Bull!

by Maggie Mahar

  Over time, stocks always outperform bonds.

  You can’t time the market.

  Just buy a good company and hold it, and over the long haul, you’ll make money.

  Unfortunately, his timing was off. Over the short term, the market moved against Vinik. Interest rates rose and Treasuries plunged. Meanwhile, technology stocks continued their climb. As a result, early in 1996 the fund’s three-year record of returns dropped below the S&P 500’s returns over the same span. (In 1995, Magellan had earned 36.8 percent, but, with dividends reinvested, the S&P did slightly better.) Magellan’s management fees fluctuate based on performance, and at this point, fees fell—from 0.73 percent to 0.47 percent. For Fidelity, that added up to a $130 million decline on a $50 billion portfolio.25

  Few were willing to wait even a year to see how Vinik’s strategy worked out—despite his strong long-term record. The media turned on him. “The knives are out for Jeffrey N. Vinik,” reported The New York Times.26

  In the spring of ’96, Gail Dudack understood why Vinik was pulling back. As chief market strategist at Warburg Dillon Read, Dudack was responsible for advising mutual fund and pension fund managers at firms like Fidelity and Merrill Lynch Asset Management on where to invest the billions piling up at their doors. Her job put her backstage on Wall Street, and by the spring of 1996, she knew that many portfolio managers were buying stocks, not out of choice but out of necessity. Vinik was one of her clients, and she respected the calm, bespectacled young fund manager’s quiet, intense intelligence. She also admired his independence and integrity.27

  Moreover, by August 1996, Dudack herself was beginning to turn bearish. At the end of the year, Richard Russell would quote her in his newsletter: “We’ve shifted to a market that’s being driven by liquidity and emotion instead of valuation. Once the market drops valuation as a benchmark, it has lost its rudder.”28

  A petite blonde baby boomer with a B.A. in economics from Skid-more, Dudack had come to Wall Street in 1970. At the tender age of 25, she appeared on Wall $treet Week with Louis Rukeyser. Before long, she became a regular on the show. Unlike many of the pros who survived the hair-raising bear market of the early seventies, Dudack remained an optimist. In the summer of 1983, sweaty-palmed veterans still traumatized by the bear were reluctant to recognize the beginning of a new cycle. They warned that the market was rising too high, too fast. But Dudack, then a senior vice president at Donaldson, Lufkin & Jenrette’s Pershing Division, warned against playing contrarian in such a strong market, predicting that the Dow would punch through 1300 before year-end.

  Dudack’s target was a little high, but she was right about the market’s direction, as she would be again in the spring of 1994, when she said that despite an 8 percent correction, the bull remained on track. That spring, Richard Russell was concerned that the market’s primary trend might be shifting, but Dudack, who by then had become the chief market strategist at S.G. Warburg, remained confident that the tide was still coming in.29

  By 1996, however, she was worried. Dudack realized that, by insisting that their equity funds remain fully invested, the Fidelitys of the world were forcing their money managers to buy stocks that were, at best, fully valued, at worst overvalued. Some of Dudack’s clients were beginning to chafe under the pressure. Jeff Vinik had rebelled.

  From the fall of 1995 through the spring of 1996, the Magellan Fund trailed the competition. The media narrowed its scrutiny, and things quickly turned nasty. As Vinik’s reputation faltered, some newspapers began to question his integrity. Reporters seized on allegations that Vinik had publicly touted Micron Technology, calling it “relatively cheap,” while he quietly sold the stock. The Boston Globe made the attack personal.

  “Mrs. Vinik, please don’t punch us in the nose,” began a Globe story in January of 1996. “But we have doubts your husband, Jeff, was telling us the truth about all those billions he had invested in technology stocks. The issue, of course, is Vinik’s rosy public musings on tech stocks in early November, about the same time his giant Fidelity Magellan mutual fund started selling those same investments to the tune of $10 billion.”30

  Rumors circulated that Vinik had become “a public relations problem” for his firm. Fidelity chairman Ned Johnson offered what might best be called lukewarm support. When asked about the allegations that Vinik had touted Micron, Johnson told The Wall Street Journal that Vinik “did nothing wrong to my knowledge, but I cannot tell you what went on inside his brain cells.”31 Ultimately, the SEC would find no basis for the allegations.

  Nevertheless, an individual investor who alleged that Vinik manipulated the price of Micron Technology by saying that the stock was “reasonably priced”—while he was in fact selling shares—filed a lawsuit. In response, Fidelity Magellan banned its fund managers from making public comments about individual companies.

  In May of 1996, Vinik left Fidelity, his reputation temporarily sullied. Barron’s “Trader” column summed up the Street’s response: “One of the big lessons of the Vinik affair is that bonds are for losers.”

  “Vinik’s dead man’s portfolio suggests a burnt-out case,” Forbes declared.32

  “Forget Jeff Vinik,” wrote Jim Cramer in his hymn to a new generation of fund managers.”33

  Gail Dudack, however, was not so ready to forget Vinik. She felt that he had gotten a raw deal at Fidelity, and that he had been “slaughtered” by the press. “What people don’t realize,” she told friends, “is that money managers like Jeff Vinik are put in an impossible position. Their firms want them to wear two hats: they’re expected to market the firm by giving media interviews, and at the same time they are supposed to manage money.”34 It was yet another sign that the marketers had taken over the mutual fund industry. Even a mutual fund manager running billions of dollars was expected to spend part of his time talking to reporters.

  Inevitably, they would ask questions about the stocks that Vinik might be trading. What could he say: “Actually, I’m thinking about selling it over the next three weeks?” If he did, “he would be violating his fiduciary responsibility to the fund’s investors,” said Dudack. On the news that the world’s largest mutual fund was trying to lighten its position, the stock would plunge, long before he had a chance to get out.

  Dudack recognized that the real reason that both the media and the public turned on Vinik was not because he failed to announce that he was going to sell technology stocks, but because he had sold them at all. By selling stocks and buying bonds, Vinik had signaled that he thought the market was overpriced.

  Vinik’s “resignation/firing” sent a message to other mutual fund managers. “In the future…few major mutual funds will have the courage to reduce risk by raising cash or holding significant treasury note or bond positions,” wrote Ned Davis of Ned Davis Research, an independent technical-analysis firm founded in 1980.35 Davis would be right. Even after the Nasdaq cracked in the spring of 2000, the vast majority of fund managers felt that they had no choice but to remain fully invested. (See chart on page 461 in Appendix.)

  Years after he left Fidelity, Vinik would be remembered as the Magellan Fund manager who tried to time the market—with disastrous results. By 2002, however, it was becoming clear that an investor who moved out of technology and into Treasuries and cash in 1996 had made a shrewd move. He would miss the Nasdaq’s peak, of course, but he would also miss the wreck that followed.

  If investors had been patient, Vinik’s market timing might have worked after all. Over the next seven years, an investor who switched to bonds at the end of March 1996 would have done far better than someone who stuck with the S&P 500. And he would have avoided the gutwrenching swings of the equity market. “Few investors noticed the fabulous performance in bonds during the nineties,” said Dudack in a 2003 interview. “In the last seven years [ending in March 2003], both corporate and treasury bonds outperformed stocks. On a total return basis, 10-year Treasuries returned 78 percent, AAA corporate bonds returned 85 percent, while the S&P 50
0 returned 46 percent—and that is with dividends reinvested. Capital gains on the S&P totaled a paltry 31 percent.”36

  “In some respects Jeff was a better strategist than Peter Lynch, in the sense of seeing things further ahead than most,” observed Michael Lipper, who considered Lynch one of the best investors of all time. “Vinik went to extremes—his timing was slightly off—but the thought patterns were correct.”37

  Nevertheless, in 1996, everyone was in a rush to become a millionaire. That spring, Vinik’s performance fell short. In the six months ending in May of ’96, Magellan had produced a total return of 0.25 percent, including dividends, trailing the S&P 500’s 10.3 percent return.38 In a market that focused on the moment, the last six months was all that counted. No matter that on Vinik’s watch, Fidelity Magellan had returned 84 percent in four years.39

  Ultimately, Vinik would be vindicated. After leaving Fidelity, he went on to set up his own hedge fund, raising $800 million from the likes of Donaldson, Lufkin & Jenrette (the Wall Street firm invested clients’ capital in Vinik’s fund) and Jeff Feinberg, chairman of the $1 billion JLF Asset Management hedge fund (who invested a portion of his personal portfolio with Vinik). These investors did not fidget. They were not in a rush to get rich. They were already rich. (The minimum investment needed to participate in Vinik’s fund was $2 million).

  Their fortitude was rewarded. By the fall of 2000, Vinik Partners had racked up a total return of 646 percent in just over four years, handily beating the S&P 500’s return of 110 percent over the same period.

  And in 2000, Vinik made the best market timing decision of his career. He retired, with a peerless record. Over the course of his 12-year career, Vinik had clocked returns that averaged 32 percent a year—nosing out even Peter Lynch, who averaged roughly 29 percent in the 13 years that he ran Fidelity’s Magellan Fund.40

  THE POWER OF THE INDIVIDUAL INVESTOR

  It is easy to blame mutual fund firms for forcing their managers to buy into the bubble. It is somewhat more difficult to blame the portfolio managers for not rising up and quitting, en masse—though it certainly would have been preferable if a larger number took Jean-Marie Eveillard’s point of view that he would rather lose his clients than lose his clients’ money.

  But the hard fact is that both the firms and their fund managers were doing what most investors wanted them to do—or thought they wanted them to do. On the one hand, investors assumed that professional managers would use their best judgment when watching over their money. But they also wanted the 14 percent annual return that many had begun to think of as their due.

  Anyone who doubted investors’ desires need look no further than the story of Foster Friess, the highly respected manager of Brandywine’s funds. A year after Jeff Vinik left Fidelity, Friess’s funds topped the charts, returning more than 30 percent annually in the three years ending September 1997. Friess’s talent as a stock picker matched his skill as a market timer. In 1990, just as Saddam Hussein invaded Kuwait, Friess predicted that the stock market would fall, and in just three days, he sold 80 percent of the stocks in the Brandywine Fund. As a result, his investors were spared the ravages of the 1990 recession—a year when the S&P 500 lost 6.6 percent. Nimbly, Friess jumped back into stocks in time to take advantage of the rally that followed.41

  By the end of 1997, Friess Associates was running some $12 billion—up from $1 billion in 1990. Sir John Templeton, founder of the Templeton Funds, numbered himself among Friess’s clients.

  Late in 1997, Friess began to suspect that his holdings had peaked. He ordered his analysts to complete a “bottom-up” review of every company in the Brandywine funds—and told them to get rid of any that looked iffy.

  Following the review, traders worked 12-to 15-hour days to unload stocks. Over 10 days, the Friess team sold about 40 percent of the stocks in the two funds. They broke only for Christmas Day. By the end of the month, they had unloaded most of the stocks both in Friess’s mutual funds and in the private accounts he managed.

  By mid-January, the market was climbing once again. At the end of the month, the Brandywine Fund had tumbled from among the top performers to a rank of 820 out of 1,011 comparable funds tracked by Lipper Analytical. The reaction from investors was swift and brutal. “People screamed and hollered,” Friess recalled. They began withdrawing millions from his funds.

  In March, Friess started to move back into stocks. “I’d like to think all this pressure wasn’t an influence,” he said later. “So what, that 50 million bucks a week is leaving? I’m going to do what I’m going to do, because the pressure is irrelevant. But in my gut, it probably wasn’t.”42

  As it turned out, Friess had moved back in at exactly the wrong time. By August, the market for the mid-cap stocks he had been buying blew up. Irate investors began pulling more and more money out of his funds.

  “He had so many redemptions, his fund started melting down,” Ralph Wanger, founder of the Acorn Funds, recalled. “His staff started defecting—they could see the whole thing was caving in.

  “The fact is if you look at the market’s advance/decline line, you’ll see that he wasn’t wrong,” Wanger continued, referring to the line on a graph that shows the percentage of stocks that have risen, versus the percentage that have fallen. “Take a look at when the average stock peaked out,” Wanger added. “He had it pretty well taped. But I can tell you, his investors were furious. I was on a finance committee of an institution here in Chicago that had his fund—and the finance committee was incensed.

  “Friess didn’t have the guts to tough it out,” Wanger continued, “and I don’t blame him. With the withdrawals, his funds were melting down. It was just awful. So finally he had to reinvest his cash—in the middle of ’98—and of course he managed to reinvest just as most stocks peaked. In the end, Friess sold his business.

  “Every other fund manager took careful heed of this. Everyone realized at that point that as a fund manager, you were basically just a purchasing agent. As a purchasing agent, it was your job to put the money that showed up in whatever stocks your fund was supposed to invest in—large-cap growth or technology or whatever. If you’re a purchasing agent, price is not the issue,” said Wanger, “you’re like the produce manager at the supermarket—you have got to have lettuce on sale the next day. No matter what the price. Maybe you can decide to buy the curly lettuce instead of the romaine. But the equity fund manager has to have stocks. You have limited control over what you’re doing.

  “You really couldn’t go to 50 percent cash and stay there,” Wanger concluded. “Your shareholders wouldn’t let you. The few guys who tried it were wrecked.”43

  THE INDIVIDUAL INVESTOR TAKES CHARGE

  Without fully realizing their power, individual investors had taken charge of the market. “As strange as it may seem, by writing all of those checks to these mutual funds, the American public was setting price levels,” said George Kelly, a technology analyst at Morgan Stanley. “The market’s own pricing mechanism was breaking down. The public was setting the valuation of these technology companies—without any understanding of the underlying fundamentals.”

  “It was a totally mechanical process,” he added. “They sent the money in, the fund managers invested it, the stocks went higher. Fund managers would say to me, ‘This is totally nuts.’”

  Cisco was one of the Nifty Fifty, and Kelly, who had helped take the company public, continued to recommend Cisco to fund managers even though he considered the company’s share price completely out of line with its earnings growth. “I remember hearing another analyst say, ‘The stock is overvalued—and it’s going higher.’ That summed up the problem,” said Kelly. “As an analyst you’re trying to be right about where the price is going—here is Cisco, which, by any traditional metrics, is worth about half of its current price, but it’s still rising. Do we say sell?”

  The truth is that the analysts like Kelly were trapped in a catch-22: if they recommended overvalued stocks, they were wrong, but if the
y downgraded those same stocks, they would also be wrong—at least for as long as the market continued to rise. “Given the inflows of money into these mutual funds, we thought stocks like Cisco were going to continue to climb, so we told investors to buy,” Kelly explained.44

  Put that way, his “buy” recommendations sound neither deceitful nor cynical. In truth, most individual investors were far more interested in where a company’s share price was headed than in the intrinsic value of the business. They just wanted to know what the next fellow might pay for the stock. And from 1996 through 1999, the next fellow was probably prepared to pay through the nose for large-cap growth stocks.

  Incredibly, individual investors were now running the show.

  “THIS MARVELOUS DANCE”

  Mutual fund investors provided the cash to fuel this final leg of the bull market. But this is not to say that individual investors bore sole, or even prime, responsibility for turning the boom into a bubble.

  “Everyone was involved—all in this marvelous dance. It is very hard to say anyone was guilt-free if they were involved in the market at all,” said Acorn Funds founder Ralph Wanger.45

  The mutual fund companies that put asset gathering ahead of conserving their customers’ assets, the brokerages that put mutual funds on a “preferred” list if they shared revenues with the brokerage, the analysts who upgraded their recommendations to justify the prices fund managers were paying, those journalists who “outsourced” their critical thinking (and published mutual fund scorecards without warning investors that three-year records told little about a fund manager’s talent), the 401(k)plan administrators so dazzled by momentum that they forgot about diversification, and, last but not least, the 401(k) investors who complained bitterly if their plan was not stacked with high-growth choices—they were all part of the dizzying dance.