Bull!

by Maggie Mahar

  Einhorn agreed. “Analysts weren’t writing for the typical individual investor. These reports were supposed to be filtered through a sales rep or a financial advisor.”26

  Of course, the average investor did not have a financial advisor. He might have a broker at Merrill—who might or might not point to the line in Blodget’s September 1999 Internet report where he wrote, “The real risk is not losing money, but missing a big upside,” and explain to his client, “You know, I don’t think what Henry is saying here really applies to you. If you miss the upside no one is going to fire you. For you the real risk is losing money.”27 The broker’s job, after all, was to sell stocks.

  Meanwhile, the majority of investors got most of their financial advice through the media, and they preferred to believe that Abby Cohen, Mary Meeker, Henry Blodget, and even Barton Biggs, grump though he might be, were speaking directly to them. By and large, the financial press did little to dispel that illusion. The media needed the gurus—they brought color and authority to financial news. They made it exciting. They made it immediate. They made it news.

  DOW 10,000

  In March, when the Dow finally broke 10,000, and The New York Times quoted Ralph Acampora—“It’s exciting. It’s America. We all should get up and sing ‘God Bless America.’”—hundreds of thousands of individual investors hummed along. 10,000 was such a nice round number. It seemed to put a floor under the market—as if now that the Dow had crossed that line, it could never go back.

  There was even a sense of Manifest Destiny: “Though 10,000 is little more than a psychological hurdle for investors, the market’s move is significant in what it reflects: the unparalleled strength of the economy and the dominance of the world economic stage by American corporations,” the Times declared.

  The Times also stressed that, amid all the exultation, there was “a lurking concern” over just “how narrow the market’s advance has been: A growing portion of Americans’ investment money is devoted to the 30 well-known companies in the Dow and the components of the Standard & Poor’s 500-stock index, which rose near its record yesterday. But many portfolios have not matched the performance of the Dow and the S&P. That is because a relatively small number of stocks have pulled the indexes higher.”

  Microsoft, IBM, Cisco, Lucent, AOL, Dell, GE, Wal-Mart…these were the stocks that individual investors were buying. In the first quarter of 1999, the indices continued to ride on the backs of a few high-flying brand names. But, the Times pointed out, Acampora was not concerned: “These are our big stocks that are leading. It’s anything but irrational,” he said.

  Still, 76 percent of all stocks were trailing the S&P by 15 percent or more. The average stock trading on the NYSE was now 33.4 percent below its peak. This was the skeleton at the feast. The broad market lacked support. “Regardless,” the Times concluded, “United States stocks are for now very much the place to be. Eight years of rising share prices are a powerful draw.”28 It was a superbly balanced story.

  MUTUAL FUND MANAGERS—IN THE CLOSET

  By the spring of 1999, portfolio managers were finding the lure of the big, market-leading companies irresistible. By the end of 1998, nearly one-fifth of all diversified U.S. stock mutual funds already owned AOL, and when the S&P added the Internet service provider to its index in 1999, other funds rushed in to buy it.29

  A year earlier, the average actively managed fund had gained just 7 percent. Small wonder that by 1999, instead of trying to beat the indices, many money managers were joining them. Rather than trying to pick stocks, they simply bought the stocks in the index, concentrating on the brand names. This meant buying technology’s blue chips—by early 2000, technology and telecom stocks would account for nearly 45 percent of the overall market value of the S&P 500.30

  And so fund managers who were measured against the S&P gritted their teeth and shelled out 50 times earnings, 100 times earnings—whatever the rest of the herd was willing to pay. In the weightless economy, price/concept ratios trumped price/earnings ratios.

  These portfolio managers were not running an index fund—a fund designed to shadow the S&P 500—but they behaved as if they were. Critics called it “closet indexing,” pointing out that individual investors were paying steep fees for active management when they could do just as well—or better—by putting their money in a low-fee index fund.

  Meanwhile, investors who thought that they had diversified by buying a range of mutual funds were badly mistaken. When David Tice, editor of Behind the Numbers, testified before Congress in June 2001, he pointed to the incredible overlap among the most popular growth-oriented mutual funds. Analyzing stocks held by Janus, American Century Ultra, Fidelity Growth, Fidelity Blue Chip, Janus Twenty, Putnam Voyager, Vanguard U.S. Growth, AIM Constellation, Fidelity Aggressive Growth, and Putnam New Opportunities, Tice revealed that Cisco was held by 10 out of 10 of the funds, followed by Sun Microsystems, (9 out of 10), GE (8 of 10), Pfizer (8 of 10), EMC (9 of 10), Microsoft (8 of 10), AIG (7 of 10), AOL (7 of 10), BEA (8 of 10), and Veritas (9 of 10). In fact, their portfolios were so similar that an analysis of how these 10 funds had performed over time showed a correlation coefficient of 80 to 95 percent. So much for the notion that by owning a variety of growth funds, individual investors could reduce risk.31

  When he looked at the portfolio manager’s favorites in the spring of ’99, Steve Leuthold was again reminded of the Nifty Fifty of the early seventies. “People clung to the belief that if you bought the premier growth companies, they would hold up well, even in a market decline,” the Minnesota money manager recalled. “These were the One-Decision stocks of the time—just buy them and hold them.” Xerox, Polaroid, Digital Equipment—these were some of the names. “Today, portfolio managers are again staking their hopes on the future performance of the crème-de-la-crème of growth stocks,” Leuthold added. “But anyone who has been in the business knows that no one has ever been able to estimate earnings 10 years out—and these stocks are priced as if you can.”

  Often, bears are prickly, but Leuthold was mellow. He did not insist that history would repeat itself. But, he suggested, history is, at the least “a vast early-warning system.” It may not provide clear signposts, but it offers “some guide to the future.”32

  With that in mind, he took a look at his firm’s list of the 99 stocks with the greatest institutional ownership as of March 30, 1999, then selected the 25 with the highest price/earnings ratios and dubbed them the “Religion Stocks.” The stratospheric P/Es suggested blind faith; these were the “must-have” stocks, irresistible at any price. That spring the roster included the usual suspects: Dell, Microsoft, Yahoo!, Lucent, Wal-Mart, MCI WorldCom—and it bore a striking resemblance to the Religion Stocks of 1972.

  Once again, technology stocks dominated. Once again, median P/Es were double those on the S&P 500. Once again, dividends were measly. And now, just as in 1972, nearly all of the companies on the list flaunted a 10-year record of double-digit earnings growth—at least that is what they reported.

  The lists differed in just one important way: in 1999, the stampede had pushed the price/earnings ratios of the market’s favorites even higher than in 1972. True believers insisted that the Religion Stocks of the nineties could support the higher valuation—this time it was different.33

  —18—

  THE LAST BEAR IS GORED

  “Wall Street is moving from fact to fiction,” Gail Dudack told her husband in the summer of 1999. “The sleaze factor is growing—people are doing things that may or may not be illegal, but the gray area is expanding.”1

  Chief market strategist at Warburg, the U.S. unit of global investment banking giant UBS A.G., Dudack had known that the boom was turning into a bubble ever since she sent a review of Kindleberger’s Manias, Panics, and Crashes to her clients in October of 1997. And she said so, not only to the money managers who paid Warburg handsomely for her advice, but publicly, on television.

  Bears can be abrasive, but Dudack’s tone was far from c
ontentious. Indeed, her style could best be described as ladylike as she laid out the unwelcome numbers, clearly and meticulously, without a trace of self-congratulatory glee. With her professional manner and melodious voice, the blonde baby-boomer became a favorite on shows like CNN’s Moneyline, CNBC’s Squawk Box, and the nation’s most-watched financial news program, the Public Broadcasting System’s Wall $treet Week with Louis Rukeyser.

  Ironically, as the bull market approached a summit, Dudack’s popularity as a television guest soared. “Financial programs wanted to ‘present both sides,’” Dudack recalled. “So they would have me on and let me present my bearish views. Then they would say, ‘Now, what stocks do you like?’ They really didn’t get it.”

  For by the late nineties, Dudack liked few stocks. Unlike many Wall Street professionals, she knew that this was not just an Internet bubble: stocks that investors thought of as “safe havens” were in fact overpriced. To her credit, even Abby Cohen was beginning to pull in her horns: at the end of ’99, Cohen declared the market “fairly valued” and predicted that, in 2000, the S&P would rise less than 5 percent. But, she still insisted that the technology stocks on the S&P 500 were not overvalued.2

  When Money magazine asked three gurus for their 2000 forecast, Dudack was the only one to suggest that a “stealth bear market” was already under way. Lehman Brothers’ Jeffrey Applegate, by contrast, was “as gungho as ever,” Money reported: Applegate expected a 15 percent gain for the year. PaineWebber’s Ed Kerschner was only somewhat more cautious, predicting that earnings on the S&P would climb 7 percent, and that the Dow would hit 12,500. As 2000 began, Kerschner was still recommending highfliers such as IBM, Lucent, MCI WorldCom, Gateway, and Cisco.3

  Meanwhile, the media continued to beat the drum with headlines such as: “The Next Big Thing: Need a Few Hot Stocks to Jump-Start Your Retirement Portfolio? Then Get Up to Speed on Tomorrow’s Technology—Today” (Smart Money, August 1999). An article that accompanied the main feature suggested that to “reduce risk,” investors over 70 should have 25 percent of their savings invested in large-cap stocks, 5 percent in small caps, and 10 percent in foreign stocks. For those who had 10 years before they retired, the story advised allocating 65 percent to equities.4

  The “media marriage of the century” also generated considerable excitement in the press. When AOL and Time Warner announced their plans to merge at the beginning of 2000, Business Week brought out the trumpets: “Welcome to the 21st Century: With One Stunning Stroke, AOL and Time Warner Create a Colossus and Redefine the Future.”5

  Predictably, The Washington Post’s Allan Sloan cast a jaundiced eye on the nuptial announcement. “Until recently,” he observed, “AOL buying Time Warner was as likely as a flea buying an elephant. But the stock market made this takeover possible by valuing 15-year-old AOL at twice the value it accorded 76-year-old Time Warner. This despite the fact that Time Warner’s businesses produce from four to six times (depending on who’s counting) the operating profits of AOL’s businesses. Thus, Wall Street says a dollar of AOL operating profits is worth eight to 12 times a dollar of Time Warner profit. New math?”6

  Dudack saw the merger as a metaphor for what was happening. “In the twilight zone that we’ve entered, things of substance—bricks and mortar—are trash,” she told friends. “What people value is paper—AOL’s stock.” So AOL, an Internet arriviste with a powerful brand name, and not much else, was able to capture Time Warner, a company with real assets, nearly five times AOL’s revenues, and verifiable earnings—earnings that the SEC did not constantly question.7 In January of 2000, AOL’s stock was sizzling, changing hands at 217 times the company’s earnings, and Steve Case, the company’s founder, seized the moment, offering to trade 1.5 shares of AOL for each share of Time Warner. The marriage would not be consummated for another year, and by that time, AOL’s shares had lost more than a third of their value. Nevertheless, AOL still paid just 1.5 shares for every share of Time Warner. Steve Case had cut it close, but his timing was superb.

  “COME ON, GAIL, GET WITH IT”

  Dudack recognized that many on Wall Street were just too young, or too naïve, to understand what was going on.

  Others, however, knowingly played the game. One of the Street’s best-known gurus appeared with Dudack on CNN’s Moneyline in 1999 and insisted that investors were pouring more and more money into equity funds. Dudack knew this wasn’t true; at that moment skittish investors were beginning to park their savings in money market funds. After the show had ended, as they waited outside for a limousine to take them back to their offices, Dudack turned to her colleague: “Have you looked carefully at those fund flow numbers? You know what you said isn’t right.”

  “Don’t worry—if the money isn’t there now, it’ll be coming in. Come on, Gail, get with it,” he added in a friendly tone. Startled, Dudack realized that he was trying to be helpful. He was attempting to give her career advice. As she had told Money magazine a few months earlier, being a bear “is not good for your career and it’s not good for making friends.”8 Not long after, she went to a meeting with a client and was accused of being “unpatriotic” because she suggested that U.S. technology stocks were overpriced. The numbers no longer matter, Dudack thought. People want to buy stocks and they want them to go up. They want to make a million dollars—and they want people to tell them things that will make it happen.

  Dudack knew that she risked being labeled a Cassandra, one of those perverse seers who insist upon forecasting doom, even though no one is interested in hearing her bad news. In the summer of 1998, when Prudential’s Ralph Acampora predicted that the Dow would crash, and Prudential wound up hiring a bodyguard to protect him, Dudack understood the public’s reaction: They believe that if you say that the market will go down, you make it happen.

  She could only imagine the dampening effect that the publicity would have on any professional’s future forecasts. “Consciously or unconsciously, after something like this, anyone would think long and hard before saying something negative about the market again,” she told her husband. “I don’t want that to happen to me—I don’t want to be at the center of controversy. I keep thinking about John Kenneth Galbraith’s description of what happens to a bear during an investment mania. You’ll be scorned, you’ll be terrorized, and when the bubble begins to collapse, the public will be very angry. It will need a scapegoat.”

  The problem was that Dudack, like a growing number of Wall Street insiders, realized that the fin de siècle bull market had become a paper market. Companies reported earnings, on paper; share prices rose, on paper; investors accumulated profits, on paper. No one knew how much of it was real. Dudack did not want to be the messenger who was shot, yet she continued to speak out. “The outlook is worse than ever,” she told The Financial Times in April of 1999.9 “At least I can sleep at night,” Dudack said privately. “I know that what I’m doing is unpopular, but I am prepared.”

  WALL $TREET WEEK—NOVEMBER 5, 1999

  Still, she wasn’t quite prepared for Louis Rukeyser to fire the first shot. The morning of Saturday, November 6, 1999, Dudack was making breakfast for her nine-year-old son when the phone rang at her Westchester home. First, a call came from a neighbor down the street. “Gail, why did they do this to you? What happened?”

  Dudack had no idea what her neighbor was talking about. She did not know that the night before, she had been humiliated, on nationwide television, in front of the millions of viewers who watched the PBS hit Wall $treet Week with Louis Rukeyser.

  Although she had been a regular on the show for more than 20 years, Dudack did not appear every week. She was part of a rotating group of technicians and market strategists that Rukeyser dubbed his “elves.” Each week, they contributed to the show’s “elves’ index,” predicting where the Dow would be in three months, but in any given week, only two or three appeared on air. So that Saturday morning, when the phone began to ring, Dudack did not know what had happened on Wall $treet Week the night
before.

  The show had opened with a special segment. Abandoning his usual, jocular manner, Wall $treet Week’s harlequin-faced host took on the role of schoolmaster, metaphorical ruler in hand, ready to rap the knuckles of unruly elves. “Tonight,” he announced, “we will be making one of our periodic checks on who the winners and sinners are among our market-forecasting elves.” He paused, just a second, for dramatic effect. “And, based on that checkup, we’re going to make one substitution tonight.” One of the elves was about to be banished.

  Rukeyser proceeded to excoriate the “one elf, and one elf only [who] has been stuck in the same position for the past 156 weeks running.” Dudack, the show’s sole bear, had been cautious since the fall of 1997.

  Like Fidelity Magellan’s Jeff Vinik, Dudack had been unpardonably early. In November of 1999, the bull was still on steroids—or so it seemed. Six months later, the Nasdaq would implode, losing 25 percent of its value in one week. But at that moment, in November of 1999, Dudack appeared terribly wrong.

  It was one of the paradoxes of Wall $treet Week that, although Rukeyser preached long-term investing, his show featured a three-month forecast. To be fair, throughout the nineties, short-term predictions dominated most financial journalism. After all, who would remember if you gave advice that panned out 18 months later?

  Dudack’s three-month forecasts had missed their target for two years, and that was too long—even if, over the long haul, she was proved right. “Lou lacked the intellectual integrity to tolerate a different opinion, and to wait and see if Gail would be correct,” Hank Herrmann, president and chief investment officer of Waddell & Reed Financial, and another frequent guest on the show, later observed.10