The Finance Buff

Today I’m reviewing the book Origins of the Crash by Roger Lowenstein. It’s on my Recommended Reading List. See my other book reviews on this list.

This book is about the 2000-2002 stock market crash. If you weren’t an investor then, it’s a good read to understand what the crash was about. If you lost a lot of money during the crash, it’s good to understand why it happened, and more importantly if a crash will happen again.

Roger Lowenstein is a columnist for Smart Money magazine. He wrote for Wall Street Journal for over 10 years. This book is very well researched. Every chapter is backed up by tons of footnotes for further exploration. This quote, at the end of the book provides a good thesis of the book:

People demand an explanation for crashes, but their origins are invariably to be found in the boom years that precede them.

So the author pursued the traces in the boom years that eventually produced the crash and he did a great job. Many people think the crash was about the dot com’s, but it’s much more than the dot com’s. Many of the leading Internet companies then are still with us today and are worth billions of dollars: Amazon, Yahoo!, eBay, Google. The biggest bankruptcies are not dot com’s: Enron, WorldCom, Conseco, Global Crossing, Adelphia, none of which are Internet companies. So why did the stock market get up so high and crash badly, as opposed to going up its average rate of 10% a year? You will have to read the book and draw your own conclusions. Here are the takeaways I got from the book:

1. Investor optimism about the stock market got separated from the underlying businesses

For a long time before the 1980s, people invested in stocks, not the stock market. Broader participation from the individual investors through 401(k) plans and mutual funds let the investors invest in the stock market. They don’t have to pay too much attention to how the companies are run or valued because they are investing in a pool of companies through mutual funds. While diversification is good for the individual investors, this also creates an illusion that the stock market has its own life path independent of the underlying companies. Quick recovery from the 1987 crash created the motto “buy on dips,” as if investing in the stock market is a sure thing. Valuation too high? Not a problem if it goes higher next month. Quick and easy money always draws in people.

2. Management effectiveness was measured by the stock performance in the short term

The emphasis on shareholder value made management base their decisions on the immediate market perception/reaction. If this quarter’s earning missed Wall Street estimate by a penny, the stock would take a beating. Management was forced to turn their attention from managing the business to managing the stock price. This encouraged playing with accounting numbers and dishonesty in financial reporting. Management is led to do whatever if fashionable on Wall Street now. If Wall Street favors acquisition, management will acquire even if the price is high. If Wall Street favors a particular new market, management will enter it regardless of the company’s competitive strength. When the management does what Wall Street favors, the stock price goes up, even if it’s only temporary.

3. Stock-based compensation encourages gambling with shareholders’ money

Because management holds stock options, they benefit from short-term spikes. The option structure makes it riskless for the management. If they create a temporary enthusiasm by taking a gamble, the stock price goes up and they can sell their stock at a high price. If the gamble didn’t work out and the stock goes down, they would receive more options at lower price. Head management wins, tail management wins again. A spike and a crash in the short term create a fortune for management even if the long term performance is flat.

Are these conditions still present today? I say yes. Is the stock market going to have another crash? Not necessarily. Is it a sure thing? Far from it.

Final verdict: **** (Excellent, highly recommended).