Saturday, April 2, 2016

The Point Of A Bear Market

In his classic book Supermoney, the writer Jerry Goodman (aka “Adam Smith”) tells a story of an investment group therapy session gone wrong. After a vicious bear market in 1969, he convened a group of investment professionals to discuss mistakes they had made in the "Go-Go Years". For a while it appears to be going well, with participants sharing the pain collectively. The meeting, however, takes an unexpected turn when Goodman asks David Babson to speak. Babson, described as “a crusty, amiable New Englander who heads the sixth biggest investment-counseling firm in the country”, proceeds to criticize professionals who got sucked into speculation. Looking out at the crowd, Babson tells them, “Some of you should leave this business.” He then pulls out a list of former speculative high-fliers that had declined dramatically or gone bankrupt. Goodman attempts to intervene several times:

“David,” I said gently into the microphone. The audience was beginning to rustle. You can tell something has happened to the good feelings when the water pitchers start to clink nervously against the water glasses in a rising cacophony.

Babson continues reading the names of former stock market darlings.

Goodman tries to interject again:

“Don’t read the list,” I said. The audience was beginning to scrape its chairs. My massive group therapy session had taken a sour turn. Nobody was going to confess if they were being accused.

Unrelenting, Babson continues to read names. Finally, Goodman cuts in:

“David,” I said, “you have passed the pain threshold of the audience.”

Phew. I attended a much milder version of a group therapy session gone awry in 2009. At a well-attended investment conference in New York, one panelist repeated a Wall Street aphorism I had never heard before. “The point of a bear market”, he said smugly, “is to return capital to its rightful owners.” There was an uncomfortable silence, as a noticeable tension filled the air. While the speaker had obviously avoided the worst of 2008, there were many in the room to whom financial markets had been less forgiving.

That adage has stayed with me all these years. But I don’t think our self-satisfied friend was quite right. The point of a bear market, I think, is to return risky assets to their rightful owners.

Put simply, assets exist on a continuum of safety. US Treasury notes are one extreme, while equities are another. As anyone familiar with the risk/reward trade-off knows, equities usually offer the possibility of high returns, but these returns face great variability. High returns compensate the investor for bearing risk.

In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets. 

David Babson, I am sure, would never have made that mistake.


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