Ignore the herd - buy when others sell

Jonathan Davis

If a week is a long time in politics, then you can certainly say the same in the stock market, where opinions and fashions can turn in days or hours. There is no better example than the great debate about "new" versus "old" economy stocks. For weeks we have heard of nothing but the wonders of dot.com stocks and the demise of many old economy stalwarts.

If a week is a long time in politics, then you can certainly say the same in the stock market, where opinions and fashions can turn in days or hours. There is no better example than the great debate about "new" versus "old" economy stocks. For weeks we have heard of nothing but the wonders of dot.com stocks and the demise of many old economy stalwarts.

Now, in just days, sentiment has turned abruptly and the boring and oversold high-yielders are back in favour, with the likes of the big brewers and banks rising 15 to 25 per cent in a couple of days in the middle of last week, while many of the newcomers saw their share prices fall by a similar margin.

Having highlighted the attractions of unfashionable blue chip stocks, and pushed their merits for last-minute ISA shoppers on grounds of their long term value, I am confident this particular rally in relative valuations has not run its course. There is some irony in that the revival in dull old high-yielding stocks should come in the month when Tony Dye, the arch exponent of traditional value investment in the London investment community, should have finally departed his employers Phillips & Drew.

It has been a standing City joke that the day Mr Dye left would be the day his long-repeated predictions of an end to the bubble markets would start to come true.

The coincidence of the revival in some old economy sectors with a wave of publicity about the arrival of many new technology companies in the FTSE 100 index does add to the irony.

If the conditions of the last week persist, not many of these newcomers will survive long in the market's top tier index, as their share prices come down and those of the venerable dispossessed (Thames Water, among others) continue to recover from the disguised bear market many large companies have endured over the past 18 months.

Can one be sure the revival is likely to persist, rather than represent a false dawn in the continued decline of the old economy? Of course not. Absolute certainties cannot exist in financial markets.

There is no doubt the underlying trend of change in the industrial and corporate landscape toward companies that operate in technology-led areas will not be reversed. New faces will continue to replace the less adaptable successes, just as they always have.

But the shift in relative valuations to yesterday's companies is a racing certainty because the trend to overweighting high-tech growth stocks has gone too far, too fast.

As the chart shows, the shift in market sentiment from value to growth stocks has been a worldwide phenomenon which has now gone off the scale of all historical experience. Growth stocks have never been so highly valued, relative to value stocks. This will correct itself, though the timing of that is impossible to forecast.

For those who believe there are underlying links between investment styles and economic cycles, the revival in commodity prices may be relevant. The most notable change is in the price of oil, more than doubled since the summer of 1998, when it was $12 a barrel and all the talk was that the price might never rise again (in fact it was another great buying opportunity).

Even in today's unusually volatile conditions, it is possible to make sense of why such sudden and dramatic shifts in sentiment do take place. At heart, they are linked to the way modern professional investment is done.

The cult of performance is central. The harsh reality is that no professional investment manager can afford to be seen to be out ofstep with the rest of the marketsfor long, if he/she wants to preserve his mandate. The reason many fund managers started piling into new economy stocks in the last quarter of 1999 was not because they were necessarily convinced by the extravagant growth stories which these stocks were said to represent. Some were, but most were privately dismissive of the valuations they were being asked to support.

The real reason is much simpler: the fund managers knew that if they missed out on a rally which everyone else was in, their end-of- year performance figures would look poor in comparison to their peers (as those of Mr Dye have done for several years).

The business of today's professional investment management these days is a game of relative, not absolute, performance. Lagging the market is a far greater professional sin than buying superhyped technology stock which you know in your heart of hearts will require a miracle to justify its current price.

One small but telling indication of reality is in the most recent monthly survey of fund manager views and intentions by the big broking firm of Merrill Lynch.

The brokers decided this month to add specific questions about the so-called TMT phenomenon - the three sectors that dominated the performance of the market inthe last year, telecoms, media and technology.

Their survey showed 60 per cent of the UK fund managers it polled were overweight in these three sectors. And 75 per cent cent of the same managers believed these shares were overvalued. In other words, they were buying these shares despite of - not because of - their inherent attractions as investments.

What is more, this phenomenon was repeated, with some differences, in every other region where the poll was done, the United States, Europe, Japan and South Africa - (the US had the lowest weighting).

That is, very simply, the way the fund management game works. There are many good reasons why it does work that way, one being that it is what most of those who employ professional fund managers want.

The fact that it contributes to unnecessarily high turnover rates and investment strategies that are not very tax-efficient is often overlooked in the mad scramble to achieve the psychological comfort of buying what so-called expert opinion is buying.

On the other hand, for canny investors who are prepared to be patient, there is always an advantage in waiting for periods of valuation extremes (such as the current disparity between growth and value stocks), then buying what others are selling, and vice versa.

It is not brain surgery, as the saying goes, but it does require a willingness to go against conventional opinion and the herdlike instincts of the majority of professionals, who, in practice, are working to a different agenda.


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