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  So, in the fall of 1987, Leuthold realized that the bull was not ready to give up the ghost. In the wake of the ’87 crash, he acknowledged that the market still looked pricey to investors accustomed to the seventies, a time when many stocks traded at seven or eight times earnings. But Leuthold believed in market history—which meant going back more than a decade to put things in historical perspective. In terms of “intrinsic value…the market is really at just about median levels,” he observed. “At 14 or 15 times earnings, price earnings ratios are about mid-way in their historical range.”

  The market might drift to a new low sometime before the end of the year, Leuthold predicted, but he anticipated “nothing that’s terribly dramatic.” Before long, he expected the bull market to resume, forecasting that in the next leg of the bull market, the Dow could easily climb to 3000.30

  Most investors fight the last war: their expectations are conditioned by what happened in the preceding cycle. But Leuthold was in a good position to put recent experience into a much broader historical context—he had been investing since the early sixties, which meant that he had already lived through two long cycles.

  Steve Leuthold

  Steve Leuthold had grown up in Minnesota in the forties. His father, the founder of a chain of clothing stores, wanted him to join the family business, but Steve had other ambitions. When he was 17, Elvis Presley recorded at the Sun Records studio. Bedazzled, Steve and three friends formed their own band, with Steve on vocals and rhythm guitar. In 1958, the group—by then calling itself “Steve Carl and the Jags”—landed a recording contract with Meteor Records and cut a demo. But nothing came of the contract, and Leuthold’s career as a rocker fizzled.

  After college, Leuthold tried out a second career: law school. Forty years later, he could still recall how much he hated it. “I saw these people grinding away in the law library and I thought, ‘Boy, I don’t want to do that!’ Later, I came to look on lawyers as the sands in the gears of progress—always saying ‘You Can’t Do That!’”31

  When Leuthold abandoned law school, he signed on as a management trainee at Cargill Grain Co., where he acquired his first real training in investments and trading. There he became interested in the commodities market. But once again his career was short-circuited; in 1960, he joined the army.

  As it turned out, the army became Leuthold’s version of Harvard Business School. Because of his background working in his father’s clothing stores, he was assigned to supply, handing out clothing to new recruits. But as it happened, the captain of his unit was an avid stock market maven, and when he heard of Leuthold’s experience at Cargill, he gave him a job in the company’s office.

  There, Leuthold’s main job was charting stocks for the captain. Sensing that it would be impolitic to disappoint, Leuthold took a correspondence course in securities analysis. He also used his own money to trade soybeans futures.

  From the army, Leuthold went to PaineWebber, where, at 22, he became a broker. By 1966, he was running a hedge fund, and in 1969, he set up his own research division at Piper Jaffray. There he began to establish a national reputation for the quality of his research. In 1980 he established his own firm, The Leuthold Group. A year later, he appeared on the PBS show Wall $treet Week with Louis Rukeyser. Now even Leuthold’s mother knew that he had arrived. “Ever since my father’s death, I had been managing her money, but she never paid much attention to my recommendations—and always questioned my judgment,” he recalled with a grin. “Then she saw me on Wall $treet Week and never questioned me again. Whatever I said was okay by her.”32

  Throughout the eighties, Leuthold maintained his independence. This was why, in the summer of ’87, he was able to call the market as he saw it, advising his clients to move out of stocks. “I could see that we were at the outer limit of all evaluation benchmarks for the stock market—price/ earnings ratio, yields, et cetera,” Leuthold said. “Unless we’d entered a new era, it was clear that we’d topped out. I’ve been in the business a long time, and I’ve heard a lot about new eras, but I’ve never actually seen one. Someday, there may be a new era. But betting on one is a lousy basis for making investment decisions.”

  If he had worked for a major Wall Street firm, Leuthold would not have been able to take a stand. But because he worked for himself, “I just do what I want to do,” he said in 1988. “I could never do that at an establishment firm. Fortunately, I’ve never been very security conscious,” he added. “I could live just as comfortably on $30,000 a year. I would enjoy life just as much.”

  Of course, even then, Leuthold earned well more than $30,000 a year. But his success dramatized another of Wall Street’s ironies: professional investors who are obsessed with money—or the idea that it makes life secure—are often less likely to succeed. When they are wrong, they have a hard time cutting their losses. Those who realize that investing is a game have the edge. They know that they cannot be right all of the time: the future is, by definition, unpredictable. This makes it much easier to ride a bull. You know that, from time to time, you will be tossed over his horns—and gored. It is part of the game.

  THE AFTERMATH: ON MAIN STREET (1987–89)

  When all was said and done, what was most remarkable about the crash of 1987 was the aftermath. Nothing happened. The economy did not collapse. The first phase of the bull market had reached its climax—the rest of the decade would be denouement.

  Old hands like John Kenneth Galbraith and Richard Russell had been right in thinking that the market was getting ahead of itself, but they were wrong on one crucial point: the bull market was not over. Less than six months after the debacle, the Dow was again floating close to 2000—just where it had been a year earlier. As for the S&P 500, it ended 1987 with a 2 percent gain, rose 12.4 percent in ’88, and climbed another 27.3 percent in ’89.

  But while the bull was resuscitated, public enthusiasm for the market did not revive. The fire-sale mood that swept the nation in the days immediately following the crash lasted only a short time. In October of 1987, net withdrawals from stock funds totaled $7.5 billion, and investors continued to pull money out of equities for 15 of the next 17 months—even as the market started to recover. Ultimately, investors withdrew $29 billion—equal to 12 percent of the assets in stock funds before the crash.33

  In October of 1988, a year after the collapse, Charles Schwab’s customers were still holding about $5.5 billion in cash on the sidelines, though Schwab himself took some comfort in the fact that they weren’t pulling their money out altogether. They might not be buying stocks, but at least they were keeping the cash in their Schwab accounts. “Black Monday did to investors what Jaws did to swimmers,” Schwab observed. “They don’t want to go in the water, but they still come to the beach.”34

  As the crash of 1987 became a misty memory, history would be rewritten. The revisionists would claim that while professional traders panicked, the small investor stood pat. Tales of the small investors’ courage became a cornerstone of the major populist myth of the nineties: that the “little guy” was smarter than the pro. (Warren Buffett “just didn’t get it”; the dentist who watched CNBC while drilling did.)

  The truth was that a year after the crash, mutual fund investors were still steering clear of stocks.35 Net sales of equity funds were only a third of what they had been a year earlier. Meanwhile, at Fidelity, redemptions had drained the firm’s equity funds: just before Black Monday, funds that invested in stocks boasted assets of roughly $47.6 billion; five months later they had shriveled to $34.8 billion. Of course, some of the shrinkage was due to market losses, but by February of ’88 the market was making a nice recovery. Yet assets in Fidelity’s equity funds remained down 27 percent from their precrash levels.36 Mutual fund redemptions did not hold the Dow down, but that was only because mutual fund investors were not major players in the equity market.

  As the eighties drew to a close, small investors became even more cautious. Insider trading scandals roiled Wall Street, and by 1989, man
y were convinced that the market was a game run by people who might be described, most charitably, as “too smart by half.” Public participation in the stock market, measured as a percentage of household assets invested in stocks or equity funds, stood far below its 1968 peak.37 What would it take to revive the people’s market of the late sixties?

  “It’s a peculiar time,” Merrill Lynch’s Bob Farrell acknowledged late in 1988. “So much publicity is given to people who make a lot of money—whether it’s a guy who wins the lottery or an investment banker, and Wall Street has been in the middle of it. Bonfire of the Vanities sums it up. Now if the standard of living goes down, or if there is a decline in the value of housing, more people will be looking for a way to ‘score.’ If the little guy views equities as a speculative game, he may be more likely to play it if he feels that he has to find a way to accumulate wealth.”38

  In other words, it might take hard times to bring small investors back in. Farrell had a point. The second leg of the People’s Market would not begin in earnest until 1991, when the economy was in recession and interest rates on money market funds had slipped to well below 5 percent. Only then did individual investors begin to think about buying stocks.

  THE AFTERMATH: ON WALL STREET (1987–89)

  As the eighties trailed off, a malaise hung over the Street. “No one wants a corner office,” confided a young executive at Merrill Lynch. “No one wants to look expensive.”39

  A year after the crash, securities transactions of all types were down 22 percent and some 15,000 Wall Streeters had lost their jobs.40 The one supposedly bright spot: the merger business continued. In 1988, PaineWebber reported, fully 29.8 percent of the appreciation of the S&P 500 was in companies that were acquired or that carried out major restructuring. But now there was a desperate edge to the takeover game. Wall Street brokerages badly needed the windfall profits that they could reap from a leveraged buyout. A single deal could generate up-front fees of $50 million or more—enough to save a firm’s quarter.41

  At first, specialized takeover firms had financed most deals, but as takeover fever grew, other Wall Street firms wanted a piece of the action. No longer content merely to collect the fees on the deals, they became buyers. By 1988, Prudential Bache owned 49 percent of Dr Pepper/Seven Up, Merrill Lynch controlled Supermarkets General, and Shearson Lehman Hutton owned Chief Auto Parts.42

  Because of the astounding returns earned in the past, cash and credit poured into the LBO market, “making it more liquid than a double martini,” PaineWebber reported in June of 1989. By then, LBO partnerships and investment banks had roughly $25 billion at their disposal. Meanwhile, commercial banks pushed into the LBO area—a survey of 28 major banks revealed that they had $46.9 billion exposed to LBOs—an amount equal to 5.6 percent of the loans, and 67.8 percent of the banks’ equity. Japanese banks also were lining up to finance LBOs and provided the major funding for the deal that capped the decade: the sale of RJR Nabisco.

  Dealmakers scrambled to put the money to work. They had raised a huge amount of capital; now they had to find places to invest. “It is tough for a financier to assemble $100 million in an LBO fund in November and then ring up a client in December to say, ‘We’ve changed our mind. There are no high-quality, reasonably priced deals available right now. We’re going to put your money in T-bills until the next recession,’” PaineWebber’s Thomas Doerflinger warned clients in June of 1989. “Instead, the financiers did what they were hired to do—deals.”43

  All the while, the junk bond market that financed the LBOs flourished. Junk had plunged, along with stocks, in October 1987, but soon recovered—thanks in large part to Mike Milken’s talent for peddling old debt in new bottles. The prince of leverage had created a network of buyers. Now he used that network to rescue junk bonds on the verge of default, trading debt that was going sour for new debt that, in many cases, promised even higher returns—which is to say that it was even riskier. Milken had created a pyramid of junk bonds and, like any pyramid scheme, it ultimately would topple under its own weight.

  Many of Milken’s most loyal buyers were savings and loans (S&Ls). He had helped the banks grow by issuing junk bonds on their behalf, and now they, in turn, bought the junk bonds of his other customers. Meanwhile, Milken arranged for a massive inflow of deposits into the S&Ls, putting them in a good position to suck up huge chunks of Drexel’s junk bond inventory. Milken knew the S&Ls did not really have to worry about how risky the junk bonds might be. After all, the banks were using the money that their customers had put on deposit, and those accounts were, in turn, protected by the FDIC (Federal Deposit Insurance Corporation). The upshot: if the bonds went bad, the government would wind up taking the hit. Of course, “the government” meant taxpayers—who else funds the government? At the end of the decade, when the junk bond market crashed, taxpayers wound up holding the bag.

  Jim Chanos had been right: even before the ’87 crash, Mike Milken’s Ponzi scheme was on the verge of collapse. His junk kingdom had been built on air. The junk bonds were “unsecured loans”—the borrower did not put up collateral to back up the loan. Instead, he promised to pay investors double-digit dividends out of future cash flow. If the cash flow proved insufficient, the investor who bought the junk bonds was left high and dry.

  And in many cases, this is exactly what happened. For as inflation faded and share prices rose, the gap between a company’s share price and the value of its underlying assets shrank. That gap had created the value that made takeovers attractive. Now, as the pool of money available to finance LBOs grew, junk bonds were being used to finance the purchase of mediocre companies at exorbitant prices.

  As the game heated up, insiders grew greedier and took greater risks. At the same time, their high-stakes game drew more and more attention from the authorities. By the fall of 1988, the SEC was moving in, ready to close the barn door. Now the SEC accused Drexel and Milken, among others, of insider trading, stock manipulation, and fraud. At year-end Drexel agreed to plead guilty to six felonies and settled SEC charges, paying a record $650 million. In March of 1989 Milken and his brother Lowell were indicted on 98 counts of racketeering and securities fraud.

  Without Milken to force-feed bonds to his clients, Drexel found it impossible to roll over weak debt. The first eight months of 1989 saw $4 billion worth of junk bond defaults and debt moratoriums.44

  In October the junk bond bubble popped. UAL Corporation, the parent of United Airlines, provided the pin by announcing that it would not be able to complete a leveraged buyout that had pushed the company’s stock price above $200 a share. “The UAL failure crystallized the symbiotic relationship between the health of the junk bond market and the ability to mount takeovers that had so pushed up prices in the stock market,” wrote James Stewart in Den of Thieves, a landmark account of the insider trading scandals of the eighties.45 Anxious buyers were no longer willing to purchase junk bonds, and without junk bonds to support the pyramid scheme, share prices swooned. On October 13, with takeover stocks leading the sell-off, the market lost 190 points. The S&P 500 still ended the year with a neat gain of 27 percent. But junk bond investors were decimated.

  When a bubble collapses, it usually gives back not just some, but all, of its gains. Over the course of the eighties, it seemed clear that returns on junk bonds would easily outstrip the profit that a cautious investor might hope to make on AAA government bonds. It was a no-brainer: higher risk equals higher return. What junk bond investors had forgotten is that higher risk does not guarantee higher returns; it merely offers the chance of higher returns. When they closed their books on the eighties, they discovered that they had lost the gamble. Over the course of the decade, money invested in the average junk bond grew just 145 percent—substantially less than the 177 percent investors would have earned in U.S. Treasuries, without taking any credit risk whatsoever.46

  As the eighties came to a close, the curtain fell on the first phase of the Great Bull Market of 1982–99. Barbarians at the Gate
was published in 1990, and its final pages reflect the sense that an era of excess had come to an end:

  “By 1990 Wall Street’s party was over, the memories of massive buyouts and takeovers receding each day…. With Drexel’s demise, and the guilty pleas of financial titans Ivan Boesky and Mike Milken in the insider-trading scandals, popular opinion turned strongly against Wall Street and the unfettered greed of the 1980s. That backlash, combined with deteriorating financial fundamentals, effectively spelled the end to an era unlike Wall Street had ever seen…. The Roaring Eighties were a new gilded age, when winning was celebrated at all costs. ‘The casino society’ Felix Rohatyn once dubbed it.” But, “as a new decade dawned,” it seemed, to many, that “a new wind was blowing” on Wall Street.47

  So the nineties began with an illusion—the illusion that the casino society was dead. With the Milkens and Boeskys behind bars, many believed that the financial fraud of the eighties was behind them.

  “In the early nineties New York Mayor Rudy Giuliani prosecuted Wall Street’s white-collar criminals—he was the sheriff who came in to clean up the town,” Jim Chanos recalled in 2001, looking back at how the decade began. “And he cleaned up Wall Street’s image. Main Street began to feel better about New York: all of a sudden, New York was a warm and fuzzy place. This, I think, was tied to the increasing credulity about the market.”48 Fear of risk faded, and investors began to believe that the market was not a casino, but a safe haven—a place to stash money that you could not afford to lose.

  In fact, the nineties would be an extension of the eighties. Act I of the Great Bull Market of 1982–99 had laid out the plot for Acts II and III: once again, liquidity would send the market skyward, as too much money chased too few good deals.