Jonathan Davis: For investors, the future's fearful

Nobody who has been following the daily trading action in the stock markets over the past week can fail to have noticed that investor sentiment is not healthy. After eight consecutive days of declines in the FTSE-100 index, on Thursday the London market broke through the lows of July and September last year. This is an important test of where the markets may be heading next: if the lows of last year are broken decisively, it will confirm we are still in a primary bear-market trend.

Many senior professional investors are privately gloomy. If the market does fall towards or through the 3500 level, that will pressure on life companies and pensions funds to sell more equity holdings, although much of the nervousness is driven by short-term concerns, including the uncertainty over the growing threat of conflict with Iraq.

A deeper underlying worry is that estimates of this year's corporate profits are almost certainly too high, on both sides of the Atlantic. This, in turn, has to be added to the longer-term structural issues of consumer debt, the US trade deficit and the high historical valuation levels of the markets.

Will life look better by the end of the year? I suspect it will, but there are still plenty of things for investors to worry about in the medium to longer term, as I found by tapping into the views of Leon Levy, a legendary Wall Street investor whose memoirs, The Mind of the Market, have just been published in the US.

Mr Levy has been a player on Wall Street for more than 50 years, helping to create two of the most successful investment boutiques, one the Oppenheimer mutual fund business, the second a private equity firm called Ulysses Partners.

In his book, finished last summer, Mr Levy says he expects the bear market to be protracted and deep, though we will come out of it. There is, he feels, "still too much buoyancy in the markets", more than is warranted when all major economies have weakened and are burdened by debt and by other legacies of the great "spending spree of the Nineties".

He believes the markets are due for a long, bad stretch, interrupted by sharp, short rallies, and he would not be surprised if stock markets were to fall back to their 1995 levels. He says if the Nasdaq market had grown at the long-term trend rate of shares from 1990 on, it would still have been trading about the 650 mark last summer; in other words, at half its present level.

As a long-time student of human and market psychology, and someone who has given millions to research the role sentiment plays in financial markets, Mr Levy says the mentality that created the recent stock-market bubble compares in scale to the great bubbles of the past (tulips, the South Sea Bubble, railway shares in the 1840s, and so on).

What makes the internet one all the more remarkable, he says, is that "it occurred in the most liquid, sophisticated and ostensibly diverse market in history, and it continued to inflate despite a drumbeat of warnings in the mainstream press that laid out in the plainest possible language the absurdity of the valuations that investors were lavishing on stocks". We can see clearly now that the basis on which the bubble was justified at the time was almost entirely illusory.

So, for example, the lofty p/e ratios investors assigned to stocks in the bubble period were said then by many to be validated by the big increase in profit margins and the productivity miracle of the late Nineties. Yet in practice, Mr Levy notes, profit margins did not increase in the late Nineties.

For the companies on high-flying Nasdaq, the losses they reported in the year 2001wiped out all the profits they had collectively reported in the previous five years. And the great "productivity miracle" of those years was really a combination of accounting sleight-of-hand and a by-product of the spending spree of consumers, whose profligate ways enabled many companies to report revenue gains without apparent increase in the number of employees. This was a period, Mr Levy says, when even the smartest professional investors "willingly suspended their sense of disbelief and perhaps, even more astonishingly, dismissed facts and figures staring them in the face". He cites the example of Amazon.com, which he says turned a corny old joke into a badge of honour. (The old joke concerns a rag-trade wholesaler who sells suits that cost him $100 at $90 a go. When asked how he could ever make any money, he replies: "Simple. I make it up on volume.")

Mr Levy is also scathing about Enron, while having the courage to admit he too was taken in for a while by the charm of Andrew Fastow, the company's chief financial officer. The latter persuaded him to invest in one of the infamous off-balance sheet partnerships designed to erase billions of dollars from Enron's books. This "brazen fraud" helped Enron pull off the remarkable achievement of going bankrupt without reporting a single, bad quarter's earnings.

With the continuing fallout from the bubble, markets will not recover quickly or easily. But Mr Levy does not say his gloomy prognosis about stock markets will play out that way. When I spoke to him last week, he rated the odds of a protracted bear market at two in three. He also denied his caution is a sign he has lost his appetite for risk with the onset of old age (which does happen).

On the contrary, he said, he is still active in the markets. One of his favourite mediums is the currency and interest rate market, where he trades eurodollar interest rate options. Like many other professional investors, he thinks the dollar is due a period of weakness and gold has its attractions now. I have rarely heard a market bear sound so cheerful. As with his life, his book reflects the inexhaustible enthusiasm of the market addict.

davisbiz@aol.com