TIP777: The 1999 Dot-Com Bubble w/ Clay Finck

28:19And if you don't participate in the run-up of the new technology stocks, then you're likely going to trail the market and face redemptions from your investors. And then third, history teaches us that all financial bubbles eventually end in tears. One of the hottest stocks from the dot-com bubble was Cisco, and I just checked the stock price chart. Many people thought that Cisco during the bubble would be a sure winner. But 25 years later, Cisco still trades below its all-time high from the dot-com bubble. Anyways, I wanted to jump back to the book here. Lonestein explains that this bubble didn't simply happen overnight.

28:56Seeds were sown throughout the 90s that enabled this to happen. From 1990 to 1998, the NASDAQ and Dow Jones average had tripled. And it wasn't just internet stocks that were richly valued. There were blue chip staples like GE and Coca-Cola too. If General Electric were valued at 40 times earnings, who's to say what the limit was for Amazon? What was even better in many investors' minds is that since Amazon did not have profits, it allowed them to just let their imaginations wander without burden of being anchored to a PE multiple to introduce at least some level of rationality. As Loenstein writes, it allowed their naive optimism to ripen into something larger and dreamier.

29:40As the world imagined what the internet would bring, the NASDAQ would go on to rise by 86 % in 1999. This points to a common theme we see throughout history. Sometimes these new technologies lead people to get rid of the investment principles that are timeless, such as knowing the value of something before you buy it, or truly understanding the business model and its prospects. If one were to assume that a new technology were to change everything and simply buy based on that basis, then you may be getting carried away with the hype related to that technology. One of the assumptions that people make is that new technology is equivalent to an investment opportunity.

30:21Revolutionary technologies do not always equate to fruitful returns for shareholders. In fact, new technologies and increases in productivity can even dampen profitability. Many new technologies level the playing field and smooth out the imperfections in the marketplace. One of the main benefits of the potential of the internet was that it was the ultimate information dispenser. It empowered individuals and leveled the disparity in knowledge, allowing consumers to be better informed on the options available to them and the prices that different companies charged. Back on episode 693, I put together an episode discussing the power law and venture capital, which was a really interesting episode to me, and the venture capital industry was all over the internet craze.

31:07From 1990 to 1999, venture capital funding went from$3 billion to$60 billion, and venture firms really helped fuel this bubble. Some venture capitalists would push these startups to IPO because they saw an opportunity to just 10x their money rather quickly. So they encouraged these firms to just spend, hire, and build, which allowed them to go public once some sort of business model was in place. And the public was willing to pay significantly higher prices for these firms at the time. So venture capitalists, for a relatively short period of time, were able to invest in internet startups almost irrespective of their prospects for success, with the hope of selling the shares to Wall Street at a much higher price.

31:51And Wall Street was, of course, fueling this fire as well, as standards for companies to go public declined, and it was common for a banker at Goldman Sachs or Credit Suisse to personally invest in a venture firm and then turn around and take one of the firm's young companies public. So when these bankers are invested in the venture firms, there's just this blatant conflict of interest between Wall Street and their customers or the general public. They ignored the internet company's lack of profits, and they ignored the history of numerous other inventions such as the railroad, that had these speculative booms and busts.

32:27But we shouldn't put all of the blame on the venture capitalists and Wall Street, as Main Street got internet fever earlier than many on Wall Street. Some people had started using the internet in their private lives, which led to increased interest in the stock market. People everywhere got exposure to market news, rumors, opinions, and anyone investing in stocks likely heard about somebody making a killing on internet stocks. Prior to the internet, if an everyday person purchased a common stock, I'd imagine that it was typically a company that they knew about in their local area, or maybe it was a well-known blue chip like Coca-Cola.

33:06Information on these companies would have traveled very slowly, and you likely wouldn't have known many other people that also own that company. And the share prices just weren't as volatile as many of these internet stocks. Now, with the internet coming about, people were able to sort of form their own bubbles. The more other people got excited about Amazon stock, the more likely you were going to join that party and fall prey to Groupthink and FOMO. So the internet forever changed how people would interact with the stock market itself. The Nasdaq would eventually hit its peak around$4 ,700 in March of 2000.

33:44In the 12 months leading up to the peak, the dot-com market went into a fever. Priceline went public at$16 a share and ended the day at$69. iVillage, a women's site without a remote possibility of profit, opened at$24 and soared to$80. Fortunes were made by investors seemingly overnight, investing in the next hot internet IPO. The top-performing IPO of 1999 was Internet Capital, an incubator of business websites. The stock went public in August at $6 a share and closed the year at$170, a 28x increase in just four months. The company was valued at$46 billion and after netting out the cash, the market was assuming that the 47 startup ventures they had investments in were worth, on average, 120 times invested capital.

34:38From 1999 to 2000, investment banks earned$3.9 billion in fees for technology deals, and Credit Suisse alone earned$780 million. Much of this money was made for brokering deals on companies that weren't remotely close to earning a profit, and mainstream investors largely paid the price for it. Instead of them giving the public actual investment opportunities, they were the casino spinning the roulette wheel. In this case, brokers or the house would always win at somebody else's expense. There are many examples in the book, but another example I needed to share was a company called AllAdvantage.

35:16This company recruited and paid millions of people to surf the net. And this was initially funded by venture capitalists who were counting on eventually selling their shares to the public. So AllAdvantage was recruiting all of these members with the hope of being able to leverage those eyeballs and convert them to advertising dollars. The company was started by three recent Stanford graduates and an older entrepreneur. The company even got the attention of President Clinton, who paid a tribute for their inventiveness in the new economy. However, advertisers felt a bit suspicious as their ad dollars weren't going near as far as they expected.

35:52After doing some due diligence on this, they discovered that the majority of clicks on AllAdvantages' website actually came from bots that were programmed to look like web surfers. And AllAdvantage was unwittingly paying for these so-called eyeballs. Credit Suisse was apparently unaware that its clients was in large measure of fraud, although they knew that they were generating ad revenue of just$9 million a quarter, which was tiny considering that they were shooting for a billion-dollar IPO. As I mentioned, Nasdaq peaked around March of 2000. There was no outward signal or obvious trigger that we hit the peak, the market was simply exhausted by the unceasing parade of IPOs.

36:33AOL about perfectly timed the peak. In January of 2000, the preeminent internet company struck a merger with Time Warner, perhaps the preeminent old media company in America. Few people were able to recognize that they were at the top of the bubble, which would serve as a lesson for all of us. Timing the market consistently is next to impossible, so one shouldn't think that they'll be able to time when a market bubble is going to end. As John Maynard Keynes said, the market can remain irrational longer than you can remain solvent. For a bubble to continue to inflate, it requires an ever-increasing level of greed and capital to help fuel it.

37:13If fundamental investors are involved, then fewer and fewer of them will be invested as the bubble inflates, which requires more and more speculators to pile in. And you can't assume that more speculators will continue to join the party as eventually, rationality will take hold. My advice to those that are fairly certain that they're in a highly inflated bubble is to not be overexposed to it as the potential for capital destruction is just significant. I'm reminded of when I was a child, the Wile E. Coyote character that runs off a cliff while chasing the roadrunner, and then for a few seconds, he doesn't fall.

37:49His legs just kept spinning and he appears to be suspended in midair. Only when he looks down and realizes there's nothing supporting him does gravity suddenly kick in and he plummets. This is analogous to the dot com bubble because there was nothing to sustain the high stock prices. If you think about all the speculators that would need to pile into profitless dot com company, when they eventually realize that the party is over, they are just going to dump their shares. They don't care about the potential long-term fundamentals of the business, and there are no greater fools who are willing to buy the shares that they bought a month ago.

38:24In just one month, Yahoo's stock was cut in half, and in mid-April 2000, the NASDAQ plunged by 10 % in a single day. By early 2001, the NASDAQ plunged from nearly$5 ,000 to under$2 ,000. Amazon went from a$37 billion valuation to$5 billion. The dot-com bubble was rooted in the insanity of speculation, but when we look at Enron, it was rooted in deception. But both stories illustrate the issue of distorted incentives in a market culture obsessed with appearances rather than profits. Wall Street in much of corporate America was really never the same after Enron was uncovered as a fraud and filed for bankruptcy in December of 2001, less than a year after they reported revenues of over$100 billion.

39:13So since this impacted financial markets so significantly, I really wanted to cover the story of Enron as well. Loenstein writes, if a single corporation could represent the corruption of shareholder value, it would be one in which the executives were riveted minute by minute on the stock price. The desire for a higher stock would dictate every facet of the company. Its disclosures would be scripted, its accounting would be rigged, its strategies, and even its lines of business would be chosen with buy or sell orders in mind. The executives would be consumed with their company's appearance, and they would enlist a network of well-paid professionals, the accountants, analysts, and even lawyers, to buttress the corporate image.

39:56It would endeavor to shift assets and related liabilities off the balance sheet and away from prying eyes." Enron's history began in the 1980s merger wave where Omaha-based pipeline Anernorth and Houston Natural Gas merged to form Enron. The new entity was led by Kenneth Lay, who would quickly become the fifth highest-paid CEO. Although Lay was very well-paid, he was fairly indifferent to the gritty details that came with being a CEO and an executive. In 1987, he was informed of some dishonest bookkeeping in their lucrative oil trading division, and he decided not to get rid of the culprits in order to try and keep the big profits rolling in.

40:40Enron ultimately lost$150 million at that time, and two traders were convicted of fraud. What's more alarming was that Enron never explained the episode to shareholders in subsequent annual reports. This was an attempt to protect the stock price and their image, which would ultimately be a short-term win, but a long-term loss. One of Kenneth Lay's favorite McKinsey consultants was Jeffrey Skilling, who wasn't too fond of Enron's traditional pipeline business, or really any traditional business, due to their capital intensity. With the gas industry deregulating, Skilling was drawn towards trading, and in 1989, he suggested that Enron established a gas bank.

41:21Lay was drawn into Skilling's ideas to reinvent the company, so he hired him to take charge of their trading division. Trading requires capital, and as Enron continued to grow, they needed access to more and more capital, which they would get through the credit markets. To remedy this issue of continuous capital needs, in 1991, they concocted a series of special-purpose vehicles that were mostly financed with credit, but to legitimize them to outsiders, they did put up a measly 3 % equity stake. Their gas assets were removed from the balance sheet and placed under these SPVs, and this allowed them to borrow more since the gas assets were no longer under its control.

42:04In an attempt to further boost reported earnings per share, Skilling managed to convince regulators to let Enron adopt a mark-to-market method of accounting, which allowed them to record the value of securities at the close of market every day. But some of the assets they owned had values that were entirely subjective, such as the pipelines they owned, and this allowed them to book earnings that were nothing more than projected profits many years into the future. Practically every year, Skilling launched a new plan or new business simply to appeal to Wall Street and appeal to the stock price. One year, it might be gas distribution in Brazil, the next year, Canadian paper mills.

42:47Such diverse ventures reflected his view that expertise was less critical than talent, which is to say that Scaling believed that Enron could fearlessly enter terrain in which it had little or no experience. With its legions of consultants and freshly minted MBAs, it's as though the company wasn't an energy company, but a vast army of consultants. Let's take a quick break and hear from today's sponsors.

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46:47But of course, real entrepreneurs like the Sam Waltons of the world are obsessed with costs. Lohnstein explains what Skilling embraced was not the spirit of entrepreneurship, but the spirit of the stock market. And Skilling was affected by a haughty arrogance. He would embark on these daring adventures like skydiving, as if he were guided by some sort of leadership manual. He urged his employees to join him. His bravado was imitated by many on Inron staff, and judging from the parking lot, Ferraris and Porsches were practically the company car. This level of arrogance led him not tolerating thoughtful disagreement.

47:23He gave latitude to those in his favor and was dismissive to those who doubted him. His black and white pattern of responding reflected his lack of comfort with attention to detail. But Skillings' personality internally apparently wasn't showcased to the public. As in an annual fortune survey, Enron was voted the most innovative company award six years in a row. The Journal of Applied Corporate Finance applauded its genius for transforming energy markets. With Enron growing swiftly, Lay declared that his goal was nothing less than to become the world's greatest energy company. In 1996, Enron's revenues were just one ninth that of ExxonMobil.

48:04Meanwhile, they had made many acquisitions that were ill-timed and unprofitable. These acquisitions left them starved for cash, and its credit rating of BBB Plus had them close to junk bond level. At the end of 1996, Skilling was promoted to the president of Enron, and he worked alongside Andrew Fastow, a 34-year-old vice president of finance, to pull more sophisticated financial hat tricks. They increasingly used special purpose vehicles to finance projects and borrow more money, but Fastow found it pretty inconvenient that these outside entities had to control the assets in order for Enron to report them as separate and off the balance sheet.

48:44So his new solution bordered on diabolical. He decided to create a new vehicle that was separate and independent of Enron, but would be controlled by Fastow personally. This new entity would be known as Chuko, named after a character from Star Wars. Enron's law firm suggested that this was just an obvious conflict of interest that would require public disclosure, which Skilling wanted to avoid. Conflicts of interest were really a common theme in Enron's story. So they decided to structure the partnership with a protege of Fastow, who was a lower-ranking employee, which meant that a disclosure requirement wasn't triggered.

49:23This new entity in 1997 was created, and it immediately bought an interest in a portfolio of Enron's investments, thereby keeping hundreds of millions of dollars off of Enron's books. Fastow then went on to tell the board that this new entity was an unaffiliated vehicle with outside and unrelated investors failing to mention his protege's role. Vinson and Elkins, Enron's law firm, they took care of the paperwork at a mere 48 hours and they wanted to get the deal closed given that Enron was their biggest client and they wanted to continue to get more business from them in the future. But to the lawyers, shareholders were just a mere abstraction.

50:03Yet it was a group that the lawyers were ultimately responsible for because it's actually the shareholders' money that paid their bills. Had they seriously acknowledged the need to look out for shareholders, they may not have been so quick to sign off, and perhaps they would have discovered the troubling facts regarding Chucco. First of all, the outside equity actually didn't exist since Fastow wasn't able to find investors for even the 3 % equity required for Chucco to be considered independent. The entire purchase price of nearly$400 million was borrowed from the banks, and Enron guaranteed both the loans and the portion of the capital that was supposedly equity.

50:42So Enron was able to sell a half interest in an energy portfolio to a paper shell managed by its own employee, and in violation of every accounting standard, they kept hundreds of millions of dollars of unprofitable assets off of its balance sheet. In 1997, Enron reported a net income figure of$105 million, and Chuko accounted for around one-fourth of that figure. By 1998, it was clear that the dot-com rages on. And Skilling, he came across a stock chart that showed how the dot-com names all traded at these elevated PE multiples, while the rest of the market tended to trade at lower multiples, of course.

51:23To no surprise, Skilling came to the conclusion that he wanted to be included with the rest of the dot-com names. Enron decided that their Enron online division would trade broadband, which were the networks that carried internet traffic across the country. and they'd also invest in a fiber network itself and acquire and build a system that would stretch 18 ,000 miles. Skilling figured that online trading, or really online anything, would get Enron's stock really moving. After a good run for the stock in the early 90s, it had modest growth until 1997, so he really needed to create this good story to help kick the stock back into gear.

52:01And Enron's managers had a good reason to try and pump the stock price. In 1998, executives and other employees received 15 million stock options, and in 1999, more than double that amount, an amount equivalent to 5 % of the outstanding shares. In decades past, this would have been an unthinkable level of dilution. Enron itself also participated in the dot-com mania. They had an investment in Rhythm's Net Connections, a startup that went public in April of 1999. It had minuscule revenues and of course, no earnings, but it was yet another blockbuster IPO leading to Enron's investment soaring. They weren't legally able to sell their position until the end of the year, so they were looking for some ways to hedge their clearly speculative position that could fall just as quickly as it rose.

52:51Management's next trick up their sleeve was putting together a partnership with what was referred to LJM and LJM2. I had to look up what this even was. It turns out that LJM stands for Andrew Fastow's family members, and this new entity would buy and sell assets from Enron to ensure that Enron's reported results continue to appear favorable on the surface. In one case, Enron was desperately trying to sell three barges that were generating power off the coast of Nigeria in order to boost their earnings for Q4 in 1999, but no one wanted them. So they contacted Merrill Lynch. They also refused, but Enron verbally promised that if Merrill did the deal, Enron would later unwind it at a profit to Merrill.

53:34So in the final days of December, with no due diligence, Merrill suddenly acquired the barges with Enron providing the financing. And six months later, LSM2 reacquired Merrill's stake at a price that netted Merrill the promised 15 % return. Enron had to pay LJM2 a hefty fee, but as far as the public was concerned, Enron got to record a profit. And the people who were following Enron's reported numbers, they would not have had the slightest idea of the deception that was yet to be uncovered. With Enron getting into the broadband business, Skilling characteristically decided that fiber optic capacity could be traded.

54:14And Kenneth Rice, the head of Enron's broadband unit, he declared publicly that the broadband trading platform would in a few years be worth$22 billion. Wall Street loved the idea of Enron trading a commodity linked to the foundation of the internet. So after a sharp rise in 1999, the stock rose by another 50 % in the first three weeks of 2000. Enron would host a conference at the Four Seasons Hotel on January 20th, 2000 to talk about their stock to the public. And as Enron executives gave their presentations, the stock was rising by the hour. Lowenstein writes, stock analysts who didn't know broadband from baseball kept breaking from the meeting to phone their clients, urging them to buy more Enron, end quote.

55:01That day, Enron's stock rose to$67, a 25 % increase in a single day. The press certainly played their part in fueling the bubble. Fortune declared that Enron had dispelled any doubt about its telecom venture, even though the business was not even off the ground. The stock, of course, continued to rise. When you're in a bubble, investors need some sort of story or narrative to latch on hope to keep the game going and keep that stock price increasing. Shares of Enron then vaulted to$90, and the company was now valued at$70 billion. Now, people love to talk about the dot-com bubble, but I think what's also important to understand and study is the telecom bubble.

55:45And this was also taking place during the same time period. Back in the 90s, as the internet was getting off the ground and gaining more and more traction, internet traffic was doubling roughly every 100 days. That's a 10x increase per year. Now, you can only grow at that pace for so many years before the growth starts to stall out a little bit because eventually you just run out of people. So that level of growth started to slow in 1997. However, the notion of tenfold growth per year, it just refused to die. In September of 2000, WorldCom's internet unit told the Washington Post that internet traffic has been doubling every three months over the past five years.

56:23Because all these companies were throwing out these insane estimates of internet usage, this led to the telecoms hugely overinvesting in their fiber bailout. Companies like WorldCom and Enron, they dove to the ocean floor, laying millions of miles of fiber that, for the most part, would remain dark. The cumulative investment marked the greatest binge in the history of private finance. In the half-decade after deregulation, telecom companies borrowed$1.6 trillion from banks and enlisted Wall Street to sell$600 billion in bonds. There was a huge misalignment of interest as managers of these high-growth sectors were eager to increase investment and make the most of their option grants.

57:08Managers got to capture much of the upside using shareholder capital, on highly risky investments. And the bankers egged them on as they got to collect fees on the capital raised. One of the companies that got caught in this spending binge was Global Crossing, who had invested in a network of 100 ,000 miles of fiber and accumulated$8 billion in liabilities. In June of 2000, the CEO of Global Crossing sent a desperate memo to their chairman, I quote, Like the colored salmon going upriver to spawn, at the end of our journey, our niche is going to die rather than live and prosper. The stock market can be fooled, but not forever, end quote.

57:49Instead of alerting shareholders, Global's executives chose to maintain the false appearance of prosperity for as long as possible, which was a pattern that was just pervasive in the industry. To masquerade the problem, telecom companies utilized a vehicle known as a capacity swap. Carriers began to swap broadband leases for large, identical sums of cash. In the money, it was simply round-tripped. Checks were being sent in both directions with no net effect, but each carrier booked its side of the swap as revenue. Around 20 public companies resorted to swaps, including AOL Time Warner and Enron.

58:25In aggregate, they padded their revenues by an estimated$15 billion. For global, these swaps accounted for more than 20 % of their revenue in virtually all of their cash flow in 2001. Worse yet, auditors of these telecoms not only were fine with the use of these swaps, but they also helped promote the use of them. Despite the concerns internally at Global, their forecasts looked more promising than ever. They promised cash flow growth of 40 % in 2001, while executives sold hundreds of millions of dollars worth of shares. In aggregate, insiders within the telecom industry sold over$8 billion dollars worth of stock in 2000 and 2001, around the peak of euphoria.

59:08Analysts were also bullish on Enron going into 2001. The stock was near an all-time high, and Fortune had recently listed it as one of 10 stocks to own for the decade, as if success was a sure thing. But the more one actually dug into what was happening at Enron, the more red flags one would uncover. For example, the company reported revenues of$100 billion. But much of this revenue was from its broker business where dollars were simply passed from the buyer to the seller, which is of course, extremely generous to consider that revenue. Enron suffered from the same problem that many of the dot-com players did.

59:45They had a lot of traffic, but they had little to no actual, real cash profits. And as the stock was peaking, Enron executives continued to paint a rosy future, claiming that the stock was undervalued, while in aggregate, selling over a billion dollars worth of stock from 1999 to 2001 and collecting bonuses that were based on the high stock price they had orchestrated. A number of executives even borrowed from the companies they worked for, essentially using shareholders' capital as an ATM machine. Kenneth Lay at Enron, for example, pledged his own shares to borrow over$70 million. The last red flag I would highlight is the involvement of auditor Arthur Anderson in helping keep the facade going.

1:00:30Arthur Anderson was central to Enron's climactic undoing. They not only audited Enron's books, but they also served as a consultant to help Enron massage their reported figures. They had around 100 employees working at the Enron headquarters full-time. This represented a disastrous conflict of interest because if the auditors didn't like the direction that Enron was heading, then they risked losing the fees they earned from the consulting side of the business. In the short term, of course, it was in Arthur Anderson's best interest to keep the party going. In 2000 alone, Arthur Anderson collected$52 million in fees for having Enron as a client.

1:01:11But finally, in March of 2001, the skeletons in the closet started to be uncovered. Bethany McLean, a young journalist at Fortune, wrote a probing piece that asked a question that was overlooked by a lot of investors. How exactly did Enron make money? Enron replied that the details were proprietary. For a company with public shareholders, it's not exactly a comforting response. During an earnings call, Enron's executives received questions on their reported results, and Jeffrey Skilling didn't help investors' uneasiness. Richard Grubman, who had been short Enron, he was curious about a line on the balance sheet listed as accumulated other comprehensive income.

1:01:53That was showed on the balance sheet it was a negative$1 billion line item, and he thought that Enron might be using the balance sheet to hide losses. Grubman thought it was suspicious that Enron was the only major financial institution that couldn't produce a balance sheet by the end of the quarter. It was available closer to their deadline. Skilling didn't have a great answer for the investors' questions during their earnings call in the spring of 2001, and this had further exposed the facade that Wall Street had fallen for. Skilling was defensive and inarticulate, and didn't really have answers to the difficult but important questions.

1:02:29In the months that followed, the stock had dropped month after month, and Skilling believed that Enron's image was beyond repair. So he just resigned in August. Enron attributed the resignation as a personal decision, and Kenneth Lay reassured the public that Enron did not have any accounting issues and that they were in the strongest shape they've ever been. Kenneth Lay then received an anonymous letter from an Enron employee sharing their concerns about the future of their employment and that a wave of accounting scandals were potentially about to unfold. In light of the 9-11 terrorist attacks that year in 2001, the stock continued to fall and in mid-October, Enron disclosed a$710 million pre-tax charge resulting from the termination of one of their special purpose vehicles.

1:03:16The market just lost faith in Enron, and they didn't have any reason to believe that more write-offs weren't just around the corner. Kenneth Lay was obviously disappointed in the situation he found himself in, but his colleagues were simply following the playbook that he implicitly gave them from the start, build the stock price, and massage the reported earnings. But as I mentioned earlier, the CEO of the global telecom company Global Crossing stated, the stock market can be fooled, but not forever. The SEC launched an investigation into the special purpose vehicles, and the final domino to crack Enron was the credit agencies downgrading them to one level above junk bonds.

1:03:55In early 2001, the stock traded for$126 and by now had already fallen by 90 % at this point. Credit from the banks was what propped up Enron, and in less than a year, trust in their ability to make good on their promises had evaporated. Shortly after, they got downgraded again to junk bond level, which required them to start repaying billions of dollars of debt, which of course they couldn't do. The stock traded down to just 70 cents and was continuing to fall. In early December, Enron filed for bankruptcy. From the moment Enron admitted to having misstated its books, Wall Street and much of corporate America were never the same.

1:04:37The Enron scandal exposed the unvarnished greed by managers, the conspiratorial neglect by gatekeepers, and the hysterical attention to share prices. And it would be foolish to think that Enron was the only one guilty. Shockingly, Enron paid$55 million in retention bonuses in the month before bankruptcy. And Arthur Anderson had undertaken a concerted effort to hide the truth by shredding loads of papers. The fall of Enron showcased to many average investors that Wall Street can't be trusted and that success in the stock market was based on false promises and rosy forecasts. Many small investors returned to older, cynical views of the stock market that the fat cats would always ultimately trump the little guy.

1:05:23The fact that Enron's executives had pocketed millions while its workers had lost more than a billion dollars in savings was agonizing. So for the first time in a decade, average investors pulled money out of equity mutual funds and rediscovered a love for bonds. By Christmas of 2001, the economy entered a recession for the first time in 11 years, and it was then clear that the reckless optimism from the 90s had been extinguished by the terrorist attacks of 9-11 and the downfall of Enron a few months later. Not too long after Global Crossing followed in Enron's footsteps and also filed for bankruptcy.

1:06:01It was then the SEC's time to make changes to prevent similar catastrophes from occurring in the future. One of the first proposals was to separate auditing from consulting and require that audit partners must rotate every five years to prevent cozy auditor relationships. At the end of July, the Sarbanes-Oxley Act was signed into law, which was the fullest and the most significant tightening of securities laws since the Great Depression. It required CEOs and CFOs to personally certify the accuracy of financial statements and the effectiveness of internal controls, making them legally accountable for fraud.

1:06:39Sarbanes-Oxley zeroed in on issues related to accounting. The adult committee of the board, not the management, had responsibility for appointing the outside auditor and for overseeing the audit. And the SEC also required to create a new board that would oversee public accountants, adding more standards related to auditing, quality control, ethics, etc. Other provisions were drafted with bad actors exactly like Enron in mind. These new laws did not prevent the stock market from continuing to fall, as Lohnstein described 2000 as the year of the locus. 60 telecom companies had failed, new IPOs had come to a standstill, investment in American businesses had plunged, and consumer confidence fell to a 10-year low.

1:07:25From peak to trough, the S &P 500 fell by around 50 % from the spring of 2000 to the fall of 2002, the Dow fell by 40%, and the NASDAQ fell by an astounding 78%. This was the largest slide by a major index since the Great Depression. Around$7 trillion of the public savings had evaporated. Lonstead explains, people demand an explanation for crashes, but their origins are invariably to be found in the boom years that precede them. The collapse of communism at the end of the 1980s and the daunting advances made Silicon Valley throughout the 90s gave a public a heady appetite to invest in shares and ultimately to speculate, end quote.

1:08:09Greed got the best of investors, managers, and Wall Street insiders. With the booms and busts that come with markets, it's inevitable that it will bring a wave of speculators. But what's more disappointing about the dot-com bubble was the abuse to the average investor by corporate and Wall Street insiders, which brought about a widespread distrust of the stock market overall. Events like these highlight the importance of becoming truly knowledgeable about investing, rather than blindly following hype or headlines. As a host here at The Investor's Podcast Network, I'm very passionate about helping increase financial literacy for our listeners and help educate people to build a strong foundation of knowledge so they can really better protect themselves from the market manias and fraud and make investments that are rooted in real value rather than speculation, which is something that is just so prevalent in today's financial landscape.

1:09:04I think it's important to highlight one of the important differences between stocks and a number of other assets. A stock is intangible, meaning that we can't touch it, we can't eat it, we can't live in it. And the price of a stock depends on what the future holds for the underlying business or what the future is perceived to hold. But for a house, people generally purchase a house to live in it. People might purchase a stock believing that they hold share in what will become the greatest company in the world. But no one purchases a house believing that it will someday become a castle. And since stocks can be traded about every single day, this leads to people speculating on where the price of a particular stock is heading, which brings about more bubbles and crashes than what you tend to see in other assets.

1:09:55This would inevitably lead to bad actors taking advantage of the inherent nature of stock prices and their dependency on the perception of the future, such as what happened at Enron. Thankfully, the SEC took action to hold managers more accountable to the information they were sharing with the public and requiring officers to personally sign on the information, which would hopefully lead them to give pause and error on the side of caution. But how we're wired as humans hasn't fundamentally changed since then, so we can use these events from the past as opportunities to hopefully avoid such catastrophes in the future.

1:10:33In light of these disastrous events from the dot-com bubble and crash, I wanted to leave our listeners with a few lessons and reminders. The first lesson is that it's most often new technologies that lead people to drop the timeless investing principles like understanding the value of what you're buying, not falling prey to FOMO, and understanding what you own. The hot technology as of today is, of course, AI, but really this could apply to any new technology. Second relates to the downfall of Enron. A company's downfall can seemingly happen overnight, so you have to do the work early. If the business feels like a black box or management continues to pump the stock while personally selling their shares, then that should give you reason to either dig deeper or just avoid it altogether.

1:11:22Third, be wary of managers using their position in the company solely to enrich themselves. Now, I'm all for managers who actually add value to the firm and are well compensated as a result, but if they're doing what they do just for the money, then they may not be the right person for the job. There's a saying that you're never going to beat somebody who's just obsessed with what they do. When executives are motivated by genuine dedication rather than personal gain, shareholders typically get far better outcomes than when a company is led by someone just trying to get their slice of the pie. Fourth, eventually the market will recognize the true underlying value of an asset.

1:12:04When the value of stocks that are in the next new technology are just quickly rising, it can be tempting to hop along for the ride, even though you know in your gut that these stocks are overvalued. I personally felt this way back in 2021, buying stocks like Shopify, which taught me this lesson the hard way. In order to be successful as an investor, you need to stay disciplined with your process and not get too carried away with the craziness happening around you. Even great ideas can be terrible investments when you pay the wrong price for them. The internet was transformative. Amazon, eBay, and Yahoo, they were onto something big.

1:12:43But extraordinary technologies don't justify infinite valuations. A great company can be a disastrous investment if you overpay. Lastly, I just wanted to share that we should likely be a bit wary of stock options. While they're often framed as aligning managers with shareholders, they can just as easily encourage reckless risk-taking when executives have little to lose but a lot to gain. Options also dilute existing shareholders, and they can create incentives to prioritize short-term increases in the stock price over long-term value creation. In many cases, managers who buy shares with their own money behave far more responsibly than those who simply receive options as a part of their compensation package.

1:13:28So that wraps up today's episode on The Origins of the Crash by Roger Lowenstein. If you'd like to pick up the book, I'll be sure to get that linked in the show notes. It's a great reminder that while the market environment is always changing, human behavior rarely changes. And understanding these past cycles can make us far better investors going forward. So with that, thanks a lot for tuning in, and I hope to see you again next time.

1:14:08is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.