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Boom and Bust Boom and Bust The equity market crisis – Lessons for asset managers and their clients A collection of essays european • asset • management • association Michael Haag The Governing Council of EAMA dedicates this book to the memory of Michael Haag, Secretary General of EAMA from its formation in October 1999 until 21st September 2003. Boom and Bust The equity market crisis – Lessons for asset managers and their clients A collection of essays european • asset • management • association October 2003 Published by European Asset Management Association 65 Kingsway London WC2B 6TD United Kingdom © Essays in this collection have either been commissioned by EAMA, or are reproduced with permission. Copyright belongs to the authors concerned, unless otherwise stated. Requests for permission for reproduction may be sent to EAMA at the above address. EAMA wishes to record its gratitude to those who have granted permission for the reproduction of existing works, and to those authors who have freely given of their time and ideas to write essays specifically for inclusion in this collection. Contributions which have been translated by EAMA into English are reproduced in an appendix in their original French versions. Printed by Heronsgate Ltd Contents Preface vi Klaus Mössle MARKET LEVELS Irrational Exuberance: The Stock Market Level in Historical Perspective 1 Robert J Shiller Professor Shiller’s seminal book, titled after a term used in a speech by Alan Greenspan following the Yale academic’s testimony to the Federal Reserve Board, was published in March 2000, right at the peak of the equity market. The opening chapter, reproduced with permission, showed that by historical standards the equity market was overpriced by reference to earnings to a greater extent than ever before. MARKET VOLATILITY A crisis which offers opportunities for a rebound 9 Alain Leclair and Carlos Pardo A summary from the French Asset Management Association of conclusions from its collection of essays on volatility in the equity markets. The authors call for more transparency and accountability for market participants, and greater representation and power for investors to restore balance with the sell-side, whilst taking into consideration initiatives in other markets so as not to distort competition and the attractiveness of markets. Excessive Volatility or Uncertain Real Economy? The impact of probabilist theories on the assessment of market volatility 15 Christian Walter The real economy leads to uncertainty about the fundamental value of shares, resulting in copycat behaviour that intensifies market fluctuations and speculative movements. Financial Markets – Is price volatility irrational? 30 Daniel Zajdenweber Bursts in stock market volatility are not at all cyclical, but are due to the absence of economic “fundamental constants”, to the characteristics of the market, and to the volatility of the fundamental value of individual stocks. The Mysteries of Unchecked Volatility, or the Shattered Dream of Lost Economic Bliss 40 François-Xavier Chevallier Market optimism resulted in declining risk aversion (as measured by an equity index risk premium) before the bubble burst, when risk aversion surged again. Volatility is another measure of risk aversion, and will be reduced only if the US and other governments respond to geopolitical, monetary, budgetary and fiscal challenges. i Conditions Conducive to Long-Term Investment Must Be Restored in Order to Stabilize Markets 45 Jean-Pierre Hellebuyck There is excessive volatility in the stock market, which shows that it is not efficient at price-formation, thereby compromising its suitability as a savings vehicle. To address this there needs to be more long-term investors, and a targeted regulatory response. THE ECONOMY The Stock Market Boom and the Silent Death of Equity: How the Crisis on the Capital Markets is Rooted in the Real Economy 48 Werner G Seifert and Hans-Joachim Voth The bursting of the speculative bubble should not be confused with the disruptions in the real economy as a consequence of the end of the 1990s boom. A range of unique, one-off factors coincided to lead to the rise and fall of equity markets. Growth of debt financing in place of equity, backed by central banks maintaining low interest rates, has contributed to the crisis in the real economy. The effects of this gearing became negative when the downturn arrived. There is a role for state intervention in eliminating the preferential treatment of debt and supervising the capital adequacy of listed companies. Blatant overshooting in the wake of the incentive problems and windfall profits – a look back at the formation of the German stock market bubble 60 Torsten Arnswald The German market was fuelled by the momentum of New Economy euphoria and an influx of new money from past gains and switching from unattractive interest rates. Management, auditors and brokers all faced conflicts of interest resulting in a focus on short term gain rather than shareholder value. The incipient equity market culture in Germany has been seriously damaged as a result. MARKET PARTICIPANTS Rational Iniquity: Boom and bust why did it happen and what can we learn from it? 64 Edward Chancellor All-time high equity market levels were justified at the time by reference to the New Economy, based on deregulation, free trade, control of inflation, a focus on shareholder value, the technology driven information revolution, and the use of derivatives to manage financial risk. Instead cheap money, management greed and dotcom fever drove the market to unsustainable levels, reinforced by a new cult of equity. Financial professionals either failed to recognise the bubble, or ignored it because it was in their interest. Rethinking Asset Management: Consequences from the Pension Crisis 81 Dr Bernd Scherer Mandates have been set with too much focus on long-term horizons, and insufficient attention to the effect of short-term fluctuations and their impact on risk tolerance. Fixed actuarial rates and smoothing of accounting values reinforce this. Aggressive asset allocations increase risks rather than reduce pension costs. A fair value framework is used to demonstrate that a less risky pension fund asset allocation enhances shareholder value. ii Lessons for and from Asymmetric Asset Allocation (AAA) 88 Thomas Bossert More than 90% of portfolio risk can be attributed to asset allocation. Clients often overestimate their risk appetite, and their risk-return profiles need to be understood and continually reviewed. Asymmetric asset allocation focusing on downside risk and absolute return meets the needs of these clients. The role of institutional investors in the boom and bust 95 Christopher S Cheetham Stock markets are not wholly efficient. However, agency related problems make it hard for institutional investors to exploit these inefficiencies and often cause them to exaggerate “excess volatility”. Going forward, these issues can be addressed only if institutional investors act more independently and if they encourage company management to focus on the creation of long-term value and less on the share price. Tracking Errors 103 Barry Riley The bubble was driven by momentum-driven fund managers, institutional risk taking, conflicted sell-side research, and agency problems in the relationship between executives and investors. This was aided by technical factors such as a focus on relative rather than absolute risk, benchmark indices that ignored limited free floats, and the effect of solvency measures applied to life insurance companies and pension funds. Lessons for the future must address each of these points. Trust me I’m your Analyst 110 Philip Augar A former analyst turned author suggests that fund managers need to clearly define their research needs, and should then pay for research that meets these needs. Memories of a US Money Manager 113 Gordon M Marchand Drawing comparisons with the Perfect Storm, in which conditions come together to cause an improbable result, this essay looks at the roles of promotion by the media, conflicted sell-side analysts, pressure on managers from consultants focused on benchmarks, the growth and lemming-like behaviour of day traders, increased central bank liquidity to support Y2K, inadequate accounting standards (particularly in not requiring expensing of stock options), and the underfunding of regulation. CORPORATE GOVERNANCE Myths and realities in corporate governance: What asset managers need to know 125 Paul Coombes Challenging the conventional post-Enron wisdoms that governance problems stem from the performance of directors, and that the United States is the worst offender, a high-level analysis framework is proposed, encompassing the “agency problem” and the institutional and environmental contexts. Reform requires greater transparency and enhanced boardroom professionalism, but also greater attention from analysts and fund managers, who should take a more activist approach as shareholders. iii REGULATION The Betrayal of Capitalism 134 Felix G Rohatyn U.S. regulators failed to control sell-side analysts, creative accounting, auditor independence, IPO allocations and conflicts of interest in integrated banks, or to maintain the ethical system on which popular capitalism depends. From tulips to dotcoms: What can we learn from financial disasters? 138 Howard Davies Past bubbles include tulipmania, the South Sea Bubble, and the Wall Street crash which led to the creation of the SEC. The 2000 bubble was a case of overshooting driven by psychological
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