When beggars and shoeshine boys, barbers and beauticians can tell you
how to get rich, it is time to remind yourself that there is no more
dangerous illusion than the belief that one can get something for nothing.
Early in my teaching career, a student named Jon told me about an exciting investment he was making. All through high school he had been collecting postage-stamp plate blocks. At the time, stamps were printed fifty stamps to a sheet and a plate block was the four stamps in a two-by-two block next to the sheet’s serial number.
Plate blocks were rare because no one had ever thought to save them. Then, unexpectedly, plate blocks became a collectible. Prices rose rapidly and Jon joined others in the gold rush. Every time a new stamp came out, Jon went to his local post office and bought several plate blocks. Sometimes, he bought complete fifty-stamp sheets in case these, too, became collectible. He kept his stamps in mint condition by storing them in protective plastic sleeves in binders. He proudly told me that he had several thousand dollars “invested.”
I told Jon that this was speculation, not investing, because his stamps didn’t generate any income. Jon insisted that it was an investment because prices had been going up. Indeed, the plate-block market was doing better than the stock market. Seeing that I was getting nowhere, I said, “Twenty years from now, let me know how it works out.”
Roughly twenty years later I got a large envelope in the mail from Jon. He told me about his career as a portfolio manager and thanked me for the class he had taken from me. The postage on the envelope consisted of dozens of stamps, shown in Figure 5-1. The plate-block market had collapsed and this was Jon’s way of saying that I was right.
When Jon tried to liquidate his stamp collection, dealers offered him $9 for every $10 of face value. Nobody wanted to buy the stamps for anything other than mailing letters and dealers didn’t want to tie their money up in inventory that wasn’t moving. Jon was stubborn, so he kept his stamps and was liquidating his collection letter by letter.
Baseball cards are another collectible. For many years, baseball cards were advertising giveaways or sold with cigars, cigarettes, and bubble gum. Children traded cards, played games with them, and stuck them in their bicycle spokes to make motorcycle sounds. Then grown-ups decided that baseball cards were a collectible, too valuable to be touched, let alone played with. They were convinced that they could get rich buying baseball cards for pennies and selling them a few years later for dollars.
Eventually, the market for new cards crashed. However, old cards are still considered valuable—simply because they are rare. In 2007 a collector paid $2.8 million for a 1909 Honus Wagner card that had originally been included in a cigarette pack. Wagner reportedly did not smoke and asked the company not to distribute the cards because he did not want children to buy cigarettes. Only about 200 cards were printed and, of these, only fifty or so were distributed. At the time of the 2007 auction, it was thought that only three cards had survived, but more have since surfaced.
Does this card’s rarity make it worth millions of dollars? No. Baseball cards have no intrinsic value because they generate no cash whatsoever. Yet some people believe that rare cards have value because they are rare. It’s sort of like people being famous for being famous. There is no rational explanation. Rarity does not make something valuable.
A former student sent me a collection of cards that are rarer than baseball cards that are thought to be worth thousands of dollars. These are economics trading cards distributed by the economics club at the University of Michigan, Flint. Each card has a picture of a famous economist on the front and some lifetime statistics on the back. The James Tobin card (see Figure 5-2) says he was born in Champaign, Illinois, in 1918, and received his bachelor’s degree and PhD from Harvard in 1939 and 1947 (interrupted by military duty during World War II).
I studied economics and made it my career for two reasons. The subject was and is intellectually fascinating and challenging, particularly to someone with taste and talent for theoretical reasoning and quantitative analysis. At the same time it offered the hope, as it still does, that improved understanding could better the lot of mankind.
If you are interested, make me an offer. Remember, this card is VERY rare.
Some people believe in the Latin saying, Res tantum valet quantum vendi potest: A thing is worth only what someone else will pay for it. That’s like many of the quotations attributed to former baseball player and manager Yogi Berra; for example, “It’s not over until it’s over.” It is literally true, but so circular as to be meaningless. Yes, something is worth what someone is willing to pay for it, if by “worth” you mean the price people pay is the price they are willing to pay. Investors think differently. As John Burr Williams said, “A stock is worth only what you can get out of it.”
What do you get out of looking at a postage stamp or a baseball card or any other so-called collectible? A collector who paid $250,000 for an early Batman comic explained that he keeps the comic in an airtight bag in a bank vault: “I’ve been toying with the idea of reading it, but I haven’t yet.”
Beanie Babies are stuffed animals with a heart-shaped hang tag. The beanie name refers to the fact that these toys are filled with plastic pellets (“beans”). Around 1995, the same time the dot-com bubble was inflating, Beanie Babies came to be viewed as collectibles because buyers expected to profit from escalating Beanie Baby prices by selling these silly bears to an endless supply of greater fools. Delusional grown-ups stockpiled Beanie Babies, thinking that they would pay for their retirement or their kids’ college education. Ah, good plan.
What is the intrinsic value of a Beanie Baby? It doesn’t pay dividends. It doesn’t pay anything! You can’t even play with a Beanie Baby. To preserve its value as a collectible, a Beanie Baby must be stored in an airtight containers in a cool, dark, smoke-free environment. Yet the hopeful and the greedy paid hundreds of dollars for Beanie Babies that originally sold in toy stores for a few dollars. They saw how much prices had increased in the past and assumed the same would be true in the future. They had no reason for believing this, but they wanted to believe.
Figure 5-3 shows the Princess Beanie Baby honoring Diana, the Princess of Wales. The Princess sold for $500 in 2000. Then the bubble popped. I bought this bear on the internet in 2008. The shipping cost more than the bear.
If you mail a letter to a person in another country, you can enclose an international reply coupon that can be exchanged for postage stamps in that country and used to mail a letter back to you. It is like enclosing a self-addressed stamped envelope, but gets around the problem of the sender having to buy foreign postage stamps. It is the polite thing to do, but also the source of the most famous swindle in history.
In 1920, a Massachusetts man named Charles Ponzi promised to pay investors 50 percent interest every forty-five days. Compounded eight times a year, the effective annual rate of return would be 2,463 percent! He said that his profits would come from taking advantage of the difference between the official and open market price of Spanish pesos. He would buy Spanish pesos cheap in the open market, use these pesos to buy international reply coupons, and then trade these coupons for U.S. postage stamps at the higher official exchange rate. If everything worked as planned, he could buy 10 cents’ worth of U.S. postage stamps for a penny. (It was not clear how he would convert these stamps into cash.) In practice, he received $15 million from investors and appears to have bought only $61 in stamps.
If he didn’t invest any money, how could he afford to pay a 50 percent return every forty-five days? He couldn’t. But he could create a temporary illusion of doing so. Suppose that a person invests $100, which Ponzi spends on himself. If Ponzi now finds two people to invest $100 apiece, he can give the first person $150, and keep $50 for himself. Now, he has forty-five days to find four people willing to invest $100 so that he can pay each of the two previous investors $150 and spend $100 on himself. These four can be paid with the money from eight new investors, and these eight from sixteen more.
Ponzi’s legacy is the Ponzi scheme. In a Ponzi scheme, money from new investors is paid to earlier ones, and it works as long as there are enough new investors. The problem is that the pool of fish is exhausted surprisingly soon. The twenty-first round requires a million new people and the thirtieth round requires a billion more. At some point, the scheme runs out of new people and those in the last round (the majority of the investors) are left with nothing. A Ponzi scheme merely transfers wealth from late entrants to early entrants (and to the person running the scam).
Ponzi’s scam collapsed after eight months when a Boston newspaper discovered that during the time that he supposedly bought $15 million in postage coupons, the total amount sold worldwide came to only $1 million. Ponzi promised that he could pay off his investors by starting a company and selling stock to other investors. Massachusetts officials were unpersuaded. They sent Ponzi to jail for ten years.
A Ponzi scheme is also called a pyramid deal, since its workings can be visualized by imagining a pyramid with the initial investors at the top and the most recent round on the bottom; the pyramid collapses when the next round doesn’t materialize. Even though it seems obvious that no one will make money unless others lose money, greed blinds participants to the likelihood that they will be among the losers.
Ponzi schemes are illegal frauds, but they usually disguise their true nature by promising to channel investors’ money to a unique investment or to a fabulous money manager. Our best protection is sober reflection and common sense. If it looks too good to be true, it probably isn’t true. But greed is a powerful emotion and often tramples common sense. One of the most notorious cases involved Bernie Madoff.
For more than a decade, Madoff told investors—many of them Jewish charitable organizations—that he was earning double-digit returns year after year using a “split-strike conversion” strategy that involves buying stock and put options and writing call options. This is actually a conservative strategy that is unlikely to generate double-digit returns. Perhaps even more suspiciously, Madoff reported negative returns in only seven months over a fourteen-year period. Skeptics looked at the ups and downs in the S&P and concluded that Madoff’s performance claims were mathematically impossible. To true believers, this added to his mystique. One of his clients raved, “Even knowledgeable people can’t really tell you what he’s doing.”
What he was doing was running a Ponzi scheme, the largest ever. In December 2008, Madoff was having severe liquidity problems and confessed to his sons that it was “one big lie,” a Ponzi scheme that was collapsing. His sons reported his confession to the government. Madoff was arrested and, four months later, pleaded guilty to eleven felonies. He admitted that he had not made any real investments for nearly two decades and that there was a $65 billion shortfall between what his clients thought they had in their accounts and what they actually had. Once the lawyers had been paid, investors got back $10 billion less than their original investment.
Madoff was sentenced to 150 years in prison and sent to a federal facility in North Carolina. He told a relative, “It’s much safer here than walking the streets of New York.”
From time to time, investors are gripped by what, in retrospect, seems to have been mass hysteria. The price of something climbs higher and higher, beyond all reason, but it’s a speculative bubble because nothing justifies the rising price except the hope that it will go higher still. Then, suddenly, the bubble pops, buyers vanish, and the price collapses. With hindsight, it is hard to see how people could have been so foolish and paid such crazy prices. Yet, at the time of the bubble, it seems foolish to sit on the sidelines while others become rich.
Some people, including Nobel laureate Eugene Fama, do not think that bubbles can even occur. They argue that since markets always set the correct prices, whatever prices those markets set must be correct.
It is hard to take this circular argument seriously if we define a bubble as a situation in which the price cannot be justified by an asset’s intrinsic value, but is instead propelled by a belief that the price will keep rising. When a Beanie Baby sold for $500, was that not a bubble? What rational explanation are we overlooking?
In 2013 Fama accepted that a bubble is “an extended period during which asset prices depart quite significantly from economic fundamentals.” Yet, he danced around this definition when he argued the following:
The word “bubble” drives me nuts, frankly, because I don’t think there’s anything in the statistical evidence that says anybody can reliably predict when prices go down. So if you interpret the word “bubble” to mean I can predict when prices are going to go down, you can’t do it. . . .
I believe markets work. And if markets work those things shouldn’t be predictable. If I can predict that housing prices will go down, if the market’s working properly, they should go down now. . . . If the market’s working properly, the information should be in the prices.
The argument that prices sometimes go far above intrinsic value does not require that we know when prices will crash. Indeed, the essence of a bubble is that people do not know when it will pop. Fama is correct in arguing that if people know that prices will go down tomorrow, prices will go down today. But he is wrong in arguing that bubbles must be predictable. And he is wrong in arguing that the fact that price changes are hard to predict proves that prices are always equal to intrinsic values. Price changes might be hard to predict because they are swayed by irrational, unpredictable emotions.
In 1720, the British government gave the South Sea Company exclusive trading privileges with Spain’s American colonies. None of the company’s directors had ever been to America, nor had they any concrete plans to trade anything. Nonetheless, encouraged by the company’s inventive bookkeeping, English citizens rushed to invest in this exotic venture. As the price of the South Sea Company’s stock soared from £120 on January 28 to £400 on May 19, then £800 on June 4, and £1,000 on June 22, some people became rich and thousands rushed to join their ranks. It was said that you could buy South Sea stock as you entered Garraway’s coffeehouse and sell it for a profit on the way out.
Soon con men were offering stock in even more grandiose schemes and were deluged by frantic investors not wanting to be left out. It scarcely mattered what the scheme was. One promised to build a wheel for perpetual motion. Another was formed “for carrying on an undertaking of great advantage, but nobody is to know what it is.” The shares for this mysterious offering were priced at £100 each, with a promised annual return of £100; after selling all of the stock in less than five hours, the promoter left England and never returned. Yet another stock offer was for the “nitvender” or selling of nothing. Yet, nitwits bought nitvenders. When the South Sea Bubble burst, fortunes and dreams disappeared.
As with all speculative bubbles, there were many believers in the Greater Fool Theory. While some suspected that prices were unreasonable, the market was dominated by people believing that prices would continue to rise, at least until they could sell to the next fool in line. In the spring of 1720, Sir Isaac Newton said, “I can calculate the motions of the heavenly bodies, but not the madness of people,” and sold his South Sea shares for a £7,000 profit. But later that year, he bought shares again, just before the bubble burst, and lost £20,000. When a banker invested £500 in the third offering of South Sea stock, he explained that “when the rest of the world are mad, we must imitate them in some measure.” After James Milner, a member of the British Parliament, was bankrupted by the South Sea Bubble, he explained that “I said, indeed, that ruin must soon come upon us but . . . it came two months sooner than I expected.”
Yes, no one knows for certain when a bubble will pop, but that does not mean that a bubble is not a bubble. The price of nitvender stock was no more related to economic fundamentals than was the price of the Princess Beanie Baby.
It is hard to imagine life without the internet—without email, Google, and Wikipedia at our fingertips. When the electricity goes out or we go on vacation, internet withdrawal pains can be overwhelming. Cell phones only heighten our addiction. Do we really need to be online and on call 24/7? Must we respond immediately to every email, text, and tweet? Do we really need to know what our friends are eating for lunch? Apparently we do.
Back in the 1990s, when computers and cell phones were just starting to take over our lives, the spread of the internet sparked the creation of hundreds of online companies, popularly known as dotcoms. Some dot-coms had good ideas and matured into strong, successful companies. But many did not. In too many cases, the idea was simply to start a company with a dot-com in its name, sell it to someone else, and walk away with pockets full of cash. It was so Old Economy to have a great idea, start a company, make it a successful business, and turn it over to your children and grandchildren.
One study found that companies that did nothing more than add .com, .net, or the word “internet” to their names more than doubled the price of their stock. Money for nothing!
A dot-com company proved it was a player not by making a profit but by spending money—preferably other people’s money. (I’m not joking!) One rationale was to be the first-mover by getting big fast. (A popular saying was “Get large or get lost.”) The idea was that once people believe that your website is the place to go to buy something, sell something, or learn something, you have a monopoly that can crush the competition and reap profits.
It is not a completely idiotic idea. It sometimes even works. (Think Amazon.) Often it doesn’t. Can you name the first-movers in the personal computer revolution? (Apple survived, but Commodore, Kaypro, and Tandy are answers to trivia questions.)
The fundamental problem is that there were thousands of dotcom companies and there isn’t room for thousands of monopolies. Of the thousands of companies trying to get big fast, very few can ever be monopolies.
Most dot-com companies had no profits. If investors had thought about stocks as money machines and noticed how little cash was being generated, they would have been skeptical rather than delirious. Instead, wishful investors thought up new metrics for the so-called New Economy to justify ever higher stock prices. They argued that instead of being obsessed with something as old-fashioned as profits, we should look at a company’s sales, spending, and number of website visitors. Companies responded by finding creative ways to give investors what they wanted. Investors want more sales? I’ll sell something to your company and you sell it back to me. No profits for either of us, but higher sales for both of us. Investors want more spending? Order another thousand Aeron chairs. Investors want more website visitors? Give stuff away to people who visit your website. Buy Super Bowl ads that advertise your website. Two dozen dot-com companies ran ads during the January 2000 Super Bowl game, at a cost of $2.2 million for thirty seconds of ad time, plus the cost of producing the ad. Companies didn’t need profits. They needed traffic.
One measure of traffic was eyeballs, the number of people who visited a page; another was the number of people who stayed for at least three minutes. Even more fanciful was hits, the number of files requested when a web page is downloaded from a server. Companies put dozens of images on a page, and each image loaded from the server counted as a hit. Incredibly, investors thought this meant something important. They should have been thinking about money machines.
Stock prices tripled between 1995 and 2000, an annual rate of increase of 25 percent. Dot-com stocks rose even more. The tech-heavy NASDAQ index more than quintupled during this five-year period, an annual rate of increase of 40 percent. Someone who bought $10,000 of AOL stock in January 1995 or Yahoo when it went public in April 1996 would have had nearly $1 million in January 2000.
In 1999, a small internet company calledfiled an SEC statement that was brutally candid: “The company is not currently engaged in any substantial business activity and has no plans to engage in any such activity in the foreseeable future.” A modern nitvender! And yet the price rose from $0.50 a share to $3.50 a share in six months. A company that doesn’t do anything or plan to do anything was valued at $22.9 million—not much for a real company, but a lot for a do-nothing company.
In March 2000, the Wall Street Journal ran a front-page story that reminded me of Bernard Baruch’s comment about barbers and beauticians. At Bill’s Barbershop in Dennis, Massachusetts, a shop I’ve been to, the locals talked about dot-com stocks while they watched stock prices dance on television. One regular said, “You get three or four times in your life to make serious bucks. If you miss this one, you’re crazy.” Another agreed: “I don’t think anything could shake my confidence in the market. Even if we do go down 30 percent, we’ll just come right back.”
Dot-com entrepreneurs and stock market investors were getting rich and they wanted to think that it would never end. But, of course, it did.
Chapter 1 recounted my warnings, delivered at a March 11, 2000, conference, on the Glassman-Hassett prediction that the Dow Jones Industrial Average would more than triple, from below 12,000 to 36,000.
How did I know that the 36K prediction was nonsense? I looked at their reasoning. The total return from a stock is the dividend yield (the dividend D divided by the price P) plus the capital gains g (the percentage change in the price).
Suppose that a representative stock at the time was selling for $12 a share and paid an annual dividend of $0.18. The dividend yield would be 1.5 percent:
Glassman-Hassett assumed that, in the long run, dividends and stock prices will grow by 5 percent a year, which is perfectly reasonable and implies a total stock return of 1.5 + 5.0 = 6.5 percent. They noted that, at the time, the interest rate on long-term Treasury bonds was 5.5 percent.
Now the trouble starts. Glassman-Hassett argued that investors should be happy to hold stocks if the anticipated returns were only 5.5 percent, the same as Treasury bonds, because stocks are safer than Treasury bonds—as evidenced by the fact that stocks, on average, have done better than Treasury bonds in the past. Not only that, because stocks are safer, they reasoned that investors should hold stocks happily if the anticipated returns were less than 5.5 percent.
Nonetheless, they made the “conservative” assumption that stocks should be priced to give a 5.5 percent return, consisting of a 0.5 percent dividend yield plus 5.0 percent growth. For the dividend yield to fall from 1.5 percent to 0.5 percent, the stock price has to be three times as high ($36 rather than $12):
Thus, they concluded that stock prices should triple, from $12 to $36 (or, in the case of the Dow, from 12,000 to 36,000).
The crucial assumption is clearly that investors would be satisfied with the same anticipated returns on stocks and bonds because stocks are as safe, or safer, than bonds. However, the fact that stocks have beaten bonds in the past does not guarantee that stocks will beat bonds in the future. The extraordinary twentieth-century performance of the U.S. stock market was, most likely, a surprise—and we can’t count on another hundred years of pleasant surprises.
Their model is also internally inconsistent. Glassman and Hassett argued that because stocks always outperform bonds, stocks should be priced to do the same as bonds—in which case, stocks won’t outperform bonds.
The second inconsistency involves what happens in their model if the Treasury rate goes up to, say, 6 percent, which it did a few months after their book Dow 36,000 appeared. For the anticipated stock return to increase from 5.5 percent to 6 percent, the dividend yield would have to double from 0.5 percent to 1.0 percent. For this to happen, the stock price would have to fall 50 percent, from $36 to $18:
How can any sane person argue that stocks are as safe as bonds if a half-percentage-point increase in interest rates causes stock prices to fall 50 percent? Nor can we rely on a hypothetical “long run” to save the day for stocks. Their model implies that if interest rates increase permanently, stocks will be a permanently disastrous investment.
A value investor would have recognized the dot-com bubble for what it was—a bubble. The 12,000 value of the Dow gave a 1.5 percent dividend yield and a predicted 6.5 percent stock return, a slim one percent risk premium over bonds. I argued at the time that a reasonable risk premium should be higher and stock prices should be lower—much lower—though I didn’t know when the dot-com bubble would burst.
I reached the same conclusion using a different model (which is explained in Chapter 6).
After the dot-com bubble popped, the Wall Street Journal made another visit to Bill’s Barbershop. Bill was now sixty-three years old and his retirement portfolio had been decimated. His $834,000 was down to $103,000, which was $50,000 less than his initial investment: “It means that I’m looking at another ten years of work, instead of being retired,” he said. Bill had given up playing the stock market. Now, he was playing blackjack and poker at a Connecticut casino and said, “I do better there than I do in the market.” Which isn’t saying much.