There have been many reasons cited for the decline of the stock market over the past few years. The blame has extended as far as the “crooked” CEO’s, the “incompetent” securities analyst, the “corrupt” investment bankers who allocated hot IPO’s to prospective clients, and the machinations of income statements by CFO’s. Actually, all of these things have contributed to the decline, but if you really want to focus in on the major cause of the decline it is all psychological.

The psychological emotions of “greed” and “fear” always come into play during extremes in the stock market, and this past financial mania set an all time record for greed. The other side of greed is fear and we have yet to experience anything close to the symmetry of the greed that occurred during the “bubble”. The emotion of greed started in the early 1990’s and built up to a crescendo of unabashed greed during the late 1990’s. The mania included almost every stock market participant, but was fueled by the greed of the individual investor, who turned his head to everything going on as long as he continued making money. How do you think the Initial Public Offerings that were allocated to prospective investment banking clients became so profitable to the recipients of the IPOs? It was only because the individual investor believed there really was a disconnect between fundamentals and the price of stocks. They gladly accepted any scenario the “street” could concoct that led to the belief that their trading profits would continue for the foreseeable future.

The scenario that the US was in a new era or new paradigm was the easiest to accept since the public essentially separated stocks from their valuation levels without regard to historical norms. Public participants would buy the IPO’s at any price in the aftermarket without regard to how much money was made from the IPO price to their purchase price. In other words, if the IPO came out at $10 or $15 per share and would open in the aftermarket at $80 to $100 per share, they didn’t mind paying the aftermarket price since they expected to sell the stock to a “greater fool” at $150 to $200 a share. The only problem was that they couldn’t control their basic emotion of greed as they watched the stock rise to higher levels. They were not aware that institutions given the privilege of purchasing shares at the IPO price were usually required to purchase additional shares on the open market in order to support the price temporarily. This allowed some recipients of the IPOs (mostly institutions or very wealthy clients) with a sense of historic values to unload at or near the peak levels. Of course some of the institutions also got caught up in the greed and wound up suffering heavy losses.

This greed we keep talking about isn’t confined to IPO’s. Just think about how the public and some institutions piled into the same stocks including the whole internet industry as well as Cisco, Lucent, Oracle, JDS Uniphase, PMC Sierra, Level One, CMGI, Internet Capital Group. We could go on and on. How much do you think the average investor in Cisco knew about routers or even the earnings of CSCO, the largest company in the US during the bubble? The answer is almost nothing. During the bubble investors used completely different metrics than were taught in investment courses of all business schools. They didn’t care about earnings, dividends, cash flow, sales, or book value. The new metrics consisted of “number of eyeballs looking at a computer screen”, whisper numbers, potential splits, number of homes passed by a telephone or cable company and many others that made no sense. These investors also allowed, and still allow, companies to start using earnings numbers that make no sense to anyone but investors who are blinded by their capital gains. All through the twentieth century, until the last decade, there was one number used to reflect earnings. There were no “operating earnings” or “pro-forma” earnings, but just one number called “ GAAP reported earnings” that everyone used. During the bubble these other forms of earnings cropped up to justify the stock prices. For example, pro-forma earnings essentially are earnings that are reported “as if” something took place like an acquisition at an earlier date or a plant being on stream for the whole year rather than half the year. Operating earnings are almost as bad since they exclude “write-offs” from the expenses of the income statements, even if the same companies continue, year after year, writing off the same “mistakes”. Even more unbelievable is that virtually every analyst and strategist on Wall Street still uses “operating” earnings.

The public, the institutions, the media and the regulators all turned their heads while CEOs and other top executives were egregiously compensated. Institutions turned their heads as many Board members, who were also excessively compensated, approved loans and option grants for the same executives that invited them to serve on their Board. Sophisticated money managers actually believed in the overly optimistic pension fund assumptions used by corporations. These double digit assumptions could only be funded through the stock market bubble. As long as everyone was making money they all pretended that everything was just fine.

We believe the U.S. stock market and economy still have many excesses left over from the financial mania of the late 1990’s. These will have to be unwound so that the emotion of fear will eventually be as powerful as the emotion of greed that built up the excesses. The fear that we expect will have to have some symmetry to the greed that occurred during the bubble and the stock market will have to go through a purging process to get to that level. This process will probably take the stock market down to levels of about 30% to 40% below the present level.