Everything new is old again

A history of market frenzies shows why volatility is not the risk

Fifty years in the markets have taught me to distinguish the fever from the disease.

A little over 50 years ago, I was starting out as a young economist specializing in energy. I thought I understood market cycles. The markets soon taught me humility.

I have watched the same story play out ever since. Capital rushes toward whatever sector is meant to define the decade. Expectations run hot, outrun what the arithmetic can deliver, and the correction – predictable but unavoidable – arrives in the end. Oil, then commercial real estate, then telecom, then structured credit, and today artificial intelligence.

Over the years I have drawn a distinction that has served me well. Volatility is the fever: It alarms, it drives the thermometer up, and most of the time it breaks on its own. The disease lies elsewhere, quieter: capital committed at too high a price that never comes back. The real risk rarely lies in how much a holding moves. It lies in the price you paid without truly weighing what you were getting.

1970s-1980s: Oil set the tone

Oil was my field, so I watched it closely. Between 1973 and 1974, the price of crude nearly quadrupled, from about US$2.90 to US$11.65 a barrel, driven by the Arab oil embargo of October 1973 and surging demand. The shock helped tip the United States into a recession that ran from late 1973 into early 1975, and American stock markets fell through both years, bottoming late in 1974 before recovering in 1975. Measures to reduce American reliance on imported oil, among them a strategic reserve, helped the economy adjust.

The second half of the 1970s was deceptively calm. For 18 months across 1976 and 1977, the Canadian market barely moved, to the point that several brokerage houses, starved of trading, had to close or merge. I remember the solemn mood of those months, brokers hushed and half-resigned, when the phones stopped ringing.

Then oil took off again, peaking at US$39.50 a barrel in the spring of 1980. This time the fever presented as inflation. It brushed 14.8% in the United States that spring and was still close to 13% in the autumn, forcing central bankers to hike rates – which pulled Canadian five-year mortgages above 21% late in the summer of 1981. Canada promptly entered the deep recession of 1981-82.

Much of the volatility came from the energy markets themselves. Growth-minded oil companies were betting on ever-higher prices and pressing governments to help fund development in the Arctic. The most famous of them, Dome Petroleum, was ready to order a fleet of icebreaking tankers for the Beaufort Sea. Buried in debt after costly acquisitions, including its 1981 takeover of Hudson’s Bay Oil and Gas, it flirted with insolvency as early as 1982 and finally ceded control to Amoco Canada in 1988. Its shareholders took a beating. The banks drew a lasting lesson: energy was too volatile; better to diversify.

Not every tremor comes with a story. On October 19, 1987, Wall Street plunged 22.6% in a single session, dragging Toronto down about 11% in its wake, on no news that could justify the move. Part of the explanation turned out to be mechanical. Pension plans had adopted “portfolio insurance” strategies that sold stock-index futures automatically as prices fell, so computers were selling because other computers were selling, each wave feeding the next. I learned that day that a market can panic entirely on its own, for reasons no one can name the next morning.

1980s-1990s: Real estate proves it’s no safe haven

Commercial real estate was the next sector. Bricks and mortar, we were told, do not lie. What could be more reassuring than a tangible asset with a mortgage behind it? The recession of 1990-91 answered the question. Rate increases meant to curb inflation brought it on; the arrival of the Goods and Services Tax (GST) and the shock of the Gulf War made it worse.

It shook the value of real estate holdings. The big towers could not find tenants. Olympia & York, the Reichmann family’s firm and an icon among Canadian developers, was undone by its London project, Canary Wharf, which became the symbol of the era’s excess. The firm collapsed under the strain in 1992, and the family lost control. Our banks were not entirely spared either, and their share prices suffered. Nothing feeds volatility like nasty surprises and grey areas. 

1990s-2000s: Telecom was going to connect the world

The first half of the 1990s set the stage for the sector that would captivate investors at the turn of the millennium: telecom. Once again, expectations left all logic about achievable returns behind. With globalization in full swing, Nortel, which had grown out of Bell Canada’s old equipment arm into a global maker of leading-edge networks, became the market’s darling. At its height in 2000, Nortel made up more than 35% of the Toronto Stock Exchange 300 index, more than the five big Canadian banks combined. No investment conversation escaped it. You had to own some, people said, or risk looking behind the times. Meanwhile, it traded at prices its earnings did nothing to justify. (Of note, Leith Wheeler owned zero shares of Nortel through this entire period due to a belief that management’s growth estimates were not plausible.)

Buying the index was no protection; it was quite the opposite. An index weighted by market size holds the most of whatever has already risen the most. In 2000, anyone who simply bought the index ended up with more Nortel than anything else, at the very top. Nobody had decided that; the weighting decided it for them. The same arithmetic runs through every frenzy in this story, and is particularly relevant today as U.S. large-cap tech dominates passively managed funds.

Global competition, falling prices, and the investment needed to keep pace got the better of Nortel: The company withered from 2001 and filed for protection from its creditors in 2009. Sooner or later, the (sometimes fatal) illness manifests from the fever. 

Structured credit, and a lesson I haven’t forgotten

After the shock of September 2001, loose American monetary policy set the stage for the next frenzy. Renewed confidence and easier credit gave rise to new instruments: asset-backed commercial paper (ABCP), short-term notes backed by pools of loans and mortgages that were neither guaranteed nor insured. In the United States, quality deteriorated as lending standards fell, and the Federal Reserve ultimately had to prop up major firms that had sold these products when the Great Financial Crisis reared its head in September 2008, kicked off by the failure of Lehman Brothers.

Canada’s story is subtler. Few investors had read, in the fine print, that the banks were committed to buying back the paper only in the event of a “general market disruption,” a clause that, when the moment came, almost never triggered. When the market froze in the summer of 2007, many individuals and businesses found themselves short of cash. The Caisse de dépôt et placement du Québec was the largest holder, with some $12.6 billion, roughly 40% of the non-bank paper in this country, and it was in Montréal, in August of that year, that the restructuring agreement known to history as the Montréal Accord was negotiated.

Both the firm I was with at the time, and Leith Wheeler, refused to buy that paper. The reason came down to one line: It offered only about a quarter of a percentage point more than Treasury bills, a premium too thin to justify a risk no one really understood. When the market froze, we were not holding the paper. I do not claim we saw what others missed; we simply judged the reward too small for the risk. It was not foresight. It was discipline. That is what prudence pays: nothing, until the day it pays everything.

2020s: The pandemic – a market Armageddon… that wasn’t

Covid-19 upended everything. Measured by the VIX index, a widely used gauge of expected market swings, volatility in March 2020 reached highs on par with the worst of 2008-09. The fear was what the virus would do to growth, to employment, and to public debt, as governments spent whatever it took to keep their economies and health-care systems standing. Equities sold off around the world as investors settled in for a prolonged market winter. Only it didn’t appear. Or at least, it only lasted 33 days, during which both U.S. and Canadian markets shed about a third of their values – before rebounding to end the year flat, and go on to new highs in 2021.

With that said, the road leading out of the pandemic was not straight for markets. Quantitative easing to fund pandemic relief coupled with huge disruptions to supply chains from the period caused the fever to spike again. Thirty years on, global inflation re-emerged, prompting rapid hikes in interest rates and causing a dual selloff in both stocks and bonds. Stocks sold off as investors worried about a recession, and bonds did what bonds do in rising rate environments – they also fell. This year reminded us that recoveries usually involve detours.

And now, artificial intelligence

For more than three years, artificial intelligence has stirred enormous optimism and dominated (particularly U.S.) markets. While it feels similar to the technology bubble of 2000, that bubble was inflated by expectations of falling prices born of fierce competition, whereas AI promises to lower operating costs across a swath of industries. It may well create immense opportunities, and just as many disappointments.

But the fever in today’s markets is unmistakable. Concentration is near all-time highs for U.S. stock markets as prices (and valuations) for AI-related companies spiral ever upward. Investors continue to pay record multiples for technology companies, discounting revenue models that are likely years away, and whose risk profiles have worsened considerably – chiefly due to mounting debt loads to fund massive infrastructure spend (both on- and off-balance sheet).

While the technology is artificial, natural intelligence will still decide how well it is used and ultimately, how much it’s worth. Paying a company 100 times the revenue you hope it will generate five years from now is still a gamble. Volatility will persist – both up, and ultimately down – before the fever ultimately breaks; it’s just a question of when.

The risk was there all along

Volatility measures our willingness to live with uncertainty. Late in a cycle, the pattern repeats itself. Return expectations drift upward and are accepted a little too easily. Those raising capital have every reason to keep the story going. Investors who have been right for years grow more confident just as the odds quietly turn against them, and some add to their positions, even with borrowed money, while the list of bad news grows. Then one day confidence in “higher, ever higher” gives way, everyone heads for the exits at once, and the risk that had been ignored stands in plain view. It had been there all along. Add a little ignorance and a little speculation, and you have the breeding ground for every frenzy I have described.

I’ve never learned to predict the next tremor, and I am wary of anyone who claims they can. More modestly, I learned to prepare for it: keep an eye on risk, and refuse to pay more for a story than it is worth. Without some volatility, after all, there would not be much to gain, nor those chances to buy good assets at good prices that always come back around.

Volatility is not the risk. That is what 50 years in the markets have taught me.

Denis Durand is Senior Advisor at Leith Wheeler Investment Counsel.

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