The Bear Stearns fire sale over the weekend is just the latest example of how cycles impart pain as well as pleasure. Pain for all those shareholders who shunned diversification and pleasure (of a kind) for JPMorgan Chase, which has bought Bear Stearns for the equivalent of $2 a share, a 93% discount to Bear’s closing price on Friday and a universe below last year’s roughly $160 peak set last summer.
The financial industry up until about six months ago could do no wrong. For five years, financial stocks were flying, convincing many that the trend was enduring. For years, the finance sector comprised the largest weight among the 10 sectors in the S&P 500 and analysts spared no expense in making arguments for why the trend reflected a new world order that would stand the test of time.
But, oh, how the mighty have fallen. Financials’ market cap now represents about 16% of the S&P 500 overall, down from 21% a year ago.
It all began to change last summer. The details are complicated, but the basic explanation is that the death of cycles has been greatly exaggerated. Ignoring this basic truth has brought trouble if not ruin to many, and for longer than some care to recognize. Prudent investing is as much about planning for cyclical peaks and troughs as it is about riding the wave of bull markets between the two points of extremes when the only risk appears to be falling behind in relative performance.
But the danger of letting emotion replace analysis and perspective is a two-way street. If it was all too easy to ignore the buildup of risk in the markets during 2002-2007, now it’s tempting to focus exclusively on the potential for loss. In fact, there is always a mix of risk and reward embedded in the world’s major asset classes. The reality is that the mix is in continual flux. Some assets always offer better terms than others. In fact, it’s the strategic and tactical blending of these assets (with an eye on valuation and respect for rebalancing and diversification) that wins over multiple cycles. The price of entry, however, is that one can’t embrace such notions at the 11th hour and expect to come out smelling like a rose. It’s only through a number of cycles that the wisdom of strategic thinking bears fruit.
Then again, it’s never too late to face reality. After all, the remainder of your life’s investment results starts now. Job one is recognizing that breaking the fundamental principles that govern success and failure courts disaster–eventually. Within the time period between the outer bounds of any given cycle, the illusion that something has changed is a powerful force. But it’s a force for capital destruction. Perhaps what’s so fascinating and frightening about these illusions is that there’s overwhelming evidence in history that they’re recurring and that naive investors are disabused of thinking otherwise once the cycle turns.
And yet there’s always a fresh crop of believers all too willing to think it really is different this time. But while the crowd’s wisdom itself may be cyclical rather than cumulative on Wall Street, there’s no reason that any one investor has to embrace the lemmings-into-water mindset. Financial fate is largely determined by every investor’s decisions, or lack thereof.
Easy to say, hard to achieve with favorable results, of course. It was easy to think that tech stocks were the equivalent of low-risk perfection in 1999. It was easy to see real estate as a sure thing in 2005. It was also easy to think that the world was coming to an end in 1974 and 2002.
There’s quite a bit of financial truth in Santayana’s dictum that “Those who cannot remember the past are condemned to repeat it.” If finance was medicine or engineering or paper manufacturing, the lessons of history would lead to enlightenment and progress. But because money is money, and greed and fear are a perennial toxin that ravages common sense, all too many otherwise intelligent beings will keep making the same basic mistakes, again and again.
Sad but true, although this durable truism also creates opportunity for those who heed the lessons of the past and take a longer-term view of cycles. And if our suspicions of late prove accurate, the current turmoil will bring opportunities of substantial magnitude. That assumes, of course, one’s able and willing to take advantage of the prevailing opportunities as they unfold in the coming weeks, months and, yes, perhaps even years.