I had two neighbors in the late nineteen nineties, one a retired doctor and the other a retired small business owner, who were never seen in the daytime when the stock market was trading. But in the evenings, they would have smiles on their faces akin to those of teenage boys who, the evening before, had talked their girlfriends into the backseat of their cars. These neighbors had both become day traders, and each of them felt that they had discovered the secret to wealth. Neither of them ever shared with me their "methods" of playing the market, but their wives worried that they were buying stocks based on hunches, rumors, recent headlines, etc. Apparently no in-depth analysis of stocks was being done, nor did they make any effort to see if they were doing any better than the market in general. All they cared about was that, on an almost daily basis, their on-paper worth was increasing. They believed that they had discovered the secret to making a lot of money without working!
They weren’t alone in their craziness. Something strange was happening to most of the country during the nineties. Computer nerds, who were never thought to be giants in the practical world of business, were given almost unlimited funds to pursue their latest business ideas related to the net or other software ventures. These newly ordained entrepreneurs told everyone that their dot-com businesses did not have to make a profit; that the idea was to develop a customer base using information technology, and the profits would come later. They used esoteric measures, like "eyeballs," to determine how many people were visiting their websites, which they felt was a measure of their business success. Or they counted how many other worthless web sites were sending visitors to THEIR worthless site. They didn’t even bother estimating when they would make a profit, nor was there any analysis of what those future profits would be. They said that the important criterion in these new-era businesses was generating customers; profits would just naturally come later. Some of their projections of customer base growth took them quickly to exceed the population of the world, but no matter. Venture capitalists and investors believed them. So did my neighbors. We ALL believed!
Not only were investors like my neighbors sucked in; grizzled CEOs of large companies, who should have known better, gazed at these dot-com companies in awe. These were the same executives that, just a few years before, were trying to look, act, and dress like the Japanese, who were the previous rock stars of industry. These techie-wannabe executives tried to do high-fives and make their companies look and perform like the dot-coms. These experienced executives took crash courses on using the net. Of course, this was only after one of their in-house techies bought them computers and taught them how to boot up. GE’s CEO Jack Welch even bragged that investors looked at GE as being equivalent to a dot-com company. He made all GE executives take courses on surfing the net, and each individual business within GE had to set up their own web site where customers could peruse that business’s management and product lines. Any project having interaction with the net got priority corporate funding. Jack Welch and many other corporate heads also did what was necessary to make their stock prices act like dot-com stocks. No matter that most of the perceived financial gains during this era came from accounting creativity that made bland corporate performance look stellar by pushing costs into future years and doing other financial wizardry.
Baby boomers, who were wondering if they were going to be able to keep up with the gains realized by their parents’ generation, suddenly saw their salvation. Like my day-trader neighbors, the baby boomers would buy stocks in this new era stock market and watch their riches grow. As more and more of them bought stocks, the demand drove prices up to ridiculous levels. The feeding frenzy had begun. As a result of all this buying pressure, in the later years of the last century the stock market performed brilliantly.
It wasn’t just naïve investors who got overconfident in their abilities related to the market. In 1994, Bill Krasker and John Meriwether, two winners of the Nobel Prize in Economics, started a company called Long Term Capital Management (LTCM). These two "geniuses" had done massive data analysis on the "spreads" between various financial instruments, like corporate bonds and Treasury bonds. When these spreads got wider than what was statistically expected (based on their computer program), LTCM would buy the financial instrument likely to gain from the correction that was expected to occur shortly.
Using this methodology, LTCM was unbelievably successful for four years. By leveraging their money, they had gained as much as 40% per year for their investors, and Bill Krasker and John Meriwether got very wealthy.
They were so successful that, by 1998, LTCM had $1 trillion in leveraged exposure in various financial market positions. Then, LTCM became victim of the "fat tail" phenomena, which is where a normally balanced distribution of data now has a lot of data far out to one end of the distribution tail. The reason this happened is that everyone who played in similar financial markets all decided to get out at once, and LTCM was seeing results that their computer models had predicted would not statistically happen in more than a billion years! Unbeknownst to them, because of the sudden exit of the others playing this financial game, the relationships of the "spreads" between various financial instruments had changed, which made the earlier computer-generated probability predictions invalid.
The risks that LTCM had taken were so dangerous that LTCM was close to upsetting the whole world’s financial institutions. Fed Chairman Alan Greenspan and several of the world’s major banks got together to offer additional credit to LTCM to successfully avert this potential global financial disaster.
