Mr. Market Miscalculates

From Chapter One: Gallery of the Immortals

First There Was J. Pierpont Morgan

April 9, 1999

The March 30 edition of The Wall Street Journal, with its unique page one makeup and exultant “Dow 10,000” headline, fairly jumped off the newsstands, and the quotes of the bullish equity strategists almost leapt off the page. “Top American corporations will command even higher valuations in the future,” said one, “because they constantly reinvent themselves.” “What price do you want to pay for a Matisse?” he asked.

Henry Clay Frick, turn-of-the-century steel titan, earlier compared another financial asset to the works of a different Old Master. “Rembrandts of investment,” pronounced Frick, referring to railroad bonds. Although mistaken about the senior securities of a fast-maturing industry, Frick did die rich.

“But while stocks never before have been so richly valued,” wrote a reporter in the same Wall Street Journal Collector’s Edition, “neither has the U.S. ever enjoyed so long a period of economic growth with declining inflation.”

Possibly, the writer did not remember the last three decades of the 19th century, when the annual rate of growth in real GNP averaged some 3.83%, and the consumer price index registered an average annual decline of 0.87%.

The perfect antidote to the suggestible millennial press is the wonderful new biography of J.P. Morgan, Morgan: American Financier by Jean Strouse (Random House, 796 pages, $34.95 at retail).Morgan’s life is testament to the importance and inevitability of financial and economic cycles, as well as to the possibility of becoming very rich while spending half the year in Europe collecting art. A Morgan partnership in the late 19th century was almost regarded as a death sentence, Strouse relates, so overworked were the principals at 23 Wall Street. Yet Morgan somehow managed to find the time to run the firm, rescue the credit of the United States, reorganize the railroads that had issued too many “Rembrandts,” create trusts, intervene to stop recurrent financial panics and, yet, to organize his personal life in such a way that his second wife and he were not often together on the same continent, let alone under the same roof.

“What’s really driving the market is peace,” another brokerage-house employee was quoted in the March 30 Journal. “Nobody’s talking about the peace dividend.”

The United States was at peace from the close of the Civil War, in 1865, to the start of the Spanish-American War, 1898 (which lasted only about as long as a modern bear market).Yet, over that span of years, creative destruction raged, panics swirled and interests clashed. Feckless and overleveraged optimists periodically came to grief, low interest rates, and the absence of a federal income tax notwithstanding.

There was no central bank in those years, either, but Morgan, de facto, almost seemed to fill the office himself. Even before he played Atlas in the Panic of 1907, he was widely viewed as the indispensable man. In 1902, when Morgan was 65, the historian Henry Adams wondered “What would happen if some morning he woke up dead?”

The year of Morgan’s death, 1913, was also the year of the passage of the Federal Reserve Act. “The king is dead…,” a perceptive New York banker wrote of Morgan’s passing. “There are no cries of ‘Long live the king,’ for the general verdict seems to be that there will be no other king; that Mr. Morgan, typical of the time in which he lived, can have no successor, for we are facing other days.”

Now they say, “Thank God for Alan Greenspan,” and many wonder what would become of the charmed stock market if the chairman left office (his term expires in 2000).What followed Morgan’s death was unimagined change. A peaceful Edwardian world went to war, governments formerly limited in their taxing power became rapacious, a gold standard turned to paper and the Rembrandts of investment (which, in truth, had been in a bear market since the turn of the century) went on depreciating. History is bigger than individuals, and there is no permanent high plateau of prosperity. On a more hopeful note (now we are thinking of Asia), there is also no permanent low plateau of depression.

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From Chapter Two: On Planet Stock Market

Crisis of the Big Guys

March 26, 1999

Remarks by James Grant before the American Council of Life Insurance, in Tucson, Ariz.:

I have a big subject to address, and big shoes to fill. As you know, I am here today only because Peter Bernstein couldn’t be. Peter, who is ailing, literally wrote the book on risk—his splendid Against the Gods appeared in 1996. You’ll agree that anyone who could make an international best-seller out of the history of risk in the speculatively charged 1990s must be a very formidable intellect indeed.

Peter’s timing was admirable. This is a risk-fraught juncture in finance; in my opinion, among the most perilous ever. I know that I have said this before, too many times, and I understand full well that my association with a bearish message does not necessarily enhance its news value. I have resolved to do better during the next once-in-a-lifetime boom.

The tricky thing about risk is that it is more threatening as it seems less obvious; and less threatening as it seems more obvious. If you concede the truth of this paradox, you are bound to agree that America is dangling by a thread, financially speaking. Rarely has risk seemed less obvious to the majority of investors than it does today. Although not actually eradicated by modern science, it is, like polio, thought to be in full retreat. Time magazine crystallized the spirit of the age last month when its cover featured a picture of Alan Greenspan, Robert Rubin and Lawrence Summers, collectively identified as “The Committee to Save the World.” The story inside implied that no financial risk is so great that it cannot be neutralized by a committee of enlightened public servants.

Like many other financial ideas, the concept of risk is forever being redefined. Its definition varies with financial and economic circumstances, and it has recently undergone a bull-market transformation. For a professional money manager in 1999, the riskiest asset isn’t necessarily interest-rate derivatives, commodity futures, Russian sovereign debt, or even domestic small-cap equities. It is probably Treasury bills. Cash is the one asset class that is positively guaranteed not to double in value in the next fiscal quarter. It is the investment that is certain not to keep up with the S&P 500.

For me, the all-cycle definition of risk is the chance of loss. It is not the risk of falling behind the S&P or of not retiring, like everyone else in one’s neighborhood, at the age of 49 to Boca Raton.(Nor, it seems to me, is the volatility of a particular security in relation to an index. If a good business can be purchased at a compelling valuation, of what significance is the flight path of its stock price?) The value investor Seth Klarman has thought long and hard on the subject. “Unquantifiable in prospect,” he writes, “risk is (surprisingly) no more measurable in retrospect. You can, of course, measure the outcome of an investment. But you cannot easily evaluate what failed to transpire, all of those seeming risks that were somehow avoided as well as those that were never even imagined.”

I think Seth would be the first one to concede that thinking about risk has lately not been the way to get rich, or to become richer. The trouble is that the risk-averse investor is competing with people who might be described as risk-oblivious. They can imagine no conceivable way in which there could be a loss—the subject has never dawned on them. I used to pity these innocents—they didn’t even have the good sense to subscribe to Grant’s. Now, I suppose, they pity me. In such a paradise as this one, the argument goes, the only relevant risk is that of underperformance—of not keeping up with one’s brother-in-law, the Internet trader. I fearlessly predict that this will change. In fact, to judge by the weakening net inflows into equity mutual funds as well as by the great and growing disparity between the chosen few stocks and the unwashed mass, it seems to be changing already.

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