Stock markets 2000: Theatre of the absurd?

A. Srikanth

UNDOUBTEDLY, stock market activity over the last few years has been a mixture of extremes and excesses, probably rivalled only by the Tulip mania, the Mississippi scheme or the South Sea bubble.

And 2000 saw the culmination of such a trend.

If the technology and the Internet stocks were over-owned and over-valued on the one hand, Old Economy stocks got shunned on the other. Just as small cap stocks stayed out of favour for many years, the large cap stocks too experienced their biggest downfall.

The companies with no earnings record attained record valuations, while those with tangible assets crashed. And yet, the stock market returns since the beginning of this decade still remain unparalleled.

But as if in a self-referential twist, 2000 witnessed the collapse of hopes and fortunes of many an optimist who believed steadfastly in the ``new economics'' of the technology revolution.

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As the Nasdaq's performance now stands unrecognisable just within nine months from its peak level on March 10, the mass exodus of talent and the dawn of reality appear to be taking the hype out of the dotcom phenomenon. But just as clarity emerges only out of chaos, the investors too have many messages to absorb from this market trend of contrasts and extremes:

* As the market prepares to go back to the basics, Mr Warren Buffet's wisdom stands out. It is being proved that despite the lasting economic impact of new technologies, it is not easy to profit from them over the long term. It appears that the greatest of the investment successes are usually limited to the initial stages of the technology revolution, especially when companies rush in to capitalise on the nascent trend.

* Two, market conditions may change drastically to make the phenomenon appear ``different''. But it appears the difference is only to the extent that ``history repeats itself, but not exactly''. What new paradigms usually discover is that the old rules are not obsolete. The prescriptions may appear poetic truth douched in philosophy. But all revelations which comes out of pain and anguish are usually so. The kernel of truth usually lies at the heart of a painful mundane existence. When the market embraces the tenets of quantum physics, rocket science and genetic algorithms, what is wrong in taking cues from the science of the self.

* Three, investors would just have to remember Newton's first law of motion to realise the significance and the universality of the process of mean reversion in stock markets. The recent experience has only highlighted the fact that while trends may last long, extremes do not. The more prices digress away from the mean, more is the risk. While it may be easy to recognise extremes, it is not easy to predict the period over which it will last.

* And higher the risk, the latent conservative attitude of all investors will find some reason to make the prices regress back to the mean. The dramatic rise and the subsequent wealth destruction that took place in technology and Internet stocks only highlight the age-old truth that the trend's extremeness will determine the severity of the reversion to mean process. If the after-effects of Tulip mania, the South Sea bubble and the Mississippi scheme are historical examples, the Japanese market debacle (1990) and the Asian crisis (1997) are recent instances.

* At the same time, investors would have also realised that the mean reversion process is a continuous one. As the market tends to exaggerate trends, the valuations go on wild swings on either side of the mean. Just as the market exaggerated the positive side of the technology and the Internet phenomenon, it tends to do the same thing with the negative side too. It is only for want of continuous action, this exaggeration process is taken to the extremes and too frequently, setting the stage for a high degree of volatility and the switchover from growth to value stocks or from cyclical to defensive stocks and vice-versa.

* The chaotic market has yet another important message for the investors -- the role played by disruptive technologies in the dramatic reversal of fortunes of many established and managed companies. As Clayton Christensen explains in his book, The Innovators Dilemma, a technology is disruptive when it is unexpected and given little consideration by established companies, yet possesses the qualities that enable a broader population of less skilled people conveniently do the work, which was traditionally the domain of the experts. The emergence of mobile telephony, hand-held appliances, online stock brokerages, ECNs, on-line retailing, e-hubs, distributed power generation, distance learning, unmanned aircraft are just some of the disruptive technologies.

The book concludes that well-managed companies fail because the very management practices that have allowed them to become industry leaders also make it extremely difficult for them to develop the disruptive technologies that ultimately steal their markets. Well-managed companies are excellent in developing sustaining technologies that improve the performance of their products in the ways that matter to their customers.

Disruptive technologies, which are different from sustaining technologies, change the value proposition in a market. Though they initially address a small niche market and offer no profits, they progress rapidly to offer cheaper solutions to the consumers. The disruptive technology products ultimately displace those developed out of sustaining technologies, to assume the centre-stage. Investors need to recognise disruptive technologies and invest selectively in them as they hold out excellent profit opportunities.

* And finally, experience over the last few years has shown that better predictions have come about through spotting broad trends or pattern recognition rather than through in-depth analysis. The huge investments that took place in technology and Internet stocks were more based on broad patterns than on any specific analysis. Any analysis would definitely not have justified such large-scale investments in non-profit making companies. Though the subsequent collapse was triggered initially by company-specific developments, it later followed broad patterns and general market sentiment.

It is being proved increasingly that it is induction rather than deduction, which helps investors come up with better predictions. In an increasingly chaotic market, investors are learning to accept the view that it is wiser to be generally correct rather than being exactly wrong.