I
Stock markets are like electricity and sewage systems: extremely useful inventions that can sometimes go haywire. Stock markets transfer resources from people who have savings they don’t know what to do with to businesses that have investment projects they don’t have enough money to finance. This may sound trivial, but it isn’t. Economic systems that have relied on other methods of mobilizing savings for investment, such as government fiat (the Soviet bloc) or the banking system (Germany), have run into problems. And stock markets don’t just allocate resources; they also provide incentives for innovation and hard work. If an entrepreneur sets up a company that does well, he or she can issue stock to investors in an IPO, a process known as “going public.” The promise of striking it rich in the stock market gets a lot of people out of bed in the morning.
The first stock market, as far as we know, was in ancient Rome, at the Forum, where men of means gathered to trade all sorts of things: land, houses, ships, cattle, slaves, stocks, and bonds. The stocks (partes) and bonds were issued by the publicani, companies that carried out many of the functions of the Roman government, such as collecting taxes, building temples, and dredging rivers. As the British historian Edward Chancellor points out in his highly informative book, Devil Take the Hindmost: A History of Financial Speculation, it is no surprise that the first stock market should have been in Rome.1 The Roman Empire had a system of laws that protected private property and allowed it to be freely traded. In the dark era that followed the collapse of Rome there was no rule of law and little trade beyond barter. It wasn’t until the Middle Ages that financial markets reappeared, with the issuing of government bonds by Italian states, such as Venice, Florence, and Genoa. The Italian city-states also created companies with tradable shares, but it was in Antwerp, Belgium, in the sixteenth century, that the first modern stock market appeared. After Spanish troops invaded Belgium in 1585, most of the traders moved to Amsterdam, which became the financial capital of its era, with banks, double-entry bookkeeping, joint-stock companies, and a stock market where people could invest in companies of all kinds.
Speculation—buying things in the hope that their price goes up before they are sold—is at least as old as stock markets, and so is the feverish mind-set that speculators invariably fall victim to. The speculators of sixteenth-century Amsterdam were “full of instability, insanity, pride and foolishness,” a contemporary testified. “They will sell without knowing the motive; they will buy without reason.” Even on their deathbeds, “their last worries are their shares.”2 It was in Holland that the first recorded speculative craze occurred—in tulip bulbs. During the “Tulipmania” of the 1630s, the price of Gouda bulbs went from 20 guilders to 225 guilders. Croenen bulbs went from 20 guilders to 1200 guilders. (The average annual wage at the time was about 300 guilders.) In February 1637, the tulip market crashed, and many speculators went broke.
The first recorded stock market mania occurred in London, in 1720, when the South Sea Company, which had been granted a government monopoly on trade with the Spanish colonies in South America, issued stock. In six months, the price of South Sea Company shares went from 128 to 1,050. A great wave of speculation took over London, and everybody from Alexander Pope to Isaac Newton to King George I got caught up in it. Enterprising men looked at the buoyant market and rushed to found new speculative vehicles. These “bubble companies,” as they were known, would post notices in the newspaper laying out their business plans and offering to take subscriptions at coffee shops in the City of London. There were technology companies, such as Sir Richard Steele’s Fish-Pool Company, which claimed to have invented a new fishing boat that would keep the catch alive until it reached port. There were financial services companies, such as Matthew West’s “Company for buying and selling South Sea stock and all other public stocks.” And there were exploration companies, such as the “Company of London Adventurers for the carrying on a trade to and settling colonies in Terra Australis.” (This half a century before Captain Cook discovered Australia.)
As the boom continued, the number of new issues multiplied—from five in January 1720 to eighty-seven in June. Some of the bubble companies were clearly fraudulent, such as the company for “extracting Gold and Silver from Lead and other sorts of ore.” One cheeky soul even set up a company “for carrying out an undertaking of great advantage but nobody to know what it is.” After gathering up the subscriptions, he fled to the Continent.3 In September 1820, the bubble burst. Stock in the South Sea Company fell by more than 75 percent, and many people, Newton among them, were ruined. Amid a public outcry, the Chancellor of the Exchequer (the British equivalent of the Secretary of the Treasury) and several directors of the South Sea Company were sent to the Tower of London. Lamented Pope: “The universal deluge of the S. Sea, contrary to the old deluge, has drowned all except a few Unrighteous men.”4
II
The United States came late to the game of stock market speculation. The New York Stock & Exchange Board opened for business on Wall Street in 1817, but it wasn’t until the Civil War and the development of the railroads that large-scale capital raising began. The banker Jay Cooke was the first person to demonstrate that ordinary Americans would part with their savings in return for pieces of paper issued by governments and businesses. During the Civil War, Cooke successfully organized the sale of $500 million worth of federal government bonds. Some of his later ventures were less successful. In 1869, he took over the Northern Pacific Railway, which linked Lake Superior to Puget Sound, and tried to sell $100 million worth of railway bonds. This proved impossible and on Thursday, September 18, 1873—the first “Black Thursday”—Cooke’s bank failed while he was paying a visit to President Ulysses S. Grant. Fear swept Wall Street, and creditors rushed to withdraw their deposits. Several other banks collapsed. “Dread seemed to take possession of the multitude,” The New York Tribune reported.5 Panic was so widespread that the New York Stock Exchange was forced to close down for ten days. Public faith in the financial markets was destroyed for a generation. Mark Twain captured the popular attitude in Pudd’nhead Wilson when he wrote: “October. This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February.”6
It wasn’t until after the First World War that Americans returned to the stock market in large numbers, a development that coincided with unprecedented confidence in the economy and in the efficacy of American business. Following the invention of the Federal Reserve System in 1913, there were few lasting recessions, and many economists came to believe that the new science of monetary policy had rendered them obsolete. Meanwhile, industrialists like Alfred Sloan, the head of General Motors, were applying novel methods to corporate management, with sterling results. In 1927, Barron’s, the financial weekly, hailed a “new era without depressions.”7 (In September 2000, the same publication would carry the front-page headline, “Can Anything Stop This Economy? Despite Recent Signs of a Slowdown, Expect the Economy to Remain Robust, with No Recession in Sight.”)8 The mood of optimism spread to the stock market, and millions of people bought shares for the first time—only to be caught out in October 1929. Groucho Marx and Irving Berlin were among the neophyte speculators who lost most of their money during the Great Crash. Charlie Chaplin was another keen investor, but he had liquidated most of his portfolio by the time the market collapsed.
During the Internet boom it became almost unpatriotic to compare the 1990s to the 1920s. People who did so were accused of carping. But for all but the willfully blind, the similarities between the two eras were legion, no more so than in the popularity of technology stocks. Among the speculators’ favorites during the 1920s were issues like Wright Aeronautics, Boeing, and, especially, Radio Company of America, RCA, or Radio, as it was then known, the most glamorous and fastest-growing corporation of the 1920s. Commercial radio was a revolutionary medium that shrunk the country like nothing before it, and Radio was the major player in the industry; it both manufactured radio sets and provided the programming they transmitted. In 1921 its stock hit a low of 1 1/2. Thereafter, it climbed steadily until 1927, when it headed for the stratosphere. In April 1929, Radio hit a high, after adjusting for stock splits, of 570. During this stunning ascent, old-timers shook their heads in disbelief. Despite its rapid growth, Radio had never paid a cent in dividends, and many of its shareholders were professional gamblers. In October 1929, the stock lost 75 percent of its value. It recovered a bit during 1930, but then collapsed again, and remained collapsed for the rest of the decade. Despite the strong growth of commercial radio, RCA’s stock didn’t recover its April 1929 level until 1964—thirty-five years later.
For a generation after 1929, the stock market was once again discredited in the eyes of many Americans. There were occasional periods of speculation, but they tended to involve institutional investors and well-to-do people who could afford to take some losses. Middle-class families kept their money in the bank, in real estate, or in other investments. The speculative episodes that did occur tended to involve technology firms. In the early 1960s, for example, there was an electronics boom, and stocks like IBM and Texas Instruments took off. The space race had begun, and electronics and computers were inextricably linked with the rocket technology that, it was hoped, would soon propel man to the moon. As stock prices rose, there was a rush of IPOs, many of them involving firms with names that played on words like “electronics,” “dynamics,” and “space.” There was Astron, Dutron, Vulcatron, Transistron, as well as Circuitronics, Supronics, Videotronics, and even Powertron Ultransonics. In one particularly egregious (and prescient) example related by the Princeton economist Burton G. Malkiel in his book A Random Walk Down Wall Street, American Music Guild, a firm whose business involved selling phonographic records and players door-to-door, changed its name to Space-Tone before going public. The shares were issued at $2 each, but quickly rose to $14.9 Almost four decades later, another music company, K-Tel International, would adopt a strikingly similar tactic, with strikingly similar results. In K-Tel’s case, the magic phrase would be “the Internet.”
III
Stocks confer ownership in a corporation, which, in turn, confers the right to receive some of the profit that the firm generates. Usually, most profits are plowed back into the firm to pay for future investment, but some money is also distributed to shareholders in the form of dividend payments. It seems reasonable to expect that a stock’s price should reflect the value of the dividends that the firm is likely to pay over the foreseeable future, which, in turn, depends on its earnings growth. That, indeed, is what countless generations of MBA students were taught. A number of mathematical equations have been developed to relate stock prices to dividends and earnings. As long ago as the 1930s, John Burr Williams, a Harvard-trained economist, came up with what is still the most widely used valuation formula: the “dividend discount model.”10 To use this formula, which Benjamin Graham and David L. Dodd popularized in their famous textbook Security Analysis, three facts about a company need to be known: its current dividend, the growth rate of its earnings, and the interest rate it faces in financing investments.11 Once these numbers are in hand, the student can plug them into the formula, which will produce an estimate of the stock’s “intrinsic value.” If the stock price is higher than the intrinsic value, the stock is overvalued and investors should sell it. If the stock price is less than the intrinsic value, the stock is undervalued and investors should buy it.
The dividend discount model is a bit complicated to explain to the general public, so Wall Street analysts also rely on simpler rules of thumb to assess whether stocks are cheap or expensive. The most famous of these is the price-to-earnings ratio, or “PE ratio,” which is calculated by dividing a company’s stock price by its earnings-per-share. If company X’s stock is trading at $100, and it made $10 per share in its latest financial year, its trailing PE ratio is 10. (Analysts also employ forecasts of future earnings to create advance PE ratios.) Companies with rapidly growing earnings tend to have high PE ratios, reflecting their bright prospects. Slow-growing companies tend to have commensurately low PE ratios. There is no “right” value for the PE ratio, but over the past century the average figure for U.S. stocks has been about 14. Among other ratios that stock analysts look at are the “dividend yield,” which is the annual dividend payment a stock yields divided by its current price, and the “price-to-book ratio,” which is a company’s stock market valuation divided by the accounting value of its assets.
None of these mathematical formulas is infallible: stock prices often bear little, if any, relation to what the formulas say they should be. Uncertainty about the future is one reason for this discrepancy. Just because a company’s profits have risen at an annual rate of 25 percent during the past five years, this doesn’t mean they will grow at that rate during the next decade. They might grow faster. More likely, they will grow more slowly. But nobody knows for sure. Depending on the growth rate that is assumed virtually any PE ratio or stock price can be rationalized. During the 1950s and the 1970s, many stocks had PE ratios in the single digits. During the 1960s and 1980s, many of the same stocks had PE ratios in the twenties. In the 1990s, PE multiples rose to levels never seen before, in many cases triple digits. During each one of these periods the majority of Wall Street analysts insisted that stock prices were reasonable.
When a firm is issuing stock for the first time in an IPO, the valuation problem is even trickier. Such firms are forced to publish their financial history in the IPO prospectus, but if they have only been operating for a year or two, as was often the case in recent years, that information isn’t much of a guide to what will happen in the future. With few hard numbers to go on, investors have to rely on guesswork and emotion. When the economy is doing well they tend to be optimistic about the future and attribute generous growth rates to companies, even to those that don’t deserve them. Stock prices tend to be high and rising, and IPOs plentiful. During an economic downturn, on the other hand, pessimism tends to be widespread, and even the stocks of fast-growing firms trade at low levels. As for the IPO market, it often shuts down completely in a recession.
During the Internet boom analysts and investors would be forced to invent new ways to value stocks. The vast majority of Internet companies made no profits and paid no dividends, so the methods taught in Graham and Dodd didn’t apply to them. If the old formulas were used, they produced an “intrinsic value” of zero for most Internet stocks. Since Wall Street was busy trying to sell these stocks to the public, it didn’t advertise this fact, but instead looked for more flexible valuation methods. Given the boundless nature of human ingenuity, especially financially motivated human ingenuity, it was sure to come up with one. Ultimately, it came up with several, but they all shared one attribute: whatever prices investors were paying for Internet stocks, the new valuation methods made them appear reasonable (or almost reasonable).
IV
Corporate earnings and crowd psychology apart, the other big influence on the stock market is the policy stance of the Federal Reserve. Generally speaking, when the Fed is cutting interest rates, or keeping them low, stock prices go up. When the Fed is raising rates, or keeping them high, stock prices go down. The bull markets of both the 1980s and the 1990s occurred during periods of low and falling interest rates. In both 1929 and 1987, a rise in interest rates preceded a stock market crash. The historic relationship between monetary policy and the stock market explains why Wall Street watches Alan Greenspan’s comments so closely. If the Fed chairman even suggests that he and his colleagues on the Federal Open Market Committee (FOMC), the Fed’s policy-making arm, might be considering a hike in interest rates, stock prices tend to fall in anticipation. If Greenspan drops the merest hint of lower rates ahead, the market tends to rally.
There are several reasons why the Fed should have so much influence on the market. The most straightforward is that when interest rates drop, the returns on savings accounts and CDs drop with them, and the stock market looks more attractive. When CD rates are down around 3 percent or 4 percent, as they often have been during the past decade, many households go searching for higher returns on their money, even if that involves taking on a higher level of risk. A fall in interest rates also reduces the borrowing costs that firms and consumers face, which leads to more spending on everything from factories to homes to automobiles. Other things being equal, this rise in spending will lead to higher demand for goods and services throughout the economy, and higher corporate earnings. When earnings are rising, individual stocks are worth more. When the Fed raises interest rates the logic works in the opposite direction. Rates on bank deposits and CDs increase, which makes them a better deal for savers. Simultaneously, consumers and firms find it more costly to borrow, which prompts them to cut back on their spending, leading to a reduction in overall demand and lower corporate profits. When earnings are falling, stocks tend to fall with them.
In raising or lowering interest rates, the Fed also controls the amount of money and credit circulating in the financial system. This is an unavoidable consequence of how it operates. The most important interest rate that the Fed controls is the federal funds rate, which is the rate that commercial banks charge each other for overnight loans. When the Fed wants to reduce the federal funds rate, it buys U.S. government bonds from Wall Street firms, paying them with freshly minted currency that is then deposited in the banking system. This increase in the money supply allows the commercial banks to make more loans, which produces an expansion of credit throughout the economy. If the Fed wants to raise interest rates, it sells some of its portfolio of U.S. government bonds to Wall Street firms. The cash that the firms use to pay for the bonds is then withdrawn from circulation, and the money supply falls. With less cash on their balance sheets, banks can make fewer loans, and the amount of credit in the economy declines. On Wall Street, the amount of money and credit available is often referred to as “liquidity.” When liquidity is plentiful the price of assets (stocks especially, but also real estate) tends to rise. When liquidity dries up, as happened in many Asian countries during 1997 and 1998, asset prices fall sharply. In the United States during the second half of the 1990s, there was an unprecedented amount of liquidity in the financial system, and this was an important factor underpinning the stock market’s rise.
Through all of these channels, the Fed can influence the rate at which the U.S. economy grows, although it often takes several interest rate moves for a policy change to have the desired effect. In nor-mal times, the Fed restricts itself to interest rate changes of a quarter percentage point or a half percentage point, but when it wants to impact the economy quickly it introduces a succession of interest rate moves, often adding up to 2 percent or 3 percent. Whether interest rates are 5.5 percent or 5.25 percent doesn’t make that much difference to the economy, but there is an enormous difference between interest rates of 3 percent and 8 percent. At 3 percent, the cost of borrowing is so cheap that it acts as a big stimulus to spending. At 8 percent, borrowing is so expensive that spending will be sharply curtailed. The Fed doesn’t like to admit it publicly, but by raising interest rates sufficiently it has the power to push the economy into recession. Every recession since the Second World War has followed a tightening of monetary policy—in most cases one intended to head off inflation. During the second half of the 1990s, the biggest danger facing investors was that Greenspan and his colleagues would decide to repeat this treatment and bring the long economic expansion to an end.