Leverage has its Risks

The bear stock market of 1980-1982 (Dow 776) ended in the fall of 1982.  A short time before, BusinessWeek issued a cover story proclaiming:  “The Death of Equities”.  That’s how America felt then, because risk-taking had become so out of favor.  Investment expectations had become so low.  A short time later, the greatest bull market in history began!

The pace of that great movement of dollars into stocks, which really started in 1982, picked up speed in 1995.  By this time, the fear of taking risks had disappeared, but there was still at least a reasonable respect for risk.  But that respect quickly dissipated. So much wealth had been created in the world over the preceding 20 years from spreading prosperity, rising asset values, and business success that the appetite for risk-taking started to accelerate dramatically.  The “story” was the internet.  It was going to revolutionize the world and create never-ending wealth which would grow to the sky.  That created the first bubble.

The popping of that bubble had some fairly predictable, as well as some unanticipated, consequences.  The foundation was in place for the perfect storm, the creation of the second bubble – “alternative” investments.  To fuel this second bubble, we had the combination of a laissez faire government and the unlimited, cheap money made available by the Federal Reserve in its panicked response to the bursting of the internet bubble.  These funds were made available for speculation in all manner of alternatives to stocks.  Fed Chairman Greenspan sold our political and business leaders on the idea that big business was infinitely trustworthy, that derivatives reduced (rather than increased) systemic risks in our financial system, and that regulation would stifle the forces of markets.  Thus, interest in hedge funds, private equity, highly-leveraged real estate investments, commodities and foreign stocks soared, creating the next bubble.  The “story” this time was that in China, India and other emerging markets, more people wanted to drive cars, eat meat and wheat products, and build new buildings, causing the prices of commodities to rise to the sky and creating endless wealth for speculators.  Now we know it was never about the foregoing.  The bubble was created because of a mass disrespect for risk.  It was about naïveté, arrogance, greed, conflicting interests, and in many cases, dishonesty.

At the center of any investment scheme is the promoter.  What clearly facilitated and amplified the creation of these bubbles were the Wall Street casinos whose dealers controlled the games.  Their gambling vehicles carried the imprimatur of the now-clearly conflicted rating agencies – the supposed watchdogs for risk – making it seem attractive for investors, including big banks all over the world, to go for the quick buck and completely ignore the growing risks.  Ironically, the great casinos (Bear Stearns, Lehman Brothers, Morgan Stanley, Merrill Lynch, Goldman Sachs, etc.) leveraged their own capital in some cases 40-to-1 and began to place bets at their own tables.  Wall Street’s self-inflicted demise nearly destroyed the whole world’s financial system and caused stock markets worldwide to simultaneously crash.

There is some good news in all of this.  Today, we are back where we were nearly 30 years ago.  The bubble has popped, and expectations for the future are as low as they can possibly be – note last week’s Time magazine cover showing Depression breadlines.  Once again, investors have a renewed respect, and some degree of fear, for taking risks.  While that respect will last, the fear should ebb, and thus the foundation has been laid for a renewed massive flow of capital into multinational blue-chip stocks, whose dividends in some cases yield three times current money market rates.

Interestingly, on a relative basis, over the last 15 years...large, blue-chip businesses have underperformed the “alternative” investments.  We now know the reason for this underperformance was that risk was viewed as “beautiful.”  Today, thankfully, just like 30 years ago, dividend-paying multinational blue-chip stocks are no longer boring, and leverage and risk are no longer beautiful.