Bull!

by Maggie Mahar

  The New Economy ushered in what seemed, to many, a New Democracy. When individual investors found that they could make more in a day online than in a month on the job, they felt the flush of power usually reserved for the very rich. Sometimes the thrill of casino capitalism lent much-needed color to otherwise drab lives: At a social gathering on Manhattan’s West Side, circa 1998, a middle-aged woman described her victories trading online. Though, she complained, she dreaded the weekends: “The market isn’t open—CNBC isn’t even on.”3

  On a larger canvas, the bull market represented a New Era not just of technology, but of hope—and not only in the United States but worldwide. With the fall of the Berlin Wall, U.S. politicians declared the Cold War at an end, and as the nineties unfolded, capitalism seemed to be sweeping the globe. From Bombay to Beijing, a new middle class was assembling. In India, young women wearing saris carried briefcases to work, while in China’s coastal cities, newly house-proud couples began renovating apartments that were, at last, their own.

  At home, the chief economic problem that had divided Democrats and Republicans for decades seemed resolved. Traditionally, Democrats had worried about high unemployment while Republicans fought rising prices—and virtually everyone agreed that you could not have both high employment and low inflation at the very same time. The nineties proved everyone wrong. When 1995 began, unemployment stood at 5.5 percent, while the consumer price index showed that inflation had fallen to 2.7 percent—“the lowest combined rate of unemployment and inflation in twenty-five years,” President Clinton announced in his 1995 State of the Union address.

  There had been early warning signs that the Age of Information might come to a bad end. In 1994, the market’s promoters trotted out the Beardstown Ladies Investment Club as living proof that virtually anyone willing to do a little research could achieve double-digit returns. Neither special training, nor talent, nor experience was required. But shortly after selling some 800,000 copies of their Commonsense Investment Guide, the ladies discovered, to their dismay, that they had made a mistake when calculating their gains. It turned out that rather than clocking returns that averaged more than 23 percent a year, as advertised, they had made only 9.1 percent annually in the 10 years from 1983 to 1993, substantially less than they would have made if, instead of picking stocks, they had invested in a mutual fund indexed to the S&P 500.4

  The miscalculation—combined with the fact that they seemed not to have noticed the difference between gaining 9.1 percent and racking up returns of 23 percent—might have suggested that not everyman, or everywoman, is cut out to serve as his or her own portfolio manager.

  That same year, California’s affluent Orange County went under after County Treasurer Robert Citron bought a grab bag of securities that he did not quite understand. Orange County’s bankruptcy hinted that listening to the financial experts was not quite a sure bet either, especially when the savants are selling something, which they usually are. Citron, who went to jail, testified that he had relied on his Merrill Lynch broker for financial advice. Merrill did not admit to any wrongdoing, but ultimately the firm would agree to pay over $400 million to settle the case. (Throughout the late nineties, Michael Stamenson, the broker in question, remained on Merrill’s payroll at $750,000 a year, spending his time not as a broker but as a prime witness in the ongoing litigation.)5

  Taken together, the two tales might have sounded a cautionary note. But the average individual investor was innocent, uninitiated, and unscarred. Meanwhile, in 1994, the final leg of the most magnificent bull market the world had ever seen was about to begin. Skepticism seemed out of place. As indeed it was. Over the next four years the bull scaled one barrier after another: Dow 4000 (February 1995), Dow 6000 (October 1996), Dow 8000 (July 1997), Dow 10,000 (March 1999).

  Because the most magnificent bull market in U.S. history was a democratic market, stratospheric stock prices seemed to reflect the will of the majority, what James Glassman and Kevin Hassett called “the collective judgment…[of] millions of people around the world” in their 1999 best-seller, Dow 36,000. Former Citicorp chairman Walter Wriston went so far as to declare markets “global plebiscites…voting machines [that] function by taking referenda.” New York Times columnist Thomas Friedman summed up the spirit of the times as he celebrated the democratization of the financial world: “One dollar, one vote.” The market, Friedman declared, had “turned the whole world into a parliamentary system…[whose citizens] vote every hour, of every day, through their mutual funds, their pension funds, their brokers, and more and more, from their own basements via the Internet.”6

  The metaphor fueled faith in “the wisdom of the market.” Who could question prices set by millions of voters? According to the received wisdom, then, in 1999 AOL was worth 305 times its previous year’s earnings, while IBM was fairly valued at 28 times earnings, because more people had voted for AOL.

  If investors actually picked stocks while seated in sealed voting booths, one might be able to correct for another’s mistakes. But people who buy stocks are social creatures, and be they pros or fledgling 401(k) investors, they are influenced, en masse, by the spirit of the times. As Bill Seidman, CNBC’s chief economic commentator and a longtime market watcher, once observed when asked where the American consumer was headed: “You never know what the American public is going to do, but you do know that they will do it all at once.”7

  As the bull market picked up steam, the media fanned the Zeitgeist. The Internet set the pace, CNBC’s breathless reports laid down the rhythm, and, to compete, print journalists learned to write in “real-time” prose, leaving little time to dig deeply, or mull over a story. Getting the news first became the priority. On deadline, many reporters simply repeated analysts’ estimates, ignoring the fact that valuations had less and less to do with the intrinsic value of a company in the real world (what another businessman on Main Street might pay for it) and everything to do with its perceived value on Wall Street (what another investor might be willing to shell out for the stock).

  Old-fashioned value investors such as Berkshire Hathaway chairman Warren Buffett still tried to assess a company’s prospects based on its “fundamental” value, measuring and comparing sales, profits, assets, and debt. At the end of the 20th century, however, the popular wisdom said that value was relative. Veterans such as Morgan Stanley’s Byron Wien seemed out of touch. On many levels of society, the whole concept of fundamental or “intrinsic” value seemed overly earnest—and by the late nineties, “earnest” itself had become a pejorative term.

  But if both Wall Street and CNBC appraised a stock based on what someone might wager the next morning, the mutual fund industry sold shares by appealing to some 70 years of stock market history. “Over the long haul,” Wall Street’s pitchmen assured investors, “U.S. stocks always outperform other investments, returning, on average, 11 percent a year over ten years.”

  Here was the fundamental, largely unacknowledged contradiction that haunted the People’s Market: Stocks were valued for the short term, yet investors were told that they should buy and hold for the long term.

  “BUY AND HOLD”

  Newsweek’s Jane Bryant Quinn was one of a handful of observers who paused to examine the idea of “the long term,” pointing out that the much-touted 11 percent average did not predict what would happen during a specific 10-year period. Rather, it reflected the average annual return if you averaged together all of the 10-year periods from 1926 to 1998.

  Since few investors buy and hold for 72 years, the truism had little practical meaning. During any particular 10-year period from 1926 to 1998, it turns out that an investor’s chance of averaging more than 10 percent a year was only about 50/50. Contrary to the popular wisdom, he stood a 4 percent chance of making nothing over 10 years—and losing some of his principal to boot. Everything depended on when he got in. And when he got out.

  Holding for 20 years, the odds that he would earn the promised 11 percent improved, but still stood at onl
y two in three—far from a guarantee. Even if he did not need to tap his savings for 40 years, his chances of earning over 10 percent rose to just four in five. In 2002, Quinn updated her numbers to include two years of a bear market. Now her results showed that over 20-year periods, chances were one in five that stocks would rise by no more than 7 percent annually. Even over 40 years, chances were almost one in five that an investor would earn no more than 8 percent. In other words, if history is any guide, even the very long term investor should not count on 10 or 11 percent.8

  Yet the mutual fund industry was inclined to embrace the “buy and hold” philosophy without complication in part because many in the industry believed it, in part because the strategy dovetailed so nicely with its own business plan. By the early nineties, “asset accumulation” was fast becoming the industry’s rallying cry. From Boston to San Francisco, marketing a fund became just as important as managing the money.

  “Suddenly, at many institutions, you started hearing about ‘asset gathering’—bringing new money into the company. Hell, I thought we were in the business of making money for our existing clients,” said Clyde McGregor, manager of The Oakmark Equity & Income Fund.9 But Oakmark, an independent, old-fashioned firm that emphasized value investing, was out of step. The mutual fund business was exploding, and most fees were based on a percentage of the assets a company had under management, or the number of funds that it distributed, not how well it did in protecting those assets. Once a company had an investor’s money, it quite naturally wanted to keep it. Besides, if customers withdrew their money every time a fund floundered, it would become all the more difficult to give new funds and new fund managers enough time to prove their mettle. “Buy and hold” made sense for everyone. Or so it seemed.

  Thanks in large part to the 401(k)—a retirement plan that allowed workers to control their own investments—the mutual fund industry’s efforts at asset gathering succeeded beyond even its own most immodest dreams. In the early nineties, 12-month flows into funds that invested in stocks barely reached $50 billion; by 2001 inflows exceeded $300 billion.10

  A tidal wave of retirement dollars flooded the mutual fund industry. The 401(k) was invented in 1981, just as the bull market began. By 1998, roughly three of every four new dollars invested in corporate retirement plans were going into 401(k)s. At the end of the decade, two-thirds of all active workers covered by a retirement plan were responsible for directing their own investments. Hands down, they chose stocks. By the end of the millennium, 401(k) investors had stashed 75 percent of their assets in equities.11 Even older employees preferred stocks: in 2000, 401(k) investors in their 50s had entrusted 49 percent of their savings to equity funds, another 19 percent to company stock.12

  Struggling to keep pace with a roaring market, fund managers chased Wall Street’s darlings. By the end of ’98, more than one-third of all diversified U.S. stock funds owned Dell, the best-performing stock of the preceding 10 years. Even so-called value funds were buying the computer maker, despite the fact that by then, investors had bid its share price up to 58 times projected earnings. When America Online was added to the S&P 500 at the beginning of 1999, 20 percent of all U.S. equity funds owned AOL, then trading at 238 times expected earnings.13

  To keep their jobs, fund managers knew they needed to try to meet, if not beat, the S&P 500. The only way they could hope to keep up with the index’s double-digit jumps was by riding the market’s leaders. By definition, of course, this meant pouring investors’ retirement savings into the market’s most expensive shares—often just as they were peaking.

  While mutual fund managers chased the hottest shares, individual investors pursued the hottest funds. “The American public was writing endless checks to these funds—and the funds then had to invest the money,” recalled George Kelly, an analyst at Morgan Stanley.14 No matter how high the market climbed, most mutual fund managers were expected to stay fully invested. The only way to dispose of the bags of money piling up at their doors was to pour it into the biggest, most liquid, and most popular names. The buying pressure would push share prices to the moon.

  THE UNSUSPECTING

  As always, the croupiers fared better than the guests they invited to their tables. David Tice, a fund manager who had founded an independent research firm in 1989, summed up what he had seen when testifying before Congress in the spring of 2001: “The unsuspecting,” said Tice, were gulled by “those most skilled at this game of speculation.” This, he noted, “was why individual investors wound up owning 75 percent of all Internet stocks—compared to only 44 percent of General Motors.”15 For novices not only bought Internet stocks, they held on to them. More experienced traders were the “price makers”; amateur investors became the “price takers.”

  At the end of the nineties, “the unsuspecting” became the target market for many initial public offerings (IPOs). Once an IPO like Ariba was in orbit, the investment bankers and other large institutional investors who launched it would begin to lighten their positions, often on the first day of trading, leaving small investors holding the bag.

  Within the companies, even novices learned how the game was played. When a 30-year-old attorney left her job at a prestigious law firm to become chief financial officer for an Internet start-up, her mother asked her, “How can you take such a risk? What if the company goes under?”

  “Oh,” her daughter replied coolly, “I’ll be out by then.”16

  Meanwhile, pointless IPOs sucked capital out of the American economy. It was not just day traders, fund managers bucking for stardom, and other amateur plungers who were duped by profitless companies. Billions of dollars that could have been invested in “viable projects” were instead squandered on “massive overinvestment throughout the technology sector,” Tice testified. “Do you wonder why our country does not have enough power plants and oil refineries, yet we have a reported 80 to 90 percent overcapacity in fiber optic cable?” he asked the congressmen. “This is a consequence of keeping stock prices artificially high for extended periods while extending credit recklessly in the midst of a mania…. As a nation, we are about to pay for this crucial misallocation of capital.”17 Reasonable men might well disagree on where the money should have gone—investment in alternative sources of energy comes to mind. But in hindsight, it was clear to nearly everyone that an enormous misallocation of capital had undermined the economy.

  Money flowed, not to where it was most needed, not into the projects with the strongest business plans, but into those with the sexiest “story”—those companies whose backers felt confident that they could take it public, at a premium, in a matter of months.

  At Morgan Stanley, Byron Wien saw the waste of capital. “A company would come to us with this new, new thing, and say, ‘You’ve got to take it public.’ The new thing might be a little better than the technology that everyone was already using,” Wein allowed, “but not that much better. Still, they would say, ‘If you don’t underwrite it, we’ll take it down the street to Goldman.’ And we would say, ‘Where do we sign?’”18

  This is not to say that the New Technology was not revolutionary. The Internet, cell phones, and affordable computers would lay the foundation for a New Era in global communication and education that could raise living standards worldwide. But what the New Economy’s promoters failed to mention was that major advances in technology usually benefit the consumer—not the investor.

  Consider, for example, the auto industry. “If you had foreseen in the early days of cars how this industry would develop, you would have said, ‘Here is the road to riches,’” Warren Buffett observed in 1999. “So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies—themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America—and also an enormous impact, though not the anticipated one, on investors…. The other truly transforming business invention of the first quarter of the century, besides the car, was the airpla
ne—another industry whose plainly brilliant future would have caused investors to salivate. So I went back to check out aircraft manufacturers and found that in the 1919–39 period, there were about 300 companies, only a handful still breathing today…. Move on to failures of airlines. Here’s a list of 129 airlines that in the past 20 years filed for bankruptcy…. The money that had been made since the dawn of aviation by all of this country’s airline companies was zero. Absolutely zero.

  “Sizing all this up,” Buffett concluded, “I like to think that if I’d been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough—I owed this to future capitalists—to shoot him down. I mean, Karl Marx couldn’t have done as much damage to capitalists as Orville did.”19

  To its credit, the mainstream press cast a cold eye on many of the more outrageous dot.com stocks: “How Long Will They Fly? A Glut of Net IPO’s May Cause Air Sickness for Investors,” U.S. News & World Report warned in the spring of 1999.20

  But a profitless IPO was a much easier target than a Tyco, a Cisco, or a WorldCom. These, after all, were companies with real earnings—even if, as investors later discovered, those profits had been inflated by executives who buried expenses, fabricated sales, and made ill-advised acquisitions, all in the name of “enhancing shareholder value.”

  THE BROAD MARKET

  In 2000, many referred to the market’s meltdown as the “tech-wreck.” The conventional wisdom of the time had it that the excesses of the nineties had been confined to high-tech stocks.