Doug's probably fast asleep just now, so here's an interesting piece he
posted on his list the other day. I'd be interested in Thaxist views on
[From the bear's den at <http://www.LeMetropoleCafe.com>]
Frank Veneroso - Veneroso Associates - November 19, 1999
The US Economy: The Stock Market
Shades of the Souk al Manakh
Is This the Moral Hazard Meltup? Probably Not.
* Valuations in the high tech sector are unprecedented. So is
the degree of speculation, despite serious underlying deterioration
in the sector's fundamentals. Nothing in the history of the G-10
stock markets can compare---not even Japan. Nothing except the
greatest bubble of them all---the Souk al Manakh.
* Global semiconductor revenues peaked in 1995. Even with a
good bounce this year, they will be below 1995's level.
* Two and half years ago global PC revenues began to stagnate
despite advance purchases to meet Y2K compliance. All the consulting
firms predict a nuclear winter with down revenues in 2000.
* Fred Hickey looked at 130 interent companies that reported in
October. Of these 130, ten reported a profit. Two---AOL and
Yahoo---reported a material profit. Of the eight remaining internet
companies with reported profits, profits were only marginal. Of the
110 companies that reported losses, revenue growth was very rapid,
averaging 100% over the last year. But, of the greatest importance,
on average losses for these companies grew by 200%. The number of
companies where losses are simply soaring relative to revenues is
* Part of this is due to sheer speculation by uninformed
household investors who extrapolate a once in a lifetime bubble in
stock prices forward forever. This is reinforced by a new era hype
fostered by Wall Street, the media, and that ever-loquacious new era
apostle, Alan Greenspan. But much of it is due to cynical relative
performance money managers who feel compelled to go where the action
is for, if they do not, they will lose performance and their jobs.
* The peak of every such bubble is marked by stock fraud. The
internet stock craze is perhaps the greatest stock fraud in history.
Most of these companies have been hatched simply as objects of stock
market speculation with the intention of bilking the public through
* Many, if not most, of the institutional money managers that
are kiting these high tech marginals light years from reality know
there is no defensible investment case for their holdings. They know
they are involved in a stock scam.
* One of these days one or several of the current ubiquitous
internet stock scams will come definitively to light. Then, fund
managers, realizing they have no justification as fiduciaries for
owning such stocks, will fear suit and will try to sell. Others,
realizing their trustees and shareholders are beholden to explore
similar actions, will try to sell as well. Under such conditions,
there may be no bids. Hear it from someone who witnessed it first
hand: that is the way the Souk ended---with no bids.
The Fed tightened. That was largely, but not completely, anticipated.
The Fed raised the discount rate. It issued a warning that the labor
force is depleting and the economy continues to grow unsustainably
above trend. These were not expected. The bond market was supposed to
like such stern Fed resolve. Instead it sold off a half point.
But the stock market proved to be another thing. The Dow rose 173
points. The Nasdaq, which had been up for 10 out of 12 days after
making a new high, soared another 73 points. Perhaps 20 stocks, most
of whom you had not heard of a year ago, rose more than 20 points.
One stock rose 1000 % in a day. Its name was China Prosperity. We
understand it is Hong Kong-China maker of toilet paper. It rose from
a dollar to ten dollars because of the news that China will be
admitted into the WTO. Today it rose further to 81. Today, 2.9
million shares traded by noon. Yesterday 521,000 shares traded. From
October 19th through November 12, daily trading volume averaged 300
shares a day.
People ask us, "Is this the moral hazard meltup?" We have
hypothesized that an unprecedentedly overvalued market amid rising
interest rates, serious fundamental deterioration at its rotten
heart---high tech, and record deterioration in breadth would be
subject to incipient crashes. If government moved to bail out the
stock market at all costs at such a juncture, it would become
apparent to all market participants that the stock market is too big
to fail. A seller's strike would ensue and the market would melt up.
That has sort of, but not quite, happened. The Dow fell 13% when it
broke 10,000 on an intra day basis the Friday before the anniversary
of the Monday October 1987 stock market crash. Over the prior week
the market had entered a crash pattern. Market breadth was atrocious.
The parallels were eerie. Yet, the market mysteriously rebounded for
no apparent reason.
Chairman Greenspan gave a series of speeches extolling a new high
tech era. The guys and gals on CNBC now frequently mention that the
market is too important to fail. Despite the Fed tightening, more and
more commentators point to a record 20% annual rate of expansion in
the monetary base, albeit mostly related to a Y2K provision of
currency, as a true measure of a Fed policy that will not let
anything go wrong through the millenium date.
What we know is that valuations in the high tech sector are
unprecedented. So is the degree of speculation, despite serious
underlying deterioration in the sector's fundamentals. Nothing in the
history of the G-10 stock markets can compare---not even Japan.
Nothing except the greatest bubble of them all---the Souk al Manakh.
High Tech---the Hardware Sector
We turned bearish on the hardware high tech sector years ago. Our
decision seems laughable now. Why did we do so? The answer is simple.
For three decades global revenues from computers and their components
and peripherals grew at perhaps a 20% rate with an annual growth rate
of 40% at cyclical peaks, roughly a zero growth rate at troughs, and
a four-year average periodicity. The prices of the stocks in this
group moved with this cycle. In the mid 1990's peak 40% annual
revenue growth lasted two to three years versus one year in prior
cycles. Excesses developed. A downturn comparable to past down cycles
could be foreseen. History indicated that the stocks would follow
What in fact transpired was worse than we ever expected. Global
semiconductor revenues peaked in 1995. They fell for three years.
Even with a good bounce this year, they will be below 1995's level.
Yet, the Sox index peaked at 300 back then and is approaching 700
Two and half years ago global PC revenues peaked. The stodgier
mainframe sector has continued to grow, but at a single digit rate.
Such a slowdown has no precedent. Worse yet, revenues were bolstered
late in this period by a surge in purchases needed to meet Y2K
compliance. Some computer purchases scheduled for the year 2000 and
beyond were made in advance in 1999 and 1998. Now that tomorrow's
computer needs have been met, all the consulting firms predict a
nuclear winter with declining industry revenues next year. Forrester
Research predicts no growth for several years. Disappointing reports
are now coming out of IBM, Hewlett Packard, Unisys, and even Dell, as
well as all the PC distributors, suggesting nuclear winter in fact
began in the third quarter. There is very considerable evidence that
this whole industry on a global basis may exhibit no revenue growth
for a half decade from early 1997 to 2001 or 2002. Yet, the stocks of
the most seriously affected companies, now at record valuations, only
go sideways. The least affected companies soar.
The disappointments are everywhere. Oracle, once a 40% grower,
reports year-over-year revenue growth of only 13%. Yet the stock
soars. Cisco's guidance calls for only a 3% sequential rise in
revenue in the fourth quarter and a decline in earnings. The stock
rises. Intel has disappointed once again. It has been disappointing
for years. In Q1 1997 it earned $.55 a share. In Q3 1999 it
disappointed, reporting $.55 a share two and a half years later. AMD
is shipping 750-megahertz chips. Intel can not meet shipments of test
quantities of 700 and 733 meg chips. The big PC vendors must have the
top of the line chips, since that is where the big profit margins
lie. Via, with Formosa Plastics and the Taiwanese government behind
it, has licensed low-end chip designs from Cyrix and IDTI, and plans
big inroads next year into the low end of the microprocessor market.
Add to this nuclear winter. Yet Intel's stock holds. Even Microsoft
suffers. According to Goldman's Rick Sherlund, Microsoft took
"unearned revenues" down in Q3 1999 for the first time, inflating
year-over-year revenue growth which was, in reality, 19%, not 28%, as
reported. The US judge ruled against them in the monopoly trial. CNBC
commentators argued that they would win in an appeal, but the expert
legal commentary in the newspapers indicated such rulings are seldom
overturned. Suits from allegedly damaged companies wait in the wings.
Before the judge's ruling, Microsoft management said its stock was
absurdly overvalued. Yet, the stock remains unfazed.
The Manic Fringe
Such disappointments do not matter, argue the high tech bulls. This
is the old high tech. The growth is in the new high tech. Of course,
the top six tech stocks ranked by market cap which account for well
in excess of 10% of the entire market cap are all driven primarily by
old tech, not new tech.
More than two years ago when the PC slowdown started, Wall Street
bulls focused on networking and servers as the new source of unending
rapid growth. Yet, now, as the fundamental disappointments surface,
they are to be found in networking and servers as well as in straight
PCs and mainframes. Maturation, saturation, competition, and Y2K
appear to be affecting virtually almost all hardware businesses.
Apparently software is also affected---witness the slowdown in real
revenue growth at Oracle and Microsoft. Even the service business has
been hit with disappointments at Unisys and IBM.
Faced with these problems, the high tech bulls have turned to the
Internet sector. More than a year ago we argued that, though the
internet was a significant technological revolution, most stand-alone
internet companies would never make a profit (There Are No Ricardian
Rents In Cyberspace, 10/14/98). Our argument was simple.
Technological innovations provide the innovators with transitory
monopoly positions and therefore transitory monopoly rents.
Therefore, technology companies at the frontier should earn large
profits early on. But, almost all internet companies were in fact
losing money. Why? Because there was too much ease of entry and
subsequent competition to allow lucrative franchises to be
established on the Net. The flood of IPO money aggravated such
competitive pressure. It also corrupted business discipline, which
could only lead to greater losses.
A case in point was Amazon.com. This early pioneer in Internet
marketing had as good a chance as any to earn a profit. It was there
first and early. Barnes and Noble and Bertelsman and Borders were
slow to compete. It was perhaps the best know brand name on the Net.
Yet, losses grew more rapidly than revenues. In order to earn a
profit, they entered more and more new businesses. Losses continued
to explode. The company soon appeared to be "out of control".
>From all we can tell, our analysis of the internet industry has been
right on target. Take Amazon. Sequential quarter-to-quarter revenue
growth fell to roughly 10% on average in Q2 and Q3, despite entry
into numerous new businesses. Apparently, their book sales have
plateaued, as saturation and competition in a low growth business
have materialized. Now, if ever, they should be making a profit.
Instead, their loss in Q3 was more than half their sales.
Year-over-year revenues rose 1.3 fold . But their loss rose 4.4 fold.
They must be burning cash at a $300 million rate. They raised $1.5
billion early this year before underwriter's fees. That is not much
greater than their current annual burn rate. In their Q3 report,
gross margins fell and they forecast yet another decline in gross
margins. The state of this alleged Internet blue chip is simply
horrendous. With $1.5 billion in convertible debt, if the stock
falls, whatever its assets, those assets will belong to the debt
holders and there will be nothing for the shareholders. This stock
could readily go to ZERO, yet the overall Internet craze buoys the
Amazon is no exception. Fred Hickey looked at 130 interent companies
that reported in October. Of these 130, ten reported a profit.
Two---AOL and Yahoo---reported a material profit. One must wonder how
real are the profits at AOL and Yahoo. AOL capitalized marketing
expense for five years and showed a profit. It then wrote off its
capitalized marketing expense; the write off exceeded its cumulative
reported prior five-year profit by fivefold. Employee compensation
via options is never expensed. Yahoo's current P&L benefits from past
write-offs of future advertising expense. There are growing reports
of ever more liberal accounting practices at internet companies which
AOL and Yahoo must share.
More importantly, of the eight remaining internet companies with
reported profits, profits are only marginal. In many cases, profits
were buoyed by interest expense earned on cash from IPO's, not from
their basic business. Of the 110 companies that reported losses,
revenue growth was very rapid, averaging 100% over the last year.
But, of the greatest importance, on average losses for these
companies grew by 200%.
The number of companies where losses are simply soaring relative to
revenues is astonishing. For the internet analysts, this does not
matter. Loss growth is good, because it shows the company is
"executing". The list of spectacular such "growers" is endless.
The Street.com, a pioneer internet investment rag with great early
exposure on CNBC and a booming high tech stock market, should be
making a profit if anyone in this market is. Yet, while sales rose
from $1.1 million to $3.9 million, loses rose from $3.2 million to
$7.2 million. The company fired its CEO and the new CEO faces rapidly
For I Village, sales rose from $4.0 million to $10.7 million quarter
to quarter and losses rose from $12.0 million to $28.4 million. Other
issues exhibit yet more stellar growth in losses. The Globe.com, the
greatest performing new issue ever, reported quarter to quarter
revenue growth from $1.6 million to $4.7 million and a growth in
losses from $4.0 million to $14.0 million. Better yet is Mortgage.com
with revenue growth from $2.0 million to $5.0 million and loss growth
from $1.3 million to $22.6 million
Investors are kiting these stocks light years from their grim
realities. Investor behavior regarding individual issues defies all
logic. Take Peapod, the internet grocer. Year-over- year the stock's
revenues barely grew from $15 million to $16 million. By contrast,
their loss exploded from $4 million to $10 million. A competitor,
Webvan, had an IPO. The market ran Peapod's stock up 40% in a day in
sympathy with an IPO from a competitor. Peapod then announced that
they were burning cash so fast they would run out of money in several
Stock market breadth has been eroding for over a year and a half.
Even though the Dow and S&P are roughly at their highs and the Nasdaq
is in all time new high ground, the A/D ratio remains just off its
lows. Even the big cap high tech favorites cannot buck their adverse
fundamentals; more often than not they are still in rounding top
formations. All the money in the market is funneling into one narrow
group of stock whose fundamentals are virtually non-existent.
Part of this is due to sheer speculation by uninformed household
investors who extrapolate a once in a lifetime bubble in stock prices
forward forever. This is reinforced by a new era hype fostered by
Wall Street, the media, and that ever-loquacious new era apostle,
Alan Greenspan. But much of it is due to cynical relative performance
money managers who feel compelled to go where the action is for, if
they do not, they will lose performance and their jobs. We have seen
in other markets how such herding behavior ends. We quote from a
piece we wrote last fall (The Apogee of the Pendulum, Nov. 1, 1998).
Now, above all, money managers are in the business of maximizing
fees, and fee income is a function of the quantity of money under
management. If households have adaptive expectations behavior
regarding returns earned by investment managers, short-term
performance results will determine assets under management and fee
income. It is a fact that the best long-term investments are often
anything but the best performing issues in the short run. This is
especially true in speculative markets when extrapolative or adaptive
expectations behavior regarding future returns become predominant and
drive asset prices ever further from long run equilibrium. Then
speculative dynamics with their short-term self-fulfilling positive
feedback loops begin to flourish. Under such conditions, managers who
focus on long term fundamentals lose clients when short run
speculative dynamics diverge from long run fundamental trends. Under
such conditions, momentum oriented managers with skills as trend
following traders attract funds. Gradually, in a process of Darwinian
selection, investment managers mirror the adaptive extrapolative
behavior (laced with a good bit of greed) of the uninformed
households who entrust them with their money. The incentive structure
of money management turns fiduciaries into bandwagon speculators.
Bandwagon money managers generally care little for long term
fundamentals. Tulip bulbs are as good a trade as any, as long as
everyone else wants to buy them. George Soros, the most celebrated
investment manager of our time, has stated clearly again and again
the rationale behind bandwagon management. According to Soros,
markets are always in error; they are always in disequilibrium. The
path to riches is to recognize these market errors early, jump on
board to enjoy the meat of the move, and then jump off before they
come a cropper.
Bandwagon management is for a time self-fulfilling. When everyone
wishes to jump aboard a bandwagon, the object of the speculation
continues to move further and further from its equilibrium. During a
period dominated by bandwagon speculation, all other approaches to
investing become discredited. Investors who look to long term
fundamentals to buy assets cheap suffer losses as they become
absurdly cheap. Timing becomes everything and the investor rooted in
time tested parameters of fundamental value is always too early,
often disastrously so.
Bandwagon management drives prices in markets ever further from their
long run equilibria. In the end, however, relative prices matter.
Prices in deep disequilibria set into motion economic processes that
act to drive prices back to their long run equilibria. The
self-fulfilling success of bandwagon speculation drives the maximum
number of market participants into markets at their extreme, and at
that point they are positioned against an array of fundamental forces
now acting against them. In the recent apogee of high performance
hedge fund investing, the bandwagon managers attracted so much money
and employed so much leverage that their positions became too large
for their markets. When they wanted to sell, not only were
fundamental market forces arrayed against them---they could not
arrange to execute their sale. There was no liquidity. And when they
were forced to sell, the markets moved in a discontinuous manner
against them. Hedge funds and proprietary traders owned most of
Russia's securities. Unwinding carry trades in the yen, a hugely
liquid market, led to the largest two day discontinuous price move of
any major floating G7 currency.
The end of the unwinding of bandwagon trades has not yet arrived.
There are still bandwagons waiting to come unwound. Most notable is
the US stock market with its huge public participation and its vast
supportive industry of "herding" money managers.
We have argued, there are no Ricardian rents in cyberspace. The
experience of the entire interent group over the last two years
provides endless evidence we are correct. There is no sign that, with
corporate maturity, comes profit. Let us put it bluntly: the US stock
market is the greatest stock market bubble in G-10 history. The high
tech subsector is the most absurd stock market bubble except for the
greatest bubble of them all---the Middle East's Souk al Manakh. The
peak of every such bubble is marked by stock fraud. The internet
stock craze is perhaps the greatest stock fraud in history. Most of
these companies have been hatched simply as objects of stock market
speculation with the intention of bilking the public through IPO's .
Never have so many instant billionaires been created, let alone on
companies that have perhaps no hope for a profit. One company,
Sycamore Networks, has sales of $11 billion through October, losses
of $21 billion, and one customer---and it just went public with an
immediate market cap of $25 billion. Such stories are endless. You
can be assured that the greatest criminal minds in the nation are
pursuing this mass stock scam. Not only will many, if not most, of
these fledgling high tech companies never show a profit; many of them
will turn out to be outright deliberate frauds. We can expect in the
future that internet moguls, faced with the inevitable demise of
their non-viable businesses, will seize the company kitty and head
for asylum abroad, Vesco-style.
Many, if not most, of the institutional money managers that are
kiting these high tech marginals light years from reality know there
is no defensible investment case for their holdings. They know they
are involved in a stock scam. Britain's largest pension manager,
Mercury Asset Management, has just been sued for 100 million pounds
by the Unilever Corporation in a suit alleging negligence in the
management of its money because of underperformance. The Surrey
Council Pension Fund and the Saintsbury Pension Fund in Britain are
considering whether they should follow Unilever on the grounds that
their trustees are under a fiduciary duty to explore similar actions
should the Unilever legal action succeed. One of these days one or
several of the current ubiquitous internet stock scams will come
definitively to light. Then, fund managers, realizing they have no
justification as fiduciaries for owning such stocks, will fear suit
and will try to sell. Others, realizing their trustees and
shareholders are beholden to explore similar actions, will try to
sell as well. Under such conditions, there may be no bids. Hear it
from someone who witnessed it first hand: that is the way the Souk
ended---with no bids.
There are elements that may make for a full-fledged moral hazard
meltup in today's market, but a conviction that the market is too big
to fail is not yet widespread enough. That may come later, after
another and more shattering stock swoon. We do not buy the hypothesis
that stocks are rising because the Fed is pouring fuel on the fire.
The explosion in the monetary base reflects a special provision of
currency and reserves through the millenium date. The monetary
aggregates and credit, not the monetary base, drive portfolios, and
these, though rapidly growing, have not accelerated. What we are
seeing is unbridled speculation of an old fashioned variety taken to
a new extreme by a Wall Street gone Madison Avenue, a media that
finds the stock market plays better than the Super Bowl, and a Fed
Chairman whose behavior has departed from that of prior central bank
governors at any time and anywhere to cheerlead on a new era market
mania. The case of China Prosperity---the Chinese toilet tissue
company---tells us a lot about the type of dynamics that are driving
the unprecedented speculation in the high tech sector. Now that the
Fed has tightened, all market participants feel free to speculate
without fear through the millenium date. Maybe we will keep melting
up, but, with everyone on one side of the boat, we could just as
easily fail again. The real moral hazard meltup, if it ever happens,
is probably an iteration or two away. ¨
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