The most fascinating aspect of Buffett’s Salomon investment is that it puts him in bed with Wall Streeters, whose general greed he has scorned in the past. 35
It was soon apparent that Buffett had badly misjudged the business. As an important and well-treated customer of Salomon’s, he had an overly rosy view of it. Two weeks after the deal, Salomon disclosed that it would lay off eight hundred employees and fold two departments, moves that would cost it $67 million. There was a sense that Gutfreund was not in control. And this was echoed by a sudden and general nervousness in stock and bond markets.
For five glorious years, the bull market had roared. Though interest rates had risen through most of 1987 (depressing intrinsic business values), the stock market had ignored them. By August, stock prices were at the historically unsustainable level of twenty-two times earnings.
As each lunatic has his vision, each bull market has its rationale. In 1987, it was that excess “liquidity” would hold prices up. This was a version of the greater-fool theory: the cash (“liquidity”) of nameless others would save the day. Japanese stocks, then at sixty times earnings, were said to provide cover. No matter how absurd the prices at home, since Japanese stocks were more absurd, U.S. stocks were held to be safe. Of course, such rationales had not kept previous rallies from abrupt and unpleasant endings. But a bull market is a bit like falling in love. When you are in one, it has never happened to anyone before.
Binkley C. Shorts, a senior vice president of Wellington Management, was representative of the pack. Shorts had a Harvard M.B.A., three kids, and a finger on the pulse of Wall Street. He acknowledged that stocks were rich, but was strong of heart:
Foreign money’s attracted to our market because it’s less expensive than their own. So maybe the market can go up regardless of fundamentals.36
No one disputed that prices were high, but the bull market had become an article of faith. Business Week suggested that “yesterday’s yardsticks” were no longer apt.37 Buffett felt that money managers were not using any yardstick. They had abandoned the effort to value stocks at all: “For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.”38
With computerized trading, fund managers were now buying groups of stocks by the bucketful in market “baskets”—a few million GM, a couple of million AT&T, and a dab of Westinghouse, on rye, please. A parallel trend was the emergence of stock-index futures in the commodity pits in Chicago. These new futures contracts, which traded next to pork bellies and cattle, enabled speculators to bet on the direction of the entire stock market. To a Graham-and-Dodd investor, of course, a stock derived its value from the underlying, individual business. But the new breed of “investor,” who was buying the market whole, did not even know which stocks he owned. Security analysis was irrelevant.
On Wall Street, if not in Omaha, “asset allocation” was the rage.39 Instead of looking for individual issues, the portfolio manager first decided how much to invest in “stocks,” treating them as a generic class. The total could be and was continually rejiggled, resulting in sudden wholesale shifts. As an offshoot, managers were letting computer models influence and even make their buy-sell decisions. Prophetically, Institutional Investor warned in September 1987 of the “false sense of security” from relying on technological masters.40
But few paid notice. “Portfolio insurance,” a high-tech nostrum for fund managers, was said to be a fail-safe. Under this strategy, managers determined in advance to automatically sell increasing amounts of stock-index futures whenever markets fell. The theory was that futures could be sold more readily than stocks. By quickly selling futures, portfolio managers would hope to cut their losses before a drop became severe.
V. Kent Green, an investment adviser at First Bank System in Minneapolis, noted that when one wanted to sell, “some of your stock positions could be very illiquid”—meaning that no one would be around to buy them. But Green was sleeping soundly; if the need arose, he could get out by the side door, in Chicago. “Futures,” he noted, “are about four times more liquid than stocks at the current time.”41
What escaped Green’s attention was that he did not need to sell futures “at the current time”; he would need to sell when markets tumbled—when, presumably, everyone else would be selling, too. When the hour came, according to a subsequent White House study, chaired by investment banker Nicholas F. Brady, some $60 billion to $90 billion of futures were poised on the same delicate trigger as Green’s.42
In retrospect, what was memorable about October was not its suddenness, but the degree to which it had been advertised in advance. Cassandras abounded. Charles Allmon, a newsletter writer, had talked of “a huge debacle of the magnitude we saw in 1929.”43 The bears knew that prices were high; the bulls knew it, too. But everyone wanted the last drink. From January 1 to the August peak of 2,722.4, the Dow rose an astonishing 44 percent. The refrain was maddening. Byron R. Wien, investment strategist at Morgan Stanley and one of Wall Street’s most-watched beacons, was ready to throw away the rule book. Even bad news, he suggested in August, might send stocks higher:
… some profoundly mysterious forces have enabled the market to advance.… So perhaps the link between reality and stock prices isn’t as tight as they taught us in business school.44
Alas, within a week or so, reality showed its face. There were hints of inflation, a naggingly stubborn trade deficit, and a worrying drop in the dollar. The Federal Reserve, hoping to stem inflation fears and to prop up the dollar, ushered in Labor Day by hiking the discount rate, the widely watched rate at which the Fed lends money to banks. Bond markets, taking their cue, went into a tumble. The stock market gave back 38 points in a day.
By early October, the yield on long-term bonds had risen to nearly 10 percent—up from only 7.4 percent as recently as March. On October 6, the Dow plunged 91.55 points, a one-day record. Markets had entered the vaporous territory in which events take on a life of their own and historical accidents may occur. In short, things were becoming serious.
On about October 12, Buffett cashed out the stock portfolio of at least one of Berkshire’s profit-sharing plans. It cleaned the larder of stocks, save for his permanent three. According to a Buffett associate, “It was a clear edict: ‘Sell everything.’ ”
Buffett was not making a forecast; he was merely obeying two cherished rules. Rule No. 1: “Never lose money.” Rule No. 2: “Never forget Rule No. 1.” Munger said, “Warren would never claim that he could call the market.” But perhaps Buffett had been glancing a bit more anxiously at the newspaper clipping on his wall—the one from 1929. In the week following, interest rates climbed above 10 percent. Japanese shares continued to rise, but now no one on Wall Street cared about Japan. On Friday, October 16, the Dow plunged 108 points.
Washington was on edge. Whenever markets failed, bureaucrats could be counted on to look for a culprit outside their ken—speculators, the gnomes of Zurich, whomever. An official resentfully blamed the fall on “twenty-nine-year-old technicians.”45 The Treasury Secretary, more mindful of appearances, told a weekend television audience that he did not expect further tightening from the Fed. But it was too late.
On Monday, October 19, sell orders jammed the market. Eleven of the thirty stocks in the Dow average could not open during the first hour of trading.46 In the interim, portfolio insurance sell programs had been triggered automatically. The futures market went into free fall, which, of course, touched off a sympathetic drop in stocks.47 In the end, it did matter where the selling occurred. The door was too small to admit everyone through, and the vaunted portfolio insurance failed to save the day. By late afternoon, the panic had become a rout.
In Boston, people lined up outside Fidelity Investments to redeem shares. Newspapers spoke of “hysteria.”48 But the New York financial district was quieter than usual. People were indoors, tethered to electronic screens. Black Monday may have been the first postmodern historic event; it seemed not to have a tangible center. The
Dow fell 508 points, or 22.6 percent.
Buffett’s net worth dropped by $342 million. He must have been one of the few investment people in America who did not have a minute-by-minute account of the crash. At one point, Buffett went into Mike Goldberg’s office and calmly told him where Berkshire was trading. Then he went back to his desk.
Two days later, Buffett’s Graham group convened in Williamsburg, Virginia. The market was still turbulent, but the group was curiously detached. No one left the seminar room to check on prices or even spoke much of them. They toured a plantation under a resplendent fall sky, admiring the foliage. Wyndham Robertson, a university administrator and journalist in the group, asked Buffett what the crash had “meant.” All he could say was “Maybe the market had gotten too high.”
Compared with Black Thursday, the great collapse of 1929, Black Monday was oddly hollow. No depression or other economic tide followed in its wake. At first it was thought that the crash would prove a socioeconomic milestone. Columnists cheered the end of the casino era, and especially of the nouveau riche captains of investment banking. But after a brief pause, Wall Street rolled on. Indeed, in 1988, bankers would cut more deals than ever, and stocks would recoup most of their lost ground. The crash seemed to leave no footprint, save for the jagged slant on the screens of traders.
Its “meaning” was evident only on a small scale. A week before the fall, Berkshire had traded at $4,230 a share. On Friday the 16th, it closed at $3,890. In the madness of Monday, it fell to $3,170. Berkshire had been worth close to $5 billion, laboriously built up over twenty-two years. Nothing in the company had changed: Stan Lipsey sold the same number of papers in Buffalo; World Book was nestled, as ever, on pupils’ shelves. Yet in the space of a week, 25 percent of the company’s market value had been wiped out. A quarter of the fruits of a generation’s work had vanished. Something was wrong.
Chapter 17
A BRIEF INTRODUCTION TO DARTS
Without due recognition of crowd-thinking (which often seems crowd-madness) our theories of economics leave much to be desired.
BERNARD BARUCH
Ben Graham had likened the behavior of stocks to that of a kindly but fickle fellow named Mr. Market. Now manic, now depressive, Mr. Market’s next quotation was anybody’s guess. The trick for the investor was to ignore his unpredictable mood changes. But on October 19, 1987, investors had fallen dumbly under his spell, selling stocks—any stocks—tick for miserable tick.
This proved to Buffett what he had already known—that Graham had been abandoned. He had been shelved for academic “witch doctors” who peddled “arcane formulae” and “techniques shrouded in mystery.” Though “Ben’s allegory” was a fitting-as-ever prophylactic against the “super-contagious emotions that swirl about the marketplace,” scarcely a business school in the country used Graham’s texts. Instead of price and value, Buffett lamented in a postmortem, “professionals and academicians talk of efficient markets, dynamic hedging and betas.”1
The crash had exposed Wall Street along its intellectual seam, but the debate had been festering there for decades. Since the sixties, Graham-and-Dodd investors, led by Buffett, had been waging a war with modern financial theorists. Oddly, the most successful investor of the age, and perhaps ever, had come to be belittled and ignored by the foremost scholars in his field. The monks of finance had shunned him as a heretic, while in Buffett’s eyes, these abbots and friars were engaged in an incestuous effort to prove, with ever greater elegance and seeming precision, that the earth, indeed, was truly flat.
The premise of Buffett’s career was that stockpicking, though difficult and subjective, was susceptible to reasoned analysis. Occasionally, certain stocks sold for far less than they were “worth.” An astute investor could profit by buying them.
In place of that rather modest maxim, scholars had substituted a seductively simple but unifying design, the Efficient Market Theory. In a nutshell, the theory said that at any moment, all the publicly available information about a company was reflected in the price of its stock. Whenever news about a stock became public, traders pounced, buying or selling until its price reached equilibrium. Underlying this truism was an assumption that the old price had been as “wise” as traders could make it. Therefore, the new price—and each succeeding new price—would be wise as well. The traders merely did the work of Adam Smith’s Invisible Hand.
Since everything worth knowing about a company was already in the price, most security analysis was, to cite a popular text, “logically incomplete and valueless.”2 The future course of a stock would depend on new (as yet unknowable) information. A stock, then, was unpredictable; it followed a “random walk.”
If markets were random, investing was a game of chance. Buffett, then, was a lucky investor but not a skillful one, just as the person who repeatedly got heads when flipping a coin was a lucky—not a skillful-flipper. This challenged nothing less than the validity of Buffett’s career.
Buffett’s record also posed a challenge, for it was the inconvenient fact that failed to follow the form. Buffett would taunt the scholars with the evidence of his career, and implicit in his taunts was a simple question: “If you’re so smart, how come I’m so rich?”
Nonetheless, at business schools and economics departments, the Efficient Market Theory acquired the power of sacrament. Its truths were regarded as absolute, whereas competing doctrines were virtually banned. The theory also permeated Wall Street, as well as the investing culture as received in financial talk shows and advice columns. It is, indeed, the intellectual basis for the eggs-in-a-thousand-baskets approach of extreme “diversification,” which is the prevailing bias of most investors today.
The theory fermented at various sites, but from similar yeasts, during the 1950s and 1960s. Among the pioneers was Paul A. Samuelson, the popular Massachusetts Institute of Technology economist and textbook writer. Samuelson was a Keynesian, but where the sardonic Lord Keynes viewed the stock exchange as a casino, Samuelson put faith in market prices. Around 1950, Samuelson subscribed to a tip sheet that charged $125 a year. He soon decided, logically enough, that if the tout service had really “known,” it would have charged far more than $125 or kept its tips to itself.3 This was a forerunner of the Efficient Market Theorist’s joke in which two economists, walking across a campus, spot a $10 bill on the ground. As one bends to retrieve it, the other says, “Don’t bother. If it were really worth $10, it wouldn’t be there.” Samuelson’s landmark “Proof That Properly Anticipated Prices Fluctuate Randomly,” published in 1965, adorned this notion in scholarly cloth. His intriguing gambit was that future events “cast their shadows before them”—that is, they are reflected in current prices.
If one could be sure that a price will rise, it would have already risen.… You never get something for nothing.4
Two years later, Samuelson appeared before the Senate committee looking into mutual funds. As noted, funds of the Go-Go era were charging exorbitant fees, yet it was hard to see that their managers merited any fee at all. The typical fund did not even beat the market averages. As Samuelson explained it, “intelligent people” were “constantly shopping around for good value,” buying bargain stocks and selling dear ones and, in the process, eliminating such opportunities even as they arose.5 The funds’ records were such that they could have done as well throwing darts. John Sparkman, the committee chairman, was stunned. Did Samuelson say darts?
MR. SAMUELSON: What my report says is that the median fund having access to this high-paid management has, in fact, done just as well and no better than twenty random stocks selected from the stock market.
THE CHAIRMAN: When you say twenty random stocks, are you referring to stocks that you just close your eyes and reach down and touch?
MR. SAMUELSON: Yes. Precisely.
THE CHAIRMAN: Or is some expert economist such as you picking them?
MR. SAMUELSON: No. Random. When I say “random,” I want you to think of dice or think of random numbers or
a dart.
The professor, however, did not advocate using darts to pick investments. For one thing, he knew, the Efficient Market Theory had some problems. Stock prices were far more volatile than the expected cash flows of the underlying companies, of which they were, in theory, a mirror. And Samuelson was corresponding with Conrad Taff, the Graham student and early Buffett devotee, who insisted that the theory was bunk. Buffett, who actually had a dartboard in his office for a while,6 was beating the darts every year, Taff would tell him. Samuelson was intrigued, and gradually became a “Warren watcher,”7 the first of many Efficient Market Theorists who puzzled over Buffett rather as an astronomer might wonder about a mysterious star.
But Samuelson did not change his mind. Part of the theory’s allure was that it extended the classical economics of Adam Smith to financial markets. Investors such as Buffett thought of intrinsic value as an inherent quality; it lay “behind, or beneath, the prices observed in the marketplace.”8 The prices themselves were approximations. But to a classicist, the Invisible Hand was perpetually driving market prices and value together. In the extreme view, value only emerged—in a sense, only existed—at the point when buyer and seller agreed on a price. If IBM was trading at $120 a share, then IBM was “worth” $120; it could not be more or less. Of course, this implied that the buyer and seller were acting rationally.
Buffett’s view, of companies and of human behavior, was more circumspect. In the first place, value was not so precise; another also rational investor might value IBM at $130. More to the point, investors were not always rational. At times, and especially under the influence of crowd psychology, investors might pay $160 for IBM—or agree to sell it for only $80.
The Efficient Market Theory had, in fact, begun as an attempt to debunk an aspect of the market’s irrationality. From the time of Graham, Wall Street had peddled the work of so-called technical analysts. By gazing into charts of previous prices, these would-be Merlins deigned to predict the future. Their lexicon was widely adopted; thus, commentators would speak of a stock’s “testing a crucial barrier,” which in fact was not a barrier but an inferred line on a chart. The Efficient Market Theorists exposed the chartists as frauds or, as the University of Chicago economist Eugene F. Fama put it, “astrologers.”9 The price “patterns” were patterns only in retrospect; no one could tell, looking at a chart, whether a stock that had fallen 10 percent would rebound or fall by 10 percent more. (For reasons known only to themselves, Merrill Lynch, Morgan Stanley, Salomon Brothers, and the rest continue to employ such soothsayers down to this day.)
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