From Riding the Wall of Worry to Jumping on a Slide

The language of the street is rich with investment maxims based on observations of historical market behavior. Market observers, especially technical analysts, use historical patterns to correlate and make sense of market behavior.

For much of the remarkable bullish run-up of 2007, one of the most overused investment maxims was the market’s ability to “climb the wall of worry.” Long before last week’s dive, some market observers, including yours truly, were already becoming greatly concerned by developments that historically accompany major market tops.

In addition to signs that are normally present in the late stages of bull markets — namely hikes in interest rates by the central banks, rising inflation rates, high stock valuations, and a slowing U.S. economy — the aging bull market had run into a collapsing housing market.

This eventually led to the subprime mortgage fiasco. In recent weeks, the collapse in securities based on subprime and other low- grade debt cut into the unprecedented credit expansion used in leveraged buyouts (LBOs) and acquisitions.

Until last week, the market’s proverbial ability to climb the wall of worry and its capacity to discount all prevailing problems were the two arguments used to assure investors that all was well.

However, last week’s sell-off proved that both assumptions were nothing but wishful thinking. Well, prior to last week, traditional equity mutual funds had become fully invested, depleting their cash reserves down to as low as 3.2% of total assets, the lowest levels ever in cash reserves.

Hedge fund managers also displayed a lack of worry in chasing market-beating returns in an overcrowded sector. Largely unregulated, they have fearlessly been risking other people’s money, using debt to place aggressive bets on commodities and exotic derivatives, including high-yield debt securities engineered by Wall Street magicians from subprime mortgages and other junk debt obligations.

The buyout frenzy suggests that LBO players and corporate riders have hardly allowed worrying to get in the way of ever-larger and riskier deals and mergers. Some of the LBO deals, such as the buyout of Chrysler, have left the auto industry experts puzzled by the LBO bold bet to succeed where Daimler-Benz failed, big time.

Even conservative and risk-averse investors, such as pension funds facing low bond yields, were found participating in LBOs as a way to boost returns. However, what has been most alarming is the lack of worry about the credit binge and the deteriorating quality of debt among debt-rating agencies.

These are the institutions getting paid to watch the quality of issued debt. Now, after a few highly leveraged multi-billion-dollar hedge funds invested in junk-debt-backed securities have been vaporized, rating agencies started to downgrade securities that previously carried high-grade ratings.

As noted in several past issues, the only investment group that displayed caution as the market kept on hitting new highs was that of public investors. The collapse of the high-tech mania of the late 1990s that still has the NASDAQ 100 trading 60% below the glory days of early 2000 remains a painful memory for an entire generation of public punters. Disgruntled by equity losses, the public turned to real estate… only to see another bubble bursting. Little wonder, then, that public investors, as a distinct group, have developed a healthy aversion to overheated markets.

The preceding has not been an attempt to discredit the validity of the “wall of worry” phenomena or the market’s ability to discount known facts. Like all investment principles and correlation, they have their limitations. It is much more realistic to look for the wall of worry after the economy slides into a recession, and after stocks are sold out and hated by public investors and institutions alike, than it is to look for a wall of worry in the late, speculative stages of an overextended bull market.