Finding Opportunity in a Bear MarketPublished: October 15, 2008 in Knowledge@Wharton
It was just four days after the Dow Jones average had plunged more than 777 points -- its biggest one-day point drop in history -- and only hours before Congress was about to vote yet again on an unprecedented $700 billion bailout package for the financial industry, with the fate of large banks and insurance firms hanging in the balance.
Simply put, it was a heck of a day to be holding the 11th annual Wharton Investment Management Conference, bringing together some of the nation's top financial experts on the aptly chosen topic of "Investing in a Volatile World." But if the session's keynote panel of investment advisors agreed on any one point, it was that the current bear market offers great opportunity to buy distressed stocks at bargain prices -- if not on that particularly turbulent day, then some time in the near future.
According to Michael Roth, a founding principal of Wisconsin-based Stark Investments, the stock market is playing out "a classic fear or greed scenario right now." While it has been fear of the unknown magnitude of losses in complex mortgage-backed securities and credit swaps that has driven the Dow down by more than 25% in just one year, eventually "people will get bored with being afraid, and there will be a herd mentality. You will see a real upside-only scenario. The market will go beyond a near-term [perspective]," he predicted.
Another member of the keynote panel, David Antonelli -- executive vice president and chief investment officer for MFS Investment Management -- agreed, noting that over the last 10 years, stock averages have increased at roughly 2% a year, even as corporate earnings have continued to rise at a rate of 8% to 9% annually, thus creating an imbalance. "There's a reason to be optimistic," he said. "A lot of extra profits have been left on the table."
But as is always the case with investing, timing is everything. And the panelists also seemed in broad agreement that despite the bad news pouring out of the world's financial markets, the worst may not be over yet, nor is it completely clear that the $700 billion federal aid package is enough to stop the bleeding.
"I think that we're somewhere in the middle," said T.K. Duggan, a managing principal of Durham Asset Management LLC, which specializes in global, event-driven distressed debt, who noted that in 1989 and 1990 it took a considerable amount of time for a massive bailout of the U.S. savings and loan industry to work its way through the economic system. This time, it has taken about a year for the initial bad news from the American housing crisis to bring Wall Street to this point, and it may take another year before the unrest is over, even though Congress did vote final approval of the bailout package that afternoon.
'Ignoring the Risk Half of the Risk-Reward Equation'
This year's Wharton Investment Management Conference marked one of the most tumultuous years since the event began, certainly since the terror attacks of September 2001. Conference co-organizer and Wharton MBA student Spencer Reich received a huge laugh when he joked that "one of our biggest fears was that the markets would stabilize and this conference would no longer be relevant."
A more somber tone for the day was established right from the start by the opening speaker, undersecretary of the U.S. Treasury David McCormick. "These are incredibly challenging and unprecedented times for the United States," said McCormick, who, since August 2007, has been the chief advisor to Treasury Secretary Henry Paulson on international economic issues. "Over the last 12 months, we have witnessed one of the most significant periods of economic turmoil that has ever faced our country."
McCormick gave the Wharton audience an overview of the events that led to a series of unprecedented developments -- including federal bailouts of insurer AIG and financial firm Bear Stearns, shoring up of mortgage giants Fannie Mae and Freddie Mac, the collapse of Lehman Brothers and, finally, the request for a $700 billion fund to encourage credit activity that has become all but frozen because of the high rate of uncertainty and risk in the market. His main explanation for the root cause of the crisis would be echoed by other speakers at the conference: That the normal rules of risk and reward for investors had collapsed over the last decade, especially with the bundling and trading of home loans that in too many cases went to buyers not worthy of credit in the first place. He traced this trend to the heady economic times of the 1990s, which caused investors and regulators to "ignore the risk half of the risk-reward equation that's at the very heart of financial markets."
Investors around the world "who, in preceding years, had enjoyed above-historical average returns on both asset classes, continued reaching for ever higher gains, and the financial services industry created a variety of complicated products to meet this demand," McCormick said. "Regulators and investors alike showed a growing complacency toward risk. And these factors blended together into a dangerous cocktail of underlying conditions that were ripe for instability."
As federal regulators learned the extent of losses in these new financial instruments backed by troubled home loans, they also discovered that this trading of mortgage-backed securities and the role of U.S. government-supported housing giants Fannie Mae and Freddie Mac were so deeply intertwined with the global financial system that a dramatic response was required, he noted.
"Fannie Mae and Freddie Mac are now so large and so interwoven in our financial system that if either one of them were to fail, it would have far-reaching effects for the U.S. economy and economies around the world, because financing would be more difficult to obtain, constraining job creation and making it harder for Americans to get home loans, auto loans and consumer credit," McCormick said.
But McCormick's outline of the problem also made clear the enormous challenge facing federal officials charged with finding solutions: If the system of economic risk and reward has careened out of balance on Wall Street, how does a massive federal bailout that essentially fails to punish risky behavior solve the problem going forward? Indeed, several members of the keynote panel said that the 1998 government intervention in the collapse of the Long-Term Capital Management hedge fund was a turning point in convincing investors that the consequences of taking greater risks would be minimal, as was the implication that then-Federal Reserve chairman Alan Greenspan would take the same steps in any similar situation.
"There has been a mismatch between risk and reward," panelist Antonelli said, adding that the sense of comfort provided by the interventionist Fed chairman created an appetite for riskier loans that carried higher returns, which is why mortgage-backed securities boomed along with the upward surge in housing prices in the first half of this decade. For much of this decade, Antonelli stated, the demand for non-investment grade paper -- offering greater earnings than much less risky AAA-rated bonds -- was so high that high-yield debt seemed immune to the laws of supply and demand.
Answering questions after his speech, Treasury secretary McCormick acknowledged the difficulty that federal officials encounter when dealing with the "moral hazard" issue. Closely related is whether investors and top executives of troubled financial firms must face some type of financial penalty for their bad judgment even as their massive and largely worthless debt is purchased by the government. "I think getting this balance right -- fulfilling the responsibility of minimizing systemic risk while maintaining market discipline -- is one of the difficult [challenges] that we have to face," he said. "And it's more difficult when you think about it in the context of the institution-by-institution response. That gives greater credibility to the more comprehensive systemic response -- where you can make sure you have that right balance."
Getting People 'off the Ledge'
But is the $700 billion package enough to halt the crisis? Here, the panelists seemed divided. Roth, of Stark Investments, suggested that the real significance of the bailout may lie less in the actual dollar amount than in the symbolic power of the U.S. government to reassure investors, who have now parked billions of dollars of cash in safe, low-interest accounts waiting for the market to hit bottom. He said that aggressive action by the Bush administration and by Congress "will get people off the ledge. There's a tremendous amount of money sitting on the sidelines." McCormick, in his opening speech, voiced a similar sentiment, noting that the $700 billion package that President Bush would sign that afternoon "sends a strong signal to markets around the world that the United States is serious about restoring confidence and stability to our financial system."
On the other hand, the panelists also acknowledged that the global nature of the financial markets poses a risk that the crisis will spiral well beyond the control of the United States government -- a worry that seemed confirmed immediately after the Wharton conference as banks in Europe faltered and as financial markets there and in Asia plunged at a faster rate than on Wall Street. "We are in a global slowdown," said Antonelli, who suggested that the crisis has undermined financial experts who claimed there has been a "decoupling" of the American economies from Japan and Europe.
Indeed, the nature of the evolving financial crisis was such that the main topic of the Wharton conference -- advice for investors in turbulent times -- seemed somewhat buried in the mix at times. According to Duggan, the expert on investing in troubled companies, the scope and magnitude of the current downturn means there are excellent opportunities for bold investors. "This is the greatest list of distressed capital that we've seen in our lifetimes," Duggan said.
Pressed to name specific sectors, he noted that retailers have been particularly hard-hit by the ongoing slowdown -- including recent bankruptcy filings by well-known chains Linens 'n Things and Steve & Barry's -- and are poised for a rebound once the economy starts turning around. He also cited U.S. automakers as another beaten-down cyclical industry that presents an investment opportunity, especially with the federal government offering a $25 billion aid package.
Understandably, the investment experts were less bullish about the financial sector. Several noted that while two leading Wall Street firms, Goldman Sachs and Morgan Stanley, have survived the turmoil as stand-alone companies, the recent move to reclassify them as traditional bank holding companies will limit their ability to make high-risk, high-yield investments. That, in turn, will reduce their ability to post the massive profits that investment houses were reporting earlier in the decade.
Touching on a subject that held great interest for the many Wharton students in the audience, the panelists also acknowledged that while the massive layoffs on Wall Street have crimped traditional job openings for MBA recipients, the radical changes in the financial markets should create different types of career options in smaller new firms, with a premium on research skills. Several noted that they had launched their own careers in finance during the late 1970s and early 1980s, during the last severe downturn. Said Roth: "There are going to be plenty of opportunities in startups."