Bull!

by Maggie Mahar

  Cramer was right: the financial “wizards” he described would indeed play a major role in deciding how to allocate the nation’s assets—though not everyone would agree that they made “close to the best possible decisions.”

  In 1996, the mutual fund managers who topped the charts chased growth, not value. Cramer praised “a new generation of fund managers” for their courage and vision. “These aggressive growth managers pay little heed to book value or balance-sheet considerations,” he wrote. “These managers don’t even care if the product works yet. If it fails the next one might not, and it might be another Cisco…. They are believers. And they bet that way.”4

  Cramer singled out “momentum players” such as Garrett Van Wagoner, manager of the Van Wagoner funds. While value investors try to buy low and sell high, momentum fund managers buy stocks that are already airborne, hoping to buy high, and sell higher. According to Cramer, this new generation of momentum players favored stocks “with promising names like Ascend, Cascade, Avanti and Pure Atria.” As an example of the type of company that they sought, he highlighted Komag, a hard-disc manufacturer that “old-line managers would never have bet on. For one, they wouldn’t have understood what the company was talking about…. But these new managers know this stuff.”

  Once again, Cramer was right: old-line value managers would not have looked high enough to find Komag. Value investors search for what Allan Sloan had called truffles on the forest floor, buying what others may overlook. They care about price. They also care if the product works. Momentum investors, by contrast, are surfers: they ride a stock while it is rising, buying it all the way up, then jumping, just as it crests, to catch the next wave. Or, at least, that is their goal.

  In its own way, momentum investing (aka “chasing a stock”) is a little like falling hopelessly in love. The further the object of desire recedes into the distance, the faster the momentum investor runs.

  In the normal course of things, higher prices dampen desire. When lamb becomes too dear, consumers eat chicken; when the price of gasoline soars, people take fewer vacations. Conversely, lower prices usually whet our interest: color TVs, VCRs, and cell phones became more popular as they became more affordable. But when a stock market soars, investors do not behave like consumers. Rather, they are consumed by stocks. Equities seem to appeal to the perversity of human desire. The more costly the prize, the greater the allure. So, at the height of a bull market, investors lust after the market’s leaders. (Conversely, when the prize is too ready at hand, investors lose interest. At the bottom of a bear market, when equities are bargains, they go begging, like overly earnest, suitable suitors.)

  And so, in the fall of 1996, the momentum players were buying Komag. By the spring of 2002, its shares would be changing hands for less than a penny. As for Van Wagoner, in March of 2003, he would liquidate three of his funds—over three years, all had fallen by more than 90 percent. That spring he also disclosed that the SEC was investigating whether his firm had overstated the value of some of its holdings. The company denied doing anything wrong.5

  In 1996, however, momentum funds were red-hot. And Gary Pilgrim’s PBGH Growth Fund was leading the pack. In 1990, Pilgrim had $12 million under management; by 1996, he was running $5 billion. In the middle of that year, PBGH Growth boasted the best 10-year record of any small company stock fund. All the while, Pilgrim made headlines as he snapped up companies with fast-growing profits, frankly unperturbed by questions of price or value: “Some are underpriced and some are overpriced; we don’t try to figure that out,” he modestly explained.6

  To Pilgrim, high growth did not necessarily mean technology. In 1995, two of his favorites were consumer stocks: Bed Bath & Beyond and Callaway Golf. By June of 1996, Corrections Corporation of America, a leader among for-profit prisons, rounded out a portfolio that reflected the values of the New Economy’s New Society. By then, Corrections traded at 146 times trailing earnings.7

  The aggressive fund managers of the mid-nineties did not confine themselves to small-cap stocks. Large-cap growth stocks also were coming into their own, and Cramer credited this new generation with creating “great wealth” for the nation by pouring investors’ savings into winners such as “Intel, Hewlett-Packard, Microsoft, Motorola, Oracle, Sun Microsystems.” And, last but not least, “Cisco.”

  CISCO

  In the six years from 1990 to 1996, Cisco’s share price snowballed, gaining over 10,000 percent. With a market capitalization of $40 billion, it was now bigger than Maytag, Phelps Dodge, Alcoa, Whirlpool, Bethlehem Steel, Woolworth, and Westinghouse combined. “This,” Cramer noted cheerfully, “despite the fact that…it will make much less money this year than those old-line companies.”8

  But fund managers looking for momentum did not care so much about actual earnings as the rate of quarterly earnings growth, the percent by which earnings grew—or were projected to grow—every three months. Their focus was short-term, their object: speed. As Cramer observed, “Cisco owes its phenomenal rise to its ability to please mutual fund managers, quarter after quarter.”

  The nation’s fund managers could not have worked the “economic miracle” Cramer celebrated without a little help from Wall Street. “As companies like Cisco continually met or exceeded their targets,” he explained, “analysts from these brokerage houses raised estimates and mutual fund managers bought more and more shares.”

  In just one sentence, Cramer had summed up how Wall Street and the mutual fund industry worked hand in hand to stoke the fire: Higher earnings estimates spurred fund managers to pay a higher price for Cisco’s shares; in turn, the fact that fund managers owned the shares encouraged analysts to boost their earnings estimates.

  After all, analysts had an incentive to raise estimates on the stocks that fund managers favored. The fund managers’ votes determined an analyst’s ranking in Institutional Investor’s annual poll, with the highest-ranking analysts commanding enormous salaries. Moreover, a mutual fund was most likely to buy huge blocks of stocks through a particular brokerage if its analysts smiled on the fund’s stocks. “Any analyst can tell stories of downgrading stocks to something as innocuous as a ‘Hold’ rating and being barraged with calls from clients, irate that a holding is falling,” Barron’s’ Michael Santoli reported in 2002.9

  From one perspective, their ire was understandable. Mutual fund managers could not afford a downgrade. As millions flowed into their funds, they had no choice but to take huge positions in individual stocks. If an analyst lowered his earnings estimate by a few pennies, a fund manager could lose a small fortune. Well aware that they themselves were being rated on a quarterly basis, fund managers put enormous pressure on both the companies they owned and the analysts who covered those companies to make sure that both earnings and earnings estimates climbed, like clockwork, quarter after quarter. Such uncannily consistent performance came to be known as “managed earnings,” not just at Cisco, but at blue chips such as GE and IBM.10

  At the end of the decade, the authorities would point to analysts, investment bankers, and corporate executives as the main culprits behind the market hype. But the mutual fund industry played a critical role. “Mutual-fund strategies that gained favor in the nineties shaped analyst priorities and behavior,” Santoli reported. The rise of momentum investing “led analysts to pump companies for each incremental bit of positive information that could be passed along to investors in the form of ‘whisper numbers.’”11

  With a little help from Wall Street, Cisco’s share price skyrocketed—growing far faster than the company itself. “In 1990, Cisco was selling at 20 times earnings—with revenues growing at a triple-digit rate. By the time we got to the mid-nineties, if you looked at a graph of the share price, the line was turning vertical—it was going straight up,” observed George Kelly, a Morgan Stanley analyst who helped take Cisco public. “The stock was trading at 80 times the next year’s earnings. Meanwhile, Cisco’s growth had slowed from over 100 percent to 30 percent. By any traditional
valuation techniques, the rise was totally irrational.”12

  Irrational or not, Cisco CEO John Chambers took the ball and ran with it, using the inflated shares to compensate his people “with an abnormal amount of stock options,” and to go on a shopping spree, buying “dozens” of companies. “Capitalism,” said Cramer, “never made more sense.”

  Unerringly, Cramer put his finger on two of the tools that Cisco used to meet or exceed analysts’ estimates, quarter after quarter. By rewarding its engineers with shares rather than cash bonuses, Cisco avoided having to subtract the full cost of employee compensation from its earnings. And by using its bloated shares to purchase other companies, Cisco was able to go on an acquisition binge, boosting its earnings—at least on paper. “To report its progress, Cisco ignored generally accepted accounting principles (GAAP) and developed its own style of bookkeeping: accounting standards that it believes more accurately reflect [its] performance (and coincidentally add more lilt to the stock price),” Jim Grant would report to his newsletter’s readers a few years later.13

  Like many of the mutual fund industry’s favorites, Cisco became a serial acquirer. Over the course of the nineties, it would use a combination of cash and its own overvalued shares to scoop up some 70 firms. Often, it bought companies that were not publicly traded, making it all but impossible, Grant noted, to determine the true value of those acquisitions. By 2002, however, it was becoming clear that the majority of the companies Cisco had bought were worth less than it paid. Many of the top talents at the companies Cisco collected had left.14 Meanwhile, Cisco’s own share price had fallen by 80 percent.

  But for a time, momentum kept the game going: mutual fund managers piled into growth stocks, analysts raised estimates for future growth, fund managers bought more shares, and corporate executives did whatever was necessary to create the appearance of earnings that matched Wall Street’s expectations. Cisco was hardly alone. Deal-happy companies such as Tyco and WorldCom shopped until they (or their share price) dropped. In many cases, they used their own overvalued stock—what some on Wall Street called “vapor money”—to finance their purchases.

  Ignoring any questions about the intrinsic value of the companies acquired, Wall Street viewed these purchases as a further excuse to hike earnings estimates. The higher estimates, in turn, led to higher share prices—creating more vapor money to fuel more deals. In this way the average acquisition price rose 70 percent over the last five years of the decade. Of course, as the acquirers grew, it took larger and larger deals to show impressive percentage gains in earnings.

  In the end, it would turn out that those gains were not quite what they seemed. “Deals give companies more ways to play with their accounting,” Robert Willens, an accounting expert and managing director at Lehman Brothers, pointed out in 2002. Perhaps this explains why, when the game finally ended, the biggest acquirers of the late nineties took a bigger fall than most large caps. In 2002, a study by The Wall Street Journal revealed that the top 50 acquirers had plunged three times as much as the Dow.15

  “IF YOU WANT MOMENTUM, BUY AN INDEX FUND”

  In the summer of 1996, the tailwind that had been propelling some of the hottest momentum funds began to peter out. After making $1.3 billion in five good years, Gary Pilgrim lost $900 million in a mere seven weeks. He was not alone. Over the next year, many momentum funds fizzled, and disillusioned investors began to withdraw their money, pulling $468 million out of AIM Aggressive Growth Fund, $206 million out of Twentieth Century Vista, and $125 million out of Van Wagoner Emerging Growth.16

  But while these momentum funds faded, “momentum investing” never died. Individual investors continued to pursue the double-digit returns that, to many, now seemed the norm. With that goal in mind, they flocked to index funds and large-cap blue-chip funds.17 In essence, these had become the new momentum funds. For by now, the benchmark indices, and the brand name stocks that drove them, were on a roll. In 1995, the S&P 500 jumped 37.5 percent. In ’96, it gained another 22.9 percent. By year-end, the S&P was trading at more than 20 times the previous years’ earnings—25 to 30 percent above its historic average. As Barron’s put it early in ’97, “If you want momentum these days, buy an index fund.”18

  The popular wisdom of the time had it that if an investor stuck to index funds, he reduced risk by spreading his money around. What the received wisdom ignored was the price of the index. When the S&P is driven by highfliers, an investor who buys the index is, by definition, buying high.

  Boston money manager Jeremy Grantham had pioneered the very idea of an index fund at Batterymarch Financial Management in 1971, before launching his own money management firm, Grantham, Mayo, Van Otterloo & Co., but unlike other indexers, Grantham never believed that the market was either consistently rational or efficient. Experience had taught him otherwise. In 1968, a self-described “gun-slinging nitwit,” fresh out of Harvard Business School, Grantham played the go-go market at its peak. By 1970, he had lost all of his money. “I like to say I got wiped out before anyone else knew the bear market started,” Grantham recalled years later. As a result, he knew that indexing makes sense early in a bull market cycle, not at the end. “Indexing in the long run is sensible,” said Grantham in 1999. “In the short run it can be lethal, particularly now.”19

  THE NIFTY FIFTY

  At the end of the decade, many would try to redline the bubble, pretending that it had been limited to that racy district known as the Nasdaq. In fact, the chimera later known as “the bubble” began to form in the mid-nineties, and it was inspired not by dot.coms but by the meteoric rise of some of the most reputable names trading on the NYSE. By August of 1996, the blue-chip favorites included Time Warner (trading at 85 times earnings), Microsoft (46 times earnings), Coca-Cola (39 times earnings), Gillette (36 times earnings), Cisco (33 times earnings), Oracle (32 times earnings), Pfizer (31 times earnings), Lilly (31 times earnings), Warner Lambert (30 times earnings), and Boeing (29 times earnings).20 The difference between a “momentum fund” and a fund that invested in the large-cap growth stocks was narrowing.

  In Minneapolis, Steve Leuthold realized that he had seen this movie before: “The 99 stocks most favored by large institutional investors are selling at price-earnings ratios 25% to 50% over historical averages,” he warned. “This group has the potential to behave like the Nifty Fifty,” he added, referring to the brand-name growth stocks that became the fund managers’ favorites at the tail end of the go-go market of the sixties—companies such as Polaroid, Xerox, and Avon.21 As the hotshot fund managers of the sixties crowded into these stocks, they bid price/earnings ratios to unheard-of heights. Within a few years, the darlings of that decade would plummet, losing 45 percent of their value in the crash of 1973–74.

  Nearly 25 years later, the mutual fund industry was assembling another Nifty Fifty. Even if the large caps were pricey, portfolio managers had ample reason to pile in. As the S&P 500 took flight, fund managers had been struggling to keep up. In 1995, just 16 percent of diversified U.S. stock funds beat the S&P 500. 1996 proved almost as discouraging: at year-end, Lipper reported that only 25 percent of the group had paced the index.

  At that point, a fund manager’s only hope was to buy the market’s leaders. From his perch at Merrill Lynch, Bob Farrell continued to keep a sympathetic eye on the human drama created by bull and bear markets, and he understood the herd instinct: “They’re buying what’s working,” he remarked in 1996. “Most managers have lagged the market, so even though big stocks are over-extended, the managers keep buying them out of fear of falling further behind.”22

  THE MUTUAL FUND INVESTOR

  While mutual fund managers pursued the hottest stocks, individual investors panted after the hottest funds. Spoilsports suggested that the United States was turning into a nation of gamblers: in 1995, more of its citizens visited casinos than theme parks.23 In truth, while some 401(k) investors enjoyed the thrill of betting, others simply felt that they had no choice. Interest rates remained l
ow, and by now, investors were convinced that if they earned anything less than 10 percent they would never be able to retire. As Peter Bernstein had noted, few gurus advised saving just a little more, investing conservatively, and settling for, say, a relatively safe 7 percent. Nor did they talk much about the risk that came with double-digit returns—the chance of losing a large chunk of your principal.

  Many investors were just plain scared. “I’m 58, I earn $47,000 a year, I finished putting my fourth child through college just six years ago, and now I’ve managed to save $200,000,” confided Sharon Cassidy, a divorced college professor in Massachusetts. “I’ve looked at the tables that tell you how much you need to save—and I know that if I want to maintain my standard of living when I retire in six years I should have $500,000. I also know I won’t have it. But I could have $400,000 if my account keeps on earning more than 10 percent. That’s why I’ve been having the maximum taken out of my paycheck each week, and I’m putting it all in stocks. I know that’s dangerous at my age,” she added. “The market could crash. But it’s the only way I can hope to have even $400,000, which still won’t be enough.”24

  Others were spurred on by what one fund manager called “the politics of envy”: “One of my partners heard again and again from clients who were infuriated that younger family members—for whom they had almost no respect—were now worth 20 or 30 times more than they were,” he recalled. “They felt a tremendous need to catch up with the nieces, the nephews, even their own children, who were now fabulously wealthy, driving the Ferraris—and ‘didn’t deserve it.’ We were too conservative for them. Eventually they withdrew their money and took it elsewhere to play a high-stakes game.”25