How to be a market darling

The stock markets of the Western World are back where they were at the end of July, and we can officially declare this summer’s sucker rally over.

The markets’ performance has pretty much proved the bears’ case: that there was still plenty of overvaluation in the broad market. That the rally deflated in the space of about two weeks — a space about the same length as its previous July plunge — says a great deal about how much confidence the few remaining bulls can muster.

Predictions that the next few years may bring neither a bull nor a bear market, but a sideways move offering steady low returns, are looking more and more accurate.

It’s a lousy market. It is important to understand, though, that there are two different kinds of lousy in the stock markets: high risk and low returns. Both those kinds of lousy make the market a bad place for investors to put their money, but they share few other similarities.

In a high-risk market, returns may be stellar; that is, in itself, an element of the risk the investor takes on. In “bubble” markets, that process is pretty obvious, because overvaluation is inevitable once returns start to climb; but returns can be maintained as long as that obliging fellow, the Greater Fool, keeps buying. It is a paradise for the day-trader, because most days the market rises. It is pleasant for money managers, because they can generally post double-digit returns on the year.

It is also ugly when it ends.

In crashing and post-bubble markets, high risk has still not left the scene, because at any moment your fellow investors may take fright and run. The market becomes dangerously volatile, so that short-term risk is immense, and values may still be inflated, so that longer-term risk can be high as well. Unit-holders dream of lynching fund managers; in a violent and immoral “downloading of risk,” day-traders shoot themselves, or others.

For investors and for issuers, the picture is bleak. The investor can’t make any money, and leaves the scene; the issuer sees its stock price tank whether or not its business justifies a lower value. This is the kind of market we have been in for some time, and it is taking its toll on the economy even though the cost of capital is unusually low; throughout the West, only house building and consumer spending are left to prop up economic growth.

In a low-return market, short-term risk — volatility, to use the precise term — can still be quite high. For day-trading dilettantes, this is about as nasty as the financial world gets: instead of doing a mid-air trapeze act, they find themselves on the ground dodging the traffic. For active managers and for many investors, it’s also a dangerous and nerve-wracking time. But outright ruin is not as common as it is during a real bear market.

In these same low-return markets, longer-term risk may be relatively low, for several reasons. Returns are low partly because a lot of money has deserted the market, whether out of fear of a high-risk episode and another crash, or out of an unwillingness to accept low returns on equity. Drained of most of its foolish money, such a market doesn’t usually produce bubbles.

That is not to say it will not produce high flyers: it is precisely when returns are poor that genuine business success makes a stock vastly more attractive.

In bull markets, which are usually high-risk, a solid future means comparatively little, because so many stocks are rising. It matters not at all to an investor whether he makes a 15% annual return from good businesses or from speculations; what is material is that he make his 15%.

One effect, strikingly demonstrated in the last bull market, is that bad business plans and good ones alike have easy access to capital, a large part of which gets wasted on the bad projects. Another effect is that, in bull markets, smart investing has less impact on returns than you’d expect.

In the contrasting case, returns are low and often stagnant over time, while businesses or whole sectors may make significant gains — witness most of the gold stocks over the last year.

That gives companies and industries a far greater chance to stand out than does a bull market. Moreover, the implications are much greater for venture-capital companies, including junior explorers, because the “home-run” returns of successful small firms will be scarce — and therefore valuable, both to individual investors and to funds.

Junior exploration companies should look hard at the present state of the capital markets. Poor returns — on both debt and equity — are everywhere. That is more reason, not less, for investors to look for a successful gamble on venture-capital stocks.

The test of the industry will be whether it can provide enough discoveries, and enough good discoveries, to make money for speculative shareholders. If the market is indeed headed for a long period of low returns, this is one of the few opportunities that will knock.