March Mayhem

The fight between Old and New continues, and expect more volatility in the future.
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Fight fans who witnessed the brawl years ago between heavyweights

George Foreman

and

Ron Lyle

will never forget it. And they may very well have been reminded of that bout by last week's action in the equity markets.

The Foreman-Lyle fight took place, if memory serves, late in Lyle's career and near the end of Foreman's first incarnation as a prizefighter. Each could punch his way through a forest of oak and neither was in the habit of dodging anything. Face-to-face and unflinching, each landed titanic shots. Each was wobbled repeatedly and was more than once on the verge of being felled like tall timber. The combat seesawed precariously but didn't last long before one nearly exhausted fighter finally clouted the other to the canvas.

That may be the big difference between pugilism and investment. The battle of New vs. Old, of

Nasdaq

vs.

S&P 500

, may last a lot longer than the four rounds of heavy action it took for Foreman to knock out Lyle.

Last week's volatility was astonishing to observe but, upon reflection, was probably inevitable. Changes in the structure and the institutions of the capital markets imply that future volatility is unlikely to remain within historical bounds. It's reasonable to expect that we haven't seen the last of the thunderous ebb and flow of value that took place on and between the Nasdaq and the

NYSE

last week.

At the end of the week, both combatants were still standing. The Old S&P 500 staged a comeback that put a halt, however temporarily, to its losing streak vs. the New Nasdaq 100. The Nasdaq remains well ahead on points, but the S&P finished the week within a whisker of a new high, having recovered virtually all the ground it lost in a 15% drop from its peak at year-end 1999. The Nasdaq, in contrast, reached a pinnacle more recently, on the Friday before last, but it took a 9.2% whuppin' in the next three rounds. It rallied halfway back on Thursday and Friday and in the process may have stunted the S&P's surge. Breadth struggled off the ropes on both exchanges and trading volume was simply enormous. There was nothing subtle about last week's action, nothing at all having to do with sweet science.

At the end of the week, total market capitalization, as measured by the

Wilshire 5000

, had made another new high. The third man in the ring -- a guy in a striped shirt by the name of

Greenspan

-- looks more and more like a pipsqueak. The fighters are paying no attention to his instructions.

It wasn't supposed to be like this. This is not the way the capital markets are supposed to work. The stock market is, supposedly, a venue for raising equity capital for the purpose of long-term finance of business investment. Investment bankers were once judicious doorkeepers, given to gimlet-eyed scrutiny of business plans and prospects and unlikely to let in any that couldn't pass tough muster. Now they seem more like merchandisers following the ethic of "give the customers what they want."

A profitable history as a private company is no longer necessary -- but a salable story surely is. Stocks have become disassociated from the underlying businesses as market caps are, in the case of New Economy, at triple-digit multiples of earnings, or whatever metric substitutes in the case of no earnings whatever. For Old Economy businesses, many had seen their stocks fall to historically cheap relative valuations as the market disdained their strong earnings performances. Cyclicals, consumer staples, financials, transports, all have shown horrific relative price performance in the past year as "story" reigned over earnings. Stocks appear to have been transformed from ownership shares in industry to trading cards; which four letters do you like today?

It wasn't supposed to be like this, but given the structural changes that have taken place in U.S. financial markets, perhaps it should have been expected. Pension reserves were once held and managed within defined benefit (DB) plans; investment risk and its management was in the hands of seasoned professional investors. Corporate restructuring in the 1990s led to the termination of many such plans and to a concomitant surge in defined contribution (DC) plans, in which the investment results and responsibility for management fall upon the beneficiaries, most of whom have challenging careers in disciplines other than investment.

The 1990s witnessed an explosion in assets under management at mutual fund families and a relative stagnation of bank deposits, where the

FDIC

and the full faith and credit of the U.S. stood between depositors and the risk -- and returns -- of capital markets. The financial structure of the U.S. economy is now one of fundamentally longer duration and broader spread of risk -- and return -- than heretofore had been the case.

The people in charge of this higher-octane version of capitalism are the same people with challenging careers in other disciplines. Thanks to "technology" they can trade instantly on a whim for a commission of $10, more or less. If they choose the mutual fund route, they can be sure that investment consultants, "style police" and compliance departments will ensure that professional fund managers stick to carefully circumscribed behaviors in running their money.

Equity portfolio managers are confined essentially to picking stocks -- and not any stocks, but only those within their purview as defined by prospectus language. Woe betide the manager who strays from mandate, whatever his or her judgment on investment merits. If the customers give you growth money, pick growth stocks. If they redeem value funds, sell value stocks. If you find yourself with anything more than frictional cash, invest it -- you're not paid, indeed not permitted, to "make the cash call." Ergo, the violent rotation we saw last week out of, and then back into, New Economy stocks.

The customers pick the styles or sectors they'd like to own, and the managers then pick the stocks within that framework. Hedge funds, less circumscribed, potentiate this dynamic by, for example, shorting the S&P to go long the Nasdaq because that's what's working. This has to be a factor in the gaping divergence that opened up between the two in the past five months and the violent closing of the gap, or partial closing, in the past five days.

Structurally, this market has a longer duration and a shorter memory than at any other time in recent decades. That is a prescription for volatility. We should expect more of it, quite possibly a lot more.

The third man in the ring is scheduled to get a lick in on Tuesday. He packs a heavier punch than either of the heavyweights today give him credit for. But it's hard to bet on him -- until he gets a little momentum of his own going.

Jim Griffin is the chief strategist at Hartford, Conn.-based Aeltus Investment Management, which manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at

GriffinJ@aeltus.com.