the market's downturn affect the availability of capital for technology start-ups?
Pottruck: I think some of the IPO [initial public offering] nonsense - where companies go out and become public and go up 200% or 300% or 400% - will peter out. People will move to a more rational view. There is still a lot of capital chasing new business concepts and new investment opportunities.
Knowledge@Wharton: What is your overall outlook for the economy?
Pottruck: I am very optimistic about the economy. I see a lot of wonderful things happening. I think the combination of increased competition, better uses of new technologies, reduced regulation, increased globalizationall this is creating a better market for the consumer and more vibrant business conditions. The worldwide investment business is being reinvented with the Internet. At Schwab, for example, we are looking to hire 5,000 people.
Siegel: The basic story of strong economic growth with low inflation is still intact. And strong earningswe're ending a very profitable quarterare still intact. Again, a few bad inflation figures may put that into question. But the basic story is still very positive.