Read an Excerpt
Toward Rational Exuberance
The Evolution of the Modern Stock Market
By B. Mark Smith Farrar, Straus and Giroux
Copyright © 2001 B. Mark Smith
All rights reserved.
ISBN: 978-1-4299-3088-8
CHAPTER 1
STEEL
"I ACCEPT."
These words, spoken by John Pierpont Morgan in early 1901, would soon reverberate throughout Wall Street. A piece of paper had just been handed to Morgan by the energetic young president of Carnegie Steel, Charles Schwab. Written on the paper was a number representing Andrew Carnegie's asking price for Carnegie Steel, the biggest producer of crude steel in the world. After a quick glance, Morgan signaled his acceptance of Carnegie's terms. With that gesture he acquired the essential building block for what would in a few weeks become the world's largest industrial corporation: United States Steel. In the rush of events that followed, Morgan did not actually get around to instructing his attorneys to draw up the contract with Carnegie for over a week. But it didn't matter; both men had given their word, and the deal was done.
U.S. Steel was a giant — or a monster, depending on one's perspective. With a capitalization of more than $1.4 billion, it dwarfed even the federal government (with an annual budget of approximately $350 million and a total national debt of slightly more than $1 billion). Senator Albert Beveridge of Indiana hailed Morgan as "the greatest constructive financier yet developed by mankind." But even normally pro-business spokesmen such as the editors of The Wall Street Journal acknowledged some "uneasiness over the magnitude of the affair." Others rendered harsher verdicts. Henry Adams, financial gadfly and descendant of two Presidents, stated bluntly, "Pierpont Morgan is apparently trying to swallow the sun." President Arthur T. Hadley of Yale, referring to the great "trusts," like U.S. Steel, that were controlled by a few imperious financiers, such as J. P. Morgan, declared that if such business combinations were not "regulated by public sentiment," the country would have "an emperor in Washington within 25 years."
Some observers on Wall Street were also critical of the new "trust," although for reasons different from Hadley's. U.S. Steel was made up of dozens of smaller firms, besides Carnegie's, that had been amalgamated into the new entity. Many analysts felt that Morgan and his associates, in their eagerness to form U.S. Steel, had paid too much for its constituent parts. According to their calculations, the $1.4 billion capitalization of U.S. Steel (representing the face value of the U.S. Steel stock and bonds to be sold to the public and issued to the owners of the acquired companies) greatly exceeded the actual value of the new corporation's assets. The whole, the critics alleged, should not and could not be worth more than the sum of the parts.
The cry of "watered stock" was raised. Legend has it that the term originated in the early decades of the nineteenth century. Daniel Drew, in his years as a cattle drover before he became a notorious Wall Street operator, is said to have hit upon the idea of plying his scrawny "critters" with salt, then depriving them of water as he drove them down the length of Manhattan to the butcher shops on Fulton Street. As the story goes, Drew would finally instruct his drovers to "let them critters drink their fill" immediately before the cattle were to be inspected by potential buyers. He knew that a thirsty cow could easily drink 50 pounds of water; he was counting on it. The Fulton Street butchers, enthused about the apparently fat cattle Drew had for sale, would pay top dollar for the bloated animals, a price that effectively included thousands of pounds of water. When Drew later hung out his shingle on Wall Street, he was frequently accused of "watering" the stock of companies he controlled, meaning that he would secretly sell stock in quantities far in excess of the amount justified by the assets of the company. The term "watered stock" stuck in the Wall Street lexicon.
J. P. Morgan was no Daniel Drew. To the extent that an aristocracy existed in the United States, Morgan was a charter member. His ancestors on both his mother's and father's sides had come to America shortly after the Mayflower, and his father had been the leading American investment banker in Europe. Morgan looked and acted the part; he was a large, physically imposing man with a gruff manner and a penetrating stare that could be very intimidating. Born to wealth and influence, Morgan was openly disdainful of the unsavory tactics employed by operators like Drew who sought to claw their way to success on Wall Street. For J. P. Morgan to water stock was unthinkable.
The debate over the capital structure of U.S. Steel had a broader significance, reflecting the first inklings of changing standards for valuing stocks. Those critics who alleged that a substantial quantity of water existed in the new trust were in a way correct, given the essentially static analysis prevalent at the time. It was customary to speak in terms of a company's "intrinsic" worth, usually defined as its "book value" — the total of assets minus liabilities. The Federal Commissioner of Corporations, later looking back on the birth of U.S. Steel, made use of the traditional valuation approach in attempting to calculate the true worth of the corporation at the time of its formation. Adding together the values of its constituent parts, he calculated that U.S. Steel at the time of its creation had actually been worth about $700 million, meaning that the other $700 million of the $1.4 billion initial capitalization was water.
The commissioner's report included one important disclaimer. It explicitly did not take into account any additional profits that would flow from the presumably great efficiencies to be reaped by the new combination. But of course it was those efficiencies that were the primary rationale for forming the giant trust in the first place. Morgan and his associates were anticipating that profits would be greatly enhanced by economies of scale and other advantages the new entity would possess; they were looking to the future, and rejected the notion that U.S. Steel was properly valued simply by summing up its constituent parts. (History seems to suggest they were correct. With the exception of a difficult period in 1903–1904, the corporation was solidly profitable for decades to come.) But conventional standards of stock market valuation did not take into account future earnings growth, which was assumed to be unpredictable. Conservative investors would not speculate on developments they believed they could not foresee. Hence the disagreement over the amount of watered stock.
The founders of U.S. Steel had unwittingly touched on a controversy that would recur repeatedly during the twentieth century — the clash between new and traditional methods for valuing stocks. Many years later, Alexander Dana Noyes, longtime financial editor of The New York Times, suggested that 1901 marked a crucial turning point. He wrote, "Probably 1901 was the first of such speculative demonstrations in history which based its ideas and conduct on the assumption that we were living in a New Era; that old rules and principles and precedent of finance were obsolete; that things could safely be done to-day which had been dangerous or impossible in the past." The events of 1901 may have marked the first such instance, but they would certainly not be the last.
The basic question asked by any investor is, What is the right price for a given stock? At the turn of the century, this question was answered by traditionalists in a very straightforward fashion. The price an investor was willing to pay for a stock reflected what he would receive from his investment — his share of the company's earnings in the form of dividends paid out to him from those earnings. Dividends were all-important, and stock prices tended to fluctuate with the level of dividend payments.
The tool most commonly used today to value stocks, the price-earnings (P/E) ratio, had its origins in this analysis, although in a way that would now be considered somewhat backward. At the turn of the century, appropriate P/E ratios for stocks were derived from dividends. For example, for most of the decade preceding 1901, the average dividend yield of industrial stocks traded on the New York Stock Exchange varied between 5% and 6%. As a standard rule of thumb, it was assumed that a mature industrial company should pay out between 50% and 60% of its earnings in dividends. Thus, if a company's annual dividend was between 5% and 6% of its stock price, and was to represent between 50% and 60% of its earnings, the earnings per share must equal 10% of the stock price. Put in the form of the price-earnings ratio, the price of a share of stock should be ten times the company's earnings per share — a P/E ratio of 10 to 1.
Simple enough. In fact, the 10-to-1 P/E ratio had become something of a standard by the turn of the century. An industrial stock trading at a 10-to-1 P/E ratio was arbitrarily considered by many analysts to be fully valued. This standard had certainly held true in the decade preceding 1901; in only one year of that decade did the composite P/E ratio for the New York Stock Exchange industrials rise significantly above 10 to 1. (In 1896 it touched 11.7 to 1.)
Price-earnings ratios were calculated on the basis of the current year's earnings. Richard Schabacker, financial editor of Forbes magazine, wrote later about accepted valuation standards in the early twentieth century: "Since it is generally impossible to prophesy what earnings the stock will show in any future time, it is necessary to base this [P/E] ratio on the probable earnings for the current year." Anything else was speculation, not investment.
This rigid, static mode of analysis yielded results that would today appear to be perverse. Since stocks were presumably riskier than bonds (which had fixed interest rates and guaranteed the return of principal on maturity), investors expected to receive dividends on stocks that were greater than the interest rates available from bonds, so as to be compensated for the extra risk. Dividend rates at the turn of the century were in fact higher than bond interest rates, and had always been so, going back as far in time as data are available. Investors, unable or unwilling to estimate future growth but cognizant of the fact that stocks were riskier than bonds, demanded a higher yield from stocks than bonds. This is the precise opposite of the relationship between stock dividends and bond yields that prevailed throughout most of the second half of the twentieth century.
The arbitrary derivation of appropriate P/E ratios from current dividend payouts resulted in relatively low stock prices. Since stock prices fluctuated with dividends, and dividend rates were relatively high, by definition stock prices had to be relatively low to produce the required high dividend rates. (The dividend rate is simply the dividend per share divided by the price per share of the stock — hence the lower the share price, the higher the dividend rate.)
In short, stocks were typically viewed by turn-of-the-century investors very differently than they are viewed today. They were valued primarily on the basis of the current income — dividends — they produced. This conservative approach resulted in stock dividends that were higher, and stock prices that were lower, than modern methods of analysis produce.
The proponents of trusts like U.S. Steel implicitly challenged these standards by citing presumably enhanced future profits as a justification for the giant business combinations. But it was only a mild challenge; once created, the shares of the trusts were still typically valued on the basis of the dividends they paid. However, some serious students of the market were exploring significantly more unorthodox ways of evaluating stock prices. In 1900 two such men, separated by thousands of miles and coming at the problem from very different disciplines, proposed theoretical approaches to analyzing the market that were fundamentally different from traditionally accepted methods.
One of these men was none other than Charles Dow, creator of the Dow Jones averages and editor of The Wall Street Journal. Dow developed an entirely new way of looking at the stock market that would later form the basis of what would be called technical market analysis. In a series of articles in the Journal between 1900 and 1902, Dow put forth a theory for predicting stock prices that had nothing to do with earnings or dividends but was based simply on the price action of the stocks themselves. His ideas were taken up by William P. Hamilton, who succeeded Dow as editor at the Journal. Hamilton refined Dow's approach, giving it a name — the Dow theory.
The Dow theory assumed that the stock market at all times accurately reflected the sum total of all knowledge as to the future course of business activity much better than any individual could possibly hope to. Therefore, little advantage could be gained by analyzing business fundamentals. But Dow and Hamilton claimed that certain patterns could be discerned in the action of stock prices that could be used to predict the market's future course. In effect, they argued that an investor should read the market as a "barometer" of business conditions, but a barometer that not only measured the present but sometimes provided clues to the future as well.
Dow believed that at any given time there were three movements present in the market — the primary trend, a secondary (or reactive) trend counter to the primary trend, and essentially random daily fluctuations. He believed that the price action of the market itself would provide signals as to when a primary trend (which could last for years) was reversing, and that these signals could be very valuable to investors. In perhaps his bestknown article on the subject, in The Wall Street Journal in 1901, he compared the action of the market to waves on a beach:
A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned.
This method holds good in watching and determining the flood tide of the stock market ... The price-waves, like those of the sea, do not recede at once from the top. The force which moves them checks the inflow gradually and time elapses before it can be told with certainty whether the tide has been seen or not.
Coincidentally, as Charles Dow was propounding his theory of stock price movements, a young French mathematician, starting with a similar conception of the market, reached profoundly different conclusions. Louis Bachelier completed his doctoral dissertation at the Sorbonne in Paris in 1900. Entitled "The Theory of Speculation," it was the first work to employ mathematical techniques to explain stock market behavior. Bachelier, like Dow, believed that the stock market at all times accurately represented the collective wisdom of all participants. He wrote, "Clearly the price considered most likely by the market is the true current price: if the market judged otherwise, it would quote not this price, but another price higher or lower." But Bachelier, unlike Dow, did not discern any means by which future prices could be predicted. In the opening paragraphs of his thesis he argues that market movements are not only impossible to predict but often hard to explain even after they have occurred:
Past, present, and even discounted future events are reflected in the market price, but often show no apparent relation to price changes ... artificial causes also intervene: the Exchange reacts on itself, and the current fluctuation is a function, not only of the previous fluctuations, but also of the current state. The determination of these fluctuations depends on an infinite number of factors; it is, therefore, impossible to aspire to mathematical predictions of it ... the dynamics of the Exchange will never be an exact science.
Bachelier had another important insight — that stock price fluctuations tend to grow larger as the time horizon lengthens. The formula he developed to describe the phenomenon bears a remarkable resemblance to the formula that describes the random collision of molecules as they move in space. Many years later this process would be described as a random walk, a key concept underlying much of the academic work on the stock market in the second half of the twentieth century.
A great deal of Bachelier's work was revolutionary. He laid the groundwork upon which later mathematicians constructed a full-fledged theory of probability, and made the first theoretical attempts to value options and futures. All this was done in an effort to explain why stock prices were impossible to predict.
Bachelier was not modest about his work. He stated openly, "It is evident that the present theory resolves the majority of problems in the study of speculation by the calculus of probability." Sixty years later a leading finance scholar agreed, saying, "So outstanding is [Bachelier's] work that we can say that the study of speculative prices has its moment of glory at its moment of conception." Bachelier anticipated by half a century the efforts of mathematicians and economists to develop rigorous models of stock market behavior. Unfortunately, Bachelier was a frustrated unknown in his own time. His dissertation was awarded "honorable mention" rather than the "very honorable mention" that was essential to finding employment in the academic world. After years of trying, he finally secured an appointment at an obscure French provincial university. The quality of his dissertation was simply not appreciated at the time, in part because he had chosen such an unusual topic for his research. One of his professors wrote, "M. Bachelier has evidenced an original and precise mind," but also commented, "The topic is somewhat remote from those our candidates are in the habit of treating." Over fifty years were to pass before anyone took the slightest interest in his work.
(Continues...)
Excerpted from Toward Rational Exuberance by B. Mark Smith. Copyright © 2001 B. Mark Smith. Excerpted by permission of Farrar, Straus and Giroux.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
