As a venture capitalist who was once a Wall Street analyst, I am continually asked about my views on the high-flying U.S. equity markets and how this affects my job as an investor in private companies. Historically, I have shied away from commenting on macro-economic trends, as the large number of relevant variables and the inherent complexities of global financial markets make predicting such things more of a theoretical discussion than an absolute analysis. However, I do believe there are some very interesting interrelationships between the state of the current market and the opportunities that have arisen as a result of the Internet. Hopefully, my position as a former insider-turned-outsider will offer an insightful perspective.
It is certainly no secret that the U.S. equity markets are enjoying one of the most prosperous bull-runs in our nation's history. The Dow Jones Industrial Average has been up 12 out of the last 13 years and has enjoyed an average return of 15 percent over the past five years. Despite this upside, there is no sign of a diminishing appetite for stocks, and every dip or correction is interpreted as a major buying opportunity. While 1998 was a little shaky coming out of the gates, this year is legging into a full sprint. The DJIA, for example, is up 8.8 percent* in only 72 days. If the market continues at this pace, we could be looking at a quite respectable annual figure of 52 percent. The tech-heavy Nasdaq, for its part, also has shown a remarkable amount of resiliency, with a five-year annual return of roughly 17 percent* and a strong 12.8 percent start in 1998. Lastly, by almost any valuation metric, U.S. markets are trading at near all-time highs, reflecting an unbridled optimism about the future.
So what are the factors that have led us to this enviable position? The most obvious and most cited factor is the strength of the U.S. economy. Growth is strong, yet there are no signs of inflation. This implies that interest rates will stay low, which helps equities in two ways: Many analysts value public companies by discounting future expected cash flows, and with rates low, future cash flows are more valuable. Also, low rates hurt the relative attractiveness of U.S. fixed income investments, the equity market's chief competitor for capital. The other frequent explanation is the establishment of the "New Economy." While the specific details of the New Economy are somewhat sketchy, the main pitch goes something like this: The rise in productivity related to our increased use of information technology allows us to economically fly at a higher level than in the past. In other words, it's different this time.
While these theories are unquestionably plausible, I would like to offer two more that deal with consumer education and the fund manager's reaction to this education. Over the past 20 to 30 years, financial advisers have sung the praises of equity markets as a great long-term instrument for capital appreciation. Over the long run, as the saying goes, stocks always have had a higher rate of return. As recently as the early '70s, most Americans were skeptical of this viewpoint. They had seen firsthand the high risk associated with stocks, and they preferred to play it simple and safe. However, the fantastic stock market returns of the '80s and '90s have confirmed the financial advisers' original premise. As a result, the average American is much more comfortable participating in the equity markets and has confirmed this by voting with his or her pocket book. Record amounts of capital continue to flow into the equity markets, and it would be hard to ignore this phenomenon as a potential contributor to the bull market.
Investors also have become more educated in how they invest in stocks. Once again, financial advisers have pointed out that investors can do just as well, if not better, investing in equity indexes (such as the S&P 500), as opposed individual funds. What?s more, index funds have lower fees and lower turnover, which equate to higher after-tax returns for the investor. Over time, individual investors have become more enamored with index funds, and as such, money flows into these funds and has continued to do so at record rates for several years. One could argue that the money flowing into these indexes drives up the demand for these stocks (such as the S&P 500), which creates a bit of a self-fulfilling prophecy. However, I think the fund manager's response to the index craze is a much more interesting phenomenon.