Part 6 (2/2)
The realThe nus ratios” They sho the price of shares is related to the history of company profits over the previous ten years So in 1980, the price of typical S&P 500 shares was nine ti the 1970s (the graph, and all these figures, are adjusted to reht 100 a year of profits in the 1970s cost 900 to buy in 1980 By 1990, shares that had brought 100 a year of profits during the 1980s would cost 1,800 to buy This means that investors in 1990 were optimistic that the 1990s would be better than the 1980s, while investors in 1980 were less optimistic that the 1980s would be better than the 1970s
By 2000, investors illing to pay 4,500 for shares that had brought 100 of profits throughout the 1990s If investors in 1990 were optimistic relative to investors in 1980, the investors in 2000 were absolutely delirious Part of that was a willingness to pay more for shares because people were more familiar with shares and more tolerant of the risks But mostly it reflected a view-and an unconscious, unquestioned view-that future profitability would be much better than past profitability, in a way that had never happened before
Let's be clear about what a massive assumption that was It wasn't a question about whether coe, over the medium term, they always have increased in a bus ra-tios like those shown in the graph have always taken into account the fact that because the econoer than today's profits Investors in 2000 were betting onthat toer than today's profits-in a way that had never been seen in the history of the stock markets, not when the railroads careat expansion of the 1950s and 1960s
The graph of price/earnings shouldn't rise like the north face of the Eiger It should be fairly flat, bouncing up and down a bit perhaps, but over the long terto pay 16 for a share that has in the past given profits of 1 a year, 1,600 for a portfolio that has in the past given profits of 100 a year, or 16 billion for a coiven profits of 1 billion a year As the corow from 10 million to 100 e over tie with interest rates and attitudes to risk, but these effects aren't nearly enough to explain what happened in the late 1990s)or this? The long view
50
”A new and perh plateau” 45 40 35 30 25 20 15 10 5 0 Source: shi+ller 2001
When pension salesraphs like this in 2000, what they hoped they were tellingBut what I saas a -ters ra-tios have always been around 16 They have often drifted away froure Yale economist Robert shi+ller has devoted so back to a P/E ratio of 16, and he has col-lected price/earnings ratios back to 1881 (Robert shi+ller's data is used in the graphs for both figures In fact, the first figure is just an extract froive is rather different) What comes out very clearly from shi+ller's data is that a ratio over 30 is not normal It only happened once before the 1990s, in 1928 As in 2000, people in 1928 cah share prices at the ti Fisher, one of shi+ller's predecessors as a noted Yale econo-mist, famously declared that shares had reached ”a new and per-h plateau” Fisher was no fool; a very influential thinker in monetary economics, he wrote a book called The Wall Street Crash-And After, giving what must at the ti share prices to stay high
After the initial dra down in the stock market at the end of the 1920s, the start of the Wall Street Crash, Fisher argued that future profits would be excellent, due to efficiencies resulting froy, the iement expertise, and the ex-pertise of the Federal Reserve The analysis seeely familiar
Unfortunately, despite the title, Fisher's book was not published after the Wall Street Crash It was published just after the first act of what turned out to be a er drama Further dramatic falls in share prices followed So, too, did the Great Depression
Thinking sensibly about scarcity We are probably not on the verge of another depression Some die-hard optimists would even claim that the stock market will bounce to justify its bubble valuations James Glassman and Kevin Hassett, the authors of Dow 36,000, a book that ust 2002 after the Dow had slumped to around 8000 and have continued to defend their book They point out, correctly, that nobody could call the market in the short term; they predict a rebound for thethe fact that in Dow 36,000 they predicted that the ht take ”three or five years” to soarthat is, until the end of 2004) Glassue that the stock market has been undervalued for a hundred years, so the historical data produced by Robert shi+ller does not prove that in-vestors in the future will make the sa for the past century As we've already discovered, once econo sensibly, it is very hard for us to say very much at all
A more productive line of inquiry is to ask whether, as bubble valuations suggested, coher in the next few years It's teument about the power of the internet, cell phones, coical advances Many Internet fans did indeed argue that it was reasonable to pay an enormous amount of money for a co everything”
Unfortunately, that is not the point Maybe the Internet really is a transfory like electricity, mass chee over time, but that answer does not actually matter much for the stock mar-ket The hidden premise is that if we are in an economic revolu-tion, shares should be very valuable This preood reason to think that fu-ture profits will be high As we know, profits derive from scar-city; for instance, ownershi+p of scarce land (protected by legal title), a scarce brand (protected by tradeaniza-tion with unique capabilities (protected by nothing anizations are hard to copy) So share prices should rise only if econoanizations control scarce resources
It's easy to see that there ht be a link between economic transformation and the control of scarcity It's far less easy to see what it is, and it seeies will increase corporate control of scarce resources” Soain; others will lose Histori-cally, there has been no clear link between econoe company In fact, the reverse is often true: economic transfor or duplicating their scarce as-sets), while the new firh failure rate and very large costs of building their businesses The advantages are enjoyed by workers who are paid higher wages on average and by custooods and services For exahed against the fall in global mu-sic industry profits of around 25 billion in the same year, a drop that industry executives blame on Internet music down-loads and easy piracy The Internet can destroy profits as well as enable them
This has always been the case with previous revolutionary tech-nologies such as railroads or electricity Because I didn't under-stand the point well enough at the ti into a sportsman's bet with the economist John Kay He wondered ould have happened if you had bought shares in the Great Western Railway, the most famous of all the rail companies in Britain, the birthplace of train travel He specu-lated that even had you bought them on the first day they were available, and held the term, your returns would have been quite modest, say, less than 10 percent a year I couldn't conceive that one of the most successful companies of the rail-road revolution could have possibly returned such a h dusty nineteenth-century editions of The Econoht Not long after the Great Western Rail-way shares were put on sale for 100 a share in 1835, there was a tremendous burst of speculation in rail shares Great Western shares peaked at 224 in 1845, ten years after the company was forain in the century-long life of the co-term investor would have received dividend payments and would have made a respectable but unremarkable 5-percent annual return on his ini-tial 100 invest at the peak of the frenzy would have lost money but would have done far better than the backers of countless rail co their lines
So, even the best rail coreat investments, and the worst were financial disasters But nobody disputes the fact that the railroads completely transformed developed econo-mies Conservative estimates are that they added 515 percent to the total value of the US econo amount, when you think about it But competition to build and operate rail lines kept profits , the railroads had little scarcity power
Scarcity and technology In the case of the dot-coy compa-nies, the case for scarcity is even harder to make A few have done well, it's true; for instance, IBM, Microsoft, and Intel IBM was an enormously successful company: at the end of the 1970s it was theof the 1980s, it nearly went bankrupt and has only recovered by radically and painfully transfor itself into a completely dif-ferent business Intel has not suffered the sa profits did fall by over three quarters in 2001 But Intel is fa to stay ahead of the competition (The chairman, Andy Grove, wrote a book titled Only the Paranoid Survive) Only Microsoft, which replaced IBM as the titan of the computer industry, seereat success of Microsoft, which has helped to fuel the frenzy to find the ”next Microsoft” Most companies are not Microsoft and never will be In truth, as far as the share price is concerned, even Microsoft is not Microsoft, because its share price at the end of the 1990s reflected not its current situation but an expectation of what Microsoft could eventually become The view of investors, perhaps correctly, is that by controlling a number of ienuine, lasting scarcity pohich will generate le of dot-coreater Many of them had businesses that could have been duplicated at minimal cost in a matter of months, and it was that fact alone that should have made it clear that their shares were really worth next to nothing It did not , because the econoe so hly profitable
Which brings us back to Graha in late 1998 The implicit idea behind his story was this: it doesn't matter whether you have any scarcity power It doesn't matter if anyone in the world can do what you do What old-rush vision-the first claim has priority If somehow Internet companies could stake out ”terri-tory” on the Internet, other coe them
When you make that ireat American myths, but doesn't really have a lot behind it Settlers and prospectors had a set of property rights, adh-and-ready ones, to defend their claim But Internet companies do not-they have a donition But easy coo: why on earth should the first company to set up an Internet business face no effective competition? It is quite easy for customers to find out about new businesses It is effortless for them to visit their websites-much easier than it is to visit a new store In fact, the advantage to businesses who move first looks smaller than it has ever been in the past As Bailey was speaking, a tiny coe in California It provided Internet search technology but was perfor just a few hundred searches an hour The co proof thaton the Internet What counts is being best Google caame late, at a ti of all search engines, but has beco itself The question for Google is whether a new coe somewhere, is about to do to them what they did to their rivals On the Internet, ev-ery company is vulnerable to competition The Web eats into scarcity power
The lessons for your own stockthe struggle to find the fastest line at a supermarket, bear in mind that all stock prices incorporate tree If you plan to try to make serious money, better have a clear idea what you think you know, and what -lasting profitability for a co some capability that others cannot match: a powerful brand in a con-servative market-think of Trojan condoms; control of a stan-dard like Microsoft's; or simple superior expertise, like General Electric Perhaps eBay has such a capability, drawn from its locked-in base of loyal buyers and sellers Very few other Internet companies do, and if you looked inside Grahahtfully you would have found it very unconvincing in 1998 His consulting firm went bankrupt in April 2001
SEVEN
The Men Who Knew the Value of Nothing
So and the value of nothing Oscar Wilde's definition of a cynic, now co an econo kind of auction, which he assures you should raise the 300,000 you think your house is worth The bids come in, and to your horror and the economist's embarrassment you some-how end up with less than 3,000 You're left homeless and nearly penniless, your wife divorces you, and you spend the rest of your days in a dank basehbor also decides to sell his house and engages a different econo kind of auction Your neighbor also expects 300,000, but the bidding just keeps on going up and he ends up with 23very siovernments The real estate in this situation was constituted not of bricks and ths of radio spectrum, to be exact, which cell-phone companies use to operate their networks Over the past few years, governhts to use this spectrum to telecom companies There is a limited amount of the spectrum available, and as we have learned, where there is scarcity there is money to be made Unfortu-nately, not all of the economists ere hired as consultants kne to set up the auction so that it was likely to produce a good price One auction really did raise less than 1 percent of as hoped for, while another raised ten times as much as expected
This wasn't down to luck but to cleverness in so air, like playing poker, is a gah stakes indeed
Love, war, and poker Many of those who knew the arded him as the ”best brain in the world,” and they had a chance to coiven that one of von Neuues at Princeton was Albert Einstein Von Neuy of al to one story, Von Neun of a new supercomputer, required to solve a new and important math-e supercomputers He asked to have the problem explained to him, solved it in moments with pen and paper, and then turned down the request
Von Neueoy, and other fields ofquantum mechanics, nuclear weapons, and the coaame theorist, is any activity in which your prediction of what another person will do affects what you decide to do Such ga for thin air in an auction Gaa,” I receive an acceptable payoff if I drive on the right and so do you I also receive an acceptable payoff if I drive on the left side, and you do too If one of us chooses to behave other-wise, I receive a very bad payoff-a ride in an ambulance (You also receive a bad payoff if we have a head-on collision, but in game theory I don't usually care about your payoff for its own sake I care about your payoffs only because they help me predict your behavior) Ga little stories or anecdotes, but these stories conceal the fact that for a gaame theo-rists are brilliant mathematicians, such as Von Neumann him-self, or nobel Prize winner John Nash, the subject of A Beautiful Mind As in the case of all gaame's outcome was an inspired application of well-understood mathematics
Von Neumann was fascinated by poker, and as he turned his ame he developed mathematical tools that are not only handy for econo froy or the cold war
The fundamentals of poker are simple: players conceal their cards until the final shohen the player with the best cards wins the pot, full of all the accua to forfeit a littleive up, you can win the pot without ever showing your cards
If you were playing poker, your basic challenge would be to work out whether it orth paying to stay in the gaet you very far It is not enough to calculate the odds that the hand you hold is better than the other hands hidden around the table You need to analyze your opponents' n of weakness, or a trick to teth? And do big bets nize that your opponents will be trying to interpret your own bets, and you must be careful not to be predictable
Poker is full of spirals of second-guessing: ”If he thinks that I think that he thinks that I have four kings, then” Poker is a gaame of secrets: each player has access to inforaht of everyone In poker, no player can see the whole truth
This is where game theory comes in Von Neu ht onto all kinds of huame where a small number of players try to outwit each other in an environment of luck, secrets, and skilled calculation But poker is not the only situation to fit that description Think of generals fighting a war, or even-if you're a cynic like ame of love itself Many human inter-actions can be interpreted as battles of wits, like poker All these interactions ca game theory
Economic life is no exception Von Neuenstern to write the bible of game theory, Theory of Games and Economic Behavior, which was pub-lished just before the end of World War II Ever since, gaa econoame theorists have been awarded the nobel Prize for Economic Sciences
If you want exa between landlord and tenant, between government and trade union, between used-car sales nations deciding whether to adhere to OPEC rules to help drive up oil prices, or produce flat out and take advantage of the high prices that others have created
Or, to take the example we'll explore in er teleco to acquire radio-spectruovernment with a limited number to offer Every bidder has some idea of how prof-itable it would be to own a license (and so how valuable a license is), but nobody knows precisely how profitable The governe is to find out some secrets: to determine which of the telecom companies can best use the licenses, and how overnn the licenses to the firovern up a valuable public asset, they also want to get the best value for the taxpayer
Poker and the spectruames in Von Neumann's sense There is an even closer sie sums of money at the heart of the process Without stakes, poker arded as ” on it, but in poker, ath and weak-ness in poker-if players are not betting with real less As we knoell by now, talk is cheap Bluffing only has consequences if real money is at stake