July 6, 2017
Taking stock of market dynamics
by Paul Carroll
After eight years of gains in stock markets and a nice pop following the election of a Republican president in the U.S. in November, an old friend of mine sounded a note of alarm in the Wall Street Journal this week that I think is worth noting—he was right in a big way before the internet bubble burst in 2000, and he’s been my proverbial canary in the coal mine since then. Based on what he wrote, I think we should all confront a scenario where the Dow Jones Industrial Average tumbles 2,000 to 3,000 points and where the fallout spreads throughout the insurance industry, affecting not only client activities but also investment portfolios and even the valuations of insurtechs, as insulated as they might seem to be from the valuations of the Fortune 500.
Here is the article by Andy Kessler, who has been a friend since we became neighbors two decades ago. The WSJ has a pay wall, so the article won’t be accessible to many, but it can be summarized briefly. The argument for alarm is essentially based on his experience both as a securities analyst on Wall Street and as a successful hedge fund manager in Silicon Valley. Andy writes:
“Are there any bells ringing now? How about a few months back when someone looked me in the eye and insisted—without cracking a smile—that Uber was a bargain at a $68 billion valuation? Or when, shades of AOL and Time Warner, Amazon bought Whole Foods for $13 billion—and then its stock went up by more than that amount? Or when Tesla missed its numbers again, and the stock rose anyway? Or when the price of a bitcoin, backed by nothing but the faith of devotees, hit $3,000, tripling over a year? Or when Hertz stock rose 14% on news of a deal with Apple for a self-driving car that is still vaporware?”
The article briefly cites his successful call in 1999 about the coming market collapse. He tells the story in more detail in his entertaining 2005 book, “Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score.” The story goes like this:
He and his partner spent years trying to raise money for a hedge fund but were mostly frustrated by a Catch-22: If you had money, people would give you more, but if you didn’t have money then you couldn’t raise any. Andy and his partner finally raised enough money to be on the map and had one of the best years of any fund in 1998, according to public rankings. People started throwing money at them. In late 1999, a group asked to have breakfast around the corner from their office in Palo Alto, CA, and it was a memorable scene.
A stretch limo pulled up outside the restaurant. Huge bodyguards piled out. Two Middle Eastern investors quickly dispensed with the chit chat and said they wanted to wire $500 million into Andy’s back account the following morning. Andy says he started calculating: The 2% carry, alone, would be worth $10 million a year to him and his partner, Fred, who operated out of a tiny office with just one assistant. That didn’t even account for the 20% of any profits they would earn. Then Andy realized that Fred was turning down the money, because they wouldn’t know what to do with it. Andy says he tried to kick Fred under the table but missed, and finally acquiesced.
Only days later, the scene repeated itself. Another stretch limo. More bodyguards. Another pair of Middle Eastern investors. Another quick offer of $500 million. (Andy says he wondered whether $500 million was a unit of currency in the Middle East that he wasn’t familiar with.) This time, Andy found himself turning down the money, because there weren’t enough good places out there to invest it. On the short walk to their office, Andy and Fred decided that, just because they had turned down $1 billion didn’t mean it wouldn’t find its way into the market and add to the already unrealistic valuations. They decided that they should get out of the market, not take on new money. They did—at the crazy valuations still possible in late 1999 and early 2000, before the crash began in April 2000.
So, when Andy calls the top of a market, I listen. I think you should, too. His piece doesn’t mean the market will crash tomorrow. Or ever, in fact. The stock market operates at its own beat—during my days at the Wall Street Journal, a reporter threw darts at a dartboard quarterly and generally did just as well as the experts in predicting stocks. But it’s worth remembering that stocks don’t just go up. They can go down, too. And we seem to be in a frothy market where a relatively small shift in sentiment could have major implications. As long as we, as an industry, are the experts in risk management, now feels like a good time to think about the risks we’d face from a major downturn in the stock market.
Any downturn won’t affect the fundamental changes happening in insurance. Disruption will continue apace. But contemplating a stumble in the stock market is an exercise I’d recommend.