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A Day At The Races

Stock Market News

March 2002

A Day At The Races

You may have noticed that on a clear bright day in February, NASCAR resumed its racing season with the granddaddy of all racing events, the Daytona 500. Admittedly, stock car racing has traditionally been considered (car racing fans forgive us) an unsophisticated sport. But in recent years the sport has enjoyed a much broader audience. The major networks now broadcast the races weekly.

If you've ever seen a NASCAR race you were probably astonished, as I have been, at how close the cars run to one another. In many instances, mere inches separate the front end of one car from the rear bumper or the side of another. And to think, these cars are traveling at close to 200 miles per hour! A split second can mean the difference between life and death, a sad lesson last year for the Earnhardt family.

So why is it that you and I maintain the standard “one car length per 10 miles per hour” distance that we learned in drivers’ education class? What happened to the two second rule? What's up with these guys? Did they miss that part of the lesson?

The answer is really very simple if you consider it. While we don’t trust the other drivers on the street, NASCAR competitors have complete trust in the abilities of the other drivers on the track. Let’s explore that for a moment.

It takes years of highly specialized training, dozens of skilled mechanics, experienced race strategists, extremely expensive equipment, and a half-million dollar car just to get on the track. The drivers are well rested, focused, and drug-tested when they get behind the wheel. Every little detail is factored into the equation long before the crowd arrives to hear “Drivers, start your engines!”

Contrast that with your daily commute. Anyone who can parallel park and spell s-t-o-p can get a drivers license. Half the cars on the road should be in the scrap heap. Women are applying make-up with one hand while talking on their cell phones with the other. Men are drinking coffee while surfing through the buttons on the radio or trying to make that next big deal on their cell phone. How many times have you gotten lost in thought only to find yourself suddenly at your destination without noticing it? Add in all of the people driving under the influence of drugs and alcohol and it’s a wonder we ever get where we are going.

So what does all this have to do with investing? Well, for starters, investing used to be a lot like stock car racing, metaphorically speaking. Investment markets used to be dominated by savvy professionals who could be trusted to do the rational thing on a predictable basis, regardless of how turbulent or unpredictable the markets were. They didn’t inexplicably swerve into another lane or slam on their brakes in traffic. In 1999, investing changed dramatically in that amateurs became so active that they actually moved entire markets and began to call into question long-held beliefs about investing fundamentals. Suddenly it was difficult to tell who was in the car three inches from your right door. Is that a professional under that helmet or some “wannabe” who has never taken turn number 2 at 175 m.p.h.?

Suddenly the cars were not as tightly bunched. The variance of outcomes grew very large. We saw some spectacular high-speed crashes in 2000 and 2001 and some incredible surprise victories. There seemed to be no way to predict what might happen any given week.

For the professionals who avoided getting taken out by inexperienced drivers, there was some good news. By the end of the September 11 aftermath, t the less experienced traders had been culled out, to the point that it was mostly the professionals left standing. The amateurs had lost their sponsors.

Would this mean a return to rational behavior? Perhaps a sense of normalcy? Could the veteran racers put the pedal to the metal taking comfort in the knowledge that the drivers around them could be trusted? Not so fast. One of the things that makes a NASCAR driver safe is confidence. Lose that and the typical driver starts acting human. He stops making cool, calculated decisions and starts reacting emotionally. He begins to feel fear and uncertainty.

A single event in fourth quarter caused a number of professional investors to lose their confidence. The Enron bankruptcy.

A large number of mutual fund and pension managers were long on a ton of Enron stock when it derailed. Some lost hundreds of millions of dollars in the collapse. Their bosses asked, “Why?" It shook the confidence of a great many managers. These managers lost confidence in the accounting firms, in their analysts, and in themselves.

The fallout from this lost confidence has been that these professionals are now running scared. They fear the possibility of owning the next Enron. Instead of assessing their holdings in the same consistent manner of a professional, they are reacting emotionally. Some very well run companies such as General Electric, Tyco, and IBM have seen their shares get bounded as a result.

A thinking driver has a decision to make. Knowing that my car is ready and the track is clear, do I risk running at high speed along side a driver I no longer trust, who, in a panic, might suddenly crash us both? Or, do I stay in the pit and refuse to race?

Like most questions of extremes, the prudent answer probably lies somewhere in the middle. Most NASCAR drivers, and investors for that matter, would agree that finishing safely in tenth or fifteenth place is better than risking everything to finish in the top three, and also better than never getting your car out of the pit.

Enough with the racing metaphors: What does all this mean? First, it means that as investors we cannot trust our fellow institutional shareholders to invest responsibly. In addition to worrying about the economy and corporate profits, we must now worry about the damage irrational shareholders can do. Second, it means that as investors we must find a measured response to this new threat. It’s a little like what you heard when you were a child. “If you quit now, it will make it easier to quit next time." Likewise with institutional shareholders, if they behaved irrationally last time, it is easier for them to behave irrationally next time. This new hit-and-run mentality might be here to stay. Therefore, we should find new means to stay in the race, but learn to drive more defensively.

Over time, changes in accounting methods and in the regulation of Wall Street analysts will serve to increase the safety of investing. Investors will benefit from clearer visibility into the profitability of America’s corporations and improved objectivity, albeit legislated, from the analysts who cover these companies. So, it is advisable to keep the seat belts tightly fastened, and a watchful eye on the mirrors. But the good news is, that if we're careful, we're likely to get where we're going in one piece.
 

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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