"Risk averse" buy & hold strategy may fail
"Yet those profoundly beneficial forces driving the American economy to competitive excellence are also engendering a set of imbalances that, unless contained, threaten our continuing prosperity. "
Alan Greenspan, recent Humphrey-Hawkins Testimony
"You have to... know when to walk away, know when to run."
Kenny Rogers – from the song, The Gambler
There was once a time when it took all of a broker’s energy to persuade clients to sell their AMBAC insured paper to take a flier on a AA state general obligation credit. Now, it’s likely those same brokers are trying to talk those same clients out of putting all of their retirement money into JDS Uniphase.
And why not? Stocks are rocketing all around them, duly reported upon by CNBC, and with assurances by Wall Street strategists that there are more good times to come. Clients who own a 10-bagger want another. Those who don’t are asking why.
What millions of new investors (and increasing numbers of old ones) don’t understand is that today’s market is not the norm. Those entering the market today finally have the proof they need that stocks are pretty good investments, so they expect a repeat performance.
So for brokers struggling with the retiree intent on opening an options account, here’s more ammunition on why reducing equity exposure would be a more prudent alternative. .
There are times when buy and hold doesn’t work. Not often, but a few times a century stocks become so inflated they provide terrible returns for years to come. For example, despite a number of mini-bull markets following the 1901 market peak, stocks closed 20% lower 20 years later. The S&P 500 was lower in 1954 than in 1929, and lower in 1982 than in 1972. Despite the recovery in Japanese stocks, the Nikkei remains about 50% below its peak of a decade ago.
Sure, investors who were not forced to sell U.S. stocks in 1921, 1952 or 1981 eventually did well. But how long is long term? Will fear, medical expenses or tuition payments force today’s investors to sell at the bottom?
The idea that it may take a decade or more for stocks to return to these levels will sound shocking to many of today’s investors. However, it’s in their best interest to shock them because it's happened in the past, and more likely than ever to happen again with the market selling at the highest level in history.
Stocks are expensive by any historical measure. You would think this argument would resonate with those thrifty clients, but there’s nothing like a mania to turn the law of supply and demand on its head. As a result, the same client who believe a dollar is an outrageous price for a loaf of bread may ask you to average up in Qualcomm. To put today’s valuations in perspective, consider that the S&P 500 is so expensive that it would have to drop 30% just to reach its 1987 PE before the 1987 stock market crash. More on the Nasdaq later.
Laggard" does not equal "bargain." Despite the Dow’s miserable recent performance, most Dow stocks are not cheap. Nonetheless, every time the Dow is down triple digits, CNBC lassos a portfolio manager who is astonished that Home Depot is 20% off its high. The fact is, a number of Dow stocks remain high priced. Despite its troubles, Coke still sells for 30x next year’s earnings estimate. Proctor & Gamble, after taking it on the chin for months, still manages a PE of 27x. And no giant finance company, even one called GE, is a bargain at 35x earnings. Yes, some Dow stocks are hitting the value investor’s radar screen. But to argue that American Express or Disney are selling at Wal-Mart prices (the store, not the stock) is wishful thinking.
The Internet/tech stock mania will end. The Internet fad has moved from ISPs, to "push technology" to content providers, to e-commerce. These concepts have disappointed, so now "B2B" is the place to be. We have long argued that the business models of many dot-coms, simply do not work. It is only the promise of the latest "new thing" that keeps the IPO after-market popping. Many, many firms are solvent only because they can raise operating money in the equity markets. The problem is so severe that long-time technology bull Kenneth Fischer of Forbes magazine said he expects 140 high tech companies to run out of cash within twelve months. It’s easy to see why he is concerned. Here is a (virtually) random sample of once-hot Internet IPOs:
Audio Highway, a very hot stock in 1998, allows users to download music from the Internet. The company spent $10 million on operations and expenditures the first nine months of last year. Despite a $13 million secondary offering, the company has just $16 million in cash to spare. How long will the market continue to pony up at this burn rate?
Earthweb, a business to business Internet company, used $13 million for operations and investment through September of 1999. That left only $29 million on the balance sheet.
At year-end, on-line grocery retailer Peapod had about enough cash to make it through the first half of 2000. Revenues exploded in the latest quarter, but losses widened. For now, the company plans to continue operating with help from a convertible preferred.
Amazon.com, of course, is the grand daddy of all cash burners. Investors have exhibited saint-like patience with Amazon.com (at least until recently), content to give the company a dollar today for a return tomorrow. But do investors know that the company plowed through $122 million in cash flow from operations in only nine months last year? No wonder, that despite their $1.3 billion debt deal in 1999, the company decided to float a huge Eurodollar deal this year.
No doubt, the IPO market continues to fund new gimmicks, but the after-market seems quicker to punish as well. That’s one reason I think time is running out for companies that depend on the market to fund their operations. This is not good news for healthy tech companies either. Many small tech companies are big tech customers. In fact, monster companies like Lucent and Motorola often provide long term financing arrangements for their upstart customers. When reality hits the profitless tech stocks, their healthy, but overpriced brethren will go down with them.
Mania sectors under perform in the subsequent bear market. In 1972, investors bid up the "Nifty Fifty" stocks to extreme valuations with the idea that those 50 companies were a bargain at any price. In reality, the flood of money into these favorites was an indication the market was topping. In the ensuring bear market, the high quality, but expensive Nifty Fifty lost 57% of its value compared to 43% for the S&P 500. Many of the most expensive Nifties fell more than 70%.
Big cap "growth" stocks had performed so well in recent years that last year, Barron’s selected a new Nifty Fifty from the largest stocks in the S&P 500. At the time, the new Nifty was trading at an average of 50x trailing earnings vs. 42x for the 1972 version. Within the last year, however, the market has narrowed further, rewarding tech companies at the expense of blue chip favorites. Of the 48 companies christened as Nifty a year ago that remain independent, 26 now trade at lower prices. Among the 22 trading higher, 11 are technology names, and many of those are up more than 100%.
It should be no surprise, then, that today’s market favorites are even more prized than the blue chips of the early 1970s. Back then, the top 20% of the S&P 500 companies sold for 3 times the overall market’s valuation. Today the top 20% sell for 4.8 times the PE of the remainder.
Even "real companies" get creamed in bear markets. The table below illustrates some of the fallout from the Nifty-Fifty mania. Despite strong revenue growth, the over-hyped stocks fell off a cliff.
Year over Year
Company Sales growth Stock performance
Coca Cola +34% -70%
GE +31 -60
GM +3 -66
Pepsi +48 -67
Phillip Morris +34 -50
Walt Disney +30 -85
And don’t forget RCA, or "Radio" as it was known in the 1920s. The company was a dominant player in a new, high growth industry. Despite its well-executed strategy, it took investors who bought Radio at the peak, thirty years to get their money back.
It’s unlikely the next ten years will be as kind to stocks as the last twenty. The 1990s were the best decade for stocks in 200 years. Throw in the 1980s, and you have the only back-to-back decades in history with double-digit stock market returns.
High tech favorites may be the most inflated stocks of all time. The Nasdaq Composite sells for about 150x earnings while sporting a return on equity of just over 4%. The stocks in the Nasdaq 100 boast an return on equity of 10% and sell at 111x earnings. Not only is that a lot of hope piled upon little performance, the Nasdaq 100 sells for almost four times the PE of the S&P 500. By comparison, at the peak of the 1983 electronics mania, the Value Line electronics industry was only 1.65 the price of the general market. .
High tech stocks have moved so far so fast, that the Nasdaq’s market cap has almost tripled in two years. But while the tech stocks are priced for the forever, is it possible for companies in the fast-paced technology industry to meet expectations? One economic consulting firm figured AOL would have to generate earnings growth of 39% a year for 20 years to justify its stock price. Can that happen? We think not, since it already controls about 60% of the US market and internet useage is stabilizing.
Look whose rolling over. Remember technology sector’s wild December run. Well, Microsoft, AOL and Amazon have given it all back. Yahoo’s performance is nothing to shout about, and even Qualcomm seems stuck in a trading range. After months of a few technology stocks moving the market higher, the field has now narrowed further.
Kenny Rogers once sang, "You have know when to fold ‘em." More important for today’s market, he also said, "You have to know when to run"
For clients with heavy equity exposure, I think the race is on.
prudentbear.com |
