There were a lot of things happening on Wall Street in 1998 and 1999 that hinted at a stock market gone out of control. Through-the-roof valuations on dotcoms that had yet to book any revenues (forget profits), widespread margin buying and the dominance of momentum investing were a few of the telltale signs. So was the explosive growth of the Nasdaq market and the new generation of "instant" millionaires created by the high-flying tech sector.
Yet it wasn't these symptoms, or even Alan Greenspan's infamous "irrational exuberance" remark, that made the biggest impression on financial advisor Stanley Ehrlich.
It took the death of a friend to convince Ehrlich something crazy was going on. "I was at the viewing, when someone leaned over and whispered to me about a stock I should be looking at-and it was a family member of the deceased,'' says Ehrlich, of S.F. Ehrlich Associates in Clinton, N.J. "I walked out just kind of shaking my head and saying, 'You know, it's everywhere.'"
It was, as some advisors put it, a time when it seemed everyone wanted to get rich, not in 10 years or two years-but next week or next month. Almost everyone knew someone who had achieved sudden wealth. Big drops in the market were no big deal. Without fail, the market bounced back and surged to new highs. It was a party, a never-ending bash, and if you were a financial advisor sticking to your asset-allocation guns, you were pretty much viewed as a loser: the party pooper. And besides, who needed your advice anyway?
"The thinking was, 'This is easy. Gosh, anybody can do this.' And in a sense, it was true,'" says Ehrlich.
How things changed in 2000. The market lost its remarkable resilience. At the start of this year, it was in the throes of a nine-month decline, during which the formerly sizzling Nasdaq index has gone into a glacial freeze, losing more than 50% of its value since March 10. Dotcoms have been falling like bowling pins, high-tech employees are worried about keeping their jobs, let alone keeping their stock options above water.
Layoffs are hitting Old Economy companies as well as New Economy ex-darlings, such as Lucent Technologies and Microsoft, both of which saw their shares plunge more than 60% last year. Ironically, some investors now view them as "value" stocks. Venture capital has dried to a drip, IPOs have slowed to a trickle and the Federal Reserve has started lowering interest rates to resuscitate the economy. The "R" word is popping up more frequently, as leading economic indicators point to a slowdown.
Humbled investors now talk about bubbles bursting and of recessions looming over the dark horizon. "You don't hear stories about day traders anymore," says financial advisor Tom Orecchio of Greenbaum and Orecchio Inc. in Oradel, N.J.
Clients who pursued the market with unbridled optimism are paying the price, he says. One prospective client came to Orecchio last year after pouring $900,000 into four stocks-Ivex, AT&T, Lucent Technologies and Priceline.com-and watching his portfolio fall to $420,000 in value. "He hadn't even told his wife," Orecchio says. "He came in asking, 'What can you do for me?'"
The party is indeed over. But where does that leave advisors and their clients? Are they dealing with clients who have truly learned a lesson from the mania of the past several years? Or are they suffering from a temporary hangover? Oppor-tunities created by the carnage clearly exist, but how can advisors exploit them to their long-term advantage?
"Quality people [advisors] are repatriating accounts. In some ways, these are glorious times because they make the amateur look so bad," notes Nick Murray, a longtime observer of the financial-services business and editor of Nick Murray Interactive. "You don't have to argue against the bubble and the dotcom insanity anymore. The question is not what the market does but what the advisor does and how they process the experience. The advisors who let new accounts talk them into playing the tech boom are paralyzed. Not without reason, those advisors are taking some heat."
Many experienced advisors say the weak market hasn't drastically changed their financial advice-but it has made them look smarter. Advisors who stuck to asset allocation and bulked up on real estate and utilities the last few years, "looked pretty stupid," says Curt Weil of Weil Capital Management in Palo Alto, Calif.
Weil continues to preach modern portfolio theory, and it's easier to get his clients to listen. Real estate and utilities have brought double-digit returns in 2000, and his gradual movement into mid- and large-cap value over the last two years has finally paid off. "My advice really hasn't changed significantly, which is to say, you have to be invested at all times because there is no accurate timing of the market," he says.
Former investing do-it-yourselfers have been coming to his door in increasing numbers. It used to be he sat on four or five client prospects at any one time, but now Weil is sitting on 25. "While we're seeing a decrease in client arrogance in their abilities to manage money, my arrogance is going up," he says with a laugh.
The worst market in two decades has given advisors a perfect opportunity to drive home the merits of a diversified portfolio, says Jeff Lancaster, portfolio manager at the financial-planning and investment-advisory firm Bingham, Osborn & Scarborough in Menlo Park, Calif. "The clients who chose to work with our firm are those who understand that they will never be concentrated in any single market," says Lancaster.
If investors are guilty of overly high expectations, Lancaster says, advisors are just as guilty for not emphasizing the potential of a diversified portfolio that has underperformed a single benchmark in a given year. In 1998 and 1999, those benchmarks happened to be the high-profile S&P 500 and Nasdaq indexes. "Very few investors who wanted to own a diversified portfolio regarded it as reasonable to compare their performance to a concentrated holding of Microsoft or Cisco," he says. "But subconsciously, they were asking, 'Why isn't my portfolio performing like those stocks?'"
To prepare his clients for 2001, Ehrlich is asking his clients a straightforward question: How do you feel about losing 12% to 14% in 2000? "I want to know if the pain they got from suffering portfolio losses [was more acute than the satisfaction from] their previous gains," he says. "If the answer is 'yes,' we have to take a more conservative turn in their investments."
None of his 70 clients-most of whom he describes as baby boomers in the forty-to-fifty age range-has asked for such a change yet, which leads Ehrlich to believe they see the 2000 market as a "blip." Some clients, meanwhile, are looking at the slide as an opportunity to get aggressive in some pockets of the market. For these clients, Ehrlich is eyeing some of the beaten-up large caps in the tech sector, such as Cisco, and the financial sector, which should benefit from any further interest-rate cuts by the Fed. "I have clients who at the end of the year got bonuses and said, 'Here is investment capital I want to start putting to work,' he says.
After losing sleep over the way her diversified portfolios were performing in 1998 and 1999, Marjorie L. Fox, a principal in Rembert, D'Orazio & Fox in Falls Church, Va., feels a lot better this year. The performance of her clients' portfolios will fall between break-even and a 10% gain for last year, so she feels her preaching about diversification was vindicated in 2000. "It feels good," says Fox.
A key decision was buying out-of-favor asset classes like real estate, natural resources and bonds in 1999, when they were hitting rock bottom. Strong performance in those sectors, she says, rescued her clients in 2000.
She says 2001 will "be business as usual," meaning portfolios will be rebalanced. Using the same principles that prompted her to invest in real estate and natural resources in 1999, Fox expects to shift new client money into large-cap growth and international equities. She will also lighten up client investments in real estate and natural resources.
"What we lighten up on is different every year," she says.
Probably the most valuable lesson of last year, advisors say, was for new investors who had yet to experience a down market. That amounts to a lot of people, because anyone entering the market over the past nine years had yet to experience a real bear market. Add all the talk about the New Economy and the technological revolution, and it wasn't hard for some investors to be lulled into thinking equity investments were the proverbial "sure thing."
In this sense, the market downturn has been a good thing, says Thomas Grzymala, president and CEO of Alexandria Financial Associates Ltd., a wealth-management firm in Alexandria, Va. "It's brought people down to reality and made people think a little bit," he says.
The sheer power of the 1990s' bull market prompted even some professionals and long-term investors to conclude that the nature of the market itself had changed-that the good times would just continue. "I remember having a conversation with a board member of a foundation I was working with, and he told me, "Small caps are dead. Small caps are a thing of the past,'" says Matthew Reading of Austin Asset Management in Austin, Texas.
Between the lines of such talk has been the presumption that there's something different about the market-whether it be the New Economy, the Internet or technology-driven productivity. It was almost as if people were saying a new era had arrived in which major market downturns were extinct, says Weil. "I heard a lot of variations on the most expensive words on Wall Street: 'This time it's different,'" he says.
That's why recent events have highlighted the importance of making clients aware of the market's up-and-down ways from the moment they walk through the door. Some advisors use a bit of simulated shock therapy. One of the first things Bingham, Osborn & Scarborough does with its new clients is show them how much money they would have lost if they had owned stock in 1973 and the first three quarters of 1974. "We will tell our clients, 'This will happen to you again,'" says Lancaster. "We tell them, 'We don't know when it will happen, and we won't see it coming. Can you handle that?'"
Part of it depends on what type of client you're talking about. Advisors say longer-term clients-those who have become comfortable with long-term investing and diversification-are probably breathing the easiest.
Not so for newcomers to the market, particularly the 30- to 40-year-old tech-millionaire crowd. "These are a lot of the ones that didn't diversify," Reading says.
As Grzymala sees it, this last group is largely composed of people who entered the market recently with high expectations. "For these clients that are new to us, the reaction has been, 'Gracious sakes alive, what's happening?'" he says. But they weren't alone. One year ago, Grzymala recalls a widow in her eighties second-guessing him and asking why they didn't sell all her Pfizer shares and invest the proceeds in Cisco, then selling for about $80 a share.
This compulsion for chasing markets and stocks drove some investors to behave like cult followers. It also caused some huge mistakes. Robert Veasey, of Sowa Financial Group in East Providence, R.I., remembers a client who bailed out of an emerging market fund in 1998 and went into a growth and income fund. The former fund went up 100% that year, while the other fund went up 6%. Then the same customer moved his money into individual tech stocks at the end of 1999-and saw them fall in value by 50%. "People chasing last year's performance is the single-most abused tactic we see," Veasey says.
Some advisors tried to distract over-anxious clients by pulling out 1% to 5% of a portfolio and using it as "play money." Christopher Carosa, of Carosa, Stanton & DePaulo Asset Management in Haneoye, N.Y., did that last year with a small-business owner who "never experienced a downturn and didn't believe that one would come." So he took $10,000 to dive into Internet stocks. Two weeks later, the money grew into $15,000. Earlier this year, it sank to $8,000, and he sold his holdings for a loss. "He came up with the best possible response. He viewed it as tuition," Carosa says.
But convincing some clients to keep things in perspective isn't easy. Many advisors send out letters to clients periodically during the year or use charts to show how indices and sectors can quickly go boom and bust from one year to the next. They say the education efforts were largely successful and, for most of their client base, prevented too much exuberance or panic over the past few years.
But, in the face of what happened in the late 1990s, the history lessons were faintly acknowledged. Sure, there were the clients who stuck with their advisors and their principles. But there were also many who yawned whenever they heard talk about the long-term picture, risk tolerance and-gasp-diversification.
For those clients, and there were many, even 25% or 30% gains weren't enough. They wanted to know why all their money wasn't being thrown into an S&P 500 fund or the one or two dotcoms they heard about on CNBC or on the Internet or from Uncle Ted at the Sunday barbecue.
"Suddenly everyone became an expert," says Larry Braunstein of the Braunstein McGorry & Co. Ltd. wealth-management firm in New York. "I had clients who were up 30% last year asking me why they weren't up 180%."
If investment recommendations didn't have a dotcom attached or were not in some way tied to the Nasdaq or S&P 500, they were seen as invalid.
Scott Kays, president of Financial Advisory Corp. in Marietta, Ga. and author of "Achieving Your Financial Potential," says things changed for him last year when he spoke at seminars and amateur investors lectured him."We would have people just verbally challenge us and talk to us in a condescending way," says Kays. At one seminar, a man stood up and said his plan was to take his wife's $300,000 portfolio and turn it into $29 million in the next 10 years. "This guy told us, frankly, 'If you can't double my money every year, I have no interest in working with you.'" At another seminar, a man raised his hand and said, "If I listened to what you had to say, I wouldn't own any of the stocks in my portfolio."
Then, in an encounter that seemed to underscore the sentiment advisors were up against, Kays remembers talking to an 18-year-old catering company employee who was cleaning up after one of the seminars. After chatting awhile, the young man said, "I work this job at night. During the day, I'm really a successful day trader."
In time, it became apparent to many advisors that they had a lot of competition-and not just from other advisors. Much of it came from the media and the endless stories of growth, growth and more growth and of people getting rich in a matter of hours. Then there was the other foe: people's high expectations.
People became fixated on the S&P 500 and Nasdaq market indexes and used those as benchmarks to judge their portfolios. Risk factors were forgotten and replaced by daily scrutiny of how the portfolio was performing against those indexes.
Put simply, people were watching friends and neighbors make sacks of money, and they wanted to share in the fun. Greed and fear are often cited as two prevailing forces in the stock market. Pride and regret also heavily influenced the mania of the late 1990s, says Rick Adkins of Arkansas Financial Group Inc. in Little Rock, Ark. "It was the pride of being able to brag about a good investment" versus the regret of not having invested, he says. "People were sitting there watching the market and talking to their friends about stocks over cocktails."
And those who won big gains were given even a bigger incentive to continue investing in risky equities. People who struck it rich early in their careers through stock options had no basis for being conservative. Sometimes, no amount of arguing could change that attitude, advisors maintain.
Reading had a 35-year-old client, an employee at a tech company, who all of a sudden had a portfolio worth $6 million. He resisted advice to exercise the options early and diversify the money. He then margined his company stock to buy a $1 million house. In 2000, the company's share price plummeted, and the client had to sell the home in midconstruction.
"There is a lot of psychology here," he says. "Here you have someone who is 35 years old with all this money coming essentially overnight like a lottery. It just didn't seem real, so it was easy to risk."
A run of successes led many people to turn a deaf ear to advisors who kept preaching diversification. Lancaster unsuccessfully tried to get several clients of his to exercise and sell stock options they had accumulated with their employer, McKesson HBOC Inc., a health-care products company in San Francisco. "It was a great company and a great stock. These clients were convinced it was going to keep growing based on their knowledge of it as employees," Lancaster says. Then, in early 1999, the company reported accounting irregularities and went on to lose more than 60% of its value.
Failure to exercise stock options has been a common bad practice among inexperienced investors the past few years, he says. "It's a touchy subject," he says, "because you're dealing with people who in many instances are very, very bright ... and correctly predicted the emergence of hot, new technologies. Now you're telling them their situation in life is very risky, and they don't get it."
This was especially true in northern Virginia, where America Online has its headquarters and where many of Fox's clients come from. "We have clients who are independently wealthy simply by having gone to AOL at the right time and getting stock options at the right time. They're set for life."
That's why, Fox says, it was hard for an advisor to defend modern portfolio theory; it simply wasn't working. Despite her best attempt to adhere to her investing principles, the big growth stocks kept growing-year after year.
As a result, Fox had to explain why she was moving money from S&P 500 index funds into bonds, real estate, small caps and natural resource equities in years when the S&P 500 was skyrocketing. "Clients were looking at us and saying, "Why do we own all these things?" In 1998, she says, her clients averaged 8% to 12% gains-and they were disappointed.
"I had some sleepless nights wondering if things had changed," she says. "Then I looked at the P/E ratios on some of these stocks and said, 'This just can't continue,' yet it did."
After several years in which practically every client walking in the door wanted an average rate of return of 30%, Weil realizes 2000 reaffirmed his convictions about diversification and long-term planning. "After being gently beat up for owning REITs and utilities, all of a sudden, I look smart," he says. "It's instant success after 30 years in the business. It's just the way it is."