Investing in the Stock Market

Lots has been written about the bursting of the tech bubble in 2000. I've read a few of those books since the start of the New Year. I think most of them are by the same people who in 1995 were saying we were in a New Economy, and you had to get on the train or get left behind. Writing a book about the train wreck is just one last gasp of hucksterism.

Here’s what I think happened in 10 simple points:

1. The creation of 401(k) plans during the Reagan presidency redirected a massive amount of capital into the stock market. I worked for a global telecommunications company at the time, and I remember an interesting meeting with one of our clients, who was a major name in the finance world. She said that her firm was actually having a great deal of challenge trying to find appropriate investments for the billions of new investment dollars pouring into their mutual funds from the 401(k) accounts. All this money needed to be invested, causing exactly what microeconomics predicts: as the demand for investment instruments exceeded the supply, the prices of the available instruments were bid up. That is, stock prices went up because all the mutual funds were buying from the same pool of available stocks.
   
2. The people dumping money into the 401(k) plans were oblivious to the fact that prices were going up because they were dumping more money into the market, and instead rejoiced that the Dow and the Nasdaq indexes seemed to keep climbing, making their mutual funds share prices to go up in response. Their net worth grew at double digit annual rates, and everyone who could started maximizing their IRAs and 401(k) contributions.
   
3. Consumers began taking note of the amount of wealth appearing in their “retirement” portfolios, and, feeling pretty well off, went on a consumer spending spree of epic scale. Many of those purchases were made on credit, but heck, their net worth still looked pretty good.
   
4. New companies began being formed for the sole purpose of getting to the stage where an Initial Public Offering (IPO) of their stock could be brought to market. Most any company with a good story could get venture funding with this goal in mind. Any company that could tie its products to Internet technology was golden. The new status symbol wasn’t a Rolex watch or a BMW, it was to be one of few who get on the “friends and family” lists and therefore have the opportunity to buy a new stock at the initial offering price. This is where the main scam begins:
   
5. The investment bankers and the owners of the company would deliberately underprice the initial offering of the stock. The textbook purpose of a stock offering is to raise capital for the company to operate with, and the company then hopefully generates an operating return for the shareholders.
   
   But during those bizarro days, the object was to bring out the IPO at a share price high enough to get sufficient capitalization for the company to stay alive for a little while, but low enough to leave a lot of room for the share price to be bid up. For example, let’s say a new company thinks it will need to spend $10million to get to a point of being cash flow positive (able to fund its ongoing operations from the sale of its products). It might then sell 1 million shares to its underwriters for $10/share. The underwriters are usually one or more of the big investment banks. This is the one and only transaction that puts any money in the treasury of the company.
   
   At that point, the underwriters own all the shares, except the fraction retained by the original investors and founders. The underwriters set a public offering price to a number large enough to give them a nice profit as they sell off their shares to the market.
   
   Let’s say they pick $11 for this stock. So for all the shares they sell, they make $1 per share. To make sure they sell these shares as quickly as possible, they will have spent weeks going around the country with the management doing a “dog & pony show” to pre-sell the stock to as many investors as possible. So on the day of the IPO, the underwriters will likely sell every single share of stock they bought from the company for a tidy profit.
   
   Now the company has its $10 million and the underwriters their $1 million profit. But we’re still not done. While some of those initial shares went to the folks on the “friends and family” list, a lot of the rest went to secondary sellers who don’t really want to hold the stock as an investment. If the stock has been hyped up successfully in the days leading up to the IPO, the demand will be high, and those secondary sellers will start taking bids from all the mutual funds and individual investors who want in on the stock. It was not unheard of for a stock to get bid up 5 to 10 times its offering prices THE FIRST DAY.
   
   Let’s say that in the case of this stock, the price went to $50 on the first trading day. Seems like the company is leaving a lot of money on the table. Why didn’t they make the underwriter pay closer to $50 for the stock? After all, if $10million was enough to get going, wouldn’t $50million be better? The answer is simple: everyone is in on the scam! The company’s management, the initial investors, the underwriters and the even the secondary sellers all benefit from having the stock price run up the first days. If the company took in $50million in capitalization, the management and initial investors would need to actually invest that money in operations to generate a return. That’s a lot of pressure, and it would take time. But by underpricing the stock and letting the market bid it up, the management, underwriters, friends & family all see their money multiply immediately. Sure the management probably has some vesting schedule on their options that makes them wait for their payoff, but they were still going to get a pot of money in a few months -- if the could continue to tell a good story prior to the money running out.
   
6. The crazy thing is that an insanely overpriced stock like this one would still attract buyers for a long time. As long as the company was still in its development stage, and not expected to generate a profit in the near future, folks were willing to believe the dream (or “drink the Kool-Aid” in a macabre reference to the Jim Jones-led tragedy in Guyana a couple of decades ago), and want to buy in so as not to miss the presumed rocket ship growth yet to come. This was the bubble starting to grow.
   
7. There was that time of fantasy were everyone in America thought they were an investing genius because their 401(k) continued to multiply, and they began playing the stock market with some after-tax money and making some bucks there too. The Bricks and Mortar retailing world was crumbling before their eyes, and they thrilled to be riding the wave into the future.
   
   To sit on the sidelines investing in CDs and dividend-paying stock was seen to be falling behind. The public began to feel it was more risky to hold cash and CDs than it was to hold stocks. I believe that at this point, we went into the mode of a two-currency system. One currency was American greenback dollars, and the other was equities. You held wealth in dollars only long enough to make a purchase (of more stocks, a house, fancy car, etc). Otherwise you held your wealth in equities. The trouble was that folks forgot that there is no government backing behind stocks like there is cash and bank deposits. The more subtle problem was that they didn’t realize that there was rampant inflation in equity prices (the supply/demand phenomenon).
   
8. Then in 1999 and 2000, many of those thousands of IPO funded startup had burned through their initial money, and had not yet reached a self-sustaining economic state. In a market that experienced 99% good news and optimism over the past decade, this wave of failures were a shock. The savvy investors who had always seen this as a bubble had started getting out beforehand ended the 20th century as very wealthy folks (look up the legend of Joseph Kennedy deciding to get out of the market in early 1929 after getting a stock tip from his shoeshine boy).
   
   For the ordinary American who never understood why stock prices went up in the first place, the first big hits took some the smile off their faces. Nonetheless, most stuck with a market that had returned 20% annual growth. After all, they could recoup a 30% loss in value in 18 months, right? Most didn’t understand the math there either: the 70% they were left with had to generate a 43% return to get back to their original level. A 50% loss required 100% growth to get back to the original point. Still, they thought, it could happen.
   
9. Then some of the really big companies started to fail. Enron and Worldcom were the pins that finally burst the bubble. Nonetheless, many people rode their portfolios to 20% or less of the peak value because they felt it just had to come back. After all, this kind of thing had never happened to them.
   
10. But it’s happened before. A wise person once said that those who ignore history are doomed to relive the past. My father, who was a young man during the Depression, had warned me repeatedly over the past 20 years that “those damn Republicans” were dismantling all the controls and safeguards that had been erected by FDR in the aftermath of the depression.

He was right.