Bull!

by Maggie Mahar

  Taleb recognized that while men resist randomness, markets resist prophecy. The fact that something has happened many times in the past does not mean that it will happen in the future. The fact that it has never happened does not mean that it cannot happen. “In 1992, who would have believed that the Nasdaq would cross 5000?” asked Taleb. “But it did. And in March of 2000, how many people believed that it could lose more than 3000 points over the next 13 months?” Yet it did. “All we can learn from history,” Taleb added in a 2002 interview, “is that the unpredictable will happen—and does—time and again. The most dangerous error that an investor can make is to mistake probability for certainty.”33

  In 2001, Taleb wrote a book that rolled down Wall Street like a small hand grenade, Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life.34 There, he described the “the black swan,” or “the rare event.” This is the event that lies outside of our experience: we have never seen a black swan, just as, until the nineties, we had never seen the Dow climb 1000 points in less than four years. Based on past experience, the run-up that followed seemed to many highly improbable—some would have said unimaginable. But, Taleb observed, the fact that an investor has not seen a black swan does not mean that he can rule it out.

  Financial history is studded with surprises that defy our efforts to find formulas. In a 2002 interview, Peter Bernstein pointed to that period in the 1950s when suddenly, low-risk, high-grade bonds offered a higher yield than stocks. In the past, stocks always paid higher dividends than AA bonds. After all, if an investor holds an AA 10-year bond for 10 years, he is all but guaranteed to get his money back, plus interest when it matures. If he buys a stock, on the other hand, he cannot be at all certain how much it will be worth in 10 years. This is why, in order to attract investors, companies that issued stock instead of bonds traditionally had to pay a higher dividend. The cause and effect seemed rational and perfectly clear. Until the 1950s, when “for the first time in history,” Bernstein noted, the old rules were turned on their heads: bonds paid the higher yield. “A relationship sanctified by over 80 years of experience suddenly came apart.”35

  In Against the Gods, Bernstein quoted the essayist G. K. Chesterton, on how the unexpected “lies in wait” for us: “The real trouble with this world of ours…is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”36

  Long Term Capital Management thought that it could calculate the market’s risks and then balance them to create a risk-free system. But the black swan was lying in wait. In this case, the black swan was not just that Russia defaulted on its debt—though this certainly was unexpected. The real wild card was this: How would that default affect a chain of intricately linked derivatives contracts that circled the globe? How would so many traders react to so much ambiguity? Would they freeze? Would they sell? How would LTCM’s own responses affect the efficient market that it thought it had modeled?

  Financial markets defy such calculations. In the physical world, it is much easier to calculate probabilities, because the possibilities are more likely to be finite. “If you roll dice, you know that the odds are one in six that the dice will come up on a particular side,” said Taleb, “because you know the dice have six sides. So, you can calculate the risk. But, in the stock market such computations are bull—you don’t even know how many sides the dice have!”

  Because the physical world offers a limited range of possibilities, events tend to arrange themselves on a symmetrical bell curve. Again, Taleb offered a practical example: “Let’s say you graph the weights of all the babies born in the U.S. over 10 years. Birth weights might range from under a pound to, perhaps, 15 pounds. If you took a large enough sample, and you plotted it on a graph, you would wind up with a smooth bell curve; there would be no babies weighing 500 pounds to skew it. In physical reality, it would be impossible for a woman to give birth to a 500-pound baby. There are limits to what can happen.”

  But if you graphed price/earnings ratios of all the stocks on the S&P over 10 years, you would have to include the black swans—the unpredictable, unthinkable “outliers,” instances of companies with a P/E of 300, or companies with no earnings and an infinite P/E. They would skew your curve. “This is why Long Term Capital Management blew up,” said Taleb. “They thought that they could scientifically measure their risks.”37

  THE FED TO THE RESCUE

  By late September, LTCM was on the verge of going under. Virtually all of the $100 billion in assets that it had amassed had been borrowed from Wall Street’s top bankers. Once again the Fed rode to the rescue. On the afternoon of September 23, William J. McDonough, president of the New York Fed, summoned the chief executives of Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney to the Fed’s 10th-floor boardroom—“not to bail out a Latin American nation,” Lowenstein reported, “but to consider a rescue of one of their own.”38

  Some were personally involved: David Komansky, the boss at Merrill Lynch, had $1 million of his own money in LTCM.

  How could some of the shrewdest CEOs on Wall Street have allowed LTCM to play fast and loose with nearly $100 billion of their institutions’ money? Presumably, they were not nearly as shrewd as their positions suggested. This, perhaps as much as greed, explains what went wrong in corporate America in the nineties.

  Ultimately the Fed managed to jawbone a consortium of banks and investment houses into taking over LTCM. Some observers suggested that they had little choice: the lenders had to save face: “The belief here is that the reason why the Federal Reserve Bank of New York engineered the rescue of the Long Term Capital Management hedge fund in September 1998 was fear that the collapse of the fund would have exposed to public view the sloppy performance of the world’s greatest financial institutions—and the careless, trusting supervision that had permitted this overconfident crowd of Ph.D. economists, mathematicians and gamblers to carry positions in excess of $100 billion…,” Martin Mayer explained in The Fed.

  Only a few days before McDonough invited the bankers to the Fed’s boardroom, “Alan Greenspan had testified to the House Banking Committee that ‘hedge funds were strongly regulated by those who lend the money,’” Mayer reported. With the LTCM debacle, “the belief that Alan Greenspan knew whereof he spoke, a central tenet of the Fed’s status, had been put in hazard.” No one wanted to lift the curtain on the wizard—least of all the CEOs who ran Oz.

  A month later, with the average stock down by one-third from its summer highs, the Fed chairman suddenly, and unexpectedly, cut rates by one-fourth of 1 percent. “In a private conversation a couple of weeks earlier, Greenspan had noted with weary regret that the whole world seemed to believe that the Fed was in control of what happened to the economy. Greenspan knew this was not true, but he also knew that if everyone believed it to be true, he must do something,” Mayer reported.

  Not two years earlier, the Fed chairman had been talking about irrational exuberance. Now it seemed that he felt responsible for keeping the bubble afloat. So, in October of 1998, “he went center stage with his top hat” and pulled a rabbit “out of the hat,” Mayer wrote. “It wasn’t Bugs Bunny or Roger Rabbit, it was a pretty scrawny little rabbit to which nobody really had to pay attention, and there wasn’t anything else left in the hat. But the magician concentrated the attention of the world on his rabbit….”39

  The market jumped.

  By the end of ’98, the S&P would be up 26.7 percent for the year. In the final quarter, however, just five stocks accounted for a little more than half of the surge according to Merrill Lynch: Dell, Lucent, Microsoft, Pfizer, and Wal-Mart.40 Far too much was riding on too few stocks.

  As for Maureen Allyn, throughout ’98, she had watched the market with growing dismay. �
��That year, Scudder sold itself to Zurich and, because I was a partner, I received a nice slug of cash,” Allyn confided. “I put it all in Treasuries and munis. People at Scudder said, ‘You’re doing what?!’

  “Most people thought I was insane. ‘You really need to have equities,’ they said. ‘This is an equity culture.’

  “Though privately, a few of the older portfolio managers said to me, ‘I don’t have any equities in my personal portfolio either.’ They had been around—they knew everything was overvalued.”

  But younger colleagues, in particular, viewed Allyn with that mixture of pity and annoyance reserved for those who fail to appreciate a New Paradigm. One tried to be tactful: “I guess, being older, you’re just not that hopeful about the future,” she said.

  Allyn’s portfolio of bonds would allow her the luxury of early retirement. In 2002, Allyn, 57, retired to her home in New Jersey, where she kept two horses. “If you want to reach me call me before 10,” she told friends. “After that, I’ll be out riding.”41

  —17—

  FOLLOWING THE HERD: DOW 10,000

  If you are a zebra and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. The grass is greener at the edge of the herd.

  —Ralph Wanger, founder,

  Liberty Wanger Asset Management

  As 1999 began, Act III of the Great Bull Market approached a climax. Morgan Stanley began building a new tower in midtown Manhattan. In May, Forbes placed Priceline.com CEO Jay Walker on its cover and anointed him the “New Age Edison.”

  In October, streaming-media company Pixelon celebrated its initial public offering with a $16 million Las Vegas shindig (eating up 80 percent of the company’s latest round of financing), featuring the Who, Tony Bennett, and the Dixie Chicks. Unfortunately, the company’s CEO, Michael Fenne, was actually a fugitive con artist named David Kim Stanley. Three years later, he would be serving an eight-year sentence in Virginia.1

  Individual investors were setting the direction for the market—and the pros were learning to ride their coattails. “Indeed, one of the great stories…has been the humbling of the vast majority of institutional portfolio managers by individuals, who increasingly are taking investment decisions into their own hands,” wrote Barron’s’ stock market editor at the end of 1998. “[Individuals], adhering to the Peter Lynch philosophy of buying stocks in companies whose products they like, have scored big in such issues as Gap, Home Depot, Microsoft, Intel and America Online.”2 Laszlo Birinyi, a research consultant and money manager in Greenwich, Connecticut, put it another way: “It’s the people standing in Charles Schwab who are running the show.”3

  Everyone, it seemed, was chasing stocks, and everyone was chasing the same stocks. In San Jose, Kathy Rubino discovered just how ubiquitous the marquee names had become when her phone rang early one morning in November. Barely awake, Rubino had just flipped on CNBC for the opening stock report when she answered the call—only to find an obscene caller on the other end of the line.

  An anonymous caller in one ear spewing lurid comments, Joe Kernen in the other ear reporting on falling stock prices—Rubino’s day was off to a bad start. Suddenly, the obscene caller interrupted himself: “Is that Kernen on CNBC?” he asked.

  Rubino, stunned, off balance—and still groggy—found herself answering him: “The market has taken a plunge this morning,” she replied.

  “Jesus,” the anonymous caller said, “any word on Cisco or AOL?”4

  At the end of 1999, Yahoo! boasted a market cap of $120 billion. By contrast, Warren Buffett’s company, Berkshire Hathaway, carried a market value of only $83 billion. Berkshire Hathaway’s class A shares were now changing hands at around $54,000 a share, down by some 23 percent for the year. (For investors, this was a rare window: by June of 2003, Berkshire would be trading at roughly $74,000 a share, up 33 percent from the end of 1999. Over the same period, the S&P 500 lost roughly 32 percent.)5

  But in 1999 Buffett was passé. This, after all, was the year that opened with the news that Henry Blodget expected Amazon.com to fetch $400 a share—which it promptly did—and ended, fittingly, with Time magazine naming Jeff Bezos, Amazon.com’s CEO, “Person of the Year.”

  HENRY BLODGET AND AMAZON.COM

  On a night flight from Houston to New York, Henry Blodget called in to check his voice mail. It was December of 1998, and Blodget, who was then CIBC Oppenheimer’s senior Internet analyst, listened to yet another message from the Oppenheimer sales force.6

  It was the question they had been asking for days: “How high could Amazon.com go?” Blodget didn’t know. No one did.

  Just two months earlier, Blodget had published his first report recommending the online bookseller’s shares. At the time, Amazon.com was trading at over $80, and he had set a one-year target of $150, adding that he thought the stock was worth somewhere between $150 and $500. But, he cautioned in his report, “Amazon is one of the most controversial stocks in our universe…. We are recommending the stock for strong-stomached, long-term investors.” Within weeks, the stock breezed past his one-year target.

  Now his firm’s sales team wanted a new target. Blodget had done some calculations. The stock was trading around $240. In another year it could go to…$300? Maybe as high as $500? The company had no earnings, so there was no way to estimate earnings growth. In any event, the share price had less to do with demand for the product than demand for the shares.

  Blodget was new to the game: he had been an analyst for less than three years. But to some degree, he understood that in a market driven by a combination of momentum and emotion he was trying to forecast investor psychology: What would someone else be willing to pay for the stock?

  $300? $500? Split the difference, he thought, and make it $400.

  In truth, Blodget’s research was not that cavalier. But when it came to setting a price, he was at a loss. How high? Who knew?

  His research reports, on the other hand, made an honest attempt to analyze the company. While Mary Meeker was known for what Barron’s called her “trademark breezy [writing] style,” Blodget tried to write old-fashioned analytical reports.7 The Amazon report that he had produced two months earlier was filled with charts and tables that attempted to compare Amazon both to barnesandnoble.com and to Dell—the model for a profitable New Economy company. Blodget made it clear that the comparison to Dell was a stretch: Dell sold computers; Amazon sold books. And Dell added value by carrying no inventory, getting the best price possible on the parts, then assembling the computers. But Blodget had to find some way to model Amazon.com’s business.

  At this point in his career, Blodget was trying hard simply to hold on to his job. A greenhorn on Wall Street, he was in over his head—though in that way he was like every other Internet analyst trying to predict what was going to happen in a completely unknown sector. The Internet was not a new industry. Was it a new medium like radio or television? Or was it merely a pipeline, in search of a business plan? Certainly it needed content. But no one yet knew what content would turn a profit over the long term, or how.

  Meanwhile, Blodget had landed his job at Oppenheimer only after a six-year search for a career. In 1988, Blodget had graduated from Yale (where he majored in history and wrote a solid senior thesis about a 17th-century cleric). He then spent a year in Japan, teaching English. When he returned to the States he wrote a book about his experiences. It was never published—“nor should it have been,” Blodget said wryly. It was, after all, a book written by a 22-year-old about the life experience of a 21-year-old.

  Back in New York, Blodget began, in his words, “casting about for something to do” and became a freelance journalist. But it was not easy for a 22-year-old to break into journalism in Manhattan. And Blodget could not take the freelance lifestyle—“the job insecurity, never knowing when I would get a paycheck…I was 27 years old and earning just $11,000 a year,” he recalled in a 2002 interview.

  By 1994, Blodget remembered, �
�I began to notice that everything I was reading had to do with the market.” He had been doing some work for CNN Business News; his father was a banker; Wall Street seemed a logical route to pursue. That year, Blodget enrolled in a training program at Prudential Securities. Two years later, he landed a position as an analyst at CIBC Oppenheimer.

  On Wall Street, Oppenheimer was a bit of a backwater, but still, it was a good job. Blodget was now earning a real salary—less than six figures, but far more than $11,000. He began receiving phone calls from headhunters looking for someone to cover Internet stocks. “At that time, Wall Street didn’t have anyone to cover the Internet,” Blodget recalled. “They had PC analysts trying to follow the Internet—but very few people on Wall Street knew much about it. And no one had any experience. The headhunters started calling me because of my ‘background’ in journalism”—Blodget smiled sardonically—“and because I was following some of the early electronic data companies.” Within months, Blodget became one of a handful of “experienced” Internet analysts on Wall Street. His main concern: “not being blown out of the water—keeping the job.”

  So in December of 1998 Henry Blodget found himself sitting on an airplane somewhere between Houston and New York, wishing for sleep. He had been working 60-and 70-hour weeks for months. But first he had to try to figure out a new number for Amazon. The sales team needed something to say—a line, a rap, a number. That is how they sold a stock. Amazon had already blown through his last target; Blodget decided that a 70 percent rise over the course of a year seemed reasonable for a company that had been growing so fast. He told himself, “It’s no different from saying that a $24 stock will go to $40.” But, of course, it was.