Why Did Wall Street Blow It?
smartmoney.com
By Matthew Goldstein
December 28, 2000
LET'S FACE FACTS: Wall Street blew it, big time.
Back when the Nasdaq Composite was still scraping the stratosphere earlier this year, hardly a bear could be found on Wall Street, and the hype machine was going at full tilt. Analysts, pundits and investment bankers were all telling investors to put their money into technology companies because New Economy stocks didn't play by the old rules. The prevailing mantra on Wall Street was: "Forget about rising interest rates. Stock valuations are irrelevant, and so are earnings." And sure enough, investors — wanting to believe it was true — lapped it up like candy.
Well, we all know now how that turned out. The Nasdaq has been chopped in half in just nine months, and is headed for its worst year ever. The Dow Jones Industrial Average will close the books on 2000 some 6% in the red, its first down year since 1990. The Standard & Poor's 500 is headed for a loss of more than 9%; its first yearly decline since 1994. The Internet may still transform the way the world does business, but it's clear now that it hasn't repealed the laws of gravity or basic economic principles. New Economy stocks, in the end, are just as susceptible to a slowing economy as their Old Economy brethren.
So how did so many get so much so wrong? After all, those Wall Street pros and pundits are supposed to be the experts, the high-paid brainiacs with special knowledge and unique insights into the ways of the market. But far from sounding the alarm, much of Wall Street fell for its own New Economy hype, costing investors billions in portfolio losses. As recently as March 9, Ralph Acampora, Prudential Securities' technical analyst, was saying he wouldn't be surprised to see the Nasdaq hit the 6,000 mark this year. That's not gonna happen, unless the composite stages a 140% rally on Dec. 29. And then there's Merrill Lynch's Internet guru and analyst, Henry Blodget, who was still maintaining an Accumulate recommendation on Pets.com, just a month before the online pet store shut down its operations in November. Of course, it probably didn't hurt that Merrill Lynch (MER) was the lead underwriter on Pets.com's initial public offering.
There are plenty of reasons that Wall Street messed up — some innocent, some not so innocent. For starters, investment pros are human (appearances to the contrary notwithstanding) — and, for all their computer models and spreadsheets, can succumb to wishful thinking. "People like to believe in good news," says James Angel, a professor at Georgetown University's McDonough School of Business. "And when bad news comes, the first reaction is to deny it." In a classic stock-market bubble, he says, it isn't just investors, it's everyone — including Wall Street professionals — who start buying the story line about stocks only going up, up, up. "There was a real gold-rush mentality," Angel says.
Wall Street's big goof also demonstrates a basic weakness in the way those who work on the Street make predictions and forecasts. Every mutual-fund ad ever printed contains the warning that past performance is no guarantee of future results, but Wall Street pundits, analysts and strategists nevertheless often make projections by looking at past trends. It's a little bit like trying to drive while staring in the rearview mirror. It works reasonably well when you're on a straight and familiar road, but it's an invitation to disaster on a road with lots of curves. And unfortunately for investors, the fourth quarter of 2000 has had the look of a dead man's curve, given all the unexpected profit warnings from big tech companies.
It was precisely that sort of extrapolation from past performance that sent analysts and market gurus so far off the rails this summer. In July, the consensus on Wall Street was that companies in the S&P 500 index would post average earnings growth of 17% in the fourth quarter, according to First Call/Thomson Financial. In fact, it wasn't until six weeks ago, when the earnings warnings really started pouring in, that most Wall Street analysts began slashing their numbers to reflect the slowdown in the economy. Now Wall Street is predicting more modest 4.8% earnings growth for those same S&P 500 companies, according to First Call.
Joe Cooper, a First Call analyst and researcher, says analysts apparently made their initial earnings predictions based on the "phenomenal numbers" posted by many big high-tech companies earlier in the year. No one on the Street, it seems, ever stopped to question whether those figures were sustainable. Says Georgetown's Angel: "Wall Street has a built-in bias to be optimistic."
To the cynics, that optimistic bias has a darker side. Wall Street's critics say the analysts and the pundits will always ignore the negative and emphasize the positive because they work for big investment and brokerage firms that derive hefty commissions from selling stocks. The last thing Wall Street pros want to do, this argument goes, is spook individual investors and dampen trading volume and the appetite for new stock offerings.
There are other inherent conflicts of interest that so-called sell-side analysts face — conflicts that can force them to be more bullish than objective. Their firms often collect huge investment-banking fees — either from work on IPOs or advising on corporate deals — from the very companies the analysts cover. It was rare, if not suicidal, for an analyst to initiate coverage of an IPO underwritten by his firm with a negative report. Goldman Sach Group's (GS) e-tailing analyst Andrew Noto, for instance, didn't finally cut his rating on eToys (ETYS) until after the stock had sunk from its all-time high of $62.50 to just over $1 a share. Goldman, of course, was the lead underwriter of the online toy store's IPO.
"The most bullish people out there were employed by companies on Wall Street," says James Stack, president and editor of InvesTech Research and a money manager of a small value fund. "No one with a vested interest wanted the game to end."
Stack, an unabashed contrarian who began predicting a bear market in technology and Internet stocks long before the first tremors were ever felt on Wall Street, says he pays little attention to economic and overall market forecasts by Wall Street pundits, and advises individual investors to do the same. "I think market analysts are very good at trying to determine which industries will be better performing than others," says Stack. But he adds, "there is a reason that not one recession has been forecast in advance."
But there are also some reasons to cut the Wall Street establishment a bit of slack for its poor performance this year. Some of what has afflicted the market in 2000 falls under the heading of "exogenous events" — developments or crises in the world at large that are, by their very nature, largely unforeseeable. After years of OPEC impotence, for example, who could have predicted the steep run-up in oil prices, which acted as a brake on consumer spending? And it would similarly have taken a crystal ball to foresee the flare-up in Middle East tensions, which helped dampen the market in the fall, and the protracted presidential-election endgame, which apparently chilled consumer spending.
And the prognosticators who declared a new era of gravity-free economics can be forgiven, at least to some degree. Technology is, indeed, transforming our economy, increasing productivity and efficiency, and creating new industries and markets. A no less rationally exuberant an observer than Federal Reserve Chairman Alan Greenspan put it, "When historians look back at the latter half of the 1990s a decade or two hence, I suspect that they will conclude we are now living through a pivotal period in American economic history. New technologies that evolved from the cumulative innovations of the past half-century have now begun to bring about dramatic changes in the way goods and services are produced and in the way they are distributed to final users." Of course, he made those remarks on March 6 — four days before the Nasdaq crested — so he may have since reined in his enthusiasm somewhat.
Still the gangbuster performance of technology stocks up until April gave lots of investment pros plenty of justification to throw caution to the wind. "I'm leery of coming down too hard on people who started saying that maybe the world has changed," says Kenneth Froewiss, a professor at New York University's Stern School of Business. But Froewiss says the bursting of the tech-bubble should serve as a warning to investors about the unpredictability of the markets and the inherent risk associated with buying stocks. The collapse of the Internet and technology sectors, he says, demonstrates the value of a diversified portfolio and of not investing solely in flavor-of-the-month stocks.
So maybe the lesson from this year's market pain for investors is nothing more than the old cliché of not putting all your eggs in one basket (no matter how famous the guru who's pointing to that basket). But if history teaches us anything, many investors will choose to ignore that sound advice and again try to beat the market. And if you do that and start loading up on stocks in a sector that's running wild, remember this: Be vigilant and ready to move quickly. "Whenever you start hearing people say things like 'This time it's different,' that's when you should be selling," says Georgetown's Angel.
In other words, as soon as the pros on Wall Street start promising investors the moon, it's time to take your profits and run.
What They Said Then... What They Say Now...
“There is no end in sight for the best economic and financial market cycle in U.S. history.”
— Jeffrey Applegate, Lehman Bros. strategist
USA Today, 6/30/00
“The market is currently undervalued. The worst is behind us.” — Jeffrey Applegate Reuters, 12/12/00
“The Nasdaq is not overpriced and we are not in a speculative bubble.” — Joseph Battipaglia, Gruntal analyst
SmartMoney.com, 1/31/00
“This year has been hard on most investors and strategists alike.”
— Joseph Battipaglia Dow Jones Newswires, 12/4/00
“The long-term bull market has many, many years left.”
— Ralph Acampora, Prudential Securities analyst, predicting Nasdaq 6000 Dow Jones Newswires, 3/9/2000
“These factors suggest that a good rally is in the offing.”
— Ralph Acampora, commenting on recent market trends.
National Post, 12/12/00
“Bull markets don't end because of old age or high price-earnings ratios; they end when there's a major resurgence in inflation.”
— Thomas Galvin, CSFB strategist, predicting Nasdaq to close at at 5500 USA Today, 6/30/00
“Economy and technology fundamentals will resuscitate sooner than expected.”
— Thomas Galvin SmartMoney.com, 12/23/00
“When the history of the market is written for 2000, I think you will find that the same lead dogs were pulling the sled at the end of the year as in the beginning.”
— Alfred Goldman, technical analyst at A.G. Edwards & Sons
Chicago Tribune, 3/14/00
“There's been a spike up in analysts' downward revisions to earning forecasts, which is a classic sign of a bottom.”
— Alfred Goldman Reuters, 12/8/00
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Jack |
