The revolution in communication was even more dramatic. For most of recorded history, information traveled as slowly as physical goods. With the invention of the telegraph by Cooke and Wheatstone in 1837, instantaneous telegraphy abruptly changed the face of economic, military, and political affairs in ways that can scarcely be comprehended by even our modern technologically jaded sensibilities. It is humbling to realize that the news of Grover Cleveland's election in 1884 traveled from New York to San Francisco and London almost as quickly as it would today. In other words, for the past century and a half, the transmission of essential news has been instantaneous. The advent of modern communication technology has simply facilitated the rapid dissemination of increasingly trivial information.

But that does not mean that the economic and financial effects of technological revolutions occur immediately. Not at all. The steam and internal combustion engines did not completely displace horses in the transport of bulk goods for nearly a century, and it took several decades for computers to travel from the laboratory into the office, and, finally, into the home. Immediately after their invention, the telegraph and telephone were the toys and tools of the wealthy. Ordinary people did not begin to routinely make long-distance calls until relatively recently.

I find the following a.n.a.logy useful for understanding the diffusion of technology. Imagine a well hand pumped by a ponderous handle. Once every several seconds, a gush of water issues from the spout. The water is then funneled into a long pipe. From the perspective of the person at the pump handle-the innovator and the wealthy first-adopter-the water is clearly coming in spurts. But to the person at the end of the pipe-the average consumer, and, more importantly, the investor-the water is flowing evenly.

To ill.u.s.trate the point, I've plotted the real gross domestic product (GDP) of the United States and Britain since 1820 on a semilog scale in Figure 5-1 Figure 5-1. Recall that the slope of a semilog plot at any point shows the true rate of growth. Note how relatively smooth and constant the rates of growth are in the two countries. The American plot slopes upward at 3.6% per year, and the British at about 1.9% per year. (Incidentally, this plot places the eclipse of the British empire in 1871, when its GDP was exceeded by that of the U.S.-about a quarter of a century earlier than suggested by the plot of consol interest rates.) About two-thirds of the difference in GDP growth between the two nations can be accounted for by the higher American population growth, and the other third by our increasing edge in labor efficiency.

The United States and Britain have been at the forefront of world technological progress for the past two centuries. What you are looking at is its flesh-and-blood track; it is also the engine of increasing stock prices.

On occasion, other nations have had even more rapid growth. For example, in the 50 years following World War II, j.a.pan's economy grew at an astonis.h.i.+ng 6.65% real rate. However, little of this was the result of technological innovation, but rather to "catch up" to the level of the rest of the world. Even today, labor productivity in j.a.pan is far below that of the United States and western Europe. It is not a coincidence that Figures 5-1 Figures 5-1 and and 1-1 1-1 have nearly the same appearance, as they are driven by the same factors. have nearly the same appearance, as they are driven by the same factors.

Now things start to get interesting. Recall that technological progress comes in spurts, but that the economic and investment rewards driven by economic activity occur relatively evenly. The capitalization capitalization of technological ideas is as uneven as the innovative process itself, however. This is because investment in new technologies is driven by the first blush of excitement surrounding their discovery. And it is almost uniformly a bad business. For example, investors in almost all of the early automobile companies did very poorly. Similarly, although RCA pioneered the young radio industry, most of its investors got taken to the cleaners in the wake of the 1929 crash. of technological ideas is as uneven as the innovative process itself, however. This is because investment in new technologies is driven by the first blush of excitement surrounding their discovery. And it is almost uniformly a bad business. For example, investors in almost all of the early automobile companies did very poorly. Similarly, although RCA pioneered the young radio industry, most of its investors got taken to the cleaners in the wake of the 1929 crash.

Generations before academic research proved that investing in young tech companies yielded low returns, J.P. Morgan grasped this fact. Consequently, he almost always avoided unseasoned companies. He made only one exception-Edison's invention of the electric light bulb in 1879. Both Morgan and Edison realized the transformative nature of this device. Edison lacked the enormous capital required to build the bulb factories and power plants necessary to exploit it, but a consortium led by Morgan provided it. And, as almost always occurs, the lion's share of the ultimate reward did not fall to the original inventor. Unfortunately, Edison Electric, with its direct current technology, steadily lost ground to Westinghouse's more efficient alternating current system. When the two companies finally merged, Edison sold out in disgust, depriving himself of a great fortune. And, as he almost always did, Morgan prospered.

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Figure 5-1. U.S. and U.K. real GDP ($billion, based on 1990 value). U.S. and U.K. real GDP ($billion, based on 1990 value). (Source: (Source: Angus Maddison, Angus Maddison, The World Economy. The World Economy.) The key point is this: the funding, or capitalization, of transformative inventions is an intensely seductive activity. After all, who doesn't want to get in on the ground floor of the next General Motors, IBM, or Microsoft? From time to time, certain technologies capture the public imagination, and huge amounts of capital are hurled at companies promising to exploit them. In other words, the flow of capital to new technologies is driven not so much by demand from the innovators as by supply from an impressionable investing public.

This cycle has been occurring in fits and starts for the past three centuries, and an examination of the process demonstrates three things: First and foremost, the capitalization of the nation's great companies occurs largely during brief periods of public enthusiasm. Second, our society owes its success and prosperity to both the inventors and the financial backers of the technological process. And last, the returns to technology's investors are low.

Let's get a bit of nomenclature out of the way. When you and I purchase shares of stock or a mutual fund, according to strict economic definition, we are not investing. investing. After all, the money we pay for our shares does not go to the companies, but, instead, to the previous owner of the shares. In economic terms, we are not investing; we are After all, the money we pay for our shares does not go to the companies, but, instead, to the previous owner of the shares. In economic terms, we are not investing; we are saving. saving. (And, contrary to popular opinion, the overall economic effect of saving is often negative.) Only when we purchase shares at a so-called "initial public offering" (IPO) are we actually providing capital for the acquisition of personnel, plant, and equipment. Only then are we truly investing. Most of the time, we are buying and selling shares in the "secondary market"; the company usually has no interest in the flow of funds, since such activity does not directly impact it. (And, contrary to popular opinion, the overall economic effect of saving is often negative.) Only when we purchase shares at a so-called "initial public offering" (IPO) are we actually providing capital for the acquisition of personnel, plant, and equipment. Only then are we truly investing. Most of the time, we are buying and selling shares in the "secondary market"; the company usually has no interest in the flow of funds, since such activity does not directly impact it.

Here's the punch line: The returns on "real investing"-that is, the purchase of IPOs-are ghastly. In 1991, academician Jay Ritter objectively confirmed what most experienced investors have known for generations-that the shares of new companies are a raw deal for everyone but the underwriters. He found that from 1975 to 1984, IPOs returned 10.37%-just 3% more than inflation-while the market returned 17.41%. He concluded, in a triumph of academic understatement, "Investors become periodically overoptimistic about the earnings potential of young growth companies." Ritter's conclusions have since been confirmed by others and are also consistent with the sorry showing by small-growth stocks discussed in Chapter 1 Chapter 1, as most IPOs fall into this category.

IPO investors thus deserve an honored place in our economic system-they are capitalism's unsung, if unwitting, philanthropists, bearing poor returns so that the rest of us may prosper. The spasmodic history of these philanthropic orgies is perhaps the most critical part of any investor's (excuse me, saver's saver's) education.

Diving For Dollars Recall that the first stock exchanges were started in Paris, Amsterdam, and London. The English "stock exchange" consisted of a cl.u.s.ter of coffeehouses in the neighborhood of Change Alley. By the late seventeenth century, these coffeehouses became the most active and advanced exchanges in the world. The average "stock jobber," as brokers were known, would have little trouble understanding the action on the floors of the New York Stock Exchange or Chicago Mercantile, although ordering a proper brew at Starbucks might strike them as overly complex.

This revolution in financial engineering quickly found its way into the era's emerging technologies. In 1687, William Phipps, a New England sea captain, docked in England with 32 tons of silver raised from a Spanish pirate s.h.i.+p, enriching himself, his crew, and his backers beyond their wildest dreams. This captured the imagination of the investing public and before long, numerous patents were granted for various types of "diving engines," followed soon after by the flotation of even more numerous diving company stock issues. Almost all of these patents were worthless, submitted for the express purpose of creating interest in their company's stock. The ensuing ascent and collapse of the diving company stocks, culminating about 1689, could be said to be the first tech bubble. Daniel Defoe, of Robinson Crusoe fame, was the treasurer of one of those companies. His insider knowledge of their workings did not prevent his bankruptcy-one of the most spectacular of the age.

The diving companies never developed any credible operations, let alone earnings. This quickly became apparent to investors, and the madness was soon over. We don't have any records of exact prices and returns, but it's a sure bet that the eventual result of investment in all of these companies was total loss. It was very similar in this regard to the dot-com craze. Aside from Phipps' enterprise, no diving company had actually ever turned a profit, and it was not immediately clear how any of these companies could ensure access to a steady stream of treasure-laden wrecks. In modern parlance, all they had was a dubious business model.

For a few months, the shares of these companies rose dramatically. There was nothing unusual, per se, per se, even three centuries ago, about the raising of capital for enterprises with questionable prospects. There was even nothing untoward about the shares of those enterprises rising temporarily in price. This is, after all, how capital markets work. even three centuries ago, about the raising of capital for enterprises with questionable prospects. There was even nothing untoward about the shares of those enterprises rising temporarily in price. This is, after all, how capital markets work.

If you have trouble with the concept that such highly dubious enterprises can command a rational price, consider the following example: a.s.sume that your neighbor Fritz tells you he thinks that sitting under his property is a huge reservoir of oil. He estimates that it is worth $10 million, but in order to produce it, he requires capital to pay for drilling equipment. He's willing to let you in for half the profits. How much would you be willing to stake him for?

Fritz has always been a bit dotty, but he's also a retired petroleum engineer, so there's a remote chance he is not blowing smoke. You estimate there is a one-in-a-thousand chance he's onto something. The expected payoff of your investment is thus $5 million (your half of his $10 million reservoir) divided by 1,000, or $5,000. Add in another factor of ten as a "risk premium," and you calculate that it might be reasonable to give your neighbor $500 for a piece of the action.

This is another way of saying that Fritz's adventure carries with it a low chance of success coupled with a high discount rate to compensate for its risk. Since you are applying such a high discount rate to the low expected cash flow, the share is worth very little. Further, subsequent reevaluation of your risk tolerance and of Fritz's chances of success will cause your estimation of the value of your share to fluctuate.

So it was not unusual that the shares of companies with dubious chances of success should have some value, or that this value should fluctuate. It's not unusual now (can you spell "biotech?"), and it was certainly not unusual 300 years ago. But from time to time, for reasons that are poorly understood, investors stop pricing businesses rationally. Rising prices take on a life of their own and a bubble ensues.

Monetary theorist Hyman Minsky comes as close to a reasonable explanation of bubbles as any. He postulates that there are at least two necessary preconditions. The first is a "displacement," which, in modern times, usually means a revolutionary technology or a major s.h.i.+ft in financial methods. The second is the availability of easy credit-borrowed funds that can be employed for speculation. To those two, I would add two more ingredients. The first is that investors need to have forgotten the last speculative craze; this is why bubbles occur about once per generation. And second, rational investors, able to calculate expected payoffs and risk premiums, must become supplanted by those whose only requirement for purchase is a plausible story. Sadly, during bubbles, not a few of the former convert into the latter.

The last two conditions can be summarized in one word: euphoria. Investors begin purchasing a.s.sets for no other reason than the fact that prices are rising. Do not underestimate the power of this contagion. Listen to hedge fund manager Cliff Asness' observations on online trading in the late 1990s: I do not know if many of you have played video poker in Las Vegas. I have, and it is addicting. It is addicting despite the fact that you lose over any reasonable length period. Now, imagine video poker where the odds were in your favor. That is, all the little bells and b.u.t.tons and buzzers were still there providing the instant feedback and fun, but instead of losing you got richer. If Vegas was like this, you would have to pry people out of their seats with the jaws of life. People would bring bed-pans so they did not have to give up their seats. This form of video poker would laugh at crack cocaine as the ultimate addiction.

Or a somewhat dryer perspective, from economic historian Charles Kindleberger: "There is nothing so disturbing to one's well-being and judgment as to see a friend get rich." In the past several years, to lack this sense of exhilaration is to have been asleep. To recap, the necessary conditions for a bubble are: * A major technological revolution or s.h.i.+ft in financial practice.* Liquidity-i.e., easy credit.* Amnesia for the last bubble. This usually takes a generation.* Abandonment of time-honored methods of security valuation, usually caused by the takeover of the market by inexperienced investors.

But whatever the underlying conditions, bubbles occur whenever investors begin buying stocks simply because they have been going up. This process feeds on itself, like a bonfire, until all the fuel is exhausted, and it finally collapses. The fuel, as Minsky points out, is usually borrowed cash or margin purchases.

The South Sea Bubble The diving company bubble was, in fact, simply the warm-up for a far greater speculative orgy. Most bubbles are like Shakespeare's dramas and comedies: the costumes, dialect, and historical setting may be foreign, but the plot line and evocation of human frailty are intimately familiar to even the most casual observer of human nature.

The South Sea Bubble's origins were complex and require a bit of exposition. For starters, it was not one bubble, but two, both beginning in 1720: the first in France, followed almost immediately by one in England. As we saw in the first chapter, government debt was a relatively late arrival in the investment world, but once the warring nation-states of the late Middle Ages got a taste of the abundant military financing available from the issuance of state obligations, they could not get enough. By the mid-seventeenth century, Spain was hopelessly behind on its interest payments, and France was also rather deep in the hole to its debtors.

Into the financial chaos of Paris arrived a most extraordinary Scotsman: John Law. After escaping the hangman for killing a man in a 1694 duel, he studied the banking system in Amsterdam and eventually made his way to France, where he founded the Mississippi Company. He ingratiated himself with the Duke of Orleans, who, in 1719, granted the company two impressive franchises: a monopoly on trade with all of French North America, and the right to buy up rentes (French government annuities, similar to prest.i.ti and consols) in exchange for company shares. The last issue was particularly attractive to the Royal Court, since investors would exchange their government bonds for shares of the Mississippi Company, relieving the government of its crus.h.i.+ng war debts.

Law's so-called "system" contained one remarkable feature-the Mississippi Company would issue money as the price of its shares increased. Yes, the company issued its own currency, as did all banks of that time. This practice was one of the central mechanisms of pre-twentieth century finance. If the bank was sound and located nearby, its banknotes would usually be worth their face value. If it was unsound or further away, then its banknotes would trade at a considerable discount. (Of course, modern banks also print money when their loans are made in the form of a bank draft, as they almost always are.) Now, all of the necessary ingredients for a bubble were present: a major s.h.i.+ft in the financial system, liquidity from the company's new banknotes, and a hiatus of three decades from the last speculation. In 1720, as the Mississippi Company's shares rose, it issued more notes, which purchased more shares, increasing its price still more. Vast paper fortunes were made, and the word millionaire millionaire was coined. The frenzy spilled over the entire continent, where new ventures were floated with the vast amounts of capital now available. was coined. The frenzy spilled over the entire continent, where new ventures were floated with the vast amounts of capital now available.

There was even a fas.h.i.+onable new technology involved: the laws of probability. Fermat and Pascal had recently invented this branch of mathematics, and, in 1693, Astronomer Royal Edmund Halley developed the first mortality tables. Soon the formation of insurance companies became all the rage; these would figure prominently as the speculative action moved to London.

The ancien regime was not the only government deep in hock. By 1719, England had incurred immense debts during the War of the Spanish Succession. In fact, a decade before, in 1710, the South Sea Company had actually exchanged government debt held by investors for its shares and had been granted the right to a monopoly on trade with the Spanish Empire in America. The government, in exchange for taking over its debt, also paid the South Sea Company an annuity.

But neither the Mississippi Company nor the South Sea Company ever made any money from their trade monopolies. The French company never really tried, and war and Spanish intransigence blocked British trade with South America. (In any event, none of South Sea's directors had any experience with South American trade.) The Mississippi Company was just a speculative sh.e.l.l. The situation of the South Sea Company was a bit more complex, as it did receive an income stream from the government.

Unfortunately, its deal with the government was structured in a most peculiar manner. The South Sea Company was allowed to issue a fixed number of shares that could be exchanged for the government debt it bought up from investors. In other words, investors would exchange their bonds, bills, and annuities for stock in the company. The higher the share price of the company, the fewer the shares it had to pay investors, and the more shares that were left over for the directors to sell on the open market.

So it suited the South Sea Company to inflate its price. The liquidity slos.h.i.+ng through the European financial system in 1720 allowed it to do so. At some point, the share price took on a life of its own, and investors were happy to exchange their staid annuities, bonds, and bills for the rapidly rising shares. The directors took advantage of the meteoric price increase to issue several more lots of stock to the public: first for government debt, then for money. The later purchasers were allowed to purchase on margin with a 20% down payment, the remainder being due in subsequent payments. In the case of the South Sea Company, even this was a fiction, as many of the down payments were themselves made with borrowed money. In the summer of 1720, share values peaked on both sides of the channel; the last subscription was priced at 1,000 and was sold out in less than a day. (The stock price was about 130 at the start of the bubble.) The South Sea Company involved itself in a fair amount of skullduggery. The government became alarmed at the rapidly rising share price-there were still some gray heads remaining who had lived through the diving company debacle-and parliament proposed limiting the share price. In the process of blocking this, the company provided under-the-table shares (which in fact were counterfeit) to various notables, including the king's mistress, and the price limitation was scotched.

The most fantastic manifestation of the speculation was the appearance of the "bubble companies." With the easy availability of capital produced by the boom, all sorts of dubious enterprises issued shares to a gullible public. Most of these enterprises were legitimate but just a bit ahead of their time, such as one company to settle the region around Australia (a half century before the continent was actually discovered by Cook), another to build machine guns, and yet another that proposed building s.h.i.+ps to transport live fish to London. A lesser number were patently fraudulent, and still others lived only in later legend, including a famous mythical company chartered "for carrying on an undertaking of great advantage but no one to know what it is." Interestingly, two of the 190 recorded bubble companies eventually did succeed: the insurance giants Royal Exchange and London a.s.surance.

The South Sea Company grew anxious over compet.i.tion for capital from the bubble companies, and, in June 1720, had parliament pa.s.s the Bubble Act. This legislation required all new companies to obtain parliamentary charters and forbade existing companies from operating beyond their charters. Paradoxically, this was their undoing. Since many of the insurance companies, which helped sustain the frenzy by lending substantial amounts to the South Sea Company and its shareholders, started out in other lines of business, they were forced to cease operation. Prime among them was the Sword Blade Company, which, naturally enough, was chartered only to make swords. When the Bubble Act forced the withdrawal of their credit from the market, the effect was electric: the bubble was p.r.i.c.ked. By October, it was all over.

The South Sea episode was a true mania, enveloping the populace from King George on down. Jonathan Swift best summarized England's mood at the time: I have enquired of some that have come from London, what is the religion there? They tell me it is the South Sea stock. What is the policy of England? The answer is the same. What is the trade? South Sea still. And what is the business? Nothing but South Sea.

A foreign visitor to Change Alley was more succinct, stating that it looked "as if all the lunatics had escaped out of the madhouse at once."

Neither the Mississippi Company nor the South Sea Company had any real prospects of foreign trade. While the former had no revenues at all, the latter had at least a stream of income from the government. Contemporary observers, eyeballing this cash flow, estimated the fair value of South Sea Company at about 150 per share, precisely where it wound up after the dust had settled.

Let's reflect on the four conditions necessary for the blowing of a bubble. First, Minsky's "displacement," which, in this case, was the unprecedented subst.i.tution of public debt with private equity. The second was the availability of easy credit, particularly the self-perpetuating output of paper money from the Mississippi Company. Third was the 30-year hiatus following the diving company episode. The last condition was the increasing domination of the market by nonprofessionals clueless about a.s.set valuation.

Although Fisher's discounted dividend method lay two centuries in the future, for centuries, investors had an intuitive working grasp of how to value an income stream, in the same way that ball players are able to catch fly b.a.l.l.s without knowing the ballistic equations. Reasonable investors might debate whether the intrinsic value of South Sea Shares was 100 or 200, but no one could make a rational case for 1,000. And the more speculative bubble companies, which in normal times might be valued like your neighbor Fritz's oil well, saw their prices go through the roof.

This, then, is the essence of a bubble: a brief period of rising prices and suspended disbelief, which, in turn, supplies large numbers of investors willing to invest in dubious enterprises at absurdly low discount rates and high prices. Bubbles streak across the investment heavens, leaving behind financial destruction and disillusionment, respecting neither intelligence nor social cla.s.s. Probably the most famous dupe of the South Sea episode was none other than Sir Isaac Newton, who famously remarked, "I can calculate the motions of the heavenly bodies, but not the madness of people."

The Duke's Failed Romance The first technological marvel that can be properly said to have transformed modern life was the development of large-scale ca.n.a.l transport. In 1758, the Duke of Bridgewater, heartbroken by an unsuccessful romance, concocted the radical notion of building a ca.n.a.l to bring coal from his mines to a group of textile mills 30 miles away. Completed nine years later and financed to the brink of his estate's financial ruin, this eventually proved enormously profitable, and within 20 years, more than 1,000 miles of ca.n.a.ls laced the English countryside.

The initial returns on the first ca.n.a.l companies were highly agreeable, and their shares soared. Naturally, the profits made by early investors aroused a great deal of attention and set into motion the by now familiar process. Large amounts of capital were raised from a gullible public for the construction of increasingly marginal routes. Dividends, which were as high as 50% for the first companies, slowly disappeared as competing routes proliferated.

Bubbles are p.r.i.c.ked when liquidity dries up. In this particular case, it was the disappearance of easy credit brought on by the French Revolution that produced a generalized price collapse. By the turn of the century, only 20% of the companies paid a dividend.

The ca.n.a.l-building bubble was the first of its kind, involving a business that not only provided healthy profits but also transformed and benefited society in profound and long-lasting ways. Although the average speed of ca.n.a.l transport was only a few miles per hour, it was a vast improvement over road conveyance, which was much slower, more dangerous, and less reliable. Until the ca.n.a.ls, sea transport was far more efficient. Travel from, say, London to Glasgow, was many times cheaper, faster, and safer by sea than by land, although it was by no means a sure thing, either. For the first time, thousands of inland villages were brought into contact with the outside world, changing England forever.

The ca.n.a.l building episode is also an object lesson for those who become enthusiastic over the investment possibilities of new technology. Even if it is initially highly profitable, nothing attracts compet.i.tion like a cash cow. Rest a.s.sured, if you have identified a "sure thing," you will not keep it a secret for long; you will attract compet.i.tors who will rapidly extinguish the initial flow of the easy profits.

The ca.n.a.ls established a pattern that has held to this day-of transformative inventions that bring long-run progress and prosperity to society as a whole, short-run profits to an early lucky few, and ruin to most later investors.

A Very Profitable Clock The ca.n.a.l episode also established another pattern in the finance of innovative technologies: it is the users, not the makers, who benefit. Over the long run, the ca.n.a.l operators did not profit nearly as much as the businesses that used the new method of transport, particularly the building and manufacturing trades that thrived in the newly prosperous inland towns.

The best example of this is a device invented about the same time as the blowing of the ca.n.a.l bubble: the marine chronometer. Profitable sea trade requires accurate navigation. This, in turn, demands the precise measurement of lat.i.tude (north/south position) and longitude (east/west position). The determination of lat.i.tude is a relatively easy task, and by the mid-eighteenth century, had been practiced for hundreds of years-a sea captain simply needs an accurate midday measurement of the sun's elevation.

But longitude is a much tougher nut. By the eighteenth century, seafarers realized that the most likely route to success lay in the development of a highly accurate timepiece. If a navigator could determine the local solar noon-the maximum elevation of the sun-and also know the time in London at the same moment, he then would know just how far east or west of London he was.

This required a timepiece that could keep time to within one-quarter of a second per day over a six-week journey-at sea. Master craftsman John Harrison finally accomplished this amazing feat in 1761. His clock-the so-called "H4," is considered a technological marvel even today; two and a half centuries ago, it was the equivalent of the s.p.a.ce shuttle. But the key point is this: neither Harrison, nor his heirs, nor his professional successors ever made very much money from this crucial invention. In fact, the clock industry has no real investment history. Until Swatch and Rolex, no great timekeeping boodles were made. But the users of this technology-the East India Company and the other great trading corporations of England and Holland-made vast fortunes with it. This is another early demonstration of the basic rule of technology investing: it is the users, users, and not the and not the makers, makers, who profit most. who profit most.

Queen Victoria and Her Subjects Get Taken for a Ride The reason why the invention of the marine chronometer did not produce an investment bubble was that its effects were not immediately visible. But if any technological marvel was both visible and revolutionary at the same time, it was the invention of the railway steam engine. Until the advent of steam power in the nineteenth century, long-distance overland travel was almost exclusively the province of the rich. Only they could afford the exorbitant fares of the coach companies, or if truly wealthy, their own coach-and-six. And even then, the poor quality of the roads and public safety made travel a dangerous, slow, and extremely uncomfortable endeavor.

At a stroke, the railroads made overland travel cheap, safe, rapid, and relatively comfortable. Even more importantly, the steam engine was undoubtedly the most dramatic, romantic, and artistically appealing technological invention of any age (aside from, perhaps, the clipper s.h.i.+p). f.a.n.n.y Kemble, a famous actress of the period, captured the mood precisely after her first trip at the footplate of George Stephenson's Rocket. Rocket. She found it: She found it: .... a snorting little animal which I felt inclined to pat. It set out at the utmost speed, 35 miles per hour, swifter than the bird flies. You cannot conceive what that sensation of cutting the air was; the motion as smooth as possible. I could either have read or written; and as it was I stood up and with my bonnet off drank the air before me. When I closed my eyes this sensation of flying was quite delightful and strange beyond description. Yet strange as it was, I had a perfect sense of security and not the slightest fear.

The public sensation surrounding rail travel was unimaginable to the modern reader-it was the jet airliner, personal computer, Internet, and fresh-brewed espresso all rolled into one. The first steam line was established between Darlington and Stockton in 1825, and in 1831, the Liverpool and Manchester Line began producing healthy dividends and soaring stock prices. This euphoria carried with it a bull market in railroad stocks, followed by a sharp drop in prices in the bust of 1837.

However, a second stock mania, the likes of which had not been seen in Britain before or since, ensued when Queen Victoria made her first railway trip in 1842. Her ride ignited a popular enthusiasm for rail travel that even modern technology enthusiasts might find difficult to fathom. Just as people today speak of "Internet time," in the 1840s "railway time" was the operative phrase. For the first time, people began to talk of distances in hours and minutes, instead of days and miles. Men were said to "get up a head of steam."

By late 1844, the three largest railway companies were paying a 10% dividend, and by the beginning of 1845, 16 new lines were planned and 50 new companies chartered. These offerings usually guaranteed dividends of 10% and featured MPs and aristocrats on their boards, who were generally paid handsomely with under-the-table shares. Dozens of magazines and newspapers were devoted to railway travel, supported by hundreds of thousands of pounds in advertising for the new companies' stock subscriptions. Nearly 8,000 miles of new railways were planned-four times the existing trackage.

By late summer 1845, with existing shares up 500%, at least 450 new companies were registered. Foreign lines were being projected around the globe, from the Bengal to Guyana. More than 100 new lines were planned for Ireland alone. In the latter part of the bubble, lines were planned literally from nowhere to nowhere, with no towns along the way. The Minsky "displacement" here was obvious. Credit was equally abundant: In the 1840s, it took the form of the subscription mechanism of purchase, in which an investor "subscribed" to the issue for a small fraction of the purchase price and was subject to "calls" for the remaining price as construction capital was needed. And, as in all bubbles, the sudden contraction of credit punctured it. By 1845, with building underway, investors sold existing shares to meet the calls for the capital necessary. By mid-October 1845, it was all over. Reporting the fiasco, the Times of London Times of London introduced the word "bubble" into popular financial lexicon when it proclaimed: introduced the word "bubble" into popular financial lexicon when it proclaimed: "A mighty bubble of wealth is blown away before our eyes."

The rapid contraction of liquidity cascaded through the British financial world in the following years, almost taking the Bank of England with it. Even consols fell; only gold provided a safe haven.

Until last year, it was commonly remarked that since so many thought the tech stock scene a bubble, it must not, in fact, be one. And yet, in the summer of 1845, it was apparent to anyone with an IQ above room temperature that railway shares would end badly. Much was also written in the press as to just how it would all end. No less than Prime Minister Robert Peel warned, "Direct interference on our part with the mania of railway speculation seems impracticable. The only question is whether public attention might not be called to the impending danger, through the public press." In short, Britain's most brilliant prime minister did everything but shout "irrational exuberance!" at the top of his lungs in Parliament.

The United States underwent its own railway mania in the post-Civil War period. But even taking into account the clocklike regularity of railroad bankruptcy and the Credit Mobilier scandal (in which this construction arm of Union Pacific plundered the parent company, not unlike the recent Enron scandal), things were a bit tamer here than in England. This was because U.S. companies were mainly financed with bonds, which are not as p.r.o.ne to bubbles as equity.

Nonetheless, the experience of the U.S. railway companies is instructive. Because of murderous compet.i.tion from the scourge of railways and ca.n.a.ls-competing parallel routes-these companies frequently went bankrupt, and returns to investors were low. On the other hand, the societal benefit of the railroads was immeasurable, allowing the settling and growth of the breadth of the continent. The financial rewards from the railroads went to the businessmen, builders, and particularly real estate brokers in places like Omaha, Sacramento, and a small junction town called Chicago.

"Wall Street Lays an Egg"

So quipped the headline of the entertainment newspaper Variety Variety on the morning of Tuesday, October 30, 1929. Worse, the most famous of all market crashes was just the opening act of the longest and most painful episode in American financial history. Actually, the market rebounded nicely soon after the crash, erasing much of the pain. By early 1930, it was at a higher level than at the beginning of 1929. But for the next two years, the market relentlessly fell, reducing stock prices to a fraction of their former value and taking the rest of the economy with it. on the morning of Tuesday, October 30, 1929. Worse, the most famous of all market crashes was just the opening act of the longest and most painful episode in American financial history. Actually, the market rebounded nicely soon after the crash, erasing much of the pain. By early 1930, it was at a higher level than at the beginning of 1929. But for the next two years, the market relentlessly fell, reducing stock prices to a fraction of their former value and taking the rest of the economy with it.

The bubble in stock prices which preceded it was equally legendary, and, of necessity, inseparable from it. Once again, the "displacement" was technological. The early twentieth century saw a rate of innovation second only to that of the post-Napoleonic period. The aircraft, automobile, radio, electrical generator, and the devices it powered-most importantly Edison's light bulb-all burst upon the scene within a few decades. And once again, an expansion of credit loosened the investment floodgates.

Ironically, if blame can be a.s.signed anywhere, it probably belongs to Winston Churchill, who, as Chancellor of the Exchequer, reinstated the gold standard and fixed the pound sterling at its prewar value of $4.86. Because of Britain's wartime inflation, this was a gross overvaluation, making British goods overly expensive abroad and foreign goods correspondingly cheap. The result was a gross trade imbalance that rapidly depleted the British Treasury of gold. The traditional solution for trade imbalance is to get your trading partners to reduce their interest rates; because low rates make investing in your partners unattractive, money flows out of those countries back to yours, solving the problem.

Unfortunately, low interest rates in the U.S. also made it easier to borrow money. In 1927, the U.S. was in the middle of an economic boom, and the last thing it needed was easier credit brought about by the lowered American interest rates sought by the British. Most American financial authorities realized that this was an awful idea. Unfortunately, Benjamin Strong, the chairman of the Federal Reserve Bank, and Montagu Norman, the Governor of the Bank of England, were close personal friends. Strong, who dominated the Fed, got his way and interest rates were lowered. This was the equivalent of throwing gasoline onto a fire.

Also in place was the third bubble ingredient. It had been more than a generation since the last great railroad enthusiasm, and there were not enough gray heads left to warn that the path led straight over a cliff. At about the same time, the final component of the mix was added as millions of ordinary citizens, completely ignorant of the principles of a.s.set valuation, were sucked into the market by the irresistible temptation of watching their friends and neighbors earning effortless profits. They were joined by tens of thousands of professionals who should have known better. Over the subsequent two and a half years, stock prices rose more than 150%.

Of all history's great bubbles, the 1920s bull market was the most "rational." Between 1920 and 1929, real GDP rose almost 50%, seemingly confirming the optimists' predictions of a "new era" born of scientific progress. Further, by today's standards, stocks were positively cheap. Until 1928, they sold at approximately ten times earnings and yielded about 5% in dividends. Even at the peak, in the summer of 1929, stocks fetched just 20 times earnings, and dividends fell only to 3%. Again, tame by today's standards.

The great bull market of the Roaring Twenties was recognized as a bubble only in retrospect. How else do you explain a price drop of 90%? Of course, there were plenty of individual stocks that were ridiculously overpriced, some the result of rampant speculation and others of outright fraud. But the history of the 1920s bubble is better told with descriptive history than with numbers.

The signature characteristic of the era was the stock pool, which consisted of a group of wealthy speculators who would get together with the exchange's specialist (the floor trader charged with providing a market for the chosen stock) to drive up a stock's price. They would begin by slowly acc.u.mulating a sizeable block of a particular stock at low prices, then commence trading with each other in carefully ch.o.r.eographed fas.h.i.+on, driving the price up and down on gradually increasing volume. As this artificial activity flashed across the ticker tape, the investing public would become aware that something was afoot, or, in the parlance of the day, that the stock was "being taken in hand." If executed properly, the stock price would be lifted on a frenzy of speculative buying by the public, at which point the pool operators would "pull the plug" and sell.

The execution of a proper pool was a high art form, its most accomplished impresario being none other than Joseph P. Kennedy, Sr. Naturally enough, a few years later, he was appointed first commissioner of the Securities and Exchange Commission (SEC). Roosevelt famously justified his appointment of the old rogue by saying, "It takes a thief to catch a thief."

In fact, until the pa.s.sage of the Securities Act of 1934, which established the SEC, the pools were perfectly legal. The most famous pools of all involved Radio Corporation of America, fondly known back then simply as "Radio." The names of Radio pool partic.i.p.ants still astound the modern reader: Walter Chrysler; Charles Schwab, the distinguished head of U.S. Steel; Mrs. David Sarnoff, wife of Radio's president and founder; Percy Rockefeller; Joseph Tumulty, former aide to President Wilson; and last but not least, John J. Raskob, who we've already encountered, and, by the time of the pool, was head of the Democratic National Committee.

The second unique inst.i.tution of the 1920s was the "investment trust." Like the modern mutual fund, it had professional managers operating large portfolios of both stocks and bonds. The key difference was that the investment trusts were themselves traded as stocks and touted to small investors as a way of obtaining diversified portfolios managed by experts. In most regards, they were identical to today's closed-end funds, and a few still survive (General American Investors, Tri-Continental, Adams Express, and Central Securities are examples). In fact, investment trusts had been a feature of the English and Scottish financial landscape for several decades, allowing small investors to diversify across a wide range of investments with just a few dozen pounds.

At first these trusts were conservatively run, but as the Roaring Twenties progressed, they began to pyramid themselves using borrowed capital similar to the "margin purchases" used by individual plungers. These "leveraged trusts" would magnify small changes in the levels of individual stocks into wild swings in the trust's price.

The Gotterdammerung was supplied by Goldman Sachs, which did not get into the trust business until late 1928. The Goldman Sachs Corporation sponsored the Goldman Sachs Trading Corporation to the tune of $100 million. Two months later, in February 1929, it merged with another trust sponsored by its parent company, the Financial and Industrial Securities Corporation. By a few days later, the merged trust was selling for twice its a.s.sets under management.

Most securities firms would have been happy with this agreeable showing, but Goldman was just getting warmed up. The merged trust began buying shares of itself, boosting its value still more. It then unloaded these inflated shares on the public. William c.r.a.po Durant, a well-known former official of General Motors like Mr. Raskob, played a highly visible role in this fraud. More, the Trading Corporation itself sponsored another huge trust, the Shenandoah Corporation. Then, just 25 days later, the Shenandoah Corporation sponsored the Blue Ridge Corporation. Both of the new companies had on their boards a young lawyer named John Foster Dulles. (John Kenneth Galbraith, in his 1954 history of the crash, was barely able to conceal his glee over the past indiscretions of Dulles, who was by then the arch-conservative Secretary of State.) Finally, in August, the Trading Corporation acquired an enormous structure of nested West Coast trusts.

Goldman Sach's timing, of course, could not have been worse. Black Thursday was just several weeks away. The trusts collapsed pretty much in the reverse order of their creation, consistent with their increasing leverage: first Blue Ridge, then Shenandoah, and finally, the Trading Corporation. Shenandoah, which had been trading at 36 soon after its formation, fell to 3 by the end of October and touched 50 cents in 1932.

The crash of 1929 and its aftermath scarred the psyche of a generation of American investors, providing them with a particularly expensive lesson in Fisher's rules of capital value. It would take the pa.s.sage of that generation before the ground would again become fertile for the seeds of financial speculation.

The Go-Go Market and the Nifty Fifty The speculative binge spanning the years 1960 to 1972 was unlike any other in the history of finance, encompa.s.sing not one, but three different bubbles. No sooner would one burst than the next was inflated. As the stock market gradually went sour in the early 1970s, more and more investors crowded into the supposed shelter of the "safe" large-cap growth stocks, until finally they, too, collapsed of their own weight, beginning the descent into the awful bear market of 197374.

It should not surprise any of you by now that the first stirrings of speculative fever began in the late 1950s, almost exactly 30 years from 1929. For almost three decades, prudent investors bought only bonds and avoided common stocks at all costs. Then the generational Wall Street waltz finally took yet another pa.s.s in front of the band, and things began to pick up again.

Minsky's "displacement" this time around was the s.p.a.ce race, and the magic words were "sonics" and "tronics." The company names seem dated, almost laughable today: Videotronics, Hydro-s.p.a.ce Technology, Circuitronics, and even Powertron Ultrasonics. (Although not nearly as ridiculous as the names of today's dot-coms will sound a few decades hence.) The initial public offerings of these companies were spectacular affairs, with typical first-day price rises of 50% to 100% followed by a rapid ascent, culminating in the inevitable price collapse as investors realized that earnings would not be forthcoming in the foreseeable future. The Tronics boom was a relatively small footnote in market history, significant mainly for its entertainment value (unless you happened to be one of the pigeons holding stock in those companies).

More serious was the acquisition frenzy that followed, which swallowed up large swaths of the nation's productive a.s.sets into increasingly inefficient, unwieldy conglomerates. For the better part of a century after the pa.s.sage of the Sherman Ant.i.trust Act in 1890, corporate America had looked for a way to achieve economies of scale without bringing down the government's wrath. Frustrated by the legal restrictions forbidding the acquisition of companies in the same industry, companies. .h.i.t upon the notion of conglomeration-the building of huge multi-industry companies.

What happened next was completely unexpected. The conglomerates began to rise in value as the investing world perceived that their acquisitions would dramatically increase overall profitability. These companies could then use their overvalued stock to buy yet more companies. As more and more companies were gobbled up, the earnings of the consumed companies were added to the balance sheets of the conglomerates. Naive investors were then presented with apparently rapidly increasing corporate earnings, mistaking this for increased efficiency. Prices ballooned even further, allowing the conglomerate to purchase even more companies. The ba.n.a.l nature of the industries under their wings was dressed up with impressive jargon: a zinc mine became a "s.p.a.ce minerals division," s.h.i.+pbuilding became "marine systems," and meatpacking became "nutritional services."

At its height, the four biggest conglomerates-A-T-O, Litton, Teledyne, and Textron-sold for 25 to 56 times earnings. Pretty heady stuff for what were essentially collections of smokestack companies. Finally, in 1968, the music stopped when Litton announced an earnings disappointment, and the whole house of cards collapsed, with the Four Hors.e.m.e.n falling over 60% each.

Worse was to come. There comes a point when the efficiencies of scale bought by increasing size are outweighed by the more subtle disadvantages of sheer bureaucratic weight. Even companies in industries that benefit most from economies of scale-aircraft and automobiles, for example-eventually suffer when they grow too large, as happened recently with DaimlerChrysler. (And in some industries, such as medical care, the optimal company size is quite small-perhaps as few as a hundred employees-a fact belatedly recognized by the recent executives and shareholders of most HMO corporations.) So by the mid-1960s, corporate America found itself blessed not by efficient multi-industry juggernauts, but rather cursed by stumbling behemoths with rapidly falling profitability.1 And by 1970, investors had had it. They were fed up with flaky tech companies and corporate investors who could wheel and deal with the best but who couldn't operate a profitable company if their lives depended on it. They wanted safety, stability, and excellence-established companies that dominated their industry and had the proven ability to generate genuine growth. And by 1970, investors had had it. They were fed up with flaky tech companies and corporate investors who could wheel and deal with the best but who couldn't operate a profitable company if their lives depended on it. They wanted safety, stability, and excellence-established companies that dominated their industry and had the proven ability to generate genuine growth.

Thus was born the "one decision stock": buy it, forget about it, and hold on to it forever. So investors loaded up on the bluest of the blue chips-IBM, Xerox, Avon, Texas Instruments, Polaroid-great companies all, at least in the early 1970s. Even in normal times, these companies were not cheap, selling at 20 to 25 times earnings with minuscule dividends. But these were not normal times. By 1972, McDonald's and Disney had risen to over 70 times earnings, and Polaroid to nearly 100.

The whole group of 50 stocks sold at 42 times earnings. What does a ratio of price-to-earnings (P/E) of 42 mean? Doing the same sort of calculation we did in Table 2-1 Table 2-1, we discover that in order for a stock to increase in price by 11% per year (i.e., obtain the market return), it must increase its earnings by about 20% per year for a period of ten years. Now, it is not usual for individual companies to do this. But it But it is impossible for the biggest of the nation's companies to all do so at the same time. is impossible for the biggest of the nation's companies to all do so at the same time. As you saw in As you saw in Figure 2-4 Figure 2-4, the long-term growth rate of corporate earnings and dividends is only 5% per year.

Almost all of these companies eventually disappointed, some more than others. The results for the stockholder were highly disagreeable.

Professor Jeremy Siegel makes the point that the Nifty Fifty were not bad long-term investments, with subsequent long-term returns nearly identical to the market. This is true, as far as it goes. The only trouble was that along the way most of these stocks lost between 70% and 95% of their value, and many never came back. A portfolio of stocks with market return and greater-than-market risk is not a blessing. Very few of the original shareholders calmly held on for the long run.

The Nifty Fifty provided another moral as well. The seven most recognizable tech names on the list-IBM, Texas Instruments, AMP, Xerox, Burroughs, Digital Equipment, and Polaroid-had truly awful returns-just 6.4% per year for the 25 years following 1972. But the cheapest 25 of the group by P/E had a return of 14.4% versus a return of 12.9% for the S&P 500. These "cheap" stocks, generally selling at P/Es of 25 to 40, were consumer companies-Phillip Morris, Gillette, and c.o.ke. They did not produce the era's technology, but they certainly used it to advantage. So history once again demonstrated that the spoils went not to technology's makers, but to its users.

Yahoo!

A small confession. I could never decide which part of speech this corporate moniker was supposed to represent. Was it an interjection, reflecting the technological and economic ebullience of the time, or was it simply a noun, meant to describe the company's shareholders?

Since the definitive history of this sorry era in investing has yet to be written, you will be stuck with my fragmentary impressions. But there are a few things that can already be said about the Great Internet Bubble. First, in the past few years, we have all had bestowed upon us a morbid historical privilege, not unlike being present at the 1906 San Francisco earthquake. I can remember the sheer wonder of my first reading of Mackay's Extraordinary Popular Delusions and the Madness of Crowds, Extraordinary Popular Delusions and the Madness of Crowds, which described the Dutch Tulip, South Sea, and Mississippi Company episodes. What must it have been like to live in such a time, I wondered? Now you and I know. Not since the diving and bubble companies of the seventeenth and eighteenth centuries have ent.i.ties with so little substance commanded such high prices. If we were not personally touched by these shooting stars, we all knew people who were. which described the Dutch Tulip, South Sea, and Mississippi Company episodes. What must it have been like to live in such a time, I wondered? Now you and I know. Not since the diving and bubble companies of the seventeenth and eighteenth centuries have ent.i.ties with so little substance commanded such high prices. If we were not personally touched by these shooting stars, we all knew people who were.

The April 2000 edition of the Morningstar Principia Pro stock module occupies an honored spot on my hard drive, and from time to time I sift through the names with awe: Terra Networks, selling at 1,200 times sales; sales; Akamai Technologies, 3,700 times Akamai Technologies, 3,700 times sales; sales; Telocity, 5,200 times Telocity, 5,200 times sales. sales. Not a one with Not a one with earnings. earnings. What were we thinking? What were we thinking?

My all-time favorite is Internet Capital Group. On August 5, 1999, it went public at $6 per share, rose to $212, then fell back to under a buck. Nothing unusual, really. What made it such an enchanted soul was that it was the direct descendant of the 1920s leveraged investment trusts-its holdings were small, private companies operating in the most wild and wooly part of the Internet scene-business-to-business (B2B). It actually issued bonds, bonds, which were of the same quality as those issued by my butcher at Safeway, if only the SEC would allow him to do so. The frosting on the cake was that it sold at an estimated ten times the value of the companies it held. So it not only owned just fluff, but was valued at ten times the fluff it held. which were of the same quality as those issued by my butcher at Safeway, if only the SEC would allow him to do so. The frosting on the cake was that it sold at an estimated ten times the value of the companies it held. So it not only owned just fluff, but was valued at ten times the fluff it held.

Again, all the ingredients were in place: First, Minsky's "displacement," this time in the guise of yet another revolutionary invention. Second, liquidity in the form of a Federal Reserve as accommodating as any red-light district house of pleasure. Third, yet another generation under the bridge since the last smashup. And, finally, one more joyous abandonment of Fisher's iron laws.

These stories of financial excess, from the diving company bubble to the dot-com mania, are not just entertaining yarns, they are also a mortal warning to all investors. There will always be speculative markets in which the old rules seem to go out the window. Learn to recognize the signs: technological or financial "displacement," excessive use of credit, amnesia for the last bubble, and the flood of new investors who swallow plausible stories in place of doing the hard math.

When this happens, keep a close hold on your wallet and remember John Templeton's famous warning: The four most expensive words in the English language are, "This time, it's different."