Bull!

by Maggie Mahar

  But Spitzer was far less feisty than Giuliani. “We didn’t want to bring the firm down,” he said in 2003. Yet in an earlier interview with The New Yorker’s John Cassidy, Spitzer admitted, “The problems were structural. Everybody [on Wall Street] had permitted analysts to become appendages to the investment-banking system.” This was why, Spitzer explained, “it didn’t seem reasonable to drop the criminal ax on Merrill Lynch because of this.”43

  Yet it did seem reasonable to drop the ax on Henry Blodget.

  Meanwhile, Rudy Giuliani, the man known for cleaning up Wall Street in the eighties, demonstrated his talents as a switch-side debater. By 2002, Giuliani had set up a consulting firm and was now representing Merrill Lynch, informally pleading its case with Spitzer. On Monday, April 8, the very day that two members of Spitzer’s staff went to the state supreme court to get an order requiring Merrill Lynch to hand over documents, Giuliani spoke to Spitzer on Merrill’s behalf.

  In 2003, Spitzer said that he “wouldn’t go into the details of the conversation,” but Giuliani, it seems, was pitching the notion that Merrill had been a “good corporate citizen” because it stayed in New York City after the September 11, 2001, attack on the World Trade Center. What that had to do with the case at hand was totally unclear.

  Spitzer agreed and claimed that he was not persuaded.44 But, that afternoon, when the SEC told him that his court order could disrupt large parts of Merrill’s business, Spitzer immediately sent his lieutenants back to the judge, to ask the court to stay the order.45 Spitzer and Merrill would try to reach a settlement. After all, Eliot Spitzer simply wanted to make a point.

  “Henry Blodget was one very small cog in a corrupt system,” he acknowledged in 2003.46 But Spitzer’s mission was to get the cog, not to upset the system.

  In the end, Spitzer’s investigation of Wall Street research was settled, over dinner, at Tiro a Segno, an Italian club on MacDougal Street in Manhattan’s Little Italy.

  There, Spitzer, Harvey Pitt, the SEC commissioner who followed Arthur Levitt (before resigning amidst a scandal over his own possible conflict of interest), Robert Glauber, chairman of the National Association of Securities Dealers, and Dick Grasso, the chairman of the NYSE, broke bread. In addition to his duties at the NYSE, Grasso served on Merrill Lynch’s board.

  A few weeks later, the group met again, in Washington, D.C., at the Georgetown Club, where, Cassidy reported, “they reached an outline agreement on the sort of settlement they wanted to arrive at.” Asked if he didn’t feel that he was sitting down with the foxes to decide how to redesign the henhouse, Spitzer expressed outrage, while simultaneously insisting that he did not understand the question.47

  In a blaze of publicity, Spitzer and Merrill eventually reached an agreement. Merrill Lynch would pay a fine of $100 million—“less than one third of what the firm paid for office supplies and postage last year,” Bill Moyers noted on NOW, his current affairs series on PBS. “And the IRS told us yesterday that both the company’s penalty and legal fees may be tax-deductible. A business expense for deceiving the public,” Moyers remarked.48

  —21—

  LOOKING AHEAD: WHAT FINANCIAL CYCLES MEAN FOR THE 21ST-CENTURY INVESTOR

  Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. This dismal fact is testimony to the insanity of valuations reached during the Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge.

  The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks—if they can be purchased at attractive prices…. But occasionally successful investing requires inactivity.

  —Warren Buffett explaining why he and his partner,

  Charlie Munger, remained unenthusiastic about stocks

  (with the S&P 500 trading at 848.17, the Dow at 8181), February 21, 20031

  “Over the long haul, U.S. stocks always outperform other investments.”

  “You can’t time the market.”

  “Buy and hold.”

  These were the truisms of investing during the Great Bull Market of 1982–99—the conventional wisdom that stood investors in good stead for nearly two decades. Unfortunately, the rules that work superbly in one cycle can prove disastrous in the next.

  Conventional wisdom, after all, is grounded in the experience of a particular time and place. As fickle as fashion, conventional wisdom masquerades as eternal truth. And we accept it as such. The consensus provides confidence, conviction, and a sense of community. (In that, it is much like CNBC.) In an era of sound bites, bromides easily become slogans, and the more often we repeat them, the less we think about them.

  Conventional wisdom rarely stands the test of time. When tested against empirical data over decades, the popular wisdom of any era tends to fall apart. This is especially true in financial markets. There are no rules that work in all cycles. “Long-term investment success just isn’t that simple,” remarked a 63-year-old Steve Leuthold in 2000. If it were, there would be many more 60-year-olds on Wall Street.2

  The most successful long-term investors are those who avoid becoming mesmerized by the week-to-week or month-to-month action of the markets, step back, and take a longer look at the larger cycles that drive a multifaceted global economy. While one bull market cycle is ending, another is beginning somewhere else—in another sector, in another class of assets, or in another country. There is always someplace in the world to make money.

  Even in the seventies, when both Treasuries and the S&P 500 disappointed, shrewd investors put their money to work by investing in real assets. From 1970 through 1980, oil returned an average of 34.7 percent, gold 31.6 percent, U.S. coins 27.7 percent, silver 23.7 percent, stamps 21.8 percent, Chinese ceramics 21.6 percent, U.S. farmland 14 percent, and housing 10.2 percent, staying nicely ahead of inflation in a decade when the consumer price index rose by an average of 7.7 percent a year.3 Some of these investments could even be found in the U.S. stock market: energy stocks, for example, soared.

  But in 1970, few investors were interested in oil and gas. Most were still obsessed with the Nifty Fifty—the market darlings that were about to betray them—and failed to notice just how cheap commodities had become. The pattern is an old one. “When a major theme ends, tremendous undervaluation exists in other sectors, because all the money was flowing during the final, manic stage of the boom into just one major investment theme,” Marc Faber, author of Tomorrow’s Gold, observed in 2002. “While everyone’s eyes are fixed on the cycle that is peaking, enormous opportunities arise elsewhere.” Over the course of a 30-year career, Faber had watched the tide turn many times: “gold, oil and gas, and foreign currencies—these were the major investment themes of the 1970s; Japanese stocks in the 1980s; emerging markets between 1985 and 1997; and US equities in the nineties.”4

  A Swiss-born, multilingual investment advisor, Faber arrived in Hong Kong in 1973 at the age of 27, armed with a Ph.D. in economics from the University of Zurich and a passion for economic history. There, he worked for White, Weld & Co. until 1978, when the investment bank merged with Merrill Lynch. Faber then became managing director of Drexel Burnham Lambert’s Hong Kong operation, a position he held until 1990, when he opened his own shop, Marc Faber Ltd. Throughout the nineties, he continued doing what he had been doing all along: managing money for some of Asia’s wealthiest Chinese families while also writing The Gloom, Boom and Doom Report, a monthly financial newsletter read on four continents. By 2003, Faber had moved his business to Thailand, where he was learning a sixth language.

  Over the years, Faber demonstrated a certain knack for spotting bubbles: In August of 1987, for example, he predicted that the Dow was headed for a nasty spill. That same year, he warned that Japan’s market was poised for a crash. In 1994, he cautioned that markets in Southeast Asia were “grossly overvalued.” And in October 1998, Faber called the top of the longest-running bull mar
ket in U.S. history. “From here on,” he told readers, “we believe that volatility in Western financial markets will increasingly be on the downside—interrupted by huge bear market rallies—and lead to widespread losses…. It is our view that a major and long-term top in the Western stock markets is already behind us.”

  In each case, Faber was right. In October of 1987, the Dow took a drubbing—just three months after he sounded the alarm. In 1988, the Nikkei’s plunge began, and from 1997 to 1998, Asia’s tigers tanked, wiping out the gains of the preceding four years. Finally, in October of 1998, just as Faber surmised, the majority of U.S. stocks already had begun to slide from the heights achieved in ’98, ’97, or, in some cases, ’96.

  As a career path, being a prophet of doom has its limits. Luckily, Faber’s fascination with history’s financial cycles also helped him sight booms (which is why his wealthy Chinese clients entrusted him with their money). In the seventies, for instance, he began investing in South Korea and Taiwan; in the mid-eighties he put his clients’ cash to work in the Philippines and Thailand; in the late eighties he moved into Latin America, and in 1993 he bravely began buying Russian stocks. In other words, Faber rode Asia in the boom years, got out when those markets reached perilous heights, and began investing in Latin America and Russia—just when everyone else was piling into Asia’s overvalued shares. In each case, his strategy was the same: move into a region when things look gloomy, wait for the boom, and get out before it turns into a bubble.

  But by the late nineties, Faber believed stocks were overpriced in virtually every corner of the world. And in 1998, when he warned that the bull market in the United States had ended, Faber urged his readers to stash their savings in Treasuries. At the time, bonds held little appeal for most investors, but those who followed his advice flourished.5

  Of course, Faber was not always right. By the end of 2000, he had cooled on the long bond: “The dollar has been so strong for so long that, inevitably, it will fall,” he predicted. “And when it does, foreigners, who own 37 percent of all Treasuries and 23 percent of all corporate bonds, will pull their money out.” As it turned out, the dollar’s decline would not begin for another two years, and as of June 2003, central banks abroad continued to support Treasuries—though a weaker dollar had begun to make U.S. stocks less attractive to some foreign investors. But while Faber’s advice to move out of the long bond was premature, the alternatives he suggested, “gold mining stocks, natural resource stocks, and highly rated municipal bonds,” proved profitable for the next three years.6

  And Faber would always rather be early than late. “The greater damage is always done during the final phase of a bull market,” he observed. Instead of trying to ride a market to the very top, he would rather bail out before the final blow-off and concentrate his energies on finding the next investment theme. For the “greater the mania in one sector of a market, or in one stock market, the more likely that neglected asset classes elsewhere offer huge appreciation potential. This,” said Faber, “is one of the cardinal rules of investing, and will always work for the patient long-term investor.”7 But first, an investor must shrug off the conventional wisdom of the previous era.

  STOCKS FOR THE LONG RUN?

  One of the most oversold “truths” of the eighties and nineties was that, over the long run, equities always outperform bonds. An entire generation of baby boomers was trained to believe that “bonds are boring.” Real Men bought stocks. In the summer of 1998, when the bear staged a dress rehearsal for the crash of 1999–2000, more than one commentator advised that investors should shift part of their portfolio into bonds only if they couldn’t take the stress of the stock market’s volatility. In other words, if they were mildly unstable.

  Ironically, during the very period when the cult of equities flourished, bonds were quietly enjoying their own magnificent bull market. Indeed, if an investor stashed half of his savings in long-term Treasuries in September of 1980, and half in the S&P 500, he would discover, in March of 2003, that the two portfolios had done equally well.

  Even looking back over 34 years, from February 1969 through March of 2003, “stocks outperformed long-term Treasuries by a paltry 1% a year,” noted Martin Barnes, editor of The Bank Credit Analyst. In other words, for 34 years an investor could have been sleeping soundly—or lying awake, making that extra 1 percent. Granted, when compounded over 34 years, 1 percent adds up, but the 1 percent was not guaranteed, making it “a dismally small gap, given the extra volatility in stocks,” Barnes observed. This Barnes called “Wall Street’s dirty little secret.”8 (See chart “Stocks for the Long Run?” on page 356.)

  Wall Street preferred to keep investors’ attention focused on equities. Selling stocks is, after all, a far more lucrative business than peddling plain-vanilla Treasuries, in part because transaction fees on equities are higher (especially now that investors can buy government bonds, commission-free, through www.treasurydirect.gov), in part because investors were willing to pay a premium to buy equities at a time when the potential gains seemed open-ended—in others words, in a raging bull market. Just as gamblers will pay more for a lottery ticket if the pot is very large, so in the nineties, equity investors accepted whatever fees Wall Street or the mutual fund industry cared to impose.

  Finally, Barnes pointed out, the fact that the long bond kept pace with the stock market from 1980 to 2003 is not as unusual as the popular wisdom of the nineties might suggest. Looking back over 80 years or so of stock market history, he reported, “The only true golden periods for stock were the 1950s and 1960s. That was when stocks persistently outperformed bonds, with only occasional short-lived reversals.”

  “The key thing to note about this ‘golden era’ of equity outperformance,” Barnes added, “is that it began when equities were very cheap: the S&P 500 was trading at 7 times [the previous year’s] reported earnings in 1950. Meanwhile, bonds were expensive because the long-term Treasury yield was pegged at around 2%, far below the underlying rate of inflation.”

  Treasuries, in turn, enjoyed their own golden period from 1980 to 2003—a cycle that began when they, too, sold for a song.

  To be sure, 10-or 20-year returns can be deceiving: “If an investor had bought the S&P 500 in, say, January of 1982, and had the foresight to sell in January of 2000, his equity portfolio would have beaten his bond portfolio hands down,” Barnes was quick to acknowledge.9

  But he or she would have had to time the market. “Buy and hold” would not be enough.

  “BUY AND HOLD”

  Inevitably the question arises: What if an investor bought stocks in, say, 1995, held until 2010, and continued to invest in the S&P each month? Would “buy and hold” work?

  No one knows. The real question comes down to this: Is the likely reward worth the risk? The danger is that, like a gambler in a casino, an investor who lost money after the bubble burst would think, “If I just stay a little longer, maybe I can make up for my losses…”

  “‘Stocks for the long run’ is an idea that has been drilled into the public—and the public has found it comforting,” Peter Bernstein, author of Against the Gods, observed in the spring of 2003. “People say, ‘I don’t care if my stocks are down. In the long run, I’ll be fine. But that’s a leap of faith. It’s not necessarily wrong—but it is a leap of faith.”10

  What made Bernstein’s comment so notable is that in the early nineties he had written the foreword to a book that soon became the gospel for buy-and-hold investors, Jeremy Siegel’s Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies.

  By the spring of 2003, however, Bernstein believed that the old rules no longer applied. “For now, equities aren’t the best place to be for the long run,” he told Kathryn Welling in an interview published in welling@ weeden. “The long run here is not necessarily going to bail you out,” Bernstein warned. “Or, even if it does, the margin by which equities will outperform could be too small to compensate for the vola
tility.”11

  But what of Siegel’s argument that for more than 200 years, U.S. stocks have returned an average of 7 percent a year, after inflation? “The average dividend yield during all those 20-year periods that Jeremy [Siegel] looked at was over 4 percent,” Bernstein replied. Capital gains contributed only2.1 percent to that long-run 7 percent annual return. The rest was dividends. But in the spring of 2003, equities offered an average dividend yield of roughly 2 percent. “Which means that in order to achieve 7 percent real growth over the next 20 years, we’d need 5 percent real growth in earnings and dividends,” said Bernstein, “and that’s not exactly a reasonable expectation over the long run. Impossible, in fact.”

  The hard truth is that the market cannot grow that much faster than gross domestic product. In March of 2000, stocks were valued at 181 percent of GDP—up from 60 percent at the beginning of the decade.12 Yet “over time,” Bernstein noted, “real growth in earnings and dividends consistently lags long-run growth rates in real GDP—not just in the United States but in all other developed countries. Between 1900 and 2001, for instance, U.S. GDP growth averaged 3.3 percent in real terms, versus 1.5 percent earnings growth and just 1.1 percent dividend growth. And the U.S. economy was the most successful on the planet!” Bernstein added.

  Of course, an investor could gamble that dividends would climb higher—or that investors would push price/earnings ratios back to stratospheric heights, boosting capital gains. “But that’s not a risk I would want to take under current circumstances,” said Bernstein in February of 2003, making it clear that whatever might happen over the short term, he was assessing prospects for the the long term (emphasis his).