When the Nasdaq composite dipped below 2,000 on March 12 for the first time in 27 months, Robert Snigaroff and Mike Munson were not surprised. They'd been expecting it for a year.
But while Messrs. Snigaroff and Munson felt vindicated in seeing the tech-laden Nasdaq lose 60% of its value since closing at a high of 5,048.62 on March 10, 2000, they're not gloating yet. As difficult as it might be for some institutional investors to hear, both men believe the Nasdaq has further to fall, and they've written a paper explaining why.
"The 21st Century Earnings Revolution, the Low Equity Risk Premium Paradigm, or the Late 20th Century Great Growth Bubble," written in August, will be published this fall in the Journal of Investing. In it, Mr. Snigaroff, former chief investment officer at the San Diego County Employees' Retirement Association, and Mr. Munson, the fund's assistant chief investment officer, argue that stocks overall are expensive, and that growth stocks - particularly in the technology sector - were and still are outrageously overpriced.
Although several months old, the conclusions have turned out to be prescient. On March 12, the Nasdaq composite plunged 6.3% to close at 1,923.25, with only a slight recovery to 1,940.71 by the close of trading March 15 - still a whopping 21.5% drop from its level at the start of this year. And strap on the life vests: it might sink further.
"People who are hoping for the big rebound in the Nasdaq could be sorely disappointed," Mr. Snigaroff said in an interview. "We thought there was a true speculative mania in the growth sector of the market that has been largely corrected. However, we do wonder about the prospects for growth stocks still at these (price-earnings) levels."
`Asset price bubble'
In their paper, Messrs. Snigaroff and Munson suggest the stock market is in what they call an "asset price bubble" brought on in part by "inexperienced" investors who have never seen a prolonged bear market. Even some institutional investors did not have the equity exposure they do now at the time of the last bear market. Additional factors are round-the-clock trading and information access, made possible by better technology; market speculation; and an abundance of cash flowing into equities.
Perhaps the most ironic conclusion the two men have reached is that pension funds themselves might be the real culprits driving the asset price bubble. Pension funds, they say, tend to rely too much on historical returns to determine asset allocations. In particular, public funds have gobbled up growth stocks in the quest to become fully funded on a par with corporate plans, which have been playing in equities for years, but have themselves increased their growth equity holdings to take advantage of the up market.
"Pension funds aren't factoring in lower expected returns," Messrs. Snigaroff and Munson wrote in their report.
As evidence of the disconnect between stock values and expected returns, the two men point out that between 1926 and 1994, stocks had an annual compound return of 10.2%. From 1994 to 1999, average annual stock returns were 28.7%, and the stock market now is more than three times as expensive as it was from 1926 to 1994. Yet the stock market's expected return, based on historical calculations, is still 11.3%. So stocks are now three times as expensive, yet their expected return is just a little over one percentage point more, and far below the 28.7% of the past few years.
Messrs. Snigaroff and Munson argue that in order to support the high price-earnings ratios stocks have today, earnings would have to continue growing at a rate that appears historically unsustainable.
"People weren't figuring how much these companies have to grow their earnings to be reasonably priced," said Mr. Snigaroff, who left San Diego County in late February to start his own money management firm focusing on value investing. "Everyone has been trying to find the next Yahoo! Inc. and bidding up all the potential contenders. Not every single stock could be the next Yahoo!, and so you have a speculative bubble."
Mr. Snigaroff made his comments after Yahoo! shares fell two weeks ago after the company said it would miss earnings forecasts and that Timothy Koogle was resigning as chief executive officer but remaining as chairman.
No changes resulted
Although it was written by pension executives at San Diego County, the board of which carefully reviewed its conclusions, the report ultimately did not persuade board members to change the plan's asset allocations, Mr. Munson said.
Still, he thinks the report is as timely today as when it was written, and will have merit when it's published later this year.
"I think a lot of people are making similar arguments ... and I think a lot more pension funds are listening, especially now that stocks have fallen significantly," Mr. Munson said. "They start looking at the arguments and whether the stocks are priced fairly now."
So where should the money go? Perhaps not surprisingly, Mr. Snigaroff said he thinks institutional investors should be looking at value stocks.
That theory makes sense to Stephen Fan, president and chief investment officer at Fan Asset Management, Mountain View, Calif. Mr. Fan, whose company manages $1.2 billion in style-neutral core products but offers several pure growth portfolios, said he thinks simple supply and demand is behind the rise in stock prices.
In 1999 and into 2000, investors bought high-growth stocks, hoping to cash in on the returns everyone else had been enjoying. The result has been a rapid buildup of assets at the high-growth end of the spectrum and much slower in low-growth, or value, stocks.
"There's too much capital chasing a limited amount of assets," Mr. Fan said.
Last year, high-growth stocks got hit with a double whammy of sorts, according to Mr. Fan: People started taking money out of equities about the same time the economy, which had been driving the tech sector, started slowing. Just as assets built up at the high-growth end faster than at the low-growth end, they also flooded out of the high-growth end more quickly.
Mr. Fan said he suspects when p-e ratios come back down, the same money will flood back into the next group of high-growth stocks, creating another inflated situation "in much the same pattern as before."
Agrees with report
Farouki Majeed, chief investment officer at the $4.9 billion Orange County Employees' Retirement System, Santa Ana, Calif., said he had seen the report by Messrs. Snigaroff and Munson and agreed with much of it. Orange County, however, typically allocates about 50% of its assets to equities, about 33 percentage points of which is in U.S. equities. That's less than other funds, which tend to have overall equity allocations of 60% and more. Consequently, Orange County hasn't changed any asset allocations in response to the report's conclusions.
But Mr. Majeed and his staff are preparing the board for lower stock returns than in the past couple of years - more in the 15% to 20% range, which Messrs. Snigaroff and Munson still consider on the high side. "Certainly I think the market expansions have been somewhat unreal," Mr. Majeed said. "We had a euphoric kind of expectation on prices, and certainly the fact that it (the market) is overvalued is now being proven in the market."
Messrs. Snigaroff and Munson are not the only people arguing that p-e ratios for many growth stocks, particularly technology companies, are unrealistic. University of Illinois finance professor Josef Lakonishok, along with fellow Illinois finance professor Louis K.C. Chan and University of Florida professor Jason Karceski, have written a paper arguing that growth stocks are overvalued and cannot hope to fulfill analysts' rosy earnings expectations. Further, a draft paper by efficient-markets theorists Eugene F. Fama and Kenneth R. French predicts a much lower equity risk premium -the higher return investors expect for buying stocks over bonds - in the future (Pensions & Investments, March 5). Others have even predicted a negative equity risk premium (P&I, Nov. 13).
While the notion of such a reversal in the equity risk premium remains controversial, the evidence that growth stocks have been overvalued continues to build. Witness the parade of technology companies that lined up to support the argument over the past couple of weeks. Yahoo! and Intel Corp., both in Santa Clara, Calif.; Nortel Networks Corp., Brampton, Ontario; and Cisco Systems, San Jose, Calif., all announced either lower earnings forecasts for 2001, job cuts, or both. Bad news at Cisco - lower sales estimates for 2001, 8,000 job cuts and a $400 million charge against earnings in 2001 - drove the company's shares down more than 8% on March 12 and helped pull the Nasdaq below the 2,000 mark.
"I think the Nasdaq, even at 2,000, is probably not so cheap, given company earnings," Mr. Lakonishok said. "It's kind of a timely paper we wrote."