by Robert Rubin
“I’m a former public servant, coming to seek your assistance,” I said with mock seriousness. “How would you advise this public servant about how to invest his savings?”
Michael laughed. He had disbanded his hedge fund but still actively managed his own not inconsiderable fortune. Karen Cook, whom I had known from the Goldman Sachs trading room, worked with him, reviewing hedge funds as possible investment vehicles. Michael generously offered me full access to Karen’s research. He told me he was investing in various stocks and hedge funds.
“But Michael, I don’t understand,” I said. “You agree that the market may well be overvalued. And yet you say that you’re invested in the market.”
“People like you keep telling me the market is overvalued,” he answered. “But tell me what you think will precipitate a correction.”
“I don’t really know exactly what will cause it,” I said. “Won’t it just fall of its own weight?”
“But something has to precipitate it,” Michael responded. “And the problem with people like you who keep talking about how overvalued the market is, you can’t point to anything that’s going to precipitate a fall.”
“Well, it’s true,” I said. “I don’t have any idea what it will be. But if it’s overvalued, it’s going to correct. Whatever the proximate precipitator is doesn’t matter. It could be anything.”
By 1999, many shrewd investors were in Michael’s position. In an analytic sense, they thought the market was overvalued but stayed invested anyway, perhaps on the “greater fool” theory that they could profit from an irrational rise and then sell their positions before it was too late. In any case, the relatively few nonbelievers were irrelevant after an eighteen-year bull market that simply fed on itself. The skeptics among market analysts and forecasters had lost their credibility. Nobody—including me—is particularly good at predicting shorter-term market movement, and if I had been invested in stocks during the later half of the 1990s, I would have sold or lightened up much too early. But it does seem to me that investors should at the least have recognized that many conditions had gone to excess by any historical standards and have given that serious consideration in their decision making.
It was striking during that period not just that financial markets went to extremes but that, when they did, people developed convincing intellectual rationales for those extremes. Those rationales seemed plausible both because they reflected real and positive economic developments and because the ongoing behavior of the market appeared to confirm them. By 1999, after an eight-year boom, many commentators were asserting that productivity growth was going to continue at much higher levels indefinitely and that business cycles were history. Two other widely held views were that the Fed was omnipotent and that the market had misunderstood equities all along, with the result that historical risk premiums—the additional return investors demand to hold stocks rather than “risk free” Treasury bonds—were much too high. While Steve Einhorn is correct that equities have outperformed bonds over any extended period of time historically, some digested this view into the shorthand that stocks simply weren’t risky over the long term, or even that short-term declines would always be temporary and that stocks would quickly bounce back.
As an aside, these views provided support for a movement to convert part of the Social Security system into private accounts that could be invested in equities—a political cause that largely faded away after the dramatic market rise of the 1990s came to an end. If this proposal is going to be seriously revived in the political arena at some future time, the very substantial risks attendant to stock ownership should be fully included in the analysis. But it concerns me that the outcome of the debate may be unduly influenced by an ebullient market environment—the only context in which such a proposal is likely to have political viability. Another problem is that there could be irresistible political pressure to make up for shortfalls in accounts for people who retire when market conditions are adverse. This could create additional fiscal problems and skew investment incentives for private account holders. My own view is that we should preserve the guarantee of Social Security, but consider establishing tax credits for savings accounts on top of that, when this is fiscally feasible. If the Social Security guarantee itself needs reform because the system is underfunded, then that is a separate matter that should be dealt with directly.
Each claim about what had changed in the economy reflected some underlying reality. But in most cases, the conclusions for markets were greatly overdrawn. Take the theory that technological advance had led to a structural increase in productivity growth. The issue may not be fully settled, but assume for the sake of argument that the theory’s proponents were right. Surely that would be good news for the economy and for stocks. But it was an immense and illogical leap, as some proponents argued, from technological development to permanent and uninterrupted prosperity, with at most brief and mild interruptions. Or consider the view that business cycles had become a thing of the past. It is true that cyclical recessions have tended to become progressively less severe since the end of the Second World War, in part because of various social safety net programs, such as unemployment insurance and welfare, which increase government spending when the economy is weaker, and because monetary policy has become more effective. However, business cycles remain, because the constants of human nature, such as greed, fear, and complacency, have not changed. As for the Fed, it has indeed become a far more important factor in the economy in recent decades, but it is not powerful enough to prevent all slowdowns. Perhaps risk premiums were once too high, but that didn’t mean that stocks weren’t still significantly riskier than Treasury bonds.
In that kind of environment, the highly charged atmosphere, not evidence and logic, tends to carry the day. Even Sir Isaac Newton, the great English mathematician and physicist of the seventeenth century, was a major investor in the most extreme financial excess of his day, which became known as the South Sea Bubble. The South Sea Bubble grew out of a scheme to convert British government obligations into common stock in a company with a theoretical monopoly on British trade with South America. Practical obstacles abounded: the company’s “officers” had never been to South America; they had scant ships or supplies; and there was no reason to believe the King of Spain would allow Britain to trade with his colonies. Thousands who invested were destroyed financially.
That episode typifies the psychology of market excess. You’re sitting on the sidelines, telling the people around you all the reasons why you think the market may be badly overvalued. And they’re all looking at you, saying, “There’s a new reality, and you don’t get it. You don’t understand how much the world has changed—which is why people like you always fall by the wayside.” That was my experience from the mid-1990s on. Though the underlying strength of the economy was very real, I thought the stock market was probably overreacting.
My concern about market excesses, as I mentioned earlier, inevitably raises a question of great importance to future policy makers: Could Treasury or the Fed have done something to moderate the stock market excesses that seemed to be developing and that could endanger the economy? Alan, Larry, and I discussed this frequently. Though I felt strongly that the markets had gone to excess, I couldn’t be sure I was right and the market wrong. (And in fact, had I chosen to give a warning, I would have done so years before what turned out to be the peak.) Secondly, it was not clear that what we said would have had any real effect. Finally, if our comments did have an effect, they could precipitate a sudden unraveling rather than an orderly decline. And issuing market forecasts that turn out to be wrong can quickly undermine the more general credibility of the prognosticating public official.
But, in speeches and TV interviews, I did the most I thought was sensible for a public official to do: I urged investors to focus seriously on risk and on valuation and said that discipline seemed to have flagged. I don’t think many people paid much attention. Some commentators have since said that tig
htening margin requirements on common stocks to limit leverage could have helped—either through the limit itself or as a symbol of concern. My own view is that doing so probably would not have had any effect, or at least not enough to make a real difference. Some have also argued that Greenspan should have managed interest rates for the express purpose of dampening the market. I strongly share Alan’s view that monetary policy should be directed toward the economy, not the stock market, both because the Fed is no more able to judge whether markets are too high, too low, or just right than anyone else, and because Fed actions driven by markets might be at variance with the best policy for the economy. But as Alan has explained in testimony to Congress, this issue can become extremely complicated, in part because the stock market affects the economy in many different ways. In any event, critics who argue for using interest rates to influence the stock market might quickly change their minds if the Federal Reserve Board actually did that.
BY THE TIME the long bull market finally came to an end, a sense of unreality permeated the entire business world. Many in Silicon Valley were of the opinion that nothing that took place outside the Valley was relevant to them. You would meet twenty-five-year-olds who thought that nothing that had happened before the Internet mattered. We were in a new world, free of business cycles and traditional notions of valuation. Those who didn’t understand these new realities were hopelessly outmoded in their thinking.
My sense of the delusions of that era is encapsulated in a story from January 2000, just before the technology bubble began to deflate. The CEO of a dot-com company came to see me at Citigroup. Just what his company did was unclear to me, but at the time it was seen as possessing new technology of immense potential. At its peak stock price, the company, which had no earnings to speak of, had a market capitalization that exceeded $20 billion—far more than that of many very large, historically profitable industrial concerns—and the CEO was a multibillionaire.
Not given to modest claims, the CEO told me that the company had developed technologies that were going to “obliterate” the financial services industry in its current form. Citigroup’s only hope for survival was to partner with him.
“You may well be right, but I’m not qualified to judge your technology, so how can I evaluate that statement?” I responded. I suggested he meet with our technology people.
He was nonplussed. “I don’t meet with technology people,” he said. “I just told you how you can save your bank. Don’t you want to save your bank?”
It was an amazing meeting. The CEO did eventually meet with people in our technology division, but nothing came of that. The company’s stock later fell dramatically.
The S&P 500 dropped from 1,527 in early 2000 to 777 in the fall of 2002. The NASDAQ went from 5,049 to less than 1,114—a drop of almost 80 percent. And the Dow Jones Industrial Average fell from a high of 11,723 to a low of 7,286. All in all, from peak to trough some $8.5 trillion in paper wealth, of what had been a total market capitalization of almost $18 trillion, was lost. More than one thousand publicly traded companies either went bankrupt or were delisted from the major exchanges.
Steve Einhorn argues that the market reversed course for specific reasons. And I agree that there were real changes in that period that certainly would have been expected to affect stock prices: the fear of terrorism after the World Trade Center attack, the economic slowdown, and the whole host of corporate governance and Wall Street issues, to name three. But, in my view, the change in market prices and market psychology was far greater than the change in the underlying economic realities. I still think that the most fundamental explanation is that the market fell of its own weight. A substantially overvalued market has to come down—and better sooner than later. Everyone would have been better off if stocks had regained a semblance of sanity sooner. But it’s good that it didn’t happen even later, with an even steeper fall from even higher levels. The market drop also caused at least some people to begin discussing valuation more realistically.
Even after the decline, however, many of the old assumptions about the long-term behavior of stocks persisted. The belated effects of the eighteen-year bull market—the only kind of market people younger than forty had ever known—continued to support unrealistic views about equities. Complacency about stocks and the view that they would regularly provide returns of 15 to 20 percent, with interruptions being brief and quickly repaired, had become so powerful that they partially survived the sharp decline and the large losses incurred.
In the search for the villains who had caused the market excesses, people tended to disregard the most obvious one of all: the widespread notion that the stock market was a path to easy riches. For many years, the securities industry has emphasized the benefits of everyone owning stocks and “investing in America.” In one sense this may be right, but my view is more complicated. The great broadening of stock ownership over the past couple of decades has been a positive force, both for individual investors and for society, by sharing the benefits of ownership more broadly and by giving more people the feeling of having a greater stake in our system. And allocating a portion of one’s assets to stocks probably does make sense for most people. But any investment should be accompanied by a realistic focus on the risks of equity ownership and a rigorous approach to valuation. Some who invest understand the risks, but too many do not. And too often, the industry—and the media—have not done a good job of explaining these risks to the investing public.
MANY OF THE FACTORS that contributed to the market excesses remain issues even after the collapse. One that continues to trouble me is the prevalence of short-term thinking and an excessive focus on quarterly earnings, rather than on long-term results. Indeed, the disproportionate attention paid to the short term, which preceded the market boom of the 1990s, seems to have survived the decline largely intact.
How did this attitude develop? There have always been people trying to get rich quickly in the stock market, of course. But my sense is that the mentality of the market changed significantly around the time I joined Goldman Sachs in the mid-1960s. During my early years on Wall Street, investing in stocks was still viewed by many as a long-term proposition, primarily for institutions and wealthy individuals, though all that was already changing rapidly. I remember Bob Danforth, the head of our research department, telling a story about the 1950s. Bob said he had sent out a research report recommending Chesebrough-Pond’s, the cosmetics company that made Pond’s Cold Cream and Vaseline. A year later, he got a big order. The client called and said, “We’ve read your report, we’ve studied it and thought about it. And now we’re ready to buy the stock.” Bob was very pleased.
In those days, markets were slower, transaction costs were higher, and middle-income people were far less focused on the stock market in general. When I graduated from law school, 6 million shares would trade on a busy day on the New York Stock Exchange, compared to an average volume today of more than a billion shares. Contrary to the common view on Wall Street, I would say that this was better in some ways. The markets were less efficient, to be sure, but there was also less emphasis on short-term trading, more emphasis on long-term prospects and the fundamentals of companies, and a more balanced sense of the risks in owning stocks.
I don’t want to draw too rosy a picture of what markets were like before the ’90s boom. Greed, fear, and complacency are constants of human nature. Speculative excesses have always occurred. The mid- to late 1960s, in particular, were marked by a lot of volatility and excess; a well-known book about that period was titled The Go-Go Years. But even at the height of the 1960s excesses, many people remained affected, at least to some extent, by the 1930s. Memories of the Great Depression influenced thinking about markets for the older generation working on Wall Street, in the media, and for much of the American public. Many people still retained a sense that stocks were inherently risky. They knew in their bones that the worst could happen in markets.
By the 1990s, most of the people of Gus Levy’
s generation, who had experienced the Depression personally, were gone, and attitudes had continued to shift more broadly. The change in mentality coincided with enormous changes in the market, driven in part by the increasing clout of institutional investors: pension funds, charitable endowments, and mutual funds. You might think that these funds, which were professionally run, would have been long-term investors, so-called patient capital. After all, pension funds fund long-term liabilities—retirement savings. But that wasn’t what happened. Pension funds became a driving force for short-term thinking in corporate America.
Consider how it worked for a big industrial company such as General Motors in the 1960s. The company’s pension fund was required to have sufficient resources to fully meet future expected pension costs. So, every year, General Motors had to make a contribution of more than $40 million to its pension fund. That contribution is a charge against earnings. But the better the performance of the stocks in the fund’s portfolio, the smaller the company’s annual contribution would have to be—or perhaps no contribution would be needed at all. Earnings would thus be higher, which would help raise the company’s stock price. So, as companies were being evaluated more and more on their quarterly earnings, those companies began to focus more on the short-term performance of their own pension-fund portfolios. The very CEOs who complained about quarterly pressure were putting quarterly pressure on their own money managers, who would in turn put pressure on the companies in whose stocks they were invested. The result was a cycle that was, depending on one’s perspective, either virtuous or vicious. And as mutual funds turned into popular investment vehicles and a competitive industry, the same phenomenon occurred there.
Other changes fueled this increased focus on quarterly earnings as well. Fixed commissions on the New York Stock Exchange were abolished on “May Day,” May 1, 1975, and firms started to give discounts on large trades. This meant that wealthy individuals and institutional investors were able to trade much less expensively, which intensified their short-term focus on the market and increased portfolio turnover. Transaction costs for middle-class investors remained relatively high until the early 1990s, which discouraged individuals from trading small quantities of stock frequently. But with the rise of discount brokerage houses such as Charles Schwab, and the advent of on-line trading, people of modest means could buy and sell a few hundred shares for a commission of $20 or less at the touch of a button. The bull market that began in 1982 and the advent of easier and cheaper trading encouraged less sophisticated investors to trade more and more. Again, the conventional view is that reduced costs and greater ease were a uniformly positive development. In my view, they were a mixed blessing.