[A-List] New economy bull
michael.keaney at mbs.fi
Wed Dec 4 05:23:46 MST 2002
>From "The Mind of Wall Street: A Legendary Financier on the Perils of Greed
and the Mysteries of the Market", by Leon Levy, with Eugene Linden. New
York: Public Affairs, 2002.
Chapter 10: False Profits (pp. 151-157)
Anyone who has been around markets long enough recognizes a bubble when he
sees one. In scale, the mania that gripped the American market in the late
1990s nearly matched the great bubbles of the past, such as the tulip bulb
mania in Holland in the 1630s, the South Sea speculative frenzy of 1719 in
England, the railway mania of 1845, and the Japanese real estate bubble of
the 1980s. But the Internet bubble was all the more remarkable because it
occurred in the most liquid, sophisticated, and ostensibly diverse market in
history, and it continued to inflate despite a drumbeat of warnings in the
mainstream press that laid out in the plainest possible language the
absurdity of the valuations that investors were lavishing on stocks.
As the bubble deflated, investors began to snap out of their trance and
ruefully look back on the myths, delusions, and outright lies they had
cherished as truths when they were blinded by a rising market. As the dust
cleared, an even more remarkable trend surfaced. As stock prices deflated,
so did many of the numbers that had propped up their prices. By August 2001,
losses by Nasdaq companies had essentially wiped out all profits for the
five previous years, according to an analysis by The Wall Street Journal.
Robert Barbera, the chief economist at Hoenig and Co., told the Journal,
"With the benefit of hindsight, the late 1990s never happened."
Not only profits disappeared; profit margins vanished too. Profit margins
are used to justify lofty price-earnings ratios. An analysis by my brother
Jay and my nephew David at the Levy Forecasting Center showed that despite
assertions that profit margins had increased by 20 percent in the 1990s, in
reality they did not increase at all.
The great bubble of the 1990s was further inflated by a much publicized jump
in productivity, a number that had lagged through the 1980s and early 1990s
at about 1 percent. To the relief of technology cheerleaders, however,
productivity gains began surging to about 2.5 percent annually by the late
1990s. The increase in productivity became one of the props of the so-called
new economy, even converting such stalwarts as Alan Greenspan to the cause.
(Greenspan contributed to the follies of the 1990s in other ways as well.
Despite warning about "irrational exuberance," he did not raise margin
requirements, and he championed the repeal of the Glass-Steagall Act.)
Financial columnist Jim Grant blew the whistle on the myth of productivity
growth, citing academic work showing that computers were the only industry
in the 1990s that experienced growth, and even there the gains were possibly
the product of creative accounting.
Part of the illusion of surging productivity came from the bull market
itself. William Lewis of McKinsey and Company has pointed out that
productivity statistics mistook a spending spree for increased efficiency.
With seemingly insatiable consumers willing to buy higher-priced goods,
those selling the goods looked more efficient because their revenues were
rising without any increase in their workforce.
There was no end to the accountants' tricks. Price-earnings ratios (for
those companies that had earnings) also turned out to be phony. Companies
artificially pumped up earnings by treating ordinary expenses as
extraordinary events (Enron, Cisco), by booking earnings and revenues long
before they were realized (Computer Associates, Calpine), by including
capital gains from investments in earnings (Microsoft, General Electric), by
buying back stocks (IBM), and by omitting the effects of options granted to
employees (Microsoft, AOL, Cisco, many others). The list goes on.
Even the intellectual underpinnings of the new economy proved to be
illusory. One article of faith was that the Internet allowed companies to
continuously monitor sales and supply chains so that inventories would never
become lopsided and recessions would disappear. Then, in the first quarter
of 2001, Cisco Systems, a bellwether company of the Internet (and for a
brief time the most valuable company on earth with a market value of $590
billion), took a $2.25 billion pretax inventory charge. This was not
supposed to happen, particularly to a company that supplied the very
backbone of the Internet and telecom revolutions. If a company like Cisco
could have inventory problems (probably because managers will do everything
to achieve targets and earn bonuses regardless of market conditions), then
maybe old-economy imbalances had not disappeared altogether.
By the summer of 2002, not only had trillions of dollars in wealth
evaporated ($4 trillion in Nasdaq market values alone), but so too had most
of the numbers that provided the underpinnings for the creation of that
wealth in the first place. The wealth came and went so fast that many
millionaires-for-a-day had no chance to spend their gains. To name but one
of dozens of examples, Theglobe.com stock soared from its $9 IPO to $97 in a
day, and then plunged to less than $1 in little more than a year. It was
indeed as though the late 1990s never happened.
Except that the bubble did happen, and its legacy is like a wretched
hangover. Long after the valuations of new-economy stocks collapsed, major
companies continued to take significant writedowns of their assets -- $40
billion for JDS Uniphase and $54 billion in the case of AOL Time Warner --
to adjust their balance sheets for the vanished wealth of their investments.
Moreover, without the prop of an irrational stock market, investors finally
tuned in to the fantasy accounting that had become pervasive in American
business, and they slaughtered stocks whose earnings came under suspicion.
Throughout the past decade, whenever markets hit a bad patch, some wise old
hand would appear on television and patiently explain to nervous viewers
that in the long run stocks have always outperformed other investments. Then
the markets would soar to new highs, breeding armies of smug new converts to
the buy-the-dips religion. One tenet of this new faith was that the Federal
Reserve and Treasury Department had learned the lessons of the Depression
and now had the tools to prevent panics from progressing to full-fledged
depressions. Thus, even before the Internet came along, investors were
encouraged to believe that stocks were not as risky as their long-term price
movements would suggest.
Corporations and investment bankers were delighted with the public's
newfound belief in the infallibility of Alan Greenspan and the automatic
road to wealth promised by the stock markets. Suddenly, here was a huge
population of investors willing to assume the risks inherent in stocks --
through their purchases of mutual funds -- and tie their fates to their
employers' fortunes by accepting payments into retirement accounts in the
form of company stock. Who could argue, since the appreciation of most
stocks was outpacing conservative investments by a country mile? Companies
took advantage of this gullibility to shovel stocks into the accounts of
their workers every way they could.
Then came the Internet in the mid-1990s, and the notion of risk was
seemingly consigned to the dustbin of history. The Internet famously
promised a "new paradigm," giving everyone with moxie access to global
markets, promising consumers the power to "name your own price" for
everything from airline tickets to groceries, and offering businesses the
allure of fantastic productivity improvements in everything from dealing
with suppliers to lowering the costs of sales.
The old ways of valuing companies went out the window, as did the notion
that stocks were inherently risky. A book called Dow 36,000 argued that even
as the Dow Jones Industrial Average pushed past 10,000, the market was
vastly undervalued, since prices were discounted for more risk than was
justified in an environment of low inflation and strong earnings growth. The
authors (James Glassman and Kevin Hassett) maintained that equities carried
no more risk than corporate bonds, and that as investors came to realize
this, they would accept less return in dividend yields and bid up prices. To
the authors, even the historically high price-earnings ratios of the late
1990s were ludicrously low.
For a while, the data seemed to back up these arguments. The productivity
surge in the late 1990s seemed to validate the claim that years of
investment in computers and other information technologies was finally
paying off. Internet companies were deemed exempt from ordinary standards of
accounting. Reporting profits was cause for shame, not pride, since profits
indicated that the company's executives were not sufficiently focused on
growth. The trick for an Internet company was to capture as many customers
as possible, even if it was losing money on every sale.
There is an old joke about the wholesaler who steals market share by selling
suits that cost him $100 for $90 each. His friend asks him, "So how do you
make money?" "Simple," replies the wholesaler, "I make it up on volume!"
This seemed to be Amazon.com's approach, which turned a joke into a badge of
honor. Stranger still, Wall Street bought it. Amazon argued that once it
achieved a preeminent position as the destination of choice for Internet
shoppers, it could begin raising its prices and rake in the profits. So far
the plan has not worked out that way.
It wasn't only the younger generation who believed the Internet would change
the world. Walter Wriston, a distinguished former chairman of Citicorp, was
a believer in the new economy. I was not -- maybe because I've never used a
computer. Wriston and I debated our differing views in the pages of Forbes
magazine. (I later expanded many of my views in an interview with Jeff
Madrick in The New York Review of Books.) Wriston argued that the Internet
was fantastic for business because it enabled nimble retailers like Dell
Computer to respond so quickly that they could get suppliers to finance
their entire business. I replied that the Internet was merely a new kind of
store, and that as with any new way of selling, others would enter the
business, driving down margins. I used the analogy of supermarkets, which
emerged in the 1930s, driving out corner grocery stores, only to have their
profit margins attacked by discount stores, which in turn found it ever more
difficult to remain profitable as others entered the business.
I told Wriston that this principle applied to Amazon.com as well, noting
that it was difficult to imagine how many books they would have to sell to
justify their market valuation (which peaked at about $42 billion). Wriston
replied that books were only the first product, to which I rejoined, "When
there are other products, there will be other Amazons."
Risks don't disappear from markets or businesses; they are merely
transferred or sold. In the end, Amazon was nothing more than a mail-order
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