100 years of investing: The triumphs and catastrophes that changed investments forever—part III
On this final episode of the history of investing, discover how the US segued from a 1970’s economic slump, to the Regan era roaring 80’s and the 1990’s internet boom.
What investments proved to be resilient and which ones failed to gain traction? Travel back in time to when computers were just getting their footing, tech companies were everywhere and Enron had the smartest guys in the room…or did they?
Remember: All investing involves risk. The content of the podcast is for informational purposes only and is not investment advice. Please always use caution and diversify.
Hello and welcome to the 23rd episode of Alternative Investing. I’m your host, Trevor Kraus, Communications Manager at MyConstant.
Last week I took an episode off from the 3 part, 100 years of investing podcast to interview a MyConstant customer, Krishna. At our company, we’re always interested in what our customers do and how they invest their money.
People often put a high value on “experts” but sometimes it’s the everyday investor that has the best advice. So as I said last week, if you’re a frequent customer of MyConstant, and you feel that you’d make for a good interview or you have some thought-provoking advice, definitely send me an email at [email protected]
So if you go back to our last history of investing episode on September 13th, we left off in the early 1980’s. In the early 1980s, the American economy was suffering through a deep recession. Business bankruptcies rose sharply compared to previous years.
Farmers also suffered due to a decline in agricultural exports, falling crop prices, and rising interest rates. But by 1983, the economy had rebounded and enjoyed a sustained period of growth as the annual inflation rate stayed below 5 percent for the remainder of the 1980s and part of the 1990s.
If you go back before this, the 1970s was a disaster on American economics. The recession during that time essentially marked the end of the post-World War II economic boom, and the United States experienced a lasting period of stagflation—a combination of high unemployment and inflation.
Not to get too involved in politics, but it’s hard to deny that the economy was one of the main reasons that Jimmy Carter was not reelected President in 1980. Voters held Washington politicians responsible for the economic state of the country and thus voten in Regan.
The economic problems of the 1970s lingered into the beginning of the 1980s. But Reagan’s economic program soon had an effect. Reagan operated on the basis of supply-side economics—the theory that advocates lower tax rates so people can keep more of their income. Proponents argue that supply-side economics results in more savings, investment, production, and, ultimately, greater economic growth.
Reagan’s tax cuts mainly benefited the wealthy, but through a chain-reaction, they also helped lower-income earners as higher levels of investment eventually led to new job openings and higher wages.
Cutting taxes was only one part of Reagan’s national agenda of slashing government spending. Reagan believed the federal government had become too large and interfering. During his presidency, he cut social programs and worked to reduce or eliminate government regulations that affected the consumer, workplace, and environment.
For the early and mid 1980s—once Regan got into power—the stock market roared. People were making a lot of money and it harkened back to America’s prosperity in the 1950’s.
If we had the industrial revolution in the 17 and 1800’s, the 1980’s was really the start of the information as well as the digital revolution. During the early 80’s of course Apple and Microsoft were just little saplings soon to become titans in their industry. In fact, if you invested $1,000 in both of those companies back in the early 80’s, you’d be a millionaire by now. But of course, we hear stories like that all the time—hindsight’s 20/20.
But before Microsoft and Apple came onto the scene, there was another tech giant that was the talk of the town—IBM. At the time, IBM along with AT&T were some of the most rewarding stocks you could buy.
I wasn’t born until January of 1986, and even though I was too young to know what was going on economically during that time, I did often watch TVs shows and movies growing up from the 80’s and based on what I saw it seemed that people were generally living a good life.
Everything was very glittery, clothing was showy. It seemed like the cars got bigger, pricey Japanese cuisine became the cool thing to eat— a way to impress your friends. On the surface, things seemed great.
At this point we come up to October 1987. For the past 5 years, stocks had done exceptionally well. Stock prices had about tripled at this point. The unemployment rate had come way down. Reagan is very popular as a president because of, I think, the economic performance at the time.
The ’80s became great again. People were really optimistic about the economy. What was happening in the United States and the stock market? This was during the peak when Japan was really looking like it was going to lead the world. I think there was some anxiety about that, but the US in terms of innovation and growth was distinctly number two at this point, even though it was a much larger economy. But overall there was quite a bit of optimism. The stock market had done really well right up to October 1987 when it crashed.
Alan Greenspan—a famous economist and managing director to many consulting firms—is in charge of the US economy and everything that ties into it at this point. In fact, he became the federal reserve chairman 2-months before the crash.
And Greenspan’s background before he joined the Fed was, he was basically an academic. He was an economic consultant, but not that much experience in high levels of politics, where you have to deal with all the different dynamics of politics. So I imagine being thrust into the Fed chairman job, at that point, when you don’t have a heavy background in politics, and then a mere weeks into the job the stock market fell more than 20% in one day.
Much like the stock market crash in 1929 the crash of ‘87 is still debated today and there’s not a lot of consensus about why it happened. If you read about it online or talk to economists you get varying stories.
If there was one technical aspect that happened in ’87, there was a thing in the 1980s that was really popular called portfolio insurance, which was a product that’s not around anymore. It was a dreadful idea. But it was essentially an insurance policy that if you owned stocks you had an insurance policy against it, and if the stocks fell by a certain amount, you had an insurance policy that would sell a basket of stocks and repay. It was a really complicated arrangement that tried to de-risk investing as a lot of investment products do.
But the practical reality of it was that if stocks started falling a little bit, these stock insurance policies would sell stocks to make up for those losses, and then it just snowballed on itself. Losses triggered selling, which triggered more losses, which triggered more selling. It happened really quick. And this is at the very early bleeding edge of when people were using computers to invest, both to execute trades and to see what was going on in the world.
I mean, computers in 1987 were absolutely archaic compared to today, but before that and for all of history, the stock market was entirely face-to-face. You had traders on the floor that would literally yell at each other to trade orders, and this was the first time that it was computers that were starting to make some of the decisions.
And from what I understand—and again, there’s not a lot of consensus about this, but because it was so early, the computers that were set up doing this had no idea what they were doing—they didn’t communicate with each other very well and were prone to all kinds of glitches. The set-up or the lay-out if you will, wasn’t really thought out very well, and it just kind of fed on itself in one day, to where selling begat more selling, and the next thing you know it feeds on itself. And that just creates fear among human investors and it just spreads from there.
And the pervasive view after this happened, the day of the crash of ’87, go back and read the newspapers. Everything had the same headline, which was, “This is the crash of 1929, and we’re going back into the Great Depression.” That was the view that everyone had back then. And it makes a lot of sense, because that was effectively how the crash of 1929 started. You had a big run-up in the ’20s, and also overnight, everything then comes to an end.
Miraculously, unlike the crash of ‘29 which pushed the world into a depression for nearly a decade, the crash of ‘87 was like a blip on the radar. Roughly eight months later, the market was back at an all-time high. Like if you look at a long-term chart of the stock market, you can barely see ’87.
While the crash of ‘87 didn’t have too negative an effect on people’s lives, It underscored the disconnect that often happens between what companies and businesses are doing and what stock prices do as they react to the architecture of the stock market that is independent from the businesses that people are investing in.
If you fast forward a few years we’re brought into the 1990’s. On the whole, most people look back on the 90’s fondly. It was a time of high growth—particularly in the US. Inflation was low, innovation high and peoples salaries increased enormously.
But this growth wasn’t evenly distributed across the decade. In fact, in 1990, While George Bush Senior was in office, we were involved in the gulf war, there was relatively high inflation, 7% unemployment and taxes were high. Obviously, these factors—among others—led to Bush’s ousting in the 1992 election.
But 1994, the economy hit its stride. Nearly 4 million jobs were created (a number that wouldn’t be passed for 20 years) and people were living well. By the late 1990’s the biggest stocks in America were all tech. Microsoft, Intell, GE and Quallcomm were all at the top.
As a finale to this three part series, I want to discuss the Enron scandal. Even though it officially came crumbling down in 2001, there was a good multi-year lead up to their demise.
Despite this being one company, it was a scandal that had far-reaching effects on individuals’ investments and was a prelude to what we’d experience 7 years later with the subprime mortgage crisis and Bernie Madoff. It was also an event that tore off the glittery veneer that people often associate with major accounting firms and degrees from top-Universities.
I also want to address it because I feel like it’s a subject that gets forgotten at this point with the latter two at the forefront of people’s minds.
Enron was founded in 1985 by Kenneth Lay in the merger of two natural-gas-transmission companies, Houston Natural Gas Corporation and InterNorth, Inc.; the merged company, HNG InterNorth, was renamed Enron in 1986.
After the US Congress adopted a series of laws to deregulate the sale of natural gas in the early 1990s, the company lost its exclusive right to operate its pipelines. With the help of Jeffrey Skilling, who was initially a consultant with Mckinsey, later became the company’s COO, Enron transformed itself into a trader of energy derivative contracts, acting as an intermediary between natural-gas producers and their customers.
The trades allowed the producers to mitigate the risk of energy-price fluctuations by fixing the selling price of their products through a contract negotiated by Enron for a fee. Under Skilling’s leadership, Enron soon dominated the market for natural-gas contracts, and the company started to generate huge profits on its trades.
Skilling also gradually changed the culture of the company to emphasize aggressive trading. He hired top candidates from MBA programs around the country and created a highly competitive environment within the company, in which the focus was increasingly on closing as many cash-generating trades as possible in the shortest amount of time. One of his brightest recruits was Andrew Fastow, who quickly rose through the ranks to become Enron’s chief financial officer. Fastow oversaw the financing of the company through investments in increasingly complex instruments, while Skilling oversaw the building of its enormous trading operation.
The tech boom and the strong market of the late 90’s helped to fuel Enron’s ambitions and contributed to its rapid growth. There were deals to be made everywhere, and the company was ready to create a market for anything that anyone was willing to trade.
So they got involved in derivative contracts for a wide variety of commodities—including electricity, coal, paper, and steel—and even for the weather. An online trading division, Enron Online, was launched during this time, and by 2001 it was executing online trades worth about $2.5 billion a day… or so they said.
As the internet-boom years came to an end and as Enron faced increased competition in the energy-trading business, the company’s profits shrank— rapidly. Under pressure from shareholders, company executives began to rely on shady accounting practices, including a technique known as “mark-to-market accounting,” to hide the troubles.
Mark-to-market accounting allowed the company to write unrealized future gains from some trading contracts into current income statements which gave the illusion of higher current profits. Throughout these years, Arthur Andersen served not only as Enron’s auditor but also as a consultant for the company. Arthur Anderson was on par with PriceWater or Deloitte at this time.
It was Spring 2001 when red flags started showing up at Enron and people began suspecting that something was amiss. Unfortunately, but this time it was too late. Forensic accountants began to dig into the details of Enron’s publicly released financial statements. And that October Enron shocked investors when it announced that it was going to post a $638 million loss for the third quarter and take a $1.2 billion reduction in shareholder equity. Shortly after that the Securities and Exchange Commission (SEC) began investigating the transactions between Enron and Fastow’s SPEs. Some officials at Arthur Andersen then began shredding documents related to Enron audits.
As more details of the accounting fraud emerged, Enron went into free fall. Fastow was fired, and the company’s stock price plummeted from a high of $90 per share in mid-2000 to less than $12 by the beginning of November 2001.
That month Enron attempted to avoid disaster by agreeing to be acquired by Dynegy. However, weeks later Dynegy backed out of the deal. The news caused Enron’s stock to drop to under $1 per share, taking with it the value of Enron employees’ 401(k) pensions, which were mainly tied to the company stock. On December 2, 2001, Enron filed for Chapter 11 bankruptcy protection.
Of course, many Enron executives were indicted on a variety of charges and were later sentenced to prison. The accounting firm, Arthur Anderson had their accounting licence revoked and therefore dissolved.
Hundreds of civil suits were filed by shareholders against both Enron and Andersen. While a number of suits were successful, most investors did not recoup their money, and employees received only a fraction of their 401(k)s.
The scandal resulted in a wave of new regulations and legislation designed to increase the accuracy of financial reporting for publicly traded companies. The most important of those measures, the Sarbanes-Oxley Act (2002), imposed harsh penalties for destroying, altering, or fabricating financial records. The act also prohibited auditing firms from doing any concurrent consulting business for the same clients.
So why is the Enron scandal important and how does it relate to investing? Well, there’s that old adage if something is too good to be true, it usually is. At MyConstant, we’re always telling customers don’t put all your eggs in one basket and this would be a prime example of why.
Enron was the first “too big to fail” kind of company in modern history to knowingly deceive their investors on such a massive, orchestrated scale. In essence, Enron is the “root” of the modern corporate governance tree that they show you in business school. The emphasis on director-independence; governance principles; “best practices”; codes of corporate ethics; financial transparency etc can be directly traced to the perceived and admitted failures of the Enron board.
Finally, the Enron scandal should provide a little “ping” in the back of anyone’s brain, that “the smartest guys in the room” have a bad habit of popping up again, and again, in executive suites across industry sectors, year after year.
Human nature and competitiveness being what they are, there is always a “type” of executive who will “push the edge of the envelope” in support of what they believe is the best interests of the company—even despite warning signals that it is not. The strong and effective board oversight provides the necessary checks and balances to aggressive management, especially in those situations when the “edge of the envelope” begins to appear.
I’m going to end here for today’s episode. Maybe in a future episode I’ll continue on for the following 20 years. But I think at this point we do have other podcasts that talk in depth about the financial crisis of 2008.
I hope you all found three podcasts informative. I certainly had a lot of fun researching these topics. It’s fascinating to research history, economics and investing because the opinions “facts” can vary enormously depending who you speak to. But I did my best to take a neutral stand on the political and economic side of things.
I think that’s all for today. Thank you so much for listening and you’ll hear from me again in two weeks.
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