Bull!

by Maggie Mahar

  ONLY “OLD FOGIES” BUY STOCKS (1975–82)

  From his perch at Merrill Lynch, Bob Farrell watched investors gradually give up. “A downturn normally has two stages, and investor sentiment goes through two fairly predictable phases,” said Farrell. “First there’s the guillotine stage—the sharp decline. That creates fear. That’s what happened in 1974. Then, the second stage goes more slowly—there’s the feeling of being sandpapered to death. The investor is whipsawed by a choppy market, and then worn down gradually. In place of fear come feelings of apathy, lack of interest, and finally, hopelessness. That is what happened for the rest of the seventies.”

  A few nimble stock-pickers made money. “But, except for a very few stocks that benefited from inflation—oil service companies, for example—it was not a buy-and-hold market,” said Farrell. “You learned to take your profits when you had them.”24

  Most investors who succeeded in the seventies did it by abandoning U.S. stocks and bonds for other types of investments. Gold, for instance, rose by an astounding 19.4 percent a year from 1968 to 1979; diamonds climbed 11.8 percent annually, while real estate became the favorite inflation hedge among small investors, with the price of single-family homes rising 9.6 percent. Shrewd investors who were in the right place at the right time made money in oil stocks—over the course of the decade oil rose 34.7 percent a year. Foreign shares also offered double-digit returns, with the European Australian and Far East Index (EAFE) averaging more than 12 percent a year from the fall of 1970 through the fall of 1980.25

  As for the Dow, it remained mired in a trading range. At the end of the decade, the index stood at 831, still down roughly 20 percent from its 1973 high. Many thought the stock market was all but washed up. In August of 1979, Business Week sounded the death knell with a cover that proclaimed “The Death of Equities.” Part of the problem, Business Week explained, was that younger investors had all but lost interest in stocks: “Only the elderly who have not understood the changes in the nation’s financial markets, or who are unable to adjust to them, are sticking with stocks. From 1970 to 1975, the number of investors under 65 who bought equities had dropped by about 25%; meanwhile the number of investors over 65 purchasing stocks grew by more than 30%.” They just didn’t get it. A “New Era” had begun. Business Week ended its story with “a young U.S. executive” asking, “‘Have you been to an American stockholders’ meeting lately? They’re all old fogies.’”26

  “‘We have entered a new financial age,’” declared Alan B. Coleman, dean of Southern Methodist University’s business school. “‘The old rules no longer apply.’” Business Week all but closed the door on the possibility of another bull market cycle: “The U.S. should regard the death of equities as a near-permanent condition. Even if the economic climate could be made right again for equity investment,” the article’s authors argued, “it would take another massive promotional campaign to bring people back into the market…. The range of investment opportunities is so much wider now than in the 1950s that it is unlikely that the experience of two decades ago, when the number of equity investors increased by 250% in 15 years, could be repeated. Nor is it likely that Wall Street would ever again launch such a promotional campaign.”27 The E-trade ads of the nineties were beyond imagining in 1979.

  In 1980, the bear, always sadistic, allowed investors a glimmer of hope. That year, the Dow scratched its way back up to 950. Then came the crash of 1980–81. The price of oil had been spiraling, and as a result, by 1980, oil and oil-related stocks accounted for nearly one-fifth of the value of the S&P500. When they toppled, so did the index, falling 27 percent. To call the crash of 1980–81 the final blow would be an overstatement. By then most investors had fled the market; the bear was now mauling a corpse.

  In 1982 the S&P 500 went begging. At its low that year, General Electric traded at $1? (after adjusting for splits), or 10 times earnings; Procter & Gamble changed hands at 8 times earnings; Colgate-Palmolive at 7 times earnings. The auto industry had been savaged: Chrysler, Ford, and General Motors were all lower than they had been 20 years earlier.28

  Little wonder, then, that on August 23, 1982, when Barron’s put a bull on its cover, some readers were only slightly less hostile than they had been when Richard Russell called the bottom of the bear market in January of 1975. Barron’s couldn’t help but celebrate; the third week in August had been so sweet. On Tuesday, the Dow gained 38.81 points; on Wednesday, a record 132.69 million shares traded on the NYSE; Thursday was delightful “because it proved that Tuesday was no fluke,” wrote Barron’s’ Alan Abelson, and Friday, the Dow rose again, “only 30 points to be sure,” he conceded, “but it topped off the week.” Nevertheless, cynical readers saw Barron’s’ cover as a contrary indicator: “This sure is encouraging to those of us who regard the upsurge of the past couple of weeks as one big bear trap—an exaggerated version of what happened in November of 1974,” wrote one sour subscriber, “he who laughs last…”29

  Barron’s itself expressed caution: “Is This Bull for Real?” the cover asked. The economy was far from strong. Unemployment was high, corporate profits unimpressive. The one positive signal: inflation was fading.

  Year after year, investors had watched inflation honeycomb their savings while consumer prices climbed: up 6.7 percent in 1977, 9 percent in 1978, 13.34 percent in 1979, 12.4 percent in 1980, and 8.9 percent in 1981. At the beginning of ’82, in a letter to Berkshire Hathaway’s shareholders, Warren Buffett described inflation as “a gigantic corporate tapeworm” gorging itself on corporate profits. “Even a business earning 8% or 10% on equity has no leftovers for expansion, debt reduction or real dividends,” Buffett observed. “The tapeworm of inflation simply cleans the plate.” In February of ’82, Buffett remained pessimistic about long-term inflationary trends.30

  But this time, the Sage of Omaha was wrong. In the spring, the tide began to turn, and by year-end, Washington would announce that the consumer price index had risen just 3.8 percent. Stock markets are supposed to anticipate changes in the economy, and the rally that began in August had done just that.

  —4—

  THE CURTAIN RISES (1982–87)

  August 1982, and the curtain rose on the Great Bull Market of 1982–99. Over the next 17 years, the drama would unfold in three acts.

  Act I stretched from the summer of 1982 through the end of 1989. First the bull learned to run—by the end of 1985, the Dow had doubled. Then he learned to jump: in 1986, the index gained almost 350 points. But it was not until 1987 that the bull jumped over the moon: Dow 2700. The first phase of the bull market reached a climax that August. Two months later, the market blew up. In one day, the benchmark index plunged 22.6 percent. Despite the shock, “Black Monday,” October 19, 1987, proved to be merely an intermission. By the end of 1989, the Dow had made up for its losses, ending the year at 2753.

  Act II began inauspiciously, with the recession of 1990–91.1 Indeed, during the early nineties, Main Street and Wall Street seemed to take separate paths. As the “downsizing” that began in the eighties accelerated, Wall Street celebrated: fewer workers meant lower costs and higher profits for corporate America. On Main Street, by contrast, downsizing meant breadwinners without jobs. Layoffs also put a cap on wages. Insecure workers would not ask for raises—good news for shareholders, bad news for wage earners. Thick-skinned, the bull forged ahead. When this second phase of the bull market came to an end in December of 1994, the Dow stood at 3834—up almost 40 percent in five years.

  Act III began in January of 1995, and now the People’s Market lifted off. As at any good play, this final act of the bull market of 1982–99 would be met with a willing suspension of disbelief.

  HOW IT ALL BEGAN: FINDING A RIDER (1982)

  The Dow had been straining to breach the 1000 barrier for some 16 years. Finally, it had succeeded. By May of 1983, the benchmark index had reached 1200. Nevertheless, the Dow still was not worth what it had been when it first brushed 1000 in 1966: Dow 1200 was equivalent t
o only about Dow 600 in 1966 dollars. If investors looked at their nest eggs in terms of their purchasing power, buy-and-hold investors who purchased stocks in 1966 remained underwater.2

  No wonder investors did not race to embrace a bull market. True, in 1982, stocks were dirt cheap—but this is only another way of saying that no one wanted to buy them. The Dow was now trading at seven times earnings. In most businesses such a sale would bring customers running. But one of the peculiarities of Wall Street is that buyers shun a bargain.

  Indeed, in the summer of 1982, Wall Street’s bull resembled nothing more than the mechanical bull in the 1980 movie Urban Cowboy. The beast in that Texas barroom would not move until someone fed it cash.

  Trouble was, there were not very many cowboys left on Wall Street. The August rally caught everyone’s attention—still, many asked, “Is it just another bear trap?” Some labeled the flurry “panic buying” by fund managers afraid of being sacked if they missed the summer surge. Wall Street’s pros had been playing defense for so long that they had forgotten what it was like to ride a winner.

  Surveying the scene that August, Morgan Stanley’s Barton Biggs was reminded of a pivotal moment in World War II. After defeating Rommel in the Battle of Alamein, British Prime Minister Winston Churchill was ready to go on the offensive. “But first,” Biggs recalled, “he had to replace his most senior officers: the officers who for so many long years had fought so bravely in rear-guard actions, retreating, containing the damage, conserving their force against…a superior enemy, by 1943 they had the wrong instincts trained into them for successful offensive action. They were simply unable to commit troops and boldly exploit victories by pursuing a fleeing enemy. They were too cautious. They always looked for the trap….”

  Drawing the parallel to Wall Street, the 50-year-old Biggs observed that “younger money managers…who have never run money in a real bull market…tend to be skeptical of stocks, and hold the highest short term money positions. I think the era of the old-timers is very close,” he added, referring to that small but hardy band of Wall Street veterans who remembered the bull market of the sixties, somehow survived the crash of 1973–74, and lived to manage money another day.3

  Biggs was right. In ’82, there were just enough professionals left on Wall Street to recognize a bull when they saw one. Bob Farrell, Merrill Lynch’s top market timer, was one of those veterans. Farrell was the fellow who turned bearish in 1969 (causing some consternation at his firm), and in August of ’82, as the rally took wing, he remained cautious. By October, however, Farrell was confident: “The move has good breadth,” he told Barron’s, “and everything’s in gear.”4 By the end of the year, the S&P 500 had gained 14.8 percent.

  “After that,” Farrell recalled years later, “the thing just fed on itself.”

  But as ’83 began, Farrell realized that there was a speculative edge to the stampede. Initial public offerings were hot—too hot. In the first quarter of 1983 corporations floated $8.7 billion of new stock, up 378 percent from a year earlier. The IPO frenzy marked the tail end of a hi-tech boom that began even before the broad market took off, in 1980, the year that both Apple Computer and Genentech, a pioneering biotechnology firm, went public. “At that point, financial institutions were buying the IPOs,” Farrell recalled. “But as the quality of the new issues fell, the individual investor came in. As the gains get more obvious and everyone sees how ‘easy’ it is, the public joins the party. It’s all a come-on game.”5 By the spring of ’83, high hopes had kited the price of some tech shares to 30 or 40 times earnings.

  From that balmy summit, the IPO market plummeted. Over the next few months, many of the new issues were cut in half. By fall, the Nasdaq, the broadest measure of technology stocks, had tumbled 18 percent from its high earlier in the year.6 Tech stocks had lost their sheen. The sector would not take off again until the end of 1990.

  The cause of technology’s plunge was clear: excess liquidity. Too much cash had been chasing too few deals. There just were not enough good companies to go around. “The broad market stayed up for the rest of ’83,” Farrell recalled, “but it stopped making progress. And in ’84—it tailed off.” That year, the S&P 500 eked out a gain of just 1.4 percent.7

  Now, the bull looked around for more fuel. But who would stoke the fire? Individual investors were not ready to place large bets. For more than a decade, small investors had been conditioned to be suspicious of rallies, and those adventurous enough to jump into the IPO rally had been badly burned. It would be years before they shifted gears. Three years after the bull market began, individuals still accounted for only 11 to 15 percent of daily volume at the New York Stock Exchange—down from more than 40 percent in 1975.8

  For 20 years, private pension funds had been driving the market, putting an average of 55 percent of the new money that came their way into equities. But they, too, had turned cautious: in 1982, pension funds invested only 24 percent of their fresh money in stocks.9 The question remained: Who would provide the liquidity needed to carry the bull market forward?

  The answer: corporate America. Every bull market finds a new buyer. In the fifties, the investing public began to step up to the plate. In the sixties, pension funds, mutual funds, and other institutional investors provided the cash. And in the eighties the bull found yet another new customer. Foreign buyers played an important role in the market of the eighties, but the real demand would come from corporations themselves, buying back their own shares or, in the case of takeovers, other companies’ shares.10

  THE TAKEOVER FRENZY

  From 1984 to 1987, mergers, takeovers, buybacks, and leveraged buyouts slashed the supply of stock available on the open market by more than $250 billion. By 1988, no less than 121 firms had vanished from the S&P 500. Demand rose while supply shrank. Inevitably, prices soared.11

  Ironically, it was inflation—the bête noire of the seventies—that inspired the takeover boom of the eighties. While share prices stagnated, inflation boosted the replacement cost of many a corporation’s real assets. The land it sat on, the factories it owned, the machinery it used all became more valuable. But at the end of a 16-year bear market, share prices did not reflect the hidden value of corporate America’s underlying assets. As early as the late seventies, shrewd investors spied a gap between what the market was willing to pay for a company’s shares, and the value of its assets if that same corporation was acquired and dismembered, its assets sold off one by one. At the same time, corporations interested in expanding recognized that it would be cheaper to acquire a competitor rather than to buy the real estate and equipment needed to enlarge its own operation.12

  In order to raise the cash for mergers, acquisitions, and leveraged buyouts, corporations issued debt. But interest rates were still steep—even in 1985, 30-year government bonds continued to pay 10 percent. In order to tempt investors, corporations had to offer high yields. Drexel Burnham Lambert’s Michael Milken, king of the high-yield “junk” bond, was happy to be of service, and by the mid-eighties, junk bonds were driving the takeover market.13

  Junk bonds offered investors of the late eighties what they craved: double-digit returns. In return, investors accepted a higher risk that the borrower would default on the loan. Typically, junk bonds were rated “BB” or below, and offered little or no real collateral to back up the loan—no real estate, no equipment, no land. Instead, the borrower pledged to pay junk bond investors dividends as high as 14 percent out of future cash flow.

  Junk bonds were used to raise the cash needed for leveraged buyouts—or LBOs. In a classic LBO, insiders, rather than outsiders, took over a corporation. Top executives found a small group of investors with deep pockets, and together they borrowed heavily to buy up the company’s shares. When the deal was done, the company’s stock had disappeared from the public market: this is what it meant to say that the company had “gone private.”

  The process transformed the capital structure of corporate America. In the past, just about the only
respectable mission for a CEO was to expand. The 1980s introduced a new and radically different goal: shrinking equity while increasing debt. As the new management sold assets and repurchased shares, the equity portion of the total might shrink from 50 percent to a closely held 5 percent (owned by the manager/owners and a select cadre of investors who had helped finance the LBO). Meanwhile, debt exploded.14

  In theory the debt would serve as a spur, goading the managers to slash costs and generate cash in order to keep up with steep interest payments. In other words, they would be motivated by fear. (In the nineties stock options would be hailed as the new “incentive” needed to motivate top management. Why handsomely paid executives needed an incentive to persuade them to do their jobs—in either decade—was never explained.)

  Dealmakers also liked to point out that by taking a company private they freed management from worrying about pleasing and appeasing a horde of outside investors. The senior executives who owned and ran the newly restructured company had to answer only to a handful of outside investors who shared their interests and long-term vision. Rather than fretting over quarterly earnings reports, management could concentrate on long-term strategy. Or at least this was the story.

  It all seemed such a splendid idea that from 1981 to 1988 almost 1,550 U.S. companies went private—nearly as many as the number still listed on the NYSE in ’88.15

  A blizzard of buyouts, takeovers, and mergers bid share prices ever higher. Inevitably, as demand mounted, the price paid for many companies exceeded the value of their underlying assets. But behind the deals stood the insatiable egos of the dealmakers. “Hoisted onto the auction block, the company became a vast prism through which scores of Wall Streeters beheld their reflected glories,” wrote Bryan Burrough and John Helyar in Barbarians at the Gate, a narrative that captures the grandiose madness of the era.16