Bull!

by Maggie Mahar

  EPILOGUE

  —2004–05—

  2004 began with a question: Is the bear dead or is he just hibernating?

  For Wall Street, 2003 had been a spectacular year: in just 12 months the Dow gained 25 percent while the S&P climbed 26 percent. But it was the Nasdaq that stunned investors, adding 50 percent to its value.

  Some of the most widely held stocks made the greatest gains. In January of 2004, Karen Gibbs, host of the Public Broadcasting System’s Wall $treet Week with Fortune, ticked off the winners: “Lucent Technology up a whopping 125 percent; Time Warner, better by 37 percent; Cisco Systems, up 85 percent; Intel, over 106 percent higher; Microsoft better by 6 percent;…General Electric, up 27 percent; Big Blue—IBM—up 20 percent; and Pfizer better by 16 percent.”

  But this did not mean that investors had recovered all of their losses. As Gibbs was quick to acknowledge, many had bought near the top of the market, and as of January 2004 remained underwater. Taking a look at how those same stocks had performed since March 1, 2000, when the bear market started, she found “Lucent, still down 91 percent—it would almost have to double its price just to break even; Time Warner, still off 67 percent; Cisco, down 59 percent; and Intel, that semiconductor blue-chip bellwether, off 43 percent; Microsoft still down 39 percent; and SBC Communications off 35 percent; General Electric, down 27 percent; Big Blue (IBM), off 6 percent.”1 Only Pfizer had survived the downturn, rewarding investors with positive returns.

  Still, after three years of brutal losses, investors were more than grateful for a year of double-digit gains, and early in 2004 many hoped for a reprise. Indeed, bullish sentiment was so strong that in the first month of the year, investors poured more than $40 billion into equity funds—the highest monthly inflow the mutual fund industry had witnessed since 1992.2

  At that point, investors’ hopes were reaching what Gail Dudack viewed as “scary” heights. “The American Association of Individual Investors reports that bullish sentiment stands at 69.5 percent of those surveyed—with only 13.4 percent declaring themselves bears,” Dudack warned SunGard’s institutional clients at the beginning of 2004. “The last time the spread between bulls and bears exceeded 40 percent,” she added, “was in January of 2000”—just a few months before the market’s collapse.3

  Had investors already forgotten what the market’s meltdown had taught them about risk? Not really, but everyone wanted to believe. They could only hope that the headline that appeared on the right-hand corner of Barron’s December 2, 2002, cover had been correct: “Welcome to the New Bull Market.”4

  ANOTHER BUBBLE?

  Yet, even while 401(k) investors flocked back into the market, some of the financial world’s most experienced investors shook their heads. When these veterans looked at the fundamentals, they saw little basis for the run-up. The rebound had not ushered in a new bull market, they warned. It had merely given birth to yet another bubble. Early in 2004, Russell summed up the sentiment: “Bill Gross is talking about Dow 5000 somewhere ahead. Warren Buffett can’t find any stocks he likes. Templeton is very bearish and talking about real estate falling 90 percent. Soros doesn’t want his money in the US at all.”5

  Warren Buffett made his views clear in his March 2004 letter to Berkshire Hathaway’s shareholders: “Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us.” As a result, at the end of 2003, Buffett was sitting, none too happily, on some $31 billion in cash. “Our capital is underutilized now, but that will happen periodically,” Buffett wrote. “It’s a painful condition to be in—but not as painful as doing something stupid. (I speak from experience).”6

  That same month Morningstar revealed that some of the mutual fund industry’s most respected managers shared Buffett’s misgivings. “Legendary investors are drowning in cash,” Morningstar’s Gregg Wolper reported. “In fact, it’s remarkable how many top-flight managers have more than 20 percent of assets in cash.” The roster of those who found the market too pricey to play included First Eagle’s Jean-Marie Eveillard. “When several of the very best managers all say they are having an extremely difficult time finding anything to buy at prices that make sense…it’s worth paying attention,” Wolper observed.7

  To value investors like Eveillard, the signs of a bubble seemed clear. Begin with valuations. Historically, the average stock on the S&P 500 has fetched 18 or 19 times the prior year’s earnings while paying dividends of 4 percent. But by the spring of 2004, the S&P was trading at close to 29 times 2003 earnings—even though it yielded less than 2 percent.

  Of course, in the year ahead, analysts expected earnings to snowball. And bulls, quite naturally, preferred to look at price/earnings ratios based on those projected earnings for 2004. By that measure, in the spring of 2004 the S&P 500 was trading at 18 times projected earnings. Normally, investors pay only about 14 times the current year’s estimated operating profits; still, a price/earnings ratio of 18 did not look so bad—if you believed the estimates.

  Trouble was, despite all of the talk about accounting reforms, those earnings “still have a lot of fluff in them,” noted Rob Arnott, editor of the Financial Analysts Journal and chairman of Research Affiliates. “There are two big items inflating earnings,” Arnott observed in April of 2004. “First, most companies still didn’t subtract the cost of the options from their profits. Secondly, many make unrealistic assumptions about how much their pension funds are likely to earn—and those hoped-for gains then show up as profits on their income statements.”

  Taken together, Arnott reckoned that these two items were padding 2004 earnings estimates by some 20 to 25 percent.8

  Arnott was not the only member of Wall Street’s Greek Chorus who took a skeptical view of the much-ballyhooed accounting reforms. Jim Chanos, the short seller best known for lifting the veil on Enron, characterized most of the new rules and regulations as “window dressing” that would lead to more paperwork—and not much else.

  “Sarbanes-Oxley makes corporate fraud a crime,” Chanos observed, referring to the 2002 legislation that required CEOs to sign off on their company’s financial statements. “Then again, fraud was always a crime.”9

  Earnings that winked at you were not the only signs of a frothy market. Consider the rally’s leadership. In December of 2003, one portfolio manager summed up the quality of this new bull market: “If you had told me that the market was going to be led this year by small, low-priced stocks of money-losing companies,” he confided to a Bloomberg columnist, “I would have said you were crazy.” (The columnist remained unperturbed: “Can nothing stop this prosperity?” he asked.)10

  Even as individual investors surged into stocks, insiders headed for the exits: in March of 2004, insiders sold $23.38 of their own stock for every $1 that they bought.11 Nevertheless, most fund managers had no choice but to be fully invested, and so they continued to load up on equities—-though the majority didn’t hold on to them for very long. “Most money managers are participating in this crazy market, but many do not believe in it,” Fred Hickey, editor of The Hi-Tech Strategist, observed in February. “They ‘rent’ stocks but don’t own them; they ‘date’ stocks but don’t marry them (this terminology is actually used).” By 2004 some of Wall Street’s most experienced value managers had retired. Younger momentum investors had taken their places, and many were gunslingers. “They’re speculators,” Hickey noted, “with their fingers on the sell triggers.”12

  THE SHAPE OF THINGS TO COME

  From the sidelines, Richard Russell cast a cold eye on the rebound that began in the spring of 2003, warning his readers that the rally was nothing other than a bear market rally—otherwise known as a “sucker” rally: “The sharpest and most explosive rallies occur not in bull markets but in bear markets,” Russell observed. “As the old-time Dow Theorists were fond of saying, ‘a bear market rally often looks better than the real thing.’ That saying came about,” Russell added, �
�following the giant bear market rally that followed the ’29 crash.”13

  Other market historians drew a parallel to the early seventies, when the crash of 1970 was followed by a spectacular rebound. By January of 1973, the Dow had hit a new high, and Alan Greenspan, then an informal advisor to President Nixon, was among those convinced that the bull was back: “It is very rare that you can be as unqualifiedly bullish as you can be right now,” he declared at the very beginning of the year.14 Within weeks, the crash of 1973-74 began. This second leg down would prove far more traumatic than the first: when it was all over, the Dow had erased some 16 years of capital gains.

  But while history may repeat, it always repeats with a difference. No two bear markets are alike. And in the spring of 2004, not everyone believed that the market faced a second leg down. Veterans such as Gail Dudack and Steve Leuthold suggested that the market might simply trade sideways for the rest of the decade, without making a new bottom—or a new top.

  “It could be a lot like the seventies,” Leuthold suggested, referring to that frustrating stretch from 1974 to 1982 when, despite numerous peaks and valleys, the Dow never managed to breach its precrash highs.

  As for the current rally, in April of 2004 Leuthold predicted: “We might have six to eight months left—at most. Then we’ll need to get defensive for another six to nine months.” Looking ahead to 2005, Leuthold expected a series of mini-bull and mini-bear markets. “Market timers and asset allocators could do pretty well in this type of market,” he added. “But this is not a market for buy-and-hold stock investors.” As Leuthold knew from experience, “buy-and-hold” works only in long “secular” bull markets.

  Most individual investors, however, did not distinguish between short, “cyclical” bull markets—which can easily turn into bear traps—and the real McCoy, “secular” bull markets, which can last for 15 or even 20 years. As far as most 401(k) investors were concerned, the bull was back, and they did not want to miss a bull run.

  Indeed, Leuthold confided that he was “amazed” to see just how quickly individual investors were “drawn back to the flame.” Nevertheless, he understood that in the spring of 2004, many felt that they had no choice but to stash their savings in stocks. With interest rates at a 46-year low, money market accounts, CDs, and even Treasuries held little more allure than the proverbial mattress. As Leuthold put it, “stocks are the only game in town.”15

  CONSUMERS LEAD THE RECOVERY

  Conservative investors who wanted to tuck their savings away in a bond and watch it compound complained about rock-bottom rates. But most understood that low rates were central to the administration’s strategy for kick-starting the market. The Fed’s aim was to reflate the economy, and the best way to do that, policy makers reasoned, would be to make it easier for consumers to borrow and spend. With that goal in mind, the Fed had slashed interest rates some 13 times in three years. Granted, the first 11 whacks seemed to have little effect on the market. It was not until November of 2002, when the Fed cut by a full half percent—bringing short-term rates down to an astonishing 1.25 percent—that Wall Street’s miserable three-year decline finally ended.

  By the spring of 2003 the rally was well under way, and in June, just to be sure, the Fed trimmed interest rates one more time, bringing the Fed funds rate down to a 45-year low of 1 percent. After adjusting for inflation, the cost of borrowing had now fallen to less than zero.

  But it was not just historically low rates that fueled consumer spending. Only a few weeks before the Fed’s thirteenth cut, President Bush signed legislation to reduce taxes by $350 billion, bringing the administration’s total 10-year tax cut package to a generous $1.7 trillion.16

  The Greenspan/Bush administration’s plan was to boost demand by putting more cash into consumers’ hands. Short-term, the strategy worked. By the spring of 2004, consumption was climbing at a real (inflation-adjusted) rate of 5 percent a year—even while real wages rose by only 2 percent.17

  This was the part that worried the skeptics. Consumers were not simply spending their tax refunds; they were spending money that they did not have. Normally, during a recession, families try to retrench and pay down debt. But this time around, they had been adding to it. By 2003, U.S. consumers had increased their spending for an unprecedented 47 quarters in a row. From 2001 to 2003 household debt rose by 15 percent. Meanwhile, the typical household’s net worth has barely budged.18

  Nevertheless, many households felt wealthier. As interest rates plunged, real estate markets soared, and for many families, rising home values, combined with the 2003 rally, offset three years of stock-market losses. Though, if truth be told, the nation’s households had simply returned to square one: at the end of 2003, their net worth totaled roughly $43 trillion—just short of the record $43.6 trillion that they had reached more than three and a half years earlier, in the spring of 2000.19

  Over the same span, some 2.7 million jobs had vanished, and real wages remained flat to down. In other words, the nation’s shopping spree was driven, not by jobs and rising incomes, but by soaring asset values. Homes and stock portfolios were now worth far more than they had been two years earlier—at least on paper. Yet, by most measures, both homes and stocks were now richly valued; those paper gains could disappear just as quickly as they had appeared.

  Nevertheless, the Fed continued to pursue what some called its “open-mouth policy,” reassuring investors, at every turn, that job and wage growth was right around the corner. Washington’s critics contended that the administration had created the illusion of recovery, ginning up the economy with easy credit and, in the process, leading both shoppers and investors to believe that things were far better than they were. Washington responded by pointing to rising gross domestic product and arguing that, ultimately, jobs always follow growth, if not always in a straight line. Whoever was right, one thing was certain: consumer confidence was crucial to the administration’s strategy. It was not just that investors needed to believe; for Washington’s politicians, their belief had become a political imperative.

  If Washington’s goal was to create a faith-based economy, it succeeded. In 2004, consumers continued to borrow and spend. Often, they took cash out of their homes, either by signing up for a home equity loan, or by refinancing and shouldering a larger mortgage. In 2003 alone, mortgage balances jumped by 14 percent—nearly double the pace of real estate appreciation.20 And, even though interest rates were lower than they had been in half a century, home owners gravitated toward variable rate loans, ignoring the fact that from these levels rates could only go up. As for the banks, they were understandably happy to write these adjustable rate loans, even when home owners could not (or chose not to) make a down payment. Early in 2004, Washington Mutual, the nation’s largest thrift, reported that in the past, 70 to 90 percent of its customers took fixed-rate loans, but now just as many were choosing the “interest-rate only” option.21

  Short-term debt also climbed. “Excluding mortgages, the average personal consumer debt is now about $18,654 per person—up 41 percent from 1998,” John Mauldin, editor of Thoughts from the Frontline, reported at the beginning of 2004.22

  Nevertheless, the bulls argued that the pile of debt was no problem. With rates so low, America’s families could afford to carry the load. Bears remained concerned: despite low rates, by March of 2004, the amount the average family now paid to service debt was approaching an all-time high. What would happen when rates rose?

  One thing was clear to even the most bullish observers: consumer spending alone could not sustain a recovery. The nation would not be able to shop its way out of a bear market. Rather than simply consuming wealth, the economy needed to begin producing it.

  Washington’s hope had been that consumer spending would lead to productive investment: if consumers created enough demand, they reasoned, this would spur businesses to make new capital investments, expand their businesses, increase production, and create enough new jobs to replace not only those that had been lost
, but those needed to absorb new graduates entering the workforce each year.

  By the spring of 2004, this still had not happened.

  TWIN DEFICITS

  Skeptics argued that a recovery based on debt was no recovery at all. And it was not just the towering wreck of consumer debt that unnerved the Greek Chorus. Washington had embarked on a spending and borrowing spree of its own. In 2000, the United States was running a $237 billion budget surplus; by 2004 the surplus had turned into a $521 billion deficit. The war on terrorism, which was expanded to include a war in Iraq, accounted for only a part of the government’s debt: from 2001 to 2004, spending outside defense, homeland security, and defense-oriented foreign aid had jumped 23 percent, or more than 7 percent annually.23

  Then there was the trade deficit. The United States continued to consume more than it produced, which meant that the gap between imports and exports was widening. By the end of 2003, the shortfall stood at a record $489 billion.

  For years, foreigners had been financing that deficit by using the dollars they received for their exports to buy U.S. Treasuries. But as U.S. debt grew, some began to fear that the world would no longer see the dollar as a safe haven. Indeed, by 2004, the greenback had fallen sharply against most major currencies.24 Yet the United States continued to depend on foreigners to buy its debt: in 2003 kind strangers owned more than a third of all government bonds. If they began to pull back, the only way the United States could attract new buyers would be by raising the yields that it paid bond investors. But that, in turn, would make it all that much harder for Washington to service its debt.

  This is what worried investors such as Warren Buffett: “For a time, foreign appetite [for U.S. debt] readily absorbed the supply,” Buffett noted in his March 2004 letter to Berkshire Hathaway investors. “Late in 2002, however, the world started choking on this diet, and the dollar’s value began to slide….” Yet, Buffett observed that an ongoing trade deficit meant “whether foreign investors like it or not, they will continue to be flooded with dollars. The consequences of this are anybody’s guess. They could, however, be troublesome—and reach far beyond currency markets.”