Toward Rational Exuberance

1
STEEL
"I ACCEPT."
These words, spoken by John Pierpont Morgan in early 1901, would soon reverberate throughout Wall Street. A piece of paper had just been handed to Morgan by the energetic young president of Carnegie Steel, Charles Schwab. Written on the paper was a number representing Andrew Carnegie's asking price for Carnegie Steel, the biggest producer of crude steel in the world. After a quick glance, Morgan signaled his acceptance of Carnegie's terms. With that gesture he acquired the essential building block for what would in a few weeks become the world's largest industrial corporation: United States Steel. In the rush of events that followed, Morgan did not actually get around to instructing his attorneys to draw up the contract with Carnegie for over a week. But it didn't matter; both men had given their word, and the deal was done.
U.S. Steel was a giant--or a monster, depending on one's perspective. With a capitalization of more than $1.4 billion, it dwarfed even the federal government (with an annual budget of approximately $350 million and a total national debt of slightly more than $1 billion). Senator Albert Beveridge of Indiana hailed Morgan as "the greatest constructive financier yet developed by mankind."1 But even normally pro-business spokesmen such as the editors of The Wall Street Journal acknowledged some "uneasiness over the magnitude of the affair." Others rendered harsher verdicts. Henry Adams, financial gadfly and descendant of two Presidents, stated bluntly, "Pierpont Morgan is apparently trying to swallow the sun."2 President Arthur T. Hadley of Yale, referring to the great "trusts,"a like U.S. Steel, that were controlled by a few imperious financiers, such as J. P. Morgan, declared that if such business combinations were not "regulated by public sentiment," the country would have "an emperor in Washington within 25 years."3
Some observers on Wall Street were also critical of the new "trust," although for reasons different from Hadley's. U.S. Steel was made up of dozens of smaller firms, besides Carnegie's, that had been amalgamated into the new entity. Many analysts felt that Morgan and his associates, in their eagerness to form U.S. Steel, had paid too much for its constituent parts. According to their calculations, the $1.4 billion capitalization of U.S. Steel (representing the face value of the U.S. Steel stock and bonds to be sold to the public and issued to the owners of the acquired companies) greatly exceeded the actual value of the new corporation's assets. The whole, the critics alleged, should not and could not be worth more than the sum of the parts.
The cry of "watered stock" was raised. Legend has it that the term originated in the early decades of the nineteenth century. Daniel Drew, in his years as a cattle drover before he became a notorious Wall Street operator, is said to have hit upon the idea of plying his scrawny "critters" with salt, then depriving them of water as he drove them down the length of Manhattan to the butcher shops on Fulton Street. As the story goes, Drew would finally instruct his drovers to "let them critters drink their fill" immediately before the cattle were to be inspected by potential buyers. He knew that a thirsty cow could easily drink 50 pounds of water; he was counting on it. The Fulton Street butchers, enthused about the apparently fat cattle Drew had for sale, would pay top dollar for the bloated animals, a price that effectively included thousands of pounds of water. When Drewlater hung out his shingle on Wall Street, he was frequently accused of "watering" the stock of companies he controlled, meaning that he would secretly sell stock in quantities far in excess of the amount justified by the assets of the company. The term "watered stock" stuck in the Wall Street lexicon.
J. P. Morgan was no Daniel Drew. To the extent that an aristocracy existed in the United States, Morgan was a charter member. His ancestors on both his mother's and father's sides had come to America shortly after the Mayflower, and his father had been the leading American investment banker in Europe. Morgan looked and acted the part; he was a large, physically imposing man with a gruff manner and a penetrating stare that could be very intimidating. Born to wealth and influence, Morgan was openly disdainful of the unsavory tactics employed by operators like Drew who sought to claw their way to success on Wall Street. For J. P. Morgan to water stock was unthinkable.
The debate over the capital structure of U.S. Steel had a broader significance, reflecting the first inklings of changing standards for valuing stocks. Those critics who alleged that a substantial quantity of water existed in the new trust were in a way correct, given the essentially static analysis prevalent at the time. It was customary to speak in terms of a company's "intrinsic" worth, usually defined as its "book value"--the total of assets minus liabilities. The Federal Commissioner of Corporations, later looking back on the birth of U.S. Steel, made use of the traditional valuation approach in attempting to calculate the true worth of the corporation at the time of its formation. Adding together the values of its constituent parts, he calculated that U.S. Steel at the time of its creation had actually been worth about $700 million, meaning that the other $700 million of the $1.4 billion initial capitalization was water.4
The commissioner's report included one important disclaimer. It explicitly did not take into account any additional profits that would flow from the presumably great efficiencies to be reaped by the new combination. But of course it was those efficiencies that were the primary rationale for forming the giant trust in the first place. Morgan and his associates were anticipating that profits would be greatly enhanced by economies of scale and other advantages the new entity would possess; they were looking to the future, and rejected the notion that U.S. Steel was properly valuedsimply by summing up its constituent parts. (History seems to suggest they were correct. With the exception of a difficult period in 1903-1904, the corporation was solidly profitable for decades to come.) But conventional standards of stock market valuation did not take into account future earnings growth, which was assumed to be unpredictable. Conservative investors would not speculate on developments they believed they could not foresee. Hence the disagreement over the amount of watered stock.
The founders of U.S. Steel had unwittingly touched on a controversy that would recur repeatedly during the twentieth century--the clash between new and traditional methods for valuing stocks. Many years later, Alexander Dana Noyes, longtime financial editor of The New York Times, suggested that 1901 marked a crucial turning point. He wrote, "Probably 1901 was the first of such speculative demonstrations in history which based its ideas and conduct on the assumption that we were living in a New Era; that old rules and principles and precedent of finance were obsolete; that things could safely be done to-day which had been dangerous or impossible in the past."5 The events of 1901 may have marked the first such instance, but they would certainly not be the last.
The basic question asked by any investor is, What is the right price for a given stock? At the turn of the century, this question was answered by traditionalists in a very straightforward fashion. The price an investor was willing to pay for a stock reflected what he would receive from his investment--his share of the company's earnings in the form of dividends paid out to him from those earnings. Dividends were all-important, and stock prices tended to fluctuate with the level of dividend payments.
The tool most commonly used today to value stocks, the price-earnings (P/E) ratio,b had its origins in this analysis, although in a way that would now be considered somewhat backward. At the turn of the century, appropriate P/E ratios for stocks were derived from dividends. For example, for most of the decade preceding 1901, the average dividend yield of industrial stocks traded on the New York Stock Exchange varied between 5% and 6%.6 As a standard rule of thumb, it was assumed that a mature industrialcompany should pay out between 50% and 60% of its earnings in dividends. Thus, if a company's annual dividend was between 5% and 6% of its stock price, and was to represent between 50% and 60% of its earnings, the earnings per share must equal 10% of the stock price. Put in the form of the price-earnings ratio, the price of a share of stock should be ten times the company's earnings per share--a P/E ratio of 10 to 1.
Simple enough. In fact, the 10-to-1 P/E ratio had become something of a standard by the turn of the century. An industrial stock trading at a 10-to-1 P/E ratio was arbitrarily considered by many analysts to be fully valued. This standard had certainly held true in the decade preceding 1901; in only one year of that decade did the composite P/E ratio for the New York Stock Exchange industrials rise significantly above 10 to 1. (In 1896 it touched 11.7 to 1.)7c
Price-earnings ratios were calculated on the basis of the current year's earnings. Richard Schabacker, financial editor of Forbes magazine, wrote later about accepted valuation standards in the early twentieth century: "Since it is generally impossible to prophesy what earnings the stock will show in any future time, it is necessary to base this [P/E] ratio on the probable earnings for the current year."8 Anything else was speculation, not investment.
This rigid, static mode of analysis yielded results that would today appear to be perverse. Since stocks were presumably riskier than bonds (which had fixed interest rates and guaranteed the return of principal onmaturity), investors expected to receive dividends on stocks that were greater than the interest rates available from bonds, so as to be compensated for the extra risk. Dividend rates at the turn of the century were in fact higher than bond interest rates, and had always been so, going back as far in time as data are available. Investors, unable or unwilling to estimate future growth but cognizant of the fact that stocks were riskier than bonds, demanded a higher yield from stocks than bonds. This is the precise opposite of the relationship between stock dividends and bond yields that prevailed throughout most of the second half of the twentieth century.
The arbitrary derivation of appropriate P/E ratios from current dividend payouts resulted in relatively low stock prices. Since stock prices fluctuated with dividends, and dividend rates were relatively high, by definition stock prices had to be relatively low to produce the required high dividend rates. (The dividend rate is simply the dividend per share divided by the price per share of the stock--hence the lower the share price, the higher the dividend rate.)
In short, stocks were typically viewed by turn-of-the-century investors very differently than they are viewed today. They were valued primarily on the basis of the current income--dividends--they produced. This conservative approach resulted in stock dividends that were higher, and stock prices that were lower, than modern methods of analysis produce.
The proponents of trusts like U.S. Steel implicitly challenged these standards by citing presumably enhanced future profits as a justification for the giant business combinations. But it was only a mild challenge; once created, the shares of the trusts were still typically valued on the basis of the dividends they paid. However, some serious students of the market were exploring significantly more unorthodox ways of evaluating stock prices. In 1900 two such men, separated by thousands of miles and coming at the problem from very different disciplines, proposed theoretical approaches to analyzing the market that were fundamentally different from traditionally accepted methods.
One of these men was none other than Charles Dow, creator of the Dow Jones averages and editor of The Wall Street Journal. Dow developed an entirely new way of looking at the stock market that would later form the basis of what would be called technical market analysis. In a series of articles in the Journal between 1900 and 1902, Dow put forth a theory forpredicting stock prices that had nothing to do with earnings or dividends but was based simply on the price action of the stocks themselves. His ideas were taken up by William P. Hamilton, who succeeded Dow as editor at the Journal. Hamilton refined Dow's approach, giving it a name--the Dow theory.
The Dow theory assumed that the stock market at all times accurately reflected the sum total of all knowledge as to the future course of business activity much better than any individual could possibly hope to. Therefore, little advantage could be gained by analyzing business fundamentals. But Dow and Hamilton claimed that certain patterns could be discerned in the action of stock prices that could be used to predict the market's future course. In effect, they argued that an investor should read the market as a "barometer" of business conditions, but a barometer that not only measured the present but sometimes provided clues to the future as well.
Dow believed that at any given time there were three movements present in the market--the primary trend, a secondary (or reactive) trend counter to the primary trend, and essentially random daily fluctuations. He believed that the price action of the market itself would provide signals as to when a primary trend (which could last for years) was reversing, and that these signals could be very valuable to investors. In perhaps his bestknown article on the subject, in The Wall Street Journal in 1901, he compared the action of the market to waves on a beach:
A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned.
This method holds good in watching and determining the flood tide of the stock market ... The price-waves, like those of the sea, do not recede at once from the top. The force which moves them checks the inflow gradually and time elapses before it can be told with certainty whether the tide has been seen or not.
Coincidentally, as Charles Dow was propounding his theory of stock price movements, a young French mathematician, starting with a similarconception of the market, reached profoundly different conclusions. Louis Bachelier completed his doctoral dissertation at the Sorbonne in Paris in 1900. Entitled "The Theory of Speculation," it was the first work to employ mathematical techniques to explain stock market behavior. Bachelier, like Dow, believed that the stock market at all times accurately represented the collective wisdom of all participants. He wrote, "Clearly the price considered most likely by the market is the true current price: if the market judged otherwise, it would quote not this price, but another price higher or lower." But Bachelier, unlike Dow, did not discern any means by which future prices could be predicted. In the opening paragraphs of his thesis he argues that market movements are not only impossible to predict but often hard to explain even after they have occurred:
Past, present, and even discounted future events are reflected in the market price, but often show no apparent relation to price changes ... artificial causes also intervene: the Exchange reacts on itself, and the current fluctuation is a function, not only of the previous fluctuations, but also of the current state. The determination of these fluctuations depends on an infinite number of factors; it is, therefore, impossible to aspire to mathematical predictions of it ... the dynamics of the Exchange will never be an exact science.9
Bachelier had another important insight--that stock price fluctuations tend to grow larger as the time horizon lengthens. The formula he developed to describe the phenomenon bears a remarkable resemblance to the formula that describes the random collision of molecules as they move in space. Many years later this process would be described as a random walk, a key concept underlying much of the academic work on the stock market in the second half of the twentieth century.
A great deal of Bachelier's work was revolutionary. He laid the groundwork upon which later mathematicians constructed a full-fledged theory of probability, and made the first theoretical attempts to value options and futures. All this was done in an effort to explain why stock prices were impossible to predict.10
Bachelier was not modest about his work. He stated openly, "It is evident that the present theory resolves the majority of problems in the studyof speculation by the calculus of probability."11 Sixty years later a leading finance scholar agreed, saying, "So outstanding is [Bachelier's] work that we can say that the study of speculative prices has its moment of glory at its moment of conception."12 Bachelier anticipated by half a century the efforts of mathematicians and economists to develop rigorous models of stock market behavior. Unfortunately, Bachelier was a frustrated unknown in his own time. His dissertation was awarded "honorable mention" rather than the "very honorable mention" that was essential to finding employment in the academic world. After years of trying, he finally secured an appointment at an obscure French provincial university. The quality of his dissertation was simply not appreciated at the time, in part because he had chosen such an unusual topic for his research. One of his professors wrote, "M. Bachelier has evidenced an original and precise mind," but also commented, "The topic is somewhat remote from those our candidates are in the habit of treating."13 Over fifty years were to pass before anyone took the slightest interest in his work.
J. P. Morgan and his associates undoubtedly never heard of Louis Bachelier and were probably quite unfamiliar with the Dow theory. The problem they faced as they attempted to bring U.S. Steel to market was much more immediate: how to ensure that the market could absorb the heavy weight of the new securities to be issued. Fortunately, the tone of the market in 1901 was good, even exuberant. The volume of trading on the New York Stock Exchange for the year would total a record 265 million shares, a number that would be exceeded only three times before 1925. Turnover would be an incredible 319%, meaning that the average share traded on the Exchange would change hands more than three times during the year. (As a comparison, in 1929 the turnover figure for the New York Stock Exchange would be 119%, and by 1940 it would fall to 12%, the lowest of the century.)
Ready buyers had been found for shares in other large trusts that had recently been formed; by 1900 there had been no fewer than 185 such amalgamations, with total capitalization in excess of $3 billion. (This represented one-third of all capital invested in American manufacturing enterprises.) The stock market had absorbed all these new issues without flinching. If ever there was a moment to bring to market a huge new batch of stock, 1901 was the time to do it.
It is tempting, looking back at the ebullient state of the market in 1901, to draw parallels with the booming Wall Street environment that would exist toward the end of the twentieth century. But today's market is vastly different. The New York Stock Exchange trading volume for the entire year of 1901 (265 million shares) was only a fraction of a single day's volume today. Public participation in the market in 1901 was tiny; it is difficult to estimate how many Americans actually owned stocks, but it could not possibly have been more than a small fraction of the total population. (The difficulty of estimating the fraction of the population that holds stocks will be discussed in greater detail in subsequent chapters.) The majority of Americans in 1901 still lived and worked on farms, without telephones or electricity. Outside New York City, most newspapers did not even print stock quotations, because of a lack of interest. The public, to the extent that it was even aware of the stock market, viewed it with a mixture of skepticism and indifference.
Such an attitude was well justified. The market in the first years of the twentieth century was still an insider's game, much as it had been throughout the nineteenth century. It was an era of caveat emptor, when a paucity of publicly available information effectively precluded potential investors from making informed choices. The information that companies listed on the New York Stock Exchange were required to make public was sketchy at best; companies whose shares traded in the so-called Unlisted Department, or on other, smaller exchanges, frequently made public nothing at all. (In 1901, 15% of the trading on the New York Exchange was still in unlisted securities. American Sugar Refineries, the most actively traded stock in the Unlisted Department, had not made public any income statements for ten years.)
The Wall Street Journal took note of the dearth of reliable information available on stocks in an 1899 article, stating that "very few figures are published and those figures are usually in such form that it is impossible to canvass the integrity of net earnings ... Consequently, in ninety-five cases out of a hundred the stockholder in an industrial company is obliged to take the word of the managers--with all that implies--for the company's net earnings."
"With all that implies" was a phrase pregnant with meaning. The average shareholder was almost entirely at the mercy of management, deprivedof reliable information and unprotected by any real regulatory authority. All too often the men who controlled the new industrial corporations at the turn of the century made use of their positions to manipulate the stock of their companies for their own benefit, not to enhance shareholder value. One particularly egregious example occurred in April 1900 and involved a man who would be a key player in the U.S. Steel transaction, John "Bet a Million" Gates.
Gates was regarded by friends as a "good character," but he could be ruthless in dealing with adversaries. Frederick Lewis Allen described him as "the sort of man who will sit up all night at a friend's bedside and then destroy the man financially the next day."14 As his nickname Bet a Million implies, Gates was an inveterate gambler. One story about Gates described how, sitting in a railroad car on a rainy day, he repeatedly bet an associate on which raindrops would first reach the bottom of a window. The terms of the bet: $1,000 per drop. Another story had it that in one of his marathon bridge-playing sessions at the Waldorf-Astoria, his game was joined by a young man who was told that the stakes were "ten a point." Thinking this meant ten cents per point, the young man played for several hours and won. The next day he was shocked to find a check in the mail from Gates in the amount of $33,000, which represented his winnings.
In 1898, Gates formed the American Steel and Wire Company. Business seemed to be good and growing, but suddenly, in April 1900, the company announced that it was closing 13 of its plants. The stock tumbled on the unexpected news. The reason for the shutdown, however, had nothing to do with business conditions. Gates had first sold the stock short, then ordered the plant closings simply as a means of causing the price to collapse. He then bought back ("covered") his short, creating a sizable profit for himself at the expense of hapless investors unaware of his machinations.
J. P. Morgan did not have a high opinion of Gates, but had no choice but to deal with him in the formation of U.S. Steel. The new trust needed Gates's company. As might be expected, Gates waited until the deal was almost done, then at the last minute tried to demand an outrageous price for his holdings. Morgan, however, was not to be bluffed. He curtly told Gates, "I am going to leave this building in ten minutes. If by that time youhave not accepted our offer, the matter will be closed. We will build our own wire plant." Gates capitulated.15
Once agreement had been reached with Andrew Carnegie, John Gates, and the other owners of the companies to be acquired, the Morgan syndicate took steps to launch the massive creation without disrupting the stock market. Carnegie, ever distrustful of the market, had insisted on receiving U.S. Steel bonds in exchange for most of his holdings of Carnegie Steel. The stockholders of the other constituent companies, however, received U.S. Steel common and preferred stockd worth over $1 billion. In addition, J. P. Morgan & Company and the Wall Street firms underwriting the new issue were to be paid in Steel common stock for their services, in the amount of nearly 1.3 million shares. A huge overhanging supply thus imperiled the market in the new Steel shares; it was assumed that many of those who had received Steel stock in the transaction would soon want to dispose of it.
J. P. Morgan & Company was not a member of the New York Stock Exchange. The most influential investment banking house in the world would not deign to do the work of a "stockjobber." But Morgan and his partners could not ignore the crass realities of the marketplace; someone would have to be found to do the messy job of facilitating trading in the new Steel shares.
The man selected was James R. Keene, known as the Silver Fox of Wall Street. At an early age Keene had made his fortune in California mining stocks; he then came east to Wall Street with $6 million in search of bigger game. According to legend, he quickly ran afoul of Jay Gould. Allegedly Gould said of Keene, "He came east in a private [rail] car. I'll send him back in a boxcar."16 In 1884, when Keene overextended himself seeking to corner the market in wheat, Gould and his allies were ready to pounce.Keene soon lost his entire fortune, actually ending up in debt to the tune of $1.5 million.
Keene would make and lose several more fortunes over his Wall Street career. But beginning in the late 1880s, when he handled the market operations of the "sugar trust," he established a reputation as a broker skilled in managing the trading of large new issues. In essence, Keene's task was to manipulate trading of the new stocks in such a way as to draw in buyers, allowing the promoters to unload their holdings. He did so quite skillfully, buying and selling stock to create the impression of activity and an upward trend in prices.
Keene's experience prepared him well for his most challenging task--handling the trading of U.S. Steel for the Morgan-led syndicate of investment banking firms that underwrote the offering. It is unlikely that Morgan himself ever talked with Keene; the Great Man would customarily delegate such tasks to others. But everyone involved recognized the importance of what Keene would attempt to do.
The backers of U.S. Steel left nothing to chance. All the principals made themselves available for frequent interviews in which they extolled the prospects of the new combination. Positive stories were fed to sympathetic journalists. Perhaps most important, Morgan very publicly attached his own prestige to the transaction, announcing that J. P. Morgan & Company, along with its fellow syndicate members, stood ready to subscribe to as much as $200 million of Steel stock if necessary.
It wasn't necessary. Demand for the new issue was huge. Steel common stock commenced trading at $39 per share, and the preferred first traded at $85; the prices of both began to rise steadily on heavy volume. Within a few weeks Keene was able to dispose of 750,000 shares of the 1.3 million the investment bankers had received as compensation for the underwriting, and many of the former owners of the companies that had been merged together to form U.S. Steel were able to unload their holdings as well. By late April, two months after the first trades, the common stock hit $55 and the preferred traded at $100.
The U.S. Steel offering was an unqualified triumph for Morgan and his partners. Keene, basking in the success of the deal, found himself portrayed in the press not as a craven manipulator of stocks but as a "sportsman." The New York Times opined, "So persistent a stock speculator was Mr.Keene that none of the Wall Street veterans considered him a money-seeker at it, but rather a sportsman, who found in manipulating stocks and bonds the same excitement other sportsmen might get from a roulette wheel or a poker game ... He could find no contentment in life except that which came from taking his money off the tape." (The muckraking era of journalism had not yet arrived; when it did a few years later, Keene and other market operators would find the press far less sympathetic.)
The syndicate underwriting U.S. Steel eventually recognized a profit of $62.5 million from the sale of its Steel shares, of which J. P. Morgan & Company received $12.5 million. Morgan himself immediately set sail for his customary European vacation, well satisfied with the results of his efforts. Keene, now regarded as the premier broker on Wall Street, continued to represent Morgan interests but also devoted an increasing amount of time to his other passion: breeding and racing thoroughbred horses. Andrew Carnegie, with more than $300 million in U.S. Steel bonds secure in a specially constructed vault in Hoboken, New Jersey, went off to live in baronial splendor in a castle he had built on the coast of Scotland, complete with medieval battlements, covered swimming pool, and miniature waterfall. There he entertained distinguished guests, and commenced the task of giving away most of his fortune. John Gates, furious at Morgan's decision to keep him off the U.S. Steel board of directors, tangled with the Great Man in a dispute over the Louisville & Nashville Railroad a few years later. Although Gates emerged from that confrontation unscathed, his gambler's luck would soon run out, forcing him to retire from Wall Street to a small Texas town.
The young (thirty-eight-year-old) president of Carnegie Steel, Charles Schwab, had so impressed Morgan that he was chosen to be the operational head of U.S. Steel. "Judge" Elbert H. Gary, a pillar of Methodist moral rectitude and a trusted Morgan associate, was selected as chairman. Gary quickly moved to impose tight ethical standards on the Steel directors; to prevent them from speculating on the basis of inside information, he refused to make them privy to any important news except at formal directors' meetings, which were invariably held after the stock market closed and were followed immediately by press releases disclosing any significant information. U.S. Steel would not become a vehicle for insider speculation if Gary could help it.
Unfortunately, Gary's attitude was atypical. Machinations like those of John Gates were the norm on Wall Street in 1901, not the exception. Much as Morgan and Gary might like to change things, even the vast power they held was insufficient to do so. A year of great turmoil, 1901 marks the beginning of what would prove to be revolutionary changes in the stock market. But the "game" as it was played on "the Street" was still fundamentally an insider's game, played by men who were unrestrained by rules or concern for the small investor. Even as Morgan sailed off for a long vacation in Europe, a dispute was brewing between two such men that would soon break into open, ugly conflict--a conflict that would devastate the Street and claim many innocent victims.
Copyright © 2001 by B. Mark Smith