Balancing Portfolios in a Dot-Com World

It's pretty straightforward. Those charged with investing public money have only four things to worry about: their fund's financial condition and cash flow; the state of the economy; what monetary and other regulators are up to; and how the markets are behaving, which is to say what other investors collectively are thinking about these same things and what they think will happen.
by | June 2000

It's pretty straightforward. Those charged with investing public money have only four things to worry about: their fund's financial condition and cash flow; the state of the economy; what monetary and other regulators are up to; and how the markets are behaving, which is to say what other investors collectively are thinking about these same things and what they think will happen.

For most of the past year, the economy has been superb, with low unemployment, roaring growth, strong corporate profits and stable prices. Government coffers at all levels have been overflowing, and the objectives of monetary policy have been clear as a bell.

What's to worry about? Plenty, and a lot of that concern has to do with figuring out the markets and what those other investors could possibly be thinking.

Despite the fiscal and economic good news, there has been a gnawing uncertainty--an apprehension over rapid, seemingly rudderless change. The economy appears to be in the process of being transformed. New ways of calculating value that seem to count cachet more than cash have been coming into vogue. The dot-coms, bulging with cash from public offerings and (not coincidentally) darlings of the media, have been dominating this new investment metric where values seem to be untethered from the standard analysis. The securities markets, so rewarding in the past few years, have been flying off in different directions as the economy split between the old bricks-and-mortar stalwarts and the upstart high-tech newcomers whose products often are ephemeral and profits are subterranean.

No, most public investors were not out chasing the hot stocks. But they were all affected by the new e-economy and its impact on monetary policy, the financial markets and, of course, the new ways business was being conducted.


The world of public sector investment divides pretty much into two sections. There are the general fund cash managers--state and local investors primarily concerned with day-to-day needs of investing largely short-term funds. Then there are the public pension fund investors--devotees of the longest-term investments.

Both types preside over very large, growing accumulations of funds. As of year end 1999, the general funds had $1.23 trillion in financial assets. These were mainly in short-term instruments such as U.S. government and agency bonds and bank CDs and repurchase agreements. But general funds do some long-term investing as well, and their assets included $125 billion in corporate equities. Public employee pension systems, where holdings are growing by leaps and bounds, had $3.05 trillion in assets at the end of last year. They once favored bonds but have been investing heavily in equities the past few years.

The two sections have their own missions and special concerns. Each gets its time, sometimes willy-nilly, in the public spotlight as it deals with risks and rewards. A few years ago, attention was riveted on Orange County, California, and its risky investment strategies that backfired. This past year, attention was directed to long-term investors--the pension funds and their adventures in the surging, volatile equities market. The skills of public money managers are being tested all the time. Investment decision making requires picking winners while taking acceptable risks. If one applies the fundamentals, the old-economy stocks and the market averages should continue to move ahead. But that's not been the case. Is the new economy of dot-coms for real or a mere bubble? In the public sector, as elsewhere, the stakes riding on getting the answers right are huge.


The U.S. economy has grown at a torrid pace--6 percent real rate of growth in the last quarter of 1999 in contrast to the 3 to 4 percent the Federal Reserve thinks is sustainable. Achieving the more leisurely pace of growth has been the Fed's goal because fast growth fosters inflationary pressure--although the relationship is elusive. Central bankers have nightmares about inflation and the Fed has stayed up nights figuring out how to fend it off.

To throttle any hint of inflation, the Fed has tightened the discount rate in quarter-point increments in a steady upward march for the past five quarters. The stock market was the object of the crackdown for two big reasons. First, a booming stock market is a leading indicator that the economy is on its way up. Its pausing or even drooping sends a powerful semaphore to firms and individuals to proceed with caution. Second, and of increasing concern, is that the stock market itself is creating by its run-up a huge demand by consumers who consider themselves wealthy and, therefore, are inclined to spend more and save less.

Despite the interest rate upticks (or maybe because of them--who knows), the economy improved. It was blasting along at a 5 to 6 percent annual growth rate and an inflation rate of 2.5 percent--all this despite historically tight labor markets. And the stock market continued to boil along, too.


Public employee pension systems, with their eye on the long term and claims to be paid out to future generations, are big-time investors in common stock. The relative portfolio share of stock in comparison with fixed-income investments has changed dramatically over the past few years. Without investing another dime in equities, those that held stock watched the investment grow as the market value of shares boomed.

Most public pension systems keep their stock holdings in companies listed on the New York Stock Exchange. They like the large-caps--the large firms that have vast amounts of stock outstanding--since there is likely to be more market liquidity. Their fund managers also are adherents of the intrinsic-value school of thought. That is, they like profitable firms that are largely proven performers. But these have not been the top performers in the past year. That honor went to the upstarts. To many, the run-up in values signaled yet another bubble to which the market is susceptible.

The stock market favored the bold in 1999. Internet stocks that had no earnings and infinite price/earnings ratios set the pace. The traditional market averages, the Dow Jones and Standard & Poor's 500, posted respectable gains. But even these were misleading in that the winners were highly concentrated within the technology sector. Despite the booming economy and handsome profits, most stocks didn't share in the run-up. A big hitter such as Micro-soft, with overpowering market value (about $600 billion at its peak, making it the largest corporation in the world in terms of market capitalization) could single-handedly dictate market averages by its movements. Furthermore, newly liberated day traders were flogging the markets mercilessly with buy and sell orders, surfing the momentum. Anyone (including investment advisers) who did not understand how the dot-com world is supposed to work was berated for underperformance.

The investment managers of public pension systems faced a dilemma: They didn't want to gamble with fund money, but how could they achieve returns akin to the market averages unless they made big-time bets on the new generation of companies that have little or no earnings and frequently are peddling technologies that few can explain? The problem was pointed up by the rocket-ship behavior of the Nasdaq index and its super elevation of price/earnings ratios.

As the year of the bubble persisted, word began to leak out that some dot-coms were hyping their results with creative accounting. Stories in Fortune raised the issue of creative accounting practices; shortly thereafter, a leading dot-com filed drastically revised sales figures and saw its market value melt to 20 cents on the prior week's dollar. It appeared that some companies used such tactics as calling gross sales their gross revenues.

Also, dot-coms were putting future share values in hock. Start-up high-tech companies control their cash outlays and attract talent by promising stock options. These can be exercised by employees when the company is in a position to come out with an initial public stock offering or is gobbled up by another firm. But the strategy dilutes future equity values.

By April 2000, things were beginning to look rocky for the stock markets. Rising interest rates were competition for the returns on stocks. Corporate bonds yielding 8 or 9 percent began to look like good bets against stocks selling at a superheated price/earnings ratio.

Higher interest rates will dampen growth profits by slowing interest- sensitive areas of the economy (such as construction) and generally increasing the cost of business. The naysayers to the new economy and the new metric were beginning to have an impact.


Much of the non-pension investment by state and local governments is focused in the short-term market for the very good reason that funds will soon be used to meet spending needs. Short-term managers have been looking pretty good since short-term rates have been escalating. Between January 1999 and March 2000, the short-term rate as measured by the three-month Treasury bill rose about 100 basis points. By going just a smidgen out of the yield curve, which gained altitude rapidly, the two-year Treasury note gained almost 200 basis points and at 6.50 percent exceeded the yield on 30-year bonds.

Staying short was just the thing to do in the fixed-income market this past year, and government investors could look forward to increasingly attractive returns on their investment of temporary fund balances. Governments have had a lot of these as investable balances because of a bumper crop of tax receipts. For those fortunate enough to have substantial fund balances, the ability to earn higher yields on short-term investments was an extra dollop of gravy.

It's different on the long-term side of fixed income. Like the maiden aunt sitting in the corner of the room, the bond portfolio has been an afterthought at the big equities market party. In state and local government retirement systems, it has crept up slowly the past few years. The spotlight has been on the equity component, while fixed income has definitely played the supporting role to diversification for most public investors.

There were no goodies for the long-term bond investors, though. Last year was painful, the worst since 1985. The level of interest rates climbed without much pause throughout 1999 and has continued to slog upward through early 2000. But those rates couldn't attract investors. This continued escalation has occurred against a backdrop of positive economic news and an official policy by the monetary authority to make sure that "good" news was more threatening than reassuring. So long as the economy bounced along and the stock markets billowed, the bond markets faced the water torture of upward-bound rates.

Nonetheless, some exciting things were happening. The surplus in the federal budget has resulted in a drying up of the supply of federal securities, particularly the 30-year long-terms, which are starting to act strangely. Anchoring the longest end of the market, they are supposed to be the upper peg on long-term interest rates of the highest credit quality. Normally investors have the least certainty about what will happen 30 years hence and therefore require the highest rates of interest--but not recently. In fact, the longest-term bonds went into a Nasdaq-like price spiral and ended up with a rare humped-back interest rate pattern where the intermediate maturity bonds had higher yields than the longest maturities.

The message theoretically being sent was that, although interest rates (and inflation) were expected to be higher in the next few years, all would be well in the long run. More likely, the continuing reductions in federal debt and the announcement that fewer long bonds would be available were sending buyers into an investment spree in anticipation of a smaller supply of these risk-frees. In any event, amid the tightening of interest rates, the holders of the pricey U.S. government long-term bonds were hardly feeling a thing.

At the other end of the quality spectrum, the dot-coms were learning a thing or two about the difference between being speculative sweethearts of momentum trading in the stock market and undergoing scrutiny by icy-hearted bean counters in the credit markets. In early 2000, these high-flying companies were attempting to cash in on their fame by borrowing instead of selling equities. But the rating agencies were more impressed by financial statements and fundamentals than by TV ads and press-release buzz. The dot-coms got junk-bond status.


The method for buying securities is changing, and investors are moving into alternative trading venues. Rather than call dealers to get quotes, investors use the Internet to post their investment needs and depend on a competitive process to get the best deal. The great promise of the new trading environment is that the cost of transactions will be lowered. That outcome of lower cost and greater efficiency seems to be the case in other areas where e-commerce has gotten a grip, such as books, toys and records. In bonds and short- term securities, the new auction mechanisms and trading platforms are squeezing margins and improving transparency.

In Ohio, Treasurer Joseph Deters instituted a competitive, Internet- based auction of Ohio short-term investments. Bid-Ohio auctions off $250 million worth of six-month certificates of deposit to the highest bidder annually in monthly increments. Any bank qualified as a state depository can bid for up to $5 million. The online auction lasts 30 minutes, and bidders are free to revise a bid during the auction. The transactions are paperless, and Deters reports that the auctions have increased rates of return to the state.

This type of "non-dealer-to-dealer" system worries securities dealers, who are scrambling to figure out how to preserve their middleman status. E-commerce has transformed investment securities into a commodity, with firms finding little value to add, and trading is fragmenting, moving away from the exchanges to electronic platforms often run by someone other than dealers. As Pittsburgh Commissioner Laura Unger said at a recent Bond Market Association meeting, the city's pioneering move to online municipal bond offerings points out something very important about e-commerce. "Its nature is to ruthlessly search out and present alternatives to transactions involving intermediaries. Going forward, fixed-income market intermediaries continually will have to prove their value to clients or risk being left in the dust of technology."


Much to the irritation of the upholders of standard norms of analysis, the "momentum" investors in the first quarter of 2000 controlled the equity markets. The result was combat between the traditional backers of intrinsic value and the new economy advocates.

The old guard is rooted in the concept of stock prices reflecting the present value of expected future earnings, adjusted for the relative risk that those values may or may not appear. The analysis has been focused on the price/earnings ratio. A high price/earnings ratio means that the market is indicating that future profit growth will be great. By the same token, if future profits are uncertain or the business is seen as having poor growth prospects, then one would expect the price/earnings ratio to be low. But even high-growth industries can face high risks. For example, businesses taken all together in a new, rapidly growing field such as electronic commerce might have large potential profits, but it is risky to bet that any particular firm will capture the flag.

The new economy, with its dot-com influence, has stood value analysis on its head. The argument is that the old rules don't apply. Dot-coms are insensitive to higher rates (they don't borrow much), and the big, new thing is to get market share, not fool with profits. As a result, dot-coms sell on hopes and sales volume, profits being supposedly somewhere in the unpredictable future. The fearless running of losses is taken as a sign of Type-A behavior. Some have noted the remarkable relationship between the market hype of the media and the explosive characteristics of dot-com stock offerings. Start-up companies sell stock and use proceeds to advertise. Media, depending on advertising and loving get-rich-quick stories, flack the dot-com world and celebrate its well-heeled nerds.

How do we identify the highest of the high fliers? The second generation of high-tech stocks tends to dominate the Nasdaq securities market, just as first-generation technology companies are more highly represented in the Standard & Poor's index.

Public pension fund mangers have likely had to ask themselves if they missed the boat on the dot-com market in 1999 or, more likely, if caution has served them better. Given the preference for widely held, old-economy stocks many systems probably turned in mediocre results last year (the number of losers outnumbers gainers in the Dow Jones in 1999). While the retirement funds do have new venture funds that are more speculative, they make up a small share of the typical portfolio.

The Nasdaq exchange, disproportionately populated with dot-com and other high-tech stocks, exploded upward in 1999 and the first quarter of 2000. But the month of April saw it taking an astounding beating, losing 25 percent of its value in a week and giving up all its gains for the year. Investors that heretofore had seen every dip as a chance to buy more, faltered, and margin calls forced even more sales.

It's too early to tell, but the sudden run-off might just be leading to a more realistic alignment of future profits with present-day stock values. That would be a confirmation of the accepted wisdom of value investing for the long-haul investor. Lancing the dot-com blister will be painful, but its shrinking and healing will be restorative to investment conventions that have served public investors well in the past.