CHAPTER TWELVE
Greed, Fear, and Complacency
WHEN I RETURNED TO NEW YORK in July 1999 and reimmersed myself in the world of markets and finance, I realized in a more palpable way how much had changed in the six and a half years since I’d left. My son Jamie, who was at that time working at the investment firm of Allen & Co., told me that even though I felt I’d kept current, the changes were greater than I thought—partly because of the Internet and technology. Once I began to focus more deeply on what was happening, I realized what Jamie meant.
I started to understand the technological aspect of the change more fully when Arthur Levitt, who was nearing the end of his tenure as chairman of the Securities and Exchange Commission, asked me to sit on an informal task force he had set up to discuss market structure. Arthur and others felt the new technology should enable better, more efficient ways of doing business, and in fact, some market participants were already beginning to do business differently. This study group afforded some insight into the battles waged by the New York Stock Exchange to preserve its traditional advantages and the changes major firms and innovative newcomers were advocating in their own self-interest. The Levitt group wasn’t intended to develop firm conclusions, but the debate did help me to understand the technological and other factors that were transforming the financial marketplace—and that continue to do so.
One element was the new scale of activity. I knew that daily trading volumes on the major exchanges had increased by a factor of five—for example, from 211 million shares traded on NASDAQ on my last day at Goldman to 1.1 billion the week I returned to New York. But you had to be around the financial services industry to get a feel for what that increase really meant. The business of private equity, for instance, had mushroomed with the growth of the market, as had hedge funds. In 1992, a hedge fund that managed $100 million in assets would have been considered large. In 1999, many funds exceeded $1 billion, a few ran more than $5 billion, and the number of funds had doubled.
In New York, the social consequences of the boom mentality were everywhere. People had made a ton of money in the market and had increased their spending just as sharply. I heard about couples who instead of getting married in New York City would fly their entire wedding party to Europe. People were building immense houses—often second or third residences. Real estate prices were crazy. Judy and I were thinking of moving out of the co-op we’d lived in since the early 1970s, and we saw an apartment we liked. So we made a bid, well below what seemed to us a bloated asking price, but in our broker’s judgment a reasonable offer. Then someone made an offer above the asking price. We gave up looking for a new apartment. What was happening just seemed bizarre.
Several years into the stock market boom, many people seemed to think we’d reached a kind of economic Nirvana. In late 1999, dot-com and telecom stock prices were still increasing rapidly. That summer when I arrived back in New York, the NASDAQ was trading at a little over 2,500—it would hit 4,000 before the end of the year and a high of 5,049 on March 10, 2000. The comments one heard called to mind the fate of Irving Fisher, an eminent economist at Yale in the 1920s. A week before the Crash of 1929, Fisher famously said stock prices had reached a “permanently high plateau.” It was always possible that the world really had changed in the way the market imagined—but a better bet was that the market had gone a bit crazy. I remember a chart I saw in a financial magazine that depicted the historical relationship of the market capitalization of all publicly held stocks to the U.S. gross domestic product. Until 1996, the value of the stock market had never risen above our GDP, which is, after all, the value of all goods and services produced in the United States. In fact, the average since 1925 is a little over 50 percent; at the market’s 1929 peak, the ratio was 81 percent. But by March 2000, it had hit 181 percent. The price-earnings ratio of the NASDAQ had risen even more drastically. During the 1980s, it averaged 18.5. In March 2000, it peaked at 82.3. At that point, information technology stocks provided around 16 percent of the earnings of the S&P 500 but represented over twice as much—around 36 percent—of its market capitalization.
Some people I greatly respect do not share my skepticism about many of the widely accepted views about the stock market. One is Steve Einhorn, whom I had worked with at Goldman Sachs, where he had been head of our investment policy and stock selection committees, and later head of global research. For several years, Steve, a top-ranked equity strategist for more than a decade by Institutional Investor magazine, has been vice chairman of a large hedge fund in New York. When I sent him a draft of this chapter for comment, Steve reminded me of our first encounter. In his third week at Goldman, he had gotten into a big dispute with me over an arbitrage question about a merger. After being advised by the partner he worked for that this was perhaps not a smart way to start his career at the firm, he came to my office to apologize. He says I told him not to apologize—and to please keep disagreeing with me in the future. A bracing clash of opinions has characterized our relationship ever since. Steve thinks that long-term investors should usually have most of their assets in equities, which have historically outperformed other kinds of investments. He did not think the market levels of the late 1990s reflected collective insanity. Given the strong underlying economic conditions and the low-interest-rate environment, Steve argued that stock prices in the late 1990s, while very high by historical standards, were not demonstrably irrational outside of the tech sector—and therefore subject to normal correction.
My view is that the late 1990s were but one example of the periodic episodes of financial excess that have occurred all through the history of markets. I remember well several of the more recent: the euphoria about conglomerates, whose stock prices went to vast multiples of their earnings in the 1960s; the so-called nifty fifty in the early 1970s—growth stocks such as Polaroid and Avon Products that had innovative products or marketing and were thought to have a limitless future of high growth; the “energy darlings” of the late 1970s; and the southwest real-estate bubble in the early 1980s. The early 1990s saw a biotech boom that foreshadowed another biotech boom at the end of the decade. Excess flows of credit produced by a similar kind of mind-set were at the heart of the Asian financial crisis.
But people involved in markets don’t seem to learn from past episodes. They always think, This time it’s different, and here are the reasons why. Often those reasons are based on genuinely constructive developments, but investors extrapolate too much from the developments and provoke a market overreaction. And that overreaction can endanger the strength of the underlying economy. You might think people would learn from the collective financial experience of mankind. For some reason, they don’t.
I expressed something of my view about the seeming inevitability of periodic excesses at the London School of Economics in February 2000, at what turned out to be the eleventh hour of the stock market boom. I said that what had struck me after returning to New York was the pervasive assumption that everything would always be well and that any interruptions in the advance of prosperity would be temporary and mild—solvable, in any case, by the Federal Reserve Board. I was surprised that relatively few others were concerned about historically extreme stock market valuations and other imbalances in the U.S. economy. But even though I was no longer Treasury Secretary, I still had to be careful, on the chance that a comment of mine might affect markets and because I’m mindful of the fact that nobody is very good at predicting the markets’ short-term behavior. So I didn’t say I thought stocks were overvalued. I said that risk premiums were at historic lows and that discipline tends to get lost in good times.
A number of the people I went to seeking career and financial advice shared my opinion that the market had gone to excess, perhaps badly so. But few were prepared to act in the face of the upward momentum of stocks and the experience of the previous eighteen years. One of the very few who both agreed and acted on that view was Warren Buffett, whom I had known since the 1960s. When we met for breakfast at The Mark hotel in Manhattan, he defended his skepticism about the market.
“Assume today’s stock prices are right,” Warren said. “What kind of earnings growth would companies need to warrant those prices?”
The number, extended out to the future and calculated as a share of GDP, was implausibly large. At that point, Buffett’s Berkshire Hathaway fund, which had avoided high-priced technology companies, was substantially underperforming the market for the first time in thirty years. People had started to write that Buffett had enjoyed a great career as an investor but hadn’t kept current. They said he just didn’t understand the fundamental changes taking place.
Others I met with had an interesting duality of view. One of the first people I went to see in New York was Michael Steinhardt, whom I’d known since I’d first gone to work at Goldman Sachs in the late 1960s. Michael had been an extremely successful hedge fund manager for more than thirty years with a reputation as a shrewd and energetic investor.
“I’m a former public servant, coming to seek your assistance,” I said with mock seriousness. “How would you advise this public servant about how to invest his savings?”
Michael laughed. He had disbanded his hedge fund but still actively managed his own not inconsiderable fortune. Karen Cook, whom I had known from the Goldman Sachs trading room, worked with him, reviewing hedge funds as possible investment vehicles. Michael generously offered me full access to Karen’s research. He told me he was investing in various stocks and hedge funds.
“But Michael, I don’t understand,” I said. “You agree that the market may well be overvalued. And yet you say that you’re invested in the market.”
“People like you keep telling me the market is overvalued,” he answered. “But tell me what you think will precipitate a correction.”
“I don’t really know exactly what will cause it,” I said. “Won’t it just fall of its own weight?”
“But something has to precipitate it,” Michael responded. “And the problem with people like you who keep talking about how overvalued the market is, you can’t point to anything that’s going to precipitate a fall.”
“Well, it’s true,” I said. “I don’t have any idea what it will be. But if it’s overvalued, it’s going to correct. Whatever the proximate precipitator is doesn’t matter. It could be anything.”
By 1999, many shrewd investors were in Michael’s position. In an analytic sense, they thought the market was overvalued but stayed invested anyway, perhaps on the “greater fool” theory that they could profit from an irrational rise and then sell their positions before it was too late. In any case, the relatively few nonbelievers were irrelevant after an eighteen-year bull market that simply fed on itself. The skeptics among market analysts and forecasters had lost their credibility. Nobody—including me—is particularly good at predicting shorter-term market movement, and if I had been invested in stocks during the later half of the 1990s, I would have sold or lightened up much too early. But it does seem to me that investors should at the least have recognized that many conditions had gone to excess by any historical standards and have given that serious consideration in their decision making.
It was striking during that period not just that financial markets went to extremes but that, when they did, people developed convincing intellectual rationales for those extremes. Those rationales seemed plausible both because they reflected real and positive economic developments and because the ongoing behavior of the market appeared to confirm them. By 1999, after an eight-year boom, many commentators were asserting that productivity growth was going to continue at much higher levels indefinitely and that business cycles were history. Two other widely held views were that the Fed was omnipotent and that the market had misunderstood equities all along, with the result that historical risk premiums—the additional return investors demand to hold stocks rather than “risk free” Treasury bonds—were much too high. While Steve Einhorn is correct that equities have outperformed bonds over any extended period of time historically, some digested this view into the shorthand that stocks simply weren’t risky over the long term, or even that short-term declines would always be temporary and that stocks would quickly bounce back.
As an aside, these views provided support for a movement to convert part of the Social Security system into private accounts that could be invested in equities—a political cause that largely faded away after the dramatic market rise of the 1990s came to an end. If this proposal is going to be seriously revived in the political arena at some future time, the very substantial risks attendant to stock ownership should be fully included in the analysis. But it concerns me that the outcome of the debate may be unduly influenced by an ebullient market environment—the only context in which such a proposal is likely to have political viability. Another problem is that there could be irresistible political pressure to make up for shortfalls in accounts for people who retire when market conditions are adverse. This could create additional fiscal problems and skew investment incentives for private account holders. My own view is that we should preserve the guarantee of Social Security, but consider establishing tax credits for savings accounts on top of that, when this is fiscally feasible. If the Social Security guarantee itself needs reform because the system is underfunded, then that is a separate matter that should be dealt with directly.
Each claim about what had changed in the economy reflected some underlying reality. But in most cases, the conclusions for markets were greatly overdrawn. Take the theory that technological advance had led to a structural increase in productivity growth. The issue may not be fully settled, but assume for the sake of argument that the theory’s proponents were right. Surely that would be good news for the economy and for stocks. But it was an immense and illogical leap, as some proponents argued, from technological development to permanent and uninterrupted prosperity, with at most brief and mild interruptions. Or consider the view that business cycles had become a thing of the past. It is true that cyclical recessions have tended to become progressively less severe since the end of the Second World War, in part because of various social safety net programs, such as unemployment insurance and welfare, which increase government spending when the economy is weaker, and because monetary policy has become more effective. However, business cycles remain, because the constants of human nature, such as greed, fear, and complacency, have not changed. As for the Fed, it has indeed become a far more important factor in the economy in recent decades, but it is not powerful enough to prevent all slowdowns. Perhaps risk premiums were once too high, but that didn’t mean that stocks weren’t still significantly riskier than Treasury bonds.
In that kind of environment, the highly charged atmosphere, not evidence and logic, tends to carry the day. Even Sir Isaac Newton, the great English mathematician and physicist of the seventeenth century, was a major investor in the most extreme financial excess of his day, which became known as the South Sea Bubble. The South Sea Bubble grew out of a scheme to convert British government obligations into common stock in a company with a theoretical monopoly on British trade with South America. Practical obstacles abounded: the company’s “officers” had never been to South America; they had scant ships or supplies; and there was no reason to believe the King of Spain would allow Britain to trade with his colonies. Thousands who invested were destroyed financially.
That episode typifies the psychology of market excess. You’re sitting on the sidelines, telling the people around you all the reasons why you think the market may be badly overvalued. And they’re all looking at you, saying, “There’s a new reality, and you don’t get it. You don’t understand how much the world has changed—which is why people like you always fall by the wayside.” That was my experience from the mid-1990s on. Though the underlying strength of the economy was very real, I thought the stock market was probably overreacting.
My concern about market excesses, as I mentioned earlier, inevitably raises a question of great importance to future policy makers: Could Treasury or the Fed have done something to moderate the stock market excesses that seemed to be developing and that could endanger the economy? Alan, Larry, and I discussed this frequently. Though I felt strongly that the markets had gone to excess, I couldn’t be sure I was right and the market wrong. (And in fact, had I chosen to give a warning, I would have done so years before what turned out to be the peak.) Secondly, it was not clear that what we said would have had any real effect. Finally, if our comments did have an effect, they could precipitate a sudden unraveling rather than an orderly decline. And issuing market forecasts that turn out to be wrong can quickly undermine the more general credibility of the prognosticating public official.
But, in speeches and TV interviews, I did the most I thought was sensible for a public official to do: I urged investors to focus seriously on risk and on valuation and said that discipline seemed to have flagged. I don’t think many people paid much attention. Some commentators have since said that tightening margin requirements on common stocks to limit leverage could have helped—either through the limit itself or as a symbol of concern. My own view is that doing so probably would not have had any effect, or at least not enough to make a real difference. Some have also argued that Greenspan should have managed interest rates for the express purpose of dampening the market. I strongly share Alan’s view that monetary policy should be directed toward the economy, not the stock market, both because the Fed is no more able to judge whether markets are too high, too low, or just right than anyone else, and because Fed actions driven by markets might be at variance with the best policy for the economy. But as Alan has explained in testimony to Congress, this issue can become extremely complicated, in part because the stock market affects the economy in many different ways. In any event, critics who argue for using interest rates to influence the stock market might quickly change their minds if the Federal Reserve Board actually did that.
BY THE TIME the long bull market finally came to an end, a sense of unreality permeated the entire business world. Many in Silicon Valley were of the opinion that nothing that took place outside the Valley was relevant to them. You would meet twenty-five-year-olds who thought that nothing that had happened before the Internet mattered. We were in a new world, free of business cycles and traditional notions of valuation. Those who didn’t understand these new realities were hopelessly outmoded in their thinking.
My sense of the delusions of that era is encapsulated in a story from January 2000, just before the technology bubble began to deflate. The CEO of a dot-com company came to see me at Citigroup. Just what his company did was unclear to me, but at the time it was seen as possessing new technology of immense potential. At its peak stock price, the company, which had no earnings to speak of, had a market capitalization that exceeded $20 billion—far more than that of many very large, historically profitable industrial concerns—and the CEO was a multibillionaire.
Not given to modest claims, the CEO told me that the company had developed technologies that were going to “obliterate” the financial services industry in its current form. Citigroup’s only hope for survival was to partner with him.
“You may well be right, but I’m not qualified to judge your technology, so how can I evaluate that statement?” I responded. I suggested he meet with our technology people.
He was nonplussed. “I don’t meet with technology people,” he said. “I just told you how you can save your bank. Don’t you want to save your bank?”
It was an amazing meeting. The CEO did eventually meet with people in our technology division, but nothing came of that. The company’s stock later fell dramatically.
The S&P 500 dropped from 1,527 in early 2000 to 777 in the fall of 2002. The NASDAQ went from 5,049 to less than 1,114—a drop of almost 80 percent. And the Dow Jones Industrial Average fell from a high of 11,723 to a low of 7,286. All in all, from peak to trough some $8.5 trillion in paper wealth, of what had been a total market capitalization of almost $18 trillion, was lost. More than one thousand publicly traded companies either went bankrupt or were delisted from the major exchanges.
Steve Einhorn argues that the market reversed course for specific reasons. And I agree that there were real changes in that period that certainly would have been expected to affect stock prices: the fear of terrorism after the World Trade Center attack, the economic slowdown, and the whole host of corporate governance and Wall Street issues, to name three. But, in my view, the change in market prices and market psychology was far greater than the change in the underlying economic realities. I still think that the most fundamental explanation is that the market fell of its own weight. A substantially overvalued market has to come down—and better sooner than later. Everyone would have been better off if stocks had regained a semblance of sanity sooner. But it’s good that it didn’t happen even later, with an even steeper fall from even higher levels. The market drop also caused at least some people to begin discussing valuation more realistically.
Even after the decline, however, many of the old assumptions about the long-term behavior of stocks persisted. The belated effects of the eighteen-year bull market—the only kind of market people younger than forty had ever known—continued to support unrealistic views about equities. Complacency about stocks and the view that they would regularly provide returns of 15 to 20 percent, with interruptions being brief and quickly repaired, had become so powerful that they partially survived the sharp decline and the large losses incurred.
In the search for the villains who had caused the market excesses, people tended to disregard the most obvious one of all: the widespread notion that the stock market was a path to easy riches. For many years, the securities industry has emphasized the benefits of everyone owning stocks and “investing in America.” In one sense this may be right, but my view is more complicated. The great broadening of stock ownership over the past couple of decades has been a positive force, both for individual investors and for society, by sharing the benefits of ownership more broadly and by giving more people the feeling of having a greater stake in our system. And allocating a portion of one’s assets to stocks probably does make sense for most people. But any investment should be accompanied by a realistic focus on the risks of equity ownership and a rigorous approach to valuation. Some who invest understand the risks, but too many do not. And too often, the industry—and the media—have not done a good job of explaining these risks to the investing public.
MANY OF THE FACTORS that contributed to the market excesses remain issues even after the collapse. One that continues to trouble me is the prevalence of short-term thinking and an excessive focus on quarterly earnings, rather than on long-term results. Indeed, the disproportionate attention paid to the short term, which preceded the market boom of the 1990s, seems to have survived the decline largely intact.
How did this attitude develop? There have always been people trying to get rich quickly in the stock market, of course. But my sense is that the mentality of the market changed significantly around the time I joined Goldman Sachs in the mid-1960s. During my early years on Wall Street, investing in stocks was still viewed by many as a long-term proposition, primarily for institutions and wealthy individuals, though all that was already changing rapidly. I remember Bob Danforth, the head of our research department, telling a story about the 1950s. Bob said he had sent out a research report recommending Chesebrough-Pond’s, the cosmetics company that made Pond’s Cold Cream and Vaseline. A year later, he got a big order. The client called and said, “We’ve read your report, we’ve studied it and thought about it. And now we’re ready to buy the stock.” Bob was very pleased.
In those days, markets were slower, transaction costs were higher, and middle-income people were far less focused on the stock market in general. When I graduated from law school, 6 million shares would trade on a busy day on the New York Stock Exchange, compared to an average volume today of more than a billion shares. Contrary to the common view on Wall Street, I would say that this was better in some ways. The markets were less efficient, to be sure, but there was also less emphasis on short-term trading, more emphasis on long-term prospects and the fundamentals of companies, and a more balanced sense of the risks in owning stocks.
I don’t want to draw too rosy a picture of what markets were like before the ’90s boom. Greed, fear, and complacency are constants of human nature. Speculative excesses have always occurred. The mid- to late 1960s, in particular, were marked by a lot of volatility and excess; a well-known book about that period was titled The Go-Go Years. But even at the height of the 1960s excesses, many people remained affected, at least to some extent, by the 1930s. Memories of the Great Depression influenced thinking about markets for the older generation working on Wall Street, in the media, and for much of the American public. Many people still retained a sense that stocks were inherently risky. They knew in their bones that the worst could happen in markets.
By the 1990s, most of the people of Gus Levy’s generation, who had experienced the Depression personally, were gone, and attitudes had continued to shift more broadly. The change in mentality coincided with enormous changes in the market, driven in part by the increasing clout of institutional investors: pension funds, charitable endowments, and mutual funds. You might think that these funds, which were professionally run, would have been long-term investors, so-called patient capital. After all, pension funds fund long-term liabilities—retirement savings. But that wasn’t what happened. Pension funds became a driving force for short-term thinking in corporate America.
Consider how it worked for a big industrial company such as General Motors in the 1960s. The company’s pension fund was required to have sufficient resources to fully meet future expected pension costs. So, every year, General Motors had to make a contribution of more than $40 million to its pension fund. That contribution is a charge against earnings. But the better the performance of the stocks in the fund’s portfolio, the smaller the company’s annual contribution would have to be—or perhaps no contribution would be needed at all. Earnings would thus be higher, which would help raise the company’s stock price. So, as companies were being evaluated more and more on their quarterly earnings, those companies began to focus more on the short-term performance of their own pension-fund portfolios. The very CEOs who complained about quarterly pressure were putting quarterly pressure on their own money managers, who would in turn put pressure on the companies in whose stocks they were invested. The result was a cycle that was, depending on one’s perspective, either virtuous or vicious. And as mutual funds turned into popular investment vehicles and a competitive industry, the same phenomenon occurred there.
Other changes fueled this increased focus on quarterly earnings as well. Fixed commissions on the New York Stock Exchange were abolished on “May Day,” May 1, 1975, and firms started to give discounts on large trades. This meant that wealthy individuals and institutional investors were able to trade much less expensively, which intensified their short-term focus on the market and increased portfolio turnover. Transaction costs for middle-class investors remained relatively high until the early 1990s, which discouraged individuals from trading small quantities of stock frequently. But with the rise of discount brokerage houses such as Charles Schwab, and the advent of on-line trading, people of modest means could buy and sell a few hundred shares for a commission of $20 or less at the touch of a button. The bull market that began in 1982 and the advent of easier and cheaper trading encouraged less sophisticated investors to trade more and more. Again, the conventional view is that reduced costs and greater ease were a uniformly positive development. In my view, they were a mixed blessing.
By the end of the long bull market, America was living through an explosion of amateur investing unlike any the world has ever known, except perhaps in the late 1920s. Twenty-four-hour business news channels such as CNBC and CNNfn began providing the background hum in airports, restaurants, and gyms. Securities analysts, once the least glamorous toilers on Wall Street, became well-paid celebrities. People with no background or training were quitting their jobs and setting up shop as day traders. All of this tremendously accelerated the emphasis on the short term.
Of course, the focus on quarterly earnings is not purely a pernicious development, but has both positive and negative consequences. In the mid-1980s, I talked about this with Mark Winkelman, my partner at Goldman, who ran our foreign exchange and commodities activities. “You know, the terrible weakness of our system is that it’s so short-term focused,” I said.
Mark didn’t agree with me, because he felt that a short-term focus forced companies to face problems. With ideal corporate managers, a focus only on the long term would be optimal. But human nature being what it is, managers can use the long term as an excuse for not addressing problems. “Look at Japan,” Mark said. “They have patient capital and a long-term focus. And the result is they don’t face their problems.” At that point, many people thought Japan had developed an economic model superior to our own. I’ve come to appreciate that Mark was at least partly right. People who aren’t held accountable in the short term often won’t make tough decisions and use the long term as their excuse. They say, “We’re investing in the future.”
But as time went on, the short-term focus became greater and the balance got out of proportion. Focus on the short term caused corporate decision makers not only to face problems—which was good—but also to give too little weight to the long term. When I left Washington in 1999, I was astonished at how much greater the short-term focus had become during the bull market. Commentators on the business news channels virtually never spoke about the five-year prospects of companies or had serious discussions of valuation. They talked instead about the short-term direction of the stock and quarterly earnings—or, with dot-coms, revenue growth, “eyeballs,” and visions of days to come. Today, an analyst who forecasts the five-year prospects for Ford Motor Company will probably never make a living. His customers want to know what the next quarter’s going to be like. Virtually every time a company misses expectations about quarterly earnings, by even a penny or so, the stock goes down in knee-jerk reaction, rather than the “missed quarter” being analyzed to see whether that miss had any ramifications for the longer term. As an illustration of how distorted the system has become, any technology purchasing manager for a big company will tell you that the best time to buy a high-tech service is in the last week before the end of the quarter, when technology companies are desperate to find income they can recognize in time to boost their quarterly earnings.
I remember one lunchtime conversation I had with the CEO of a well-known industrial company. He said, with great frustration, that the market’s short-term focus made it impossible for him to adequately implement an exciting long-term strategy his company had developed. To make the point, he described how he had just met with a major institutional investor and had set forth his company’s long-term strategy. “To accomplish this long-term purpose, we need to invest now,” he had said, “and we’ll have these wonderful benefits down the road.” And the institution’s response had been: “We don’t want you investing for the future. Not because we disagree with you about the long-term benefits, but because we’re not going to be there for the long-term. What we care about is your next quarter.”
When I got to Citigroup and began working at a public company for the first time in my life, the realities of this problem were driven home to me. My initial reaction was that Sandy Weill was focused on quarterly results in a way that might not maximize our income over time. But I’ve come to recognize that Sandy’s near-term drive exemplified what’s sensible about the Mark Winkelman point—and is one of Sandy’s great strengths as a manager. Sandy’s view is that you have to keep on top of people ferociously with respect to the current quarter for two reasons. The first is that people are forced to face issues they might otherwise defer. The second is that the short-term stock price does matter. A quarterly numbers disappointment generally drives a stock down. And the lower stock price hurts morale, reduces your ability to make acquisitions, and makes it harder to retain key employees who have been given stock options or shares that become theirs only after they’ve been with the company for a specified period. In fact, stock options themselves have been greatly criticized for exacerbating the problem of excessive short-term focus. But properly used, they can serve a useful purpose in giving employees a long-term ownership stake in the company.
But to the extent that companies place undue weight on short-term performance, corporate earnings may be suboptimal over the long term and our economy as a whole may fail to realize its full potential. Given the realities of life, companies may rightly feel that the right balance is more toward the short term than is needed to accomplish the purposes Mark Winkelman identified. The thus far unanswered policy challenge is what, if anything, can be done to create an environment where investors—and, by extension, companies—shift their focus more toward the longer term.
ONE FACTOR IN the changing public attitudes toward the stock market was the wave of corporate scandal that overtook markets beginning in late 2001. After companies including Enron, WorldCom, and Tyco, once touted as models of the new economy, collapsed in recriminations, investigations, and prosecutions, the idealization of corporate America gave way to a sense of mistrust. Citigroup was enmeshed in this because it was involved in lending, structured finance, or other transactions with many of these companies, which were among the largest in the country. In addition, Citigroup owned Salomon Smith Barney, one of Wall Street’s major investment banking firms. And while the specific circumstances differed from place to place, all of the major firms were engaged in activities that, while clearly troubling in retrospect, were common to the whole industry. Practices such as allocating desirable IPO shares to favored customers and not clearly separating stock research from investment banking were well known to the regulators and the media, but they had seldom been seen as problematic until the great bull market came apart.
Once people focused on these practices, it was obvious that they, as well as issues around accounting and corporate governance, needed to be addressed. Citigroup did that by making some fundamental changes in the way it did business, and it settled with its regulators on Wall Street research issues as well as Enron-structured finance transactions, though private civil litigation relating to these matters is likely to continue for some time. The other major Wall Street firms went through a similar process and all adopted roughly the same new standards and practices. There were also important and useful legislative responses, such as the Sarbanes-Oxley Act of 2002, as well as new regulations from the federal agencies—though all of this is not without cost in terms of increased process and paperwork.
But a broader question remains—one that, if understood, may help to minimize the incidence of future problems. Why didn’t regulators, legislators, and industry participants—myself included—recognize and act upon these issues much sooner? Why didn’t more members of the media, who in writing about some of the accomplishments of star research analysts sometimes cited their success in developing investment banking business, focus on the issue of conflict of interest? How was it that the gatekeepers—the accountants and lawyers—did not recognize and act on these matters? Perhaps the answer is that the great bull market masked many sins, or created powerful incentives not to dwell on problems when all seemed to be going so well—a natural human inclination. Also, I do think most people assumed that, even with the conflicts, research analysts—and, in the context of another set of issues, accountants—wouldn’t intentionally mislead investors, and I think that was true in the great preponderance of cases.
The key to successful reform—with both corporate governance issues and Wall Street practices—was to make sure legislative and regulatory responses effectively addressed the problems without undermining the efficiency of our capital market system or the many strengths of our corporate government system. One cautionary note is that many worry that what has been done has had unintended effects on corporate decision making. Jack Welch put it well at a small dinner we attended together in 2003. He said that the only topic CEOs used to want to talk about was growth. Now all they wanted to talk about was corporate governance. In a climate where in hindsight honest mistakes or risk-taking decisions that turn out badly are confused with dishonesty, managers can become far less willing to take a chance of failure. While clearly there was a need for additional protections, the key going forward is to make sure reforms are implemented in a way that preserves the strengths of our system.
THE ENRON STORY also had an unexpected side effect for me. In November 2001, when Enron was already in very serious financial trouble, the company was seeking to merge with Dynegy, another energy-trading firm. Citigroup was a creditor of Enron and would ultimately recognize losses on that position. Enron’s well-being also raised a substantial public policy issue for the country—a concern, widely reported in the press, that the company’s possible bankruptcy could seriously disrupt energy markets in the United States because Enron was the central trading hub in a number of those markets. Although those feared consequences ultimately didn’t materialize, at the time they resembled the concerns about the collapse of Long-Term Capital Management, which had led to intervention by the New York Fed in 1998.
In Enron’s case, creditors were concerned that if the credit rating agencies downgraded Enron’s debt, counterparties would no longer be willing to engage in trades or long-term contracts with Enron. That would almost surely doom a Dynegy merger and lead to Enron’s collapse since, at this point, without the financial support of Dynegy, Enron could no longer remain a viable trading company. Enron’s creditors would certainly suffer if it went bankrupt, but many feared that the economy as a whole could take a significant hit as well.
Several banks that were Enron creditors agreed that they might be willing to put up more money to support Enron in order to maintain its credit ratings and the strength necessary to keep trading, thus allowing the Dynegy merger to go through. There was, however, a substantial concern that the ratings agencies would downgrade Enron before the rescue package could be put in place, and a corresponding view that with just a few more days, a package might well be assembled. In that context, I placed a call to Peter Fisher, a senior official at the Treasury Department, whom I had known when he was at the Federal Reserve Bank of New York. I asked Peter whether he thought it would make sense for him or someone else at Treasury to place a call to the rating agencies and suggest briefly holding off on any downgrade of Enron’s debt while the banks considered putting in more money. I prefaced our conversation by saying that my suggestion was “probably a bad idea,” but that I wanted to see what he thought. As it happened, Peter thought it would be a mistake for Treasury to intervene in this manner, and that was the end of it.
I was, however, subjected to a good deal of subsequent scrutiny about my call to Peter. Of course, in the wake of Enron’s implosion and the stunning revelations of fraud and misconduct that followed, it became obvious that the company couldn’t have been salvaged. I can see why that call might be questioned, but I would make it again, under those circumstances and knowing what I knew at the time. There was an important public policy concern about the energy markets—not just a parochial concern about Citigroup’s exposure—and I felt that if a modest intervention by Treasury could potentially make the difference in avoiding a significant economic shock for the country it was worth raising the idea with an official there.
I was guided in this thinking by the knowledge that I would have wanted to hear suggestions of that kind when I was at Treasury, and knowing that I would have been entirely comfortable rejecting them if I thought they didn’t make sense for the country. I believed that Peter Fisher would have a similar mind-set—interested in hearing ideas that might conceivably be helpful, but unabashed about turning such ideas down if he thought that was the right course. And that is exactly what Peter did.
A subsequent bipartisan congressional staff review of my call to Peter concluded that nothing improper had transpired. By that time, however, the call had become fodder for a personal attack against me, not because of anything related to the call itself, but because of my role in the ongoing debate about economic policy and because I’d come to personify the policies of the Clinton era. At that time, the economy was still very weak and commentators were increasingly comparing President Bush’s economic stewardship unfavorably to President Clinton’s. I wrote a lengthy op-ed piece in the Sunday Washington Post about how to rebuild economic confidence, which expressed great concern about tax cuts that undermined long-term fiscal discipline. My engagement in the economic debate seemed to infuriate some tax-cut proponents, who then seized upon the Peter Fisher call and everything else they could think of to attack me. (“You’re a mouse and they think you’re a gorilla,” Bob Strauss pointed out.) The nature of the attack became clear when the Republican National Committee e-mailed hundreds of journalists an inflammatory “opposition research” memo that dredged up long-discredited accusations that I misled Congress during the debt-limit crisis in 1995 and made various unwarranted assertions about Enron. A Republican congressman went on CNN and made the connection explicit: he said my call to Peter Fisher was fair game for attack because I had chosen to criticize the administration’s economic policies.
After my years in government, I suppose I shouldn’t have been surprised about being the object of ad hominem attacks when I challenged the opposition on policy issues. But I still think that this approach to policy differences and to politics does a deep disservice to the vigorous exchange of views so essential to our democratic political system.
ANYONE WHO PARTICIPATES in financial markets—whether as an individual investor, a Wall Street bond trader, or a company CEO—has to make fundamental decisions about risk. At an individual level, such choices affect one’s financial well-being and peace of mind. At the corporate level, they affect profitability levels. And at the broadest collective level, decisions about risk have potentially enormous economic consequences. In a world of immense global trading markets, the success of institutions, the liquidity and efficiency of markets, and the safety of our financial system depend to a great extent on how well the complex process of risk determination is carried out by the vast numbers of participants—individuals and businesses—involved in the financial markets.
Many people arrive at accepting some level of market or trading risk through instinct, aversion, or feel. My approach, by contrast, has always been to try to make risk decisions on an analytic basis—even if they involve judgments about such intangibles as how much one can handle emotionally and the less-than-rational actions of others in the markets.
In making any decision about risk, the logical first step is to try to determine at what point additional risk no longer carries potential rewards that exceed the potential losses, given the respective probabilities of the good and the bad. The actual measurement of these probabilities, of course, is immensely complicated. But this calculation, which can be organized on an expected-value table, remains the most fundamental basis for decisions about risk.
However, the problem quickly grows more complicated. As an illustration, consider the choice a major financial institution such as Citigroup faces in choosing an optimal level of trading risk—that is, the level of risk incurred by the firm’s own traders trying to maximize return on some portion of the firm’s own capital. That is a far more complex question than it might seem to be at first, with many dimensions that can’t be quantified on an expected-value table.
To begin with, a public company such as Citigroup is very different from the private firm Goldman Sachs was when I was there. A public company’s stock price is a function of its earnings and the multiple the market decides to put on those earnings. And financial markets value stable earnings growth more highly than a volatile earnings path, even if the total profits at some projected end point are the same. So a public company has to determine both what will maximize its earnings over time—adjusting that calculation for risk—and also the effect of greater volatility on the multiple. Only after making these judgments can one make an educated guess about what level of risk will maximize a company’s share price over time.
At a large financial company today, none of this is easy. In part, the difficulty arises because of the immense size and complexity of a firm’s positions, which typically include stocks, bonds, derivatives, and currencies. In part, it arises because of the intrinsic difficulty of deciding which risks correlate with one another and which are likely to offset one another. And in part, it is due to the inherent uncertainty in trying to estimate rewards, risks, and probabilities. It is also extremely difficult to get managers to be ruthlessly analytic and to put their emotions and opinions aside.
Nor is that the end of the road with respect to risk management. Maximizing the expected value of results over time is a critical but not sufficient guide to decision making. Even when the expected value for additional risk is positive, every trader or investor—from the smallest individual to the largest commercial or investment bank—must decide, as a separate matter, how much loss he or it can tolerate, financially and psychologically. As an additional complication, there is one type of financial risk, the risk of remote contingencies—which, if they occur, can be devastating—that market participants of all kinds almost always systematically underestimate. The list of firms and individuals who have gone broke by failing to focus on remote risks is a long one. Even people who think probabilistically, and are highly analytical and systematic, often dismiss remote contingencies as irrelevant.
In this regard, I often think of an example from Goldman Sachs when Jon Corzine, then the firm’s exceedingly successful head of fixed-income activities, wanted to take a large position in farm credit bonds. The expectation was of a high return, and because the bonds were backed by the “moral obligation” of the U.S. government through a new agency known as Farmer Mac, the probability of their defaulting seemed close to zero. But what Steve Friedman and I asked Jon was “What if a problem develops in farm credit and as extremely unlikely as it might be, the government declines to stand by its so-called moral obligation?”
“That’s silly,” Corzine replied. It was inconceivable to him that the government would not honor its moral obligation, and in a sense he was right.
But Steve and I didn’t want Goldman Sachs to cease to exist after 130 years because something that we agreed was virtually inconceivable actually happened. In theory, you don’t ever want to be in a position where even a remote risk can hurt you beyond a certain point—and you have to decide what that point is. Too often, risks that seem remote are treated as essentially nonexistent. In this case, the remote contingency never occurred, but the decision to limit the risk was right.
As a practical matter, if you want to be in the business of trading or want to invest, all sorts of remote contingencies have to be set aside, from systemic financial collapse to catastrophic meteorites to nuclear war. We once explored this idea at Goldman and concluded that if we really wanted to take into account every catastrophic contingency, we couldn’t be in business. But even if you can’t avoid all distant risks in practice, it’s sensible to think explicitly about which ones you’re choosing to take and which should be diminished or avoided.
WHEN I ARRIVED at Citigroup, it had of course done much risk analysis, and Sandy Weill and his team had reached judgments suited to the institution. But from time to time, senior executives revisited the issue. After becoming Citigroup’s president in 2002, Bob Willumstad raised a risk-related question not just about trading but about our allocation of capital overall. We had more than $80 billion in equity capital employed in our various businesses. Were our assets allocated in the most effective way possible? Perhaps a bit more should be in Brazil and a bit less in credit cards, or vice versa. Willumstad pointed out that at Citi, as at any company, all kinds of operating assumptions had built up over time, none of which was necessarily right. Some additional analytical work on risks and returns could challenge a lot of the conventional thinking, perhaps causing us to reduce some activities and increase others.
This kicked off an even broader discussion of how to evaluate conventional wisdom inside a company. I remember one meeting in my office that included Hamid Biglari, an Iranian-born Ph.D. in nuclear physics who was then our head of corporate strategy; Chuck Prince, then Citi’s chief administrative officer; Kim Schoenholtz, our chief economist; and Lewis Alexander, our chief emerging-market economist. My response to Willumstad was that any institution will always have immense resistance to conclusions that differ from the conventional wisdom. Any conclusion that pointed toward significant change would inevitably be attacked. People with a vested interest in the status quo would find flaws in the study’s methodology, in the way risks were calculated, in indirect effects and factors that hadn’t been considered. Under that kind of attack, a program for change can easily dissolve into an endless, irresolvable debate.
Moreover, the people who raised these objections to analytic conclusions pointing to change wouldn’t necessarily be wrong. Analytic rigor was a critical starting point for the discussion. But financial analysis could never encompass all of the relevant considerations. There were factors in some of our businesses that couldn’t be quantified but that could have great economic impact, including synergies between the businesses, impact on our image, and so on.
Not long after I became a partner at Goldman in the early 1970s, the late Hyman Weinberg, our capable CFO, did a business-by-business profit and loss statement. That would now seem rudimentary, but we’d never done one because some people felt it might cause discord in the partnership. Hy found that investment banking—the business Goldman was best known for—wasn’t actually profitable for the period he was looking at. John Whitehead, the highly respected head of investment banking at the time, responded that he knew that investment banking was profitable. If Hy’s methodology didn’t show that result, the methodology must be flawed.
Oddly enough, both Hy and John may have been correct. Investment banking is people-intensive, and the people tend to be extremely well paid. Thus at times good profit margins can be hard to achieve, although, as in Goldman Sachs’s case, the business can be highly profitable over long periods, when conditions are at least moderately favorable. But even if Hy was right about investment banking not being profitable for the period he was looking at, John may also have been right in the sense that investment banking probably made a substantial nonquantifiable contribution to profitability by enhancing the prestige and standing of the firm, thereby attracting clients in other areas.
The right conclusion, I think, is that ongoing change is critical to success, and even to survival, but that ultimately challenging conventional wisdom is a matter of judgment. For example, measuring risk-adjusted returns on capital, as Bob Willumstad originally suggested, can be very useful as a tool to inform judgments. But a great danger for any institution is that such tools can take on a bureaucratic life of their own—especially as they come to be viewed as more sophisticated and “scientific”—and begin to drive decisions formulaically rather than contributing as inputs to broader judgments.
EVEN AFTER THE MARKET had started to fall, the tendency of otherwise intelligent and thoughtful people not to think clearly about stocks and investing continued to strike me. I remember when a shrewd venture capitalist came to my office and gave me a book. “These people have a system that works,” he said.
“Well, you know, I’m pretty skeptical about systems,” I responded.
And my friend said, “You read this, and you’ll see. These people have done it.”
The book covered a period from about 1995 to 1999, during which the stock market had essentially gone straight up except for a severe downdraft in 1998. Once I saw the four-year track record, I didn’t bother reading to see what the theory was. During those years, all you had to do was buy stocks to do extremely well. I threw the book out because I was afraid someone might see it on my desk.
During the strong market of the 1990s, most investors who rode the wave ignored traditional ideas about valuation. Some money managers remained invested on the basis of a practical calculation: “If the market continues to rise and I’m not participating, I’ll lose my job. But if it falls dramatically, I’ll be in the same situation as everyone else.” Others were conscious market cynics who thought they could successfully exploit the foolishness of others. Momentum investors didn’t need an opinion about valuation. They were consciously saying, “The market may be overvalued—we don’t know and we don’t care. All we know is, it’s been going up, and we’re going to invest as long as it does—and get off the train before everyone else.” The problem lies in executing the greater-fool theory. If you get off every time the market ticks down and then reestablish your position when the market starts to go up again, you’re going to get killed, because even rising markets fluctuate on the way up. And if you wait, you risk going down with everyone else.
With the stock market decline after 2000, many of the new-paradigm theories lost credibility. That should have brought renewed attention to the failure of most “active” fund managers—people who pick individual stocks rather than passively investing in an index—to outperform the market over the long run. Over long periods, the S&P 500 index has done better than the preponderance of active managers. Few mutual funds, hedge funds, or money managers consistently beat the indexes over a decade, let alone several decades.
When I express these kinds of views in speeches or interviews, I am often asked, “How should people with limited resources think about investing?” I’m not in the business of giving financial advice, but I have learned something about how to think about these matters. My guidance is fairly conventional and hardly exciting. But however commonplace it may seem, people tend not to follow it, especially when the adrenaline starts rushing.
The most important part of my answer is that investors should recognize the risks they’re taking. Stocks outperformed bonds for every decade of the twentieth century, except for the 1930s and a roughly equal performance in the 1970s. But there is no guarantee that the future will replicate the past or, at the least, that there won’t be long periods of poor or mediocre stock market performance. And even if stocks as a whole continue to outperform bonds over the long run, many individual stocks will still perform badly. You might simply pick the wrong stocks and as a result significantly underperform the market—just as many professional money managers do.
And even if the historical outperformance of equities holds true and you do not pick the wrong stock or group of stocks, there may still be extended periods of adverse market performance. You, as an investor, simply may not be able to stand a wait of five to ten years or even longer, either financially or psychologically. Stocks that outperform bonds in the long run may also underperform them badly for lengthy periods within that “long run.” Over the seventeen-year stretch from the last day of 1964 to the last day of 1981, the Dow closed at the same level—874 in 1964 versus 875 in 1981. While the S&P 500 did rise by 45 percent during the same period, that is still only roughly 2½ percent per annum (plus the average dividend yield of roughly 4 percent). And after several years of difficulty, you have no way of knowing if the markets will improve or continue to deteriorate. Investors who want to retire or send their children to college may discover that they can’t continue to wait for the hoped-for benefits of the long term, while other investors may simply not be able to live with the stress of large loans and the uncertainty of what might happen next. In reality, people often can’t tolerate an extended downturn, so they get out and take their losses, only to reinvest when the market rises. When it falls again, they get whipsawed.
Even with all those qualifications, most investors who are in a position to have a long-term perspective should probably have some portion—and in appropriate cases even a fairly substantial portion—of their savings in stocks. The threshold questions are: How much? And should decisions about asset allocation be subject to short-term market views? There are all kinds of models that recommend the proportion of investible assets to put into stocks, based on performance data in stocks over some long prior period of time and the circumstances of the individual investor. An alternative is for an investor to start with a full understanding of the risks and then to decide how much he could live with losing if his investments fell substantially. That would set the outer limit of the equity allocation. The amount to actually invest in equities within that limit would be affected by a whole host of factors, including the investor’s time horizon and income needs, and a disciplined approach to calculating likely risks and rewards over whatever the time horizon may be. In my own case, I have also made the judgment that I should avoid what I thought were times of market excess, while recognizing the uncertainty of those judgments. I certainly would not put all of my money into stocks, or put too much into a single stock or small number of individual stocks, or into any one sector of the economy. And I would buy stocks based only on the long-term prospects of a company, with a view toward holding any investment for a very long time unless those prospects change or valuation rises to irrational levels.
Warren Buffett is famous for this “value investing” approach—buying companies only when their prices are low relative to their long-term earnings prospects, with a view to being a very-long-term holder of the stock. I think that approach, carefully and consistently executed, provides the best opportunity to outperform the market indexes over time. Those who aren’t particularly well positioned to make judgments about individual stocks can choose a mutual fund that has executed this approach successfully for a long time or a financial advisor who seems well equipped to do so. Another approach is simply to invest in an index fund, whose performance will track the market’s. For those with sufficient resources, a wider range of possibilities has become available: so-called alternative investments, such as a private equity fund or various kinds of hedge funds. Conceptually, these alternatives can make good sense, but they are now becoming popular and faddish and may quickly become a new set of excesses, with unhappy results for many investors. For example, one postboom fashion has been “long-short” funds that attempt to be at least somewhat market-neutral by having long and short portfolios that are close to equal in size. The idea is to get the benefit of your selections whether stocks as a whole go up or down. Most active managers have made money over the last twenty years not because of their active management but because the market as a whole went up so much. With a market-neutral approach, you take away the one factor that has allowed most active managers to reap gains over the last twenty years—namely, the rise in stock prices—and keep the factor that history has shown most don’t succeed at—namely, active management. I do believe that some investors have the judgment, skills, and patience to outperform the market indexes over time and, consequently, some long-short funds will almost surely do well, but I would guess that the great majority probably will not.
Finally, there is the challenge of evaluating results. For stretches of time, a stock picker may outperform the market for reasons that have nothing to do with skill. He may simply be in sync with the biases of the market—favoring telecommunications stocks, for example, during a period when the market as a whole favors them. Or he may be lucky. The “random walk” theory posits that if a large number of monkeys pick stocks by throwing darts at stock tables, half will do better than the average stock picker and half will do worse. If the winning monkeys then repeat the exercise once each year for ten years in a row, one out of 1,024 will beat the average every year, merely on the basis of probabilities. A stock picker who beats the S&P 500 ten years running will almost surely be lionized as having a special genius—and some may—but others will do so merely as a matter of chance.
THINKING BACK ON my own financial behavior, I’m reminded how commonly markets fail to behave the way you expect, feel, and hope. I’ve always had a cautious view toward stocks and have never invested a lot, partly because for most of my career I had significant exposure to the behavior of markets through my stake in Goldman Sachs. But in 1973, when the market slumped badly, a few companies whose fundamentals I knew well had come way down and seemed very cheap relative to their long-term value. Yet from the time I bought them to the time the market bottomed out in 1974, my investments fell in price by 50 percent.
The point of that story is that even a careful and highly disciplined investor can’t see a market bottom any more easily than he can see the top. The broader point is that no one is very good at predicting the direction of the market in the relatively near term, and investors should allocate their assets based on long-term judgments about risks, rewards, and personal risk tolerance. However, as I said, that’s a bit of advice I’ve never taken myself, tending instead to inject my own shorter-term market views. If I remember only the times I was right, for example 1998 to 2000, I have a terrific track record. If I’m more honest and remember all my judgments, I’m probably not much better than fifty-fifty on shorter-term market judgments—and I don’t think anyone else is either. My experience in 1973 is probably also a warning that one should never be an absolutist about anything—including being a contrarian. If you see a long trend in one direction, question its soundness. But if you decide to bet against the herd, as I did in 1973, recognize that the stampede may go on for a very long time—and the herd may even be right. As my Goldman partner Bob Mnuchin used to say, people who sell at the bottom aren’t stupid. The problems are real and the outcome is uncertain. Only in retrospect can you tell when the worst is over.