Needles and Pinsa
dowjones.com
Pins And Needles: What Catalyst Can
Deflate Stocks?
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
How will you know the end is near?
Assume for now that the craze for technology stocks is indeed a bubble.
The urgent task for investors is obvious: Spot the pin that pricks it, then sell.
If only it were that simple.
A look through recent stock-market history reveals many manias that drove
stocks well beyond reasonable valuations, from conglomerates in the late
1960s to biotech in the early 1990s. Sometimes broad economic factors,
such as interest rates, brought down the curtain, sometimes bad news from
one of the market's favorite companies, sometimes both.
Unfortunately, both bubble and pin are usually apparent only after the fact.
Many leading market watchers argue that there is no bubble in the market.
Technology companies' extraordinary valuations are justified by their
unprecedented growth and the rush of technological advance, they argue.
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Bears thought the tech-dominated Nasdaq Composite Index had received
its comeuppance many times in the past three years, most recently the
heart-stopping 12% plunge between its record close of 5048.62 two weeks
ago today and intraday low six days later. False alarm: The Nasdaq has
already retraced much of those losses, to stand at 4963.03.
"We're all looking for the catalyst," says Merrill Lynch senior investment
adviser Robert Farrell, who has been analyzing market behavior since the
1960s. "Most of the time we only recognize it by hindsight, except for some
very brilliant people. You only know that the market eventually gets itself
susceptible to change when it gets extremely extended in one direction."
Consider the landscape in 1973. To some, it looked as if a bear market had
begun as the Federal Reserve raised rates and the Dow Jones Industrial
Average slid 19% between January and August. Yet many of the "Nifty
Fifty" stocks whose heady valuations had long defied skeptics like Mr.
Farrell continued to hold up. And further defying skeptics, the Dow roared
back and by early October was just 7% from its January high. Then, war
broke out in the Middle East. It would, Mr. Farrell wrote to clients, give
"the market its first test since the high volume advance began three weeks
ago. Uncertainty such as the Arab-Israeli conflict cannot be ignored but
neither should it be an important determinant of the underlying trends."
In hindsight, the October war in the Middle East and resulting Arab oil
embargo were key catalysts of what remains the deepest bear market since
the 1930s, ultimately taking the Dow down 45%. The leaders of the Nifty
Fifty, like Polaroid and Avon Products, suffered far more, ultimately losing
more than 80% of their peak values.
Mr. Farrell sees many warning signs today, in particular the rush of money
into a narrowing selection of market leaders, in this case companies such as
Cisco Systems and Sun Microsystems, while the average stock slumps. In
1973, "the oil embargo ... was the defining event that put the Nifty Fifty out
of the game, but most stocks had been declining since 1968 or 1969."
Jeremy Siegel, a finance professor at the University of Pennsylvania's
Wharton School and author of "Stocks for the Long Run," says by definition
no one agrees on the signals that bring a boom to an end, or the signals
wouldn't work. But both boom and bust result from the market environment
itself, and when the environment is right, almost anything can start the
process. One example was the seemingly innocuous announcement by
President Clinton and British Prime Minister Tony Blair on March 14 that
gene data should be free. Biotechnology stocks, already under pressure
because of some company-specific disappointments, plunged 13% that day.
"Two months ago, Clinton speaking about biotech wouldn't have had any
effect at all because everyone was so optimistic,"says Prof. Siegel. "The
truth is a lot of big moves aren't accompanied by a big reason. If the market
is in the mood for correcting, you can blame it on any news event."
Robert Shiller, a Yale economics professor, in his new book "Irrational
Exuberance," offers a laundry list of things that could interrupt the blissful
backdrop now driving stocks higher. They range from a resurgent labor
movement or an oil crisis to class-action lawsuits or an unstoppable
computer virus. "The list can never be complete," he notes.
Prof. Shiller's book owes its title to Federal Reserve Chairman Alan
Greenspan's famous warning about stock values in late 1996. The Fed
chairman has remained worried as stocks sailed higher since then, but his
warnings and rate rises have done little to shake confidence.
Edward Kerschner, chief investment strategist of PaineWebber, thinks the
overall market, including most of the biggest tech stocks, are reasonably
valued. But he thinks the craze for profitless Internet infrastructure and
business-to-business companies, like Akamai Technologies and Ariba,
resembles previous periods when investors concluded traditional valuation
doesn't matter -- to their regret.
For example, Mr. Kerschner says, leveraged buyouts in the 1980s began as
a sensible way to restructure companies whose private, breakup value
exceeded their stock-market value. But by July 1987, everything seemed in
play, from Texaco and American Express to Gillette, and many poor
candidates were being bought out at sky-high prices. The craze survived
and even grew after the October 1987 crash.
The real end came in 1989. Peter J. Solomon, then head of mergers and
acquisitions at Lehman Brothers and now head of his own investment
banking advisory firm, says the curtain began to drop with the leveraged
buyout of Ohio Mattress Co. (now Sealy Corp.). The company that took it
private in March failed five months later to refinance a bridge loan by selling
junk bonds, one of the first victims of the collapsing junk-bond market. "It
was a disaster," he recalls.
The coup de grace was the failed attempt to buy out UAL Corp., which
spurred the 6.9% "minicrash" in the Dow industrials on Oct. 13, 1989.
From its peak, UAL fell 70%, notes Mr. Kerschner.
In the 1960s, Wall Street was in love with conglomerates as a new
generation of business managers convinced investors they could put
unrelated businesses together and create a more profitable, synergistic
enterprise. Burton Malkiel, author of "A Random Walk Down Wall Street,"
says most of the supposed benefits were in fact accounting legerdemain.
The beginning of the end, he writes, came on Jan. 19, 1968, when Litton
Industries announced profit would be much less than expected.
Conglomerate stocks quickly fell 40%. At their 1969 lows, Litton's stock
was off 54% from its 1967 high, Teledyne's 60% and A-T-O's 85%.
The 1970s ended with a mania for energy stocks as experts predicted oil
would top $80 a barrel. After that mania broke, energy-service stars
Schlumberger fell 64% and Halliburton 75%.
While a disappointment from a leading company is often the catalyst for a
bursting bubble, the problem for investors is knowing which one. The
1991-92 biotech bubble came crashing to a halt in early 1992 with some
spectacular stock drops, most notably that of market darling Centocor,
which fell 82% in early 1992 amid regulatory obstacles to some of its drugs.
But there had already been false alarms. In November, Immune Response
was sliced in half, taking much of the sector with it as well as the Nasdaq
composite, after encountering a setback to the AIDS vaccine it was
developing. The sector bounced back to make new highs later that year.
Internet stocks have already had numerous high-profile slides since the
boom began with Netscape's initial public offering in 1995, including a
plunge for Netscape itself. Investors have rotated through browsers,
Internet-service providers, portals, and business-to-consumer companies,
only to move on to a new sector, often leaving broken stocks in their wake.
Along the way bellwether America Online (which eventually bought
Netscape) has lost half or close to half its value on at least three separate
occasions; it returned to new highs after the first two, and may do so again.
Indeed, this may be proof that Internet stocks have staying power, and
aren't simply a bubble.
The surge in rapid-fire trading by individual investors, often using borrowed
money, has produced wild swings in stocks and could make the end to the
boom -- should it come -- faster and more steep. On the other hand,
investors' ingrained habit of buying every dip suggests any such sell-off
could unfold gradually, over several years.
A Merrill Lynch survey of 251 global mutual-fund managers two weeks ago
found that most have a greater-than-market weighting of technology, media
and telecom stocks, most think they are overvalued, and most are looking
for a company-specific event as the signal to sell. But Merrill strategist
Trevor Greetham warns that the stocks "did not rise on a
company-by-company basis. They rose en masse. We think
macroeconomic factors will drive the reversal when it comes."
Mr. Kerschner says, "Don't look for when it starts to fall apart. The right
reason to get out is when there's no fundamental reason to own the stocks."
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