Monday 15 July 2002

Equity Meltdown

Maltastar 
 
International equity investors are getting dizzy and hurt by the progressive and extended period of price meltdown from the obscene high figures reached in March of 2000.

Two questions on every investor’s mind are: Why did this happen? Have we reached the bottom and will equity prices bounce back?

If I had the perfect answers to these questions I could get rich fast. No one can have a perfect answer in the face of irrational and obscure market behaviour. But I do have opinions which I propose to put over to you.

 
“It is not normal that a pullback goes this far back. So why did it happen this time?”
 

Why Did This Happen?

The stratospheric valuations reached in the first quarter of 2000 were unsustainable. A pullback was unavoidable and indeed healthy for orderly market progression. But few could have imagined that the bubble will not only burst, but that the valuations will go back to where they were in 1997.
 
It is not normal that a pullback goes this far back. So why did it happen this time?

I can cite three main reasons which are in themselves a new experience never experienced by the market before. New experiences bring uncharted reactions and therefore past record and experience serve as little or no guide to where the market had to go in future.

The first of such experience was the mad dance in auctioning 3G mobile licenses which forced mobile phone operators to bid incredibly high prices in order not to be locked out of the potential high revenue from the new culture of doing business over the mobile phone – m-commerce.

Many such mobile operators had to pay billions to get such licenses and in the process leveraging their finances with unsustainable debt levels at a time they needed to make large investments in the networks and hardware necessary to exploit the expensive licenses.

This realisation started to sink in at a time when news from the technology side showed that there could be substantial delays until the 3G technology could be effectively rolled-out for consumer use. And at a time when it started becoming increasingly doubtful how much the expected revenue streams from m-commerce were realistic when the revenue streams from e-commerce were already disappointing the growth expectations.

This explains why the market savagely cut back valuations of mobile giants like Vodafone from over four sterling pounds in March 2000 to current valuation of less than one pound sterling.

The second reason is that one of the most important criteria on which investors base their judgement of value is the current trading performance and the strength of the corporate balance sheet as evidenced in the published financial statements that are announced to the market from time to time.

Suddenly the investor is finding that judgement passed on such information could be quite defective, as companies have to re-state their published figures due to corporate fraud or irresponsibility. The saga of Enron, Worldcom, Vivendi, Merck and others under investigation has pulled the carpet from underneath the investors’ feet.

The investor just cannot understand how auditors, meant to protect the shareholders' interest, let themselves get into conflict of interest positions by accepting highly profitable assignments from corporate management against whose abuses auditors were meant to protect the investors. Small investors are just wondering how this well-known and glaring conflict of interest was allowed to prevail by those who had responsibility to preclude it and who now try to profile themselves as champions to the investors’ cause.

 
“The market is ruled by sentiment not by fundamentals. Sentiment can take the asset valuation very far away from their fundamental values.”
 

The third reason is that investors base their investment decisions on the future expected earnings of the corporations in which they buy shares and to do this they rely on recommendations of investment analysts especially from the investment banks that boast of wide resources of research and great experience in investment judgement.

Investors are again hurt to learn that the investment bankers who were freely dishing out positive buy recommendations on over-priced shares were putting themselves in conflict of interest situations by taking mandates from the corporations for highly profitable merger and acquisition deals which brought value to management not to shareholders.


Have We Reached The Bottom And Will Equity Prices Bounce Back?

With valuations back to where they were 5 years ago it is quite safe to presume that on professional valuation basis the prices have now reached very realistic levels, and indeed could have crossed into bargain territory.
 
But this is not the same as saying that prices will not fall further. The market is ruled by sentiment not by fundamentals. Sentiment can take the asset valuation very far away from their fundamental values.

On thing is however sure. When there is a great gap between the sentiment driven prices and valuations based on fundamentals there is created rare opportunities for sure wins in the investment world for those who know how to step in at or near the bottom and wait until sanity returns to the market as it is eventually bound to do.

So just as in the first quarter of 2000 the market was positioning itself for an overdue and sharp correction sending signals to careful investors that it was time to move out as sentiment driven investment valuations had by far distanced themselves from fundamental valuations, in this 3rd quarter of 2002 the opposite is happening. When the pendulum goes in one extreme position, it never reverts to its equilibrium position, but swings to the other side with almost similar destabilisation from equilibrium.
 
 

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