Bull!

by Maggie Mahar

  There was just one catch: as the LBO market took off, junk bonds, not cash, drove the market. As investors would later discover, “BB” bonds provided a shaky foundation for a boom.

  THE SHORTS—JIM CHANOS (1985)

  By 1985, the party was in full swing. Leveraged buyouts, takeovers, and share buybacks were vacuuming up the supply of stocks. As always, while the size and price of the deals rose, the quality declined. In the financial world, “good ideas become bad ideas through a competitive process of ‘Can You Top This?’” noted Jim Grant in 1989.17

  The editor of Grant’s Interest Rate Observer would become a leading member of the bull market’s Greek Chorus—a group that was largely ignored by the investors who drove the plot forward. As the bull market advanced, Grant would play out the thankless role that fate had assigned him, offering his sardonic commentary on unfolding events, often foreshadowing the action to come. This is, of course, another way of saying that he was early.

  By the end Act III, however, it would become apparent how often Grant was right—even if his timing was off. “Jim realized what was wrong with Cisco’s earnings long before any of us,” Byron Wien, Morgan Stanley’s chief domestic strategist, pointed out in 2002.18 But then, a Greek Chorus is always out of synch with the rhythm of the play.

  As the buyout binge continued, Grant worried about the debt that was “larding the Forbes Four Hundred.”19 He could see that, just as at the beginning of the decade, there were not enough good deals to go around. For as demand spiraled, supply shriveled: by September of ’85, $190 billion worth of stock had disappeared from the open market in just nine months. And the deal making showed no sign of letting up.20 The market was awash in cash, and the broad index rose with the tide. In early November, the Dow punched through 1400; by the end of ’85 the S&P 500 had gained 26.3 percent—31.7 percent with dividends reinvested. (Dividends were still high enough that they made quite a difference.)

  Inevitably, such a rich market brought out the “shorts”—investors who make their money by betting that stocks are overvalued. In June of ’85, The Wall Street Journal reported, the number of shares sold short on the New York Stock Exchange had reached a record 253 million. At that point, the Journal decided to launch a three-month investigation into what was seen, in some quarters, as the dark art of short selling: “Loosely Allied Traders Pick a Stock, Then Sow Doubt in an Effort to Depress It—Gray Area of Securities Law,” the subheadline read.21

  The story reflected the mood of the time. Some form of short selling has been around as long as there has been a stock market, but in the tender years of a bull market, “the controversy it generates is becoming increasingly sharp,” Wall Street’s paper of record reported. By the summer of 1985, Jim Chanos, a 27-year-old analyst and vice president at Deutsche Bank Capital Corp., the New York investment affiliate of Deutsche Bank, had become one of the most visible short sellers on the Street. That made him a special target for the critics who charged that modern short sellers often employed “innuendo, fabrication, and deceit” to swamp a vulnerable stock.

  Tall and lanky, wearing wire-rimmed glasses, Chanos looked more like a college professor than a Wall Street sharpshooter. His manner was modest, but he could not help but agree that his reputation loomed large: “People think I have two horns and spread syphilis.”

  Yet, in his own way, Chanos was simply a value investor: his success rested on his research into the fundamentals of the companies he shorted. The only difference was that while most value investors try to make a profit by buying low and selling high, short sellers reverse the process: their aim is to sell high and buy low.

  When a short seller spots a stock that he thinks is overvalued, he borrows a block of its shares from a broker or large institutional investor and then turns around and sells the borrowed shares. He then watches the stock, hoping that it will tumble before he must repay the loan. If he is lucky, and the stock craters, he buys the shares he needs to cover the loan and pockets the difference between what he pays for the new shares and what he made when he sold the borrowed shares. But if the stock climbs, the short seller must pay more to replace the shares, and he takes a loss—sometimes a big loss.

  While some shorts attempt to make a living simply by spreading rumors and sowing seeds of doubt, they are not likely to stay in business for long, at least not in a bull market. For one, the institutional investor who lends the shares to the short seller can demand their return at any time. If the short is forced to repay the loan while the stock is still rising, the cost can be enormous. In essence, then, a short seller is placing his faith in a relatively efficient market: he is betting that the market will discover its mistake and correct the price of the overvalued stock before he is forced to repay the loan.

  To survive in a bull market, shorts must be right more often than they are wrong. This means being able and willing to do the in-depth research needed to expose slippery accounting—research that most Wall Street analysts have neither the training nor the motivation to do. By default, short sellers frequently become the market’s whistle-blowers. While Wall Street’s analysts may close their eyes and say a stock is worth whatever the public is willing to pay, shorts have a material interest in doing the hard work needed to get the numbers right.

  What made Chanos stand out was both the quality of his research and the fact that he chose his targets carefully. Many shorts take a shotgun approach on the theory that if they short scores of overvalued companies, some of the prices will tumble. Chanos, by contrast, typically spent months researching a stock, and then took a large position for a long period of time.

  Nevertheless, few corporate executives appreciated his efforts. “This guy has caused us such grief: we can’t stand this guy,” the chairman of one company confided in the fall of ’85, after acknowledging that his company was part of a group that launched a private investigation of Chanos in hopes of catching him doing something wrong. (Chanos later reported that a maintenance man at his town house saw someone going through his garbage.) Some of his conversations were secretly taped. In the end, the detectives found nothing. One summed up the results: “Chanos lives a nice, quiet yuppy existence.”22

  Chanos himself viewed his situation with some irony. He had, after all, come to the financial world by default. After graduating from Yale in 1980, he cast about for a profession. “I didn’t get into law school,” he recalled without much regret. “And at the tail end of the bear market, Wall Street was not the place to be. The really good jobs were in commercial banking,” he remembered, grinning. “At that point, kids right out of college could get into banking and make loans to Latin American countries,” said Chanos—referring to the bad loans that nearly destroyed some of the biggest banks in the United States. “Those were the hot jobs—you got to travel and hand out all that money.”23

  Since Chanos was not able to land one of those plum posts in Latin America, he had to settle for a job as an analyst at Blyth Eastman Webber in Chicago, before moving to Gilford Securities, another Chicago firm. Then, in August of 1982, just two years out of college, the 23-year-old’s career caught fire. That year, he spotted trouble at Baldwin-United, a huge life and mortgage insurance company. Taking a close look at Baldwin’s financials, he realized that the company’s supposed earnings were coming largely from questionable tax credits and complex asset-shuffling among its 200-plus subsidiaries. Chanos urged Gilford’s clients to sell the stock. In fact, he had the temerity to go one step further: he advised them to sell the stock short.

  Chanos was a maverick. Even in the early eighties Wall Street analysts shied away from issuing “sell” recommendations, let alone “short” recommendations. After all, most worked for brokerages, and their firms made their money by persuading investors to buy. In 1983, major brokerage houses issued 10 “buys” for every “sell,” according to Zacks Investment Research. Analysts feared offending the captains of industry. For their information, many depended on tips from executives they had befriended. If they cri
ticized a company, they feared losing access to top management.24

  Predictably, Wall Street ignored Chanos’s warnings. Baldwin-United was a market darling; after the young analyst put out his report, the stock more than doubled. But Chanos knew that the company had “gamed” its books, and for more than six months, the 23-year-old sweated it out.

  Baldwin threatened to sue. Gilford Securities’ clients got the jitters. Outraged at being found out, Baldwin’s president branded Chanos and Gilford “those vultures in Chicago.” Finally, in March of 1983, Baldwin-United admitted that it could not repay $800 million of short-term debt. In the months that followed, almost every day brought new revelations of Baldwin’s crumbling finances. In August, Baldwin announced that it was filing for bankruptcy. Ultimately, some $6 billion of stock market wealth evaporated, and holders of billions of Baldwin-United annuities were left in the lurch.

  Reportedly, veteran analysts had missed the holes in Baldwin-United’s accounting because many were “mesmerized by the salesmanship of Morley Thompson,” the company’s former president. By contrast, Chanos never met with Thompson—and so never risked being overwhelmed by the man’s much-touted charisma. It was as if, in 1999, a Wall Street analyst passed up a chance to meet Cisco CEO John Chambers and, instead, decided to study Cisco’s books. Using the well-known but tedious technique called cash-flow analysis, Chanos discovered that Baldwin-United was paying out more cash than it was pulling in.25

  “When Baldwin-United went under, suddenly my whole life changed,” Chanos recalled.26 The media compared him to David, slaying Goliath. Gilford made him a partner. Other major firms made lucrative offers. Before long, Chanos landed the job that he held in the summer of ’85, as an analyst and vice president at Deutsche Bank in New York.

  At that point, another freewheeling company caught Chanos’s attention: Drexel Burnham. It was apparent to Chanos that Mike Milken, the father of junk bonds, had set up a daisy chain of interlocking deals that were close to collapse. Again he issued a warning. But this time, his employer was not pleased. The word came down from management in Germany: “We do business with Drexel—tell him to keep quiet.” Chanos was told that if he persisted, his days at Deutsche Bank were numbered.

  “I didn’t want to keep quiet,” Chanos recalled in 2001.27 “That summer—the summer of ’85—I decided to look for something else.” As luck would have it, at about that time a client who ran a hedge fund offered Chanos a chance to begin managing a large sum on the short side. In October of 1985, just one month after the Journal published its report on shorts, Chanos opened an investment partnership. Its bearish approach would produce compound annual growth, before fees and expenses, of 26.2 percent from its inception, in October of 1985, through June of 1991, handily beating the S&P 500’s 17.9 percent return.28

  When Chanos launched his investment firm, he christened it Kynikos Associates Ltd. He took the name from the Kynikos, a group of ancient Greek philosophers who believed that independence of thought and self-discipline were the way to true light—and whose name became the root of the word “cynic.” On his lunch hours, the 27-year-old played basketball at a nearby court.

  Seventeen years later, Chanos’s name would become known well beyond Wall Street when he blew the whistle on a company called Enron, going public with his information a full year before the energy trader collapsed. Had investors listened, they could have saved millions. But Chanos, like Grant, was part of the Greek Chorus.

  ON MAIN STREET—THE INDIVIDUAL INVESTOR (1982–87)

  On Wall Street, in the mid-eighties, the dealmakers danced while the shorts looked on askance, but, by and large, individual investors stayed at home. Understandably loath to abandon the hard-won lessons of the late sixties and seventies, most small investors were wary of putting money into stocks. Everyone talked about Wall Street, but few participated.

  Through most of the eighties, the individual investor would be a voyeur. Although he was titillated by tales of the swashbuckling wheeler-dealers novelist Tom Wolfe dubbed “Masters of the Universe,” he did not identify with the high rollers. In the eighties, after all, the average middle-class American did not expect to become a millionaire.

  This is why most Americans do not remember Act I of the bull market in great detail. For Wall Street’s masters of the universe, the period from 1982 to 1987 marked an era of getting and spending, but relatively few shared in the bounty. From 1981 through the end of 1985, the New York Stock Exchange estimated, the number of individual investors increased by just 6 million.29 Over the same span, some 10.8 million Americans lost their jobs in plant closings and layoffs while corporate restructuring and mergers eliminated an estimated 600,000 management positions.30

  In many ways, Wall Street’s surge seemed strangely self-contained. Although share prices rose by more than 200 percent, national output increased barely 40 percent before inflation—and only 20 percent after inflation was taken into account. And while companies used their cash and credit to buy back stock, capital spending, adjusted for inflation, increased only modestly. “The stock market strikes me as being all by itself,” said Charles P. Kindleberger, who was then emeritus professor of economics at Massachusetts Institute of Technology. “There is no real industrial investment boom behind it. It’s a puzzle.”31

  But if the average baby boomer was not participating in the equity boom, he was beginning to think about his future. Anticipating his needs, Wall Street carpet-bombed the populace with financial advice. Tax-deferred 401(k)s and IRAs (individual retirement accounts) were becoming increasingly popular, and newly deregulated S&Ls were learning how to hustle: once staid banks now pasted grocery-store-sized ads on their plate-glass windows: “ONLY 5 DAYS UNTIL APRIL 15. OPEN AN IRA TODAY.”

  Still, the average small investor was not yet snapping up stocks. Why would he? At the beginning of the eighties, money market funds and bank CDs were paying double-digit returns. Between 1980 and 1985, investors who stashed their money in long-term Treasuries enjoyed returns averaging almost 12 percent. To meet the competition, Wall Street peddled a wide array of new products: Ginnie Maes, REITs (real estate investment trusts), tax-free bond funds, and every possible flavor of money market fund. The hullabaloo created the impression that everyone was investing, though in fact everybody was not investing in equities—they were buying other products. (As late as 1992, the largest share of 401(k) money would still be invested in GICs, fixed income investments offered by insurance companies.)32

  Granted, mutual fund ownership grew fivefold in the eighties, but for the majority of investors, “mutual funds” were not yet synonymous with equities. Most preferred fixed-income funds that invested in money markets or bonds. In 1983, Peter Lynch’s Fidelity Magellan fund returned 39 percent, sealing its 10-year record as the best fund in America, but despite Fidelity’s best efforts, mutual fund investors continued to choose dividends over capital gains. In 1986, Americans bought only $28 billion of equity funds—roughly one-fourth of the $120 billion that they poured into bond funds.33 In fact, from the middle of 1983 through October of 1987, there were just two months when more money flowed into stock funds than into bond funds—April 1987 and August 1987.34 Unfortunately, those two banner months came on the eve of the bloodiest one-day crash in U.S. stock market history.

  —5—

  BLACK MONDAY (1987–89)

  August 1987, and on the 14th of the month, The New York Times noted, “The Dow gained, ho-hum, another 22.17 points as Wall Street marked the fifth birthday of the bull market.”1

  The Times’ comment was but one of many signs of greed sated. Even The Wall Street Journal carried a whiff of decadence, telling the story of David Herrlinger, a well-born Cincinnati investment advisor who called the Dow Jones News Service to announce that he was bidding $70 a share for Dayton Hudson.

  “Before anyone could confirm that Mr. Herrlinger had neither backing nor funds,” Jim Grant reported to the readers of Grant’s Interest Rate Observer, “the stock levitated.”


  Asked where the financing for his offer would come from, “Mr. Herrlinger told the Journal, ‘that’s still undecided.’ Asked whether the offer was ‘a hoax,’ he said, ‘I don’t know. It’s no more of a hoax than anything else.’”2

  Mr. Herrlinger was ahead of his time, his offer a harbinger of things to come. Fourteen years later, widespread confusion about the difference between reality and a hoax would allow AOL to acquire Time Warner without putting down a penny of cash.

  In 1987, signs of a top were not limited to Cincinnati. In Florida, Shearson Lehman Brothers had opened a “money management camp” for 10-to 15-year-olds. For only $500, parents could enroll their offspring in a weeklong investment seminar held at a hotel in the Sunshine State where they could play golf or tennis, confident that their children were learning to read both The Wall Street Journal and a balance sheet.3

  There were other, less local signs that the market was getting ahead of itself. While share prices had climbed 200 percent in five years, GNP rose by just 40 percent, 20 percent after adjusting for inflation.4 In late August, when the Dow hit a high of 2722, shares were changing hands at 20 times earnings—a multiple not seen since the market’s peak in January of ’73—just before the catastrophic crash that ended in 1974. And even as stocks became more expensive, Wall Street analysts became more exuberant: for the first time since 1980, more analysts were raising earnings estimates than lowering them.5

  As might be expected, Warren Buffett cast a baleful eye on valuations created by a market built on LBOs and junk bonds. In the 22 years since Buffett had taken over Berkshire Hathaway (which had become, in effect, his new “investment club”), Berkshire’s per-share book value had compounded by an average of 23.3 percent a year. In 1986, the Sage of Omaha enjoyed another incredible year: Berkshire’s net worth grew 26.1 percent. But in the spring of 1987, Buffett revealed that he was no longer shopping for new stocks. In his view, the market was overpriced. Rather than buying equities, he explained, he had put some $700 million into medium-term tax-exempt bonds, the “least objectionable alternative” to bloated shares. Indeed, as far as he was concerned, stocks were so overvalued that “there’s nothing that we can see buying, even if it went down 10%.”6