Forget the panic and start picking bargains

Jonathan Davis

So how has the experience been for you so far, Mrs Lincoln? There are some interesting aspects of the market dramas of the past two weeks which are worthy of comment. Of these, the fact that technology shares have taken a bath and threatened to bring about a wider market panic - a threat which at the time of writing has not yet materialised - is surely the least interesting and least surprising.

So how has the experience been for you so far, Mrs Lincoln? There are some interesting aspects of the market dramas of the past two weeks which are worthy of comment. Of these, the fact that technology shares have taken a bath and threatened to bring about a wider market panic - a threat which at the time of writing has not yet materialised - is surely the least interesting and least surprising.

Rarely if ever can a stock market bubble have been so widely debated, nor its demise so widely predicted, as this one has been. You would have had to have spent most of the past few months on the planet Zog to have been unaware of the serious warnings from serious people that new technology shares were absurdly overvalued, at levels which could not be sustained.

Nonetheless, it is fascinating and instructive to have lived through an actual real-world experience of a market bubble starting to pop. It is one thing to read all the learned treatises on how these things have happened in the past, but quite another to see it going on all around you.

No amount of storytelling about tulipmania, railway stocks and the like quite prepares one for the experience of seeing normally sensible people being sucked, often against their own better judgements, into acting on something they know in their heart of hearts is an impossible nonsense. We have seen the phenomenon in other commodities often enough - Barlow Clowes in the early 1980s, housing in the late 1980s, golf-course building in the early 1990s, ostrich meat a few years ago - but even the 1987 stock market was not as obviously overvalued as today's new technology sector.

Warren Buffett, as so often, has given us a powerful and appropriate parable, a story about the man who gets to Heaven only to find that the place is full. To wangle his way in, he starts a rumour that gold has been found in Hell. The place empties in a mad rush. But as the man is about to take his undeserved place in Heaven, he turns to St Peter and says: "On second thoughts, I am off to Hell. There might just be something in these rumours after all."

Anyone who partakes in such market manias is (a) a speculator rather than an investor (however much they might be in denial about it); and (b) reliant, to a greater or lesser extent, on testing the Greater Fool Theory. This says that the only way you can come out ahead when trading bubble markets all the way to the top is by finding someone who is an even Greater Fool to come and take what you have already bought at an absurd price off you for an even more absurd price.

The good news is that there are always plenty about, which makes the lure of the gamble more appealing, until the music stops, the chickens come home to roost and all the other familiar cliches are brought out of the cupboard again.

If one notable feature of the current stock market technology bubble is that so many participants have been taking part in it with their eyes open, another is that this is arguably the first stock market bubble in which so many ordinary investors have been able to have a genuine ringside seat at the spectacle.

Thanks to the internet, the daily gyrations of the market have been accessible, in graphic minute-by-minute detail, to anyone with the time and inclination to sit in front of their screens all day. Thousands of people, we now know from the day-trading phenomenon, have been doing just that.

How they react to the latest events will in large measure determine what happens now. The first rule of all market crashes is that the scale of the event is inextricably linked to the amount of leverage (or borrowed money) that has been committed to the market or sector concerned.

The buildup in margin lending for stock market punters has been one of the most worrying features of the last six months in the United States, which, as usual, is the key market. Note also how the market reactions have been most extreme in Far East markets, such as Hong Kong and Taiwan, where leveraged buying is most common. Those who borrow most inevitably squeal most and have to move fastest to unwind their positions. It is also why rising interest rates are almost invariably a signal that overvalued markets are due for something of a correction.

We don't know yet how and where Alan Greenspan and his delightfully named "plunge protection team" are going to play the current market conditions, which are still some way short of constituting a genuine crash on any meaningful definition of the term. It will depend in part on how long the drama lasts and how sensibly buyers in both the institutional and retail market react to the shock of last week's falls in Nasdaq and the wider market indices. As yet, there are some good reasons to believe that the fallout in Nasdaq need not mark the start of a brutal wider market correction.

Those reasons include the fact that the wider market, as defined by the largest companies outside the magic circle of technology, media and telecoms, has already experienced a bear market for some 18 months; by the fact that most professional investors do know that the bubble in net stocks has been just that, and by the fact that marketwide crashes are rarely brought about by a single cause of this kind. Even now, the Nasdaq index is back to the levels it reached before the whole thing took off in November.

The wider concern that remains is the worry that inflation may be resurgent, that oil prices have risen sharply and that the great economic boom of the 1990s may finally have reached its natural limit, meaning that a recession is now imminent. None of these concerns, it need hardly be said, are very positive for the stock market in the near term.

Fortunately, the appropriate way to react to market gyrations of the kind we have just witnessed has been set out many times before. The short answer is: don't be panicked into doing things that you would not have done before; start getting ready to put some money into sectors that get oversold on the way down - financials and drug companies already look a good bet; and remember that it is always easier to make money for the long term when assets are cheap than it is when they are expensive. (For an orthodox but sensible summary of how investors should react, I can recommend the excellent Vanguard website, vanguard.com).

As for the technology sector, it will not go away. It seems obvious that investors will soon start to discriminate much more between those big or promising companies which have genuine growth prospects and those which are merely fruits or symbols of the current mania. For the latter there is almost certainly a good deal further to fall. There will be buying opportunities later in the year once the sector retreat has run its course. Keep an eye on the price of Microsoft, Cisco and the like.

Most of all, it will pay to remember that if you weren't a short-term trader before, there is no need to become one now. Equity markets are no more risky today than they have ever been. All we are seeing are market prices reminding us that the risk has been there all the time.

davisbiz@aol.com

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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