Herd on the Street: A Quarterly Stampede
By Daniel Yergin
The Washington Post
Opinion
Sunday, June 30, 2002; Page B01
The thud you just heard was not just WorldCom -- which once soared through the sky at $64.50 a share -- hitting earth and skidding to nine cents a share. It was also the sound of the end of an era. The shock waves have devastated employees and hit shareholders hard. They have also jolted the broader public, now cynical about markets and worried about retirement portfolios, and foreigners, who no longer look to U.S. stocks as a secure redoubt. Coast to coast, business people talk perplexedly about the "malaise," a phrase not heard in an economic context for more than 20 years.
The beginning of the end was more than two years ago, in March of 2000, when the Nasdaq blew out at 5085 and began its long descent to its current level under 1500. It continued through the autumn of 2000, when the bottom suddenly fell out for many businesses, through the grievous shock of Sept. 11, through Enron and accounting scandals, and now to WorldCom's fall from the heavens.
But what an era it had been, a triumph of economics over politics. Just a few years ago, the wife of a prominent politician had noted her surprise that CEOs had become more important and powerful than governors. Indeed for several years, CEOs became merchant princes, some seemingly anointed with supernatural powers.
Yet the 1990s had started off with a mild recession and deep pessimism that the United States was losing out to Germany and Japan. It was not until more than halfway through the decade that people began to believe it would be a boom period. But the boom was built upon two decades of economic reform -- reducing overly rigid regulatory systems, whipping inflation and reshaping companies -- that had produced a more flexible, fleet-footed and entrepreneurial economy. In the 1980s and 1990s, the United States created almost 40 million new jobs.
But then two things happened. The focus on the quarterly performance of corporations, a hallmark of American capitalism, was transformed. Though derided in countries like Germany as "short-termism," it was a powerful discipline. By the end of the 1990s, however, the discipline turned into something more like a cult. Companies were expected to make each quarter better than the last, or they would be punished with a sharp fall in their stock price. If a company missed the "consensus forecast" by a few pennies, this was treated by stock analysts and the business media as an apocalyptic event.
The name of the game was to keep those quarterly earnings coming. Not because they meant dividends, which went out of fashion. The whole system depended on rising stock prices. Who was calling the shots? To a considerable degree, it was all of us -- and our $11.5 trillion fortune of retirement savings. The quest for "shareholder value" and higher returns was the guarantee that our retirements would be okay, and we expected our money managers to deliver. Their compensation and even their jobs depended upon their performance. For instance, a pension fund or university endowment might have 20 investment managers. Each year, it might drop the five with the lowest returns. That, in turn, meant money managers put incredible pressure on companies to increase earnings and stock values. If executives didn't deliver, they risked being turned out, or having their company taken over by serial acquirers like WorldCom.
But the money managers were speaking to the converted. Here's where one of those "laws of unintended consequences" that bedevil regulation came in. In response to a populist outcry about executive compensation, Congress capped the tax deductibility of CEO salaries. So boards shifted the weight of executive compensation toward option packages. At last, it seemed, one of the holy grails of shareholder value was to be achieved -- managements' incentives were now said to be "aligned" with the interests of shareholders. But not quite. Unlike shareholders, executives suffered no out-of-pocket penalty if the share price went down. Moreover, the options, which could eventually be worth tens or even hundreds of millions of dollars, were not charged as an expense, masking their real cost to the company and its shareholders.
Still, with huge incentives to drive up stock prices, executives felt they needed to make each quarter look good. Stock analysts cheered companies on. But then the economy began to flatten out. Business was not so great, after all. The name of the game now was just to keep the game going. That's when some mixture of temptation, pressure, greed, ego, arrogance and fear came into play, leading some managements into gray areas -- or worse. Compliant auditors made it easier. At some point, some people simply crossed the line. That might have been the story at WorldCom, where the size of the improper accounting adjustment was just big enough to enable the company to meet profit projections.
The other change during the 1990s was the technology boom. The Internet was adopted at lightning speed. With it came a proliferation of companies that had dazzling promise, but no business model for making money and no discernible "PtoP" -- path to profitability. But their stock prices soared to unbelievable levels.
For savvy investors, the party not to be missed was "TMT" -- technology, media and telecommunications. WorldCom, which happens to carry 50 percent of the world's e-mail traffic, was a beneficiary. So was Global Crossing, which was formed in 1997. Taken public in 1998, its market capitalization soon reached $10 billion. When that milestone was achieved, one of its senior executives penned a simple note to an acquaintance: "God bless America." By Feb. 2000, the blessings of God and enthusiastic investors bestowed upon Global Crossing a market capitalization of nearly $50 billion, substantially more than the market capitalization of General Motors. (Global Crossing is now in bankruptcy.)
This was the new economy. Cycles were banished. There would never be another downturn. If you weren't new economy, you were, by definition, "old economy," and definitely out of it. Millions and millions of Americans became obsessed with the stock market. Politics was out. Money was in. Day trading was very in. People thought they were investing; in too many cases, they were gambling.
In such circumstances, people discount risk and fret about missing the upside. A noted investor, Ralph Wanger, explains it through the parable of the zebra herd. No lions have been seen for a while, and some the zebras begin to doubt that lions ever existed. If they once did, they're surely extinct. So the younger members of the herd break off, searching for lusher grass. They find some, and in due course others follow them in what turns into a stampeding herd. But the lions suddenly reappear and the carnage begins. "Then the younger zebras," says Wanger, "complain to the older zebras 'Why didn't you warn us about the lions?' "
Profound economic and technological change went hand in hand with a speculative bubble and "irrational exuberance" -- the phrase made famous by Federal Reserve Chairman Alan Greenspan in December 1996, when the Dow was at 6,437. This was not the first speculative bubble. The broadband boom has its match in the railway boom of the late 19th century. And the Internet boom resembled the radio boom of the 1920s, when one of the favorite stocks, RCA, went from $1 a share to almost $600 a share in just a few years. And, of course, investors believed there was a "new economy" in the 1920s, too. More recently, the Japanese bubble economy of the late 1980s and the euphoria that preceded the Asian financial crisis of the late 1990s offer striking analogies. In each case, it was assumed that trees would grow to heaven. When the end came, it turned out that there was much more debt than people had imagined, unmanageably high levels. There was also funny accounting.
The change in public attitudes is dramatic. Suspicion has replaced adulation. Can the numbers be trusted? CEOs are no longer heroes or heroines. They and their companies are now on the defensive. The loss of confidence is very real, and it's dangerous.
How to fix this crisis of corporate governance and credibility? Observing the activities of the SEC, Congress, the Justice Department and the attorney general of the state of New York, one is hard-pressed to say that there is an absence of regulation. The laws are there to be enforced, and they will be. New rules will limit the amount of company stock that can be in 401(k) plans. For accountants, the marriage of auditing and consulting is already over. The independence and responsibilities of auditors will likely be augmented, and accounting may shift from rule-based to principle-based standards. (Exactly how much clarity does the Financial Accounting Standards Board's 804-page rule on derivatives provide anyway?) Options will be more regulated and are likely to be expensed, although it would be better to do so when they are exercised, rather than when they are granted. Dividends might even come back into fashion. In the meantime, most major boards are already changing the way they handle compensation and accounting.
Markets don't exist in vacuums. They depend on laws, regulations, self-regulation, norms, standards and values. Without these, markets are -- as Russians used to say during their "Wild East" economy of the early 1990s -- more like bazaars. The legitimacy of markets depends in part on the quality of the rules that govern them and the way those rules are implemented and enforced. All that is now under scrutiny. And with the dollar weakening and prospects of a new financial contagion increasing in Latin America, government and business leaders have an urgent responsibility to help restore confidence.
For several months now, one has noticed a split between many economists, who foresee a decent or even strong recovery, and senior business people, who are reluctant to restart investment because of their pessimism. Part of the business pessimism can be explained by a conviction that there is already over-capacity in many industries.
But part of their pessimism is linked to a malaise in America that is about more than the turmoil and machinations in the boardroom. This is also wartime. A new study from the OECD warns that the medium-term economic consequences of Sept. 11 may be greater than initially thought. The fear of what's next, concern about disruptions to world trade and communications, the reappearance of government budget deficits -- all of these are contributing to this malaise, the caution, the shakiness in markets. It would be hard enough working one's way out of the post-new economy bust without the geopolitical risk. But it's even more trying in the midst of a new kind of war. Remember that the last time we heard about malaise, in the 1970s, the geopolitical overlay was also war and turmoil in the Middle East.
America's $10.4 trillion economy is flexible and resilient, and it has enormous depth. The process of reform has already begun. But the economy's mettle -- and its institutions -- are now being tested on more than one front, both from within and without. No question, this is a different era.
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Daniel Yergin is chief commentator for and an executive producer of the PBS series about global markets, "The Commanding Heights," based on the book of the same name that he coauthored (Touchstone).
© 2002 The Washington Post Company
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