GENERAL MARKET--FROM RED HERRING
<<<The big question
By the Editors
Red Herring
June 15, 2001
This article is from the June 1, 2001, issue of Red Herring magazine.
What John Doerr so smugly described as "the largest legal creation of wealth in the history of the world" has degenerated into the largest -- or at least steepest -- legal loss of wealth in the history of the world.
By mid-April of this year, the Nasdaq had shed more than 60 percent of its value from its high on March 10, 2000 -- whereas it took three years for the Dow to drop 89 percent following the 1929 crash. In recent months, and despite the bull rally following the Fed's mid-April rate cut, nearly every day has brought bad news: the abrupt slowdown in capital spending led to an inventory overhang, which led companies to rein in forecasts, which led analysts to slash estimates, which wreaked havoc on the markets. Initial public offerings plunged from $12.3 billion in the first quarter of 2000 to $3.9 billion for the same quarter of 2001. And the secondary market was hit even harder: secondaries dropped from first quarter 2000's $43.3 billion to $7.2 billion in the same period of 2001.
And then there is the drying up of investment in startups -- total venture capital investments were down by nearly half in the first quarter of 2001 from the same period last year. In 2000, VC investments totaled $103 billion. This year, that sum is expected to plunge to $40 billion. All the bad news has left everyone asking one lingering question: how long will the troubles last?
We asked 66 of the world's most important and influential thinkers -- economists, policy wonks, industry insiders, and financial analysts -- to predict when the market will recover. While their opinions varied enormously, they agreed overwhelmingly that by early spring the stock market had not yet reached bottom. The majority of the experts we polled predicted that the current economic woes will end either in fourth quarter 2001 or first quarter 2002, with equal votes for each of those periods. Underpinning their views was a nearly equal split between those who envision a short downturn and recovery -- what economists call the V scenario -- and those who expect a true recession, defined as two successive quarters of negative gross domestic product growth.
The most pessimistic respondent was Stephen Roach, the notoriously bearish Morgan Stanley Dean Witter economist who predicted the economic slowdown months in advance. He says we're at risk for stagcession -- a combination of stagnation and recession, without inflation. He sees U.S. GDP growth averaging 1 to 2 percent through the end of 2002. "That's going to feel terrible relative to what we've been cruising at," Mr. Roach says, which is 4 to 5 percent a year. Much more typical of the respondents was Uri Dadush, director of the development prospects group for the World Bank; he predicts that the global economy will achieve 3.5 percent growth rates in 2002.
Most of our experts argued that all the economic indicators suggest the potential for a healthy recovery -- very few thought our fate would be similar to that of Japan, which, astonishingly, has experienced almost no growth in a decade. Investment in IT throughout the '90s did more than merely bolster the pre-bust Nasdaq; it essentially energized productivity growth. "Structurally speaking, technology is fundamentally changing work and the terms of competition," explains Robert Reich, the secretary of labor in President Clinton's first administration. "In a year or two, this long-term structural reality will still be with us." Inflation is nominal, and unemployment, while creeping up, remains relatively low. And while the private sector's level of debt relative to assets is the highest since World War II, the growth in the M2 money supply -- household currency and deposits -- has not slowed to a rate indicating a recession.
WHO'S TO BLAME?
There was no shortage of opinion about who caused the hyperactivity that presaged the reversal of fortune. Federal Reserve Board Chairman Alan Greenspan, more than anyone else, is taking the rap from our respondents -- despite four half-point rate cuts so far this year. Many think the recent moves have been too little, too late. They point to the Fed's six rate increases between June 1999 and May 2000. T.J. Rodgers, the brash president and CEO of Cypress Semiconductor (NYSE: CY), echoes other critics when he says, "He should not have been beating on an economy that was about to slow down all by itself." The irony that Mr. Greenspan was also largely credited with preserving the economic momentum of the '90s is not lost on observers like David O'Rear, Asia regional economist for the Economist Conferences, who points out, "Everyone cheered Alan Greenspan for having avoided recession for ten years, and now they are criticizing him for avoiding it for ten years. You can't have it both ways."
Respondents also blamed corporations for excesses in hiring and technology spending. They blamed investors, as well. "Tech vendors and tech investors made the mistake of assuming that this special period in our history represented a real trend," says Arnold Berman, technology strategist at the Wit SoundView Group and a frequent Red Herring contributor. "It didn't."
"Everyone in part, but nobody in whole, is responsible," concedes analyst-turned-VC Lise Buyer, a partner at Technology Partners. "I can't figure out who behaved irrationally. Investors watched their neighbors make piles of money, and they just followed suit. And venture capitalists are in the business of returning as much as possible to their investors, so we were just letting them do their job. In the aggregate, we all behaved irrationally; in the specific, no one did." Linux creator Linus Torvalds adds, "It's too easy just to blame greed. Outrageous stock prices allowed people to do completely stupid stuff, which is how you get creative. Too bad if 90 percent of it is stupid. That's how creativity works."
John Gantz, senior vice president and chief research officer at the research firm IDC, assigns some of the blame to overly optimistic Internet and technology researchers, but adds that his organization warned of a downturn. For his part, Robert Shiller, a Yale University economist and the author of Irrational Exuberance (Broadway Books, 2001), says, "I'm not blaming the media for the current downturn, but they certainly didn't help. CNBC always has these bullish people on saying these reassuring things. I think it's irresponsible." Harvard Business School professor Rosabeth Moss Kanter is critical of the prevailing attitude among Internet proponents. "During the bubble, if you raised a skeptical question, people accused you of 'not getting it,'" she says.
"We all look like geniuses in an up market and all look like goats in a down market," explains Regis McKenna, chairman of the McKenna Group, the Silicon Valley consulting firm that helped Apple Computer (Nasdaq: AAPL) launch the first Macintosh. He says that companies were "hiring and growing so fast they didn't have time to look at quality of business." Ed Mlavsky, chairman of Israel's Gemini Capital Management, sees it from another perspective when he says, "I think it's a Darwinian process that cleans up the species once in a while."
HOW MUCH #$@&! LONGER?
Peter Schwartz, a scenarist at the Global Business Network and a frequent Red Herring columnist who made his name by predicting the 1986 collapse in OPEC's oil prices, believes that what he cleverly calls the "wealth of creation" of the '90s will, after a brief pause, continue in the new millennium (see "Boom, interrupted," May 1 and 15 [Editor's note: This story ran as "Is it simply boom, interrupted?" on RedHerring.com]). He views the current slowdown as a mere interruption of what he has famously called "the long boom." "By early next year the stock market will have recovered and will be back on track," he says. "By the first quarter of 2002, things should have turned back up. The productivity numbers we're still seeing suggest the long boom is not dead and should be accelerating again by the middle of next year." In fact, despite the market's turmoil, U.S. productivity grew by 5 percent last year. Mr. Schwartz is sanguine about the future: "Demand for high-technology products and services will again take off as a new generation of products takes hold, especially broadband and wireless."
Merrill Lynch global technology strategist Steve Milunovich likens the current transition period in technology to the one that occurred in 1984, when the PC boom-bust followed the shift from mainframe computers. "Today, we're at the end of the PC wave and early in the Internet wave. What that means is that there's creative destruction going on in the industry. The previous leaders are now about to fall on hard times, and we're still just beginning to identify the next-wave leaders. The good news is that in each of the technology waves -- which last about 15 years -- the market value of technology stocks increases tenfold. So eventually, the Internet will provide a tenfold increase over the PC era. But it doesn't all come at once. Internet businesses aren't built in Internet time."
Until then, Paul Wick, portfolio manager for J. & W. Seligman & Company's $6.5 billion Communications & Information Fund, sees the slowdown in tech spending getting worse, "maybe through the end of the year." Mr. Wick's slowdown thesis is supported by the fact that the second-hand equipment of bankrupt dot-coms is flooding the market and stands to hurt the likes of EMC (NYSE: EMC), Cisco Systems (Nasdaq: CSCO), and Sun Microsystems (Nasdaq: SUNW).
"My sense is that the magnitude of the inventory correction is, in some ways, unfathomable," says Roger McNamee, a cofounder and general partner of Integral Capital Partners. He says that the booming financial markets enabled so many startups to bloom that actual demand just couldn't keep up with the glut of technology equipment supply, adding, "We're going to have to reallocate those resources before the industry can return to a growth path. That suggests that the June quarter will be materially worse than the March quarter and may well represent a bottom fundamentally."
But David R. Henderson, a research fellow with the Hoover Institution, a public policy research center, makes the point that inventories are still substantially lower than they were in the recessions of the '70s and '80s. "Recessions and slowdowns will last a shorter time because of leaner inventories," he says.
Frank Quattrone, managing director and head of Credit Suisse First Boston's technology group, is cautious in his predictions. He sees capital spending on technology picking up -- but slowly, and in stages. "Spending on equipment that will increase production in existing plants will come back a few quarters before spending related to new plants. Spending on things that are nice to have, but not essential, will not improve until a sustainable recovery is in place for two to four quarters and confidence improves, which might not be until late 2002."
"Once we start working through the inventory issue and gross margin pressure -- which I don't believe will happen until early next year -- the companies that have survived and continue to invest aggressively in products will see a new generation of product purchases, which will lead them to a dramatic increase in growth," predicts Jim Breyer, managing partner at Accel Partners. "But it's a one-year process."
Hal Varian, dean of the University of California at Berkeley's School of Information Management and Systems, sees a modest recovery in six months but adds a caveat. "The one dark cloud on the horizon is the Asian situation," he says, reasoning that fresh memories of the last panic could trigger an overreaction in Asia to the current U.S. slowdown. "A big drop in Asian markets would make me more pessimistic about the prospects for a quick U.S. recovery."
What does this mean for the markets? Deutsche Banc Alex. Brown's chief investment strategist, Ed Yardeni, suggests that lower interest rates combined with "earnings [expectations] revised to zero" could trigger a bounce in some technology sector stocks by late summer or early fall. "We will have done that by the summer, so at least [the market] won't get those absolute shockers every time earnings are announced," he says. His view is echoed by industry pundit Stewart Alsop, a VC at New Enterprise Associates: "I think the Nasdaq will stay between 1,500 and 2,000 for another four to six months before starting to climb again this fall."
A broad improvement in the IPO market will lag a recovery in existing public stocks by at least one to two quarters, says Mr. Quattrone. "With well over 90 percent of the IPOs from the past two years trading well below issue price, the prevailing view is, Why should I buy a new, illiquid stock with unpredictable earnings when there are tons of undervalued, liquid stocks with a known trading history? We'll need to see public stocks up 50 percent, maybe 100 percent, and we'll need to see very strong aftermarket performance of the most recent IPOs before things improve much. So it might not be until well into 2002 at the earliest."
Other bankers are slightly more optimistic. Michael Christenson, managing director and global head of technology investment banking for Salomon Smith Barney, says, "You'll start to see a reasonable flow [of IPOs] late in the second half of 2001. If I were to predict a sector that would be successful, it would be software -- the margins are high, they're not capital intensive, and, if successful, they have a shorter path to profitability."
WHO WILL BOUNCE BACK FIRST?
Mr. Christenson adds, "I don't see technology making quantum leaps in 2002. The technologies that will be successful for 2002, particularly in telecommunications, will be those that make the installed base more efficient and eliminate bottlenecks. The people who are going to be successful are those who are able to [create a] bridge to the next generation of technology."
Our respondents were in agreement on some of the sectors that would rebound first, and among these was semiconductors. Explains Wit SoundView's Mr. Berman: "When the Internet was new, users needed to buy all sorts of new software, storage, and communications gear -- which often had not yet been invented. Small companies had a great shot at getting to be big companies. Concept stocks ruled." Now, he says, "stocks will not be driven by concepts, but by units. In such an environment, chips will lead." Adds Pip Coburn, global technology strategist with UBS Warburg and a frequent contributor to our Tactics column: "Semiconductors and semiconductor capital equipment will lead the recovery, because they are the most economically sensitive sectors."
Others see rosy prospects in anything that can make speedy and measurable improvements across the supply chain. "Recovery will come from technologies that can deliver savings within months, not years, and that means advances in enterprise and collaboration software," explains Richard Kramlich, a cofounder and general partner of New Enterprise Associates, a VC firm.
"It's only the large ROI [return on investment] supply-chain projects that will continue to get funded and not get cut back," says Mr. Breyer, who adds that Accel Partners is sitting on more than $1 billion in cash for early-stage investment. "Some of the most interesting opportunities for us [VCs] over the next 12 to 18 months are logistics and supply-chain companies that provide tremendous ROI."
And still other experts pointed to pharmaceuticals, biotech, and health care, three industries with beneficial products that investors readily understand.
HAVE WE LEARNED ANYTHING?
When it comes to suggesting ways to prevent a similar bubble from occurring in the future, once again respondents assign responsibility to the Fed. Explains Mr. Yardeni of Deutsche Banc Alex. Brown: "Americans are entrepreneurs, and we have this tendency to get in harm's way. We all want to get rich, and we take risks." But Mr. Yardeni lays the blame squarely at the feet of Alan Greenspan. "He was going around since the end of 1996 doing a Hamlet -- is it or isn't it a bubble? I don't think the head of the Fed should be having this monologue in public. If there was any suspicion in Alan Greenspan's mind that it was a bubble, all he had to do was raise margin requirements."
But also, there is a new understanding that, even with technology providing the tools to improve decision making, perhaps too many decisions were made by inexperienced executives. "Companies that have developed infrastructure to see what's going on in operations and the customer base still have to make human decisions," says Mr. McKenna. "Since we are quarterly focused, we tend to put off decisions for three months. Even with knowledge and information, these decisions take experience. We have a lot of young people running business today."
Trouble is, even the folks who claim responsibility for the hyperactivity admit that all the self-examination isn't likely to amount to much -- not if the same scenario repeats itself. Says Ms. Buyer: "If we saw the same situation in a different sector, there would be a lot of skeptics at first. But then, as things kept going up, they'd look increasingly wrong, and eventually they'd capitulate, too. You'll see it in genomics. We all have a great tendency to overestimate what we can accomplish with a new technology in a two-year period and underestimate what we can do in ten years."
She lays out the scene: "There were analysts who were negative through 1996 and 1997, when the early public market players shot through the roof. You can be pessimistic for a few months. But when things keep going up month after month, you're going against the market. If you keep telling people to sell, you're wrong. The performance of Internet stocks led analysts to distrust their own judgment. Long-term market history says, Do not fight the tape -- you will lose."
Ms. Buyer explains investing in a bubble environment: "As an analyst, you say things are going up but that it's speculative, that they're going up for no reason and they will go down for no reason. It's like betting on a roulette wheel. As an investor, you have to set triggers for getting out: if I've made X percent, I'll get out; if I've lost X percent, I'll get out. You have to set limits, and it's the hardest thing in the world to do."
Why don't we learn our lesson? "Human behavior repeats itself without outside and continual influence," says UBS Warburg's Mr. Coburn.
IS THERE GOOD NEWS?
"The underlying story is still a fairly positive one," says the World Bank's Mr. Dadush. "Any time the economy slows down, you get a handful of people coming out and saying the world now is near an end, the whole damn thing is going to the dogs. The same is true on the upside. When the economy is booming, you always get a handful of people saying the new golden age has begun, the world will double its standard of living in the next eight years. The truth is usually in between."
Many of our respondents agree with Mr. Dadush -- that the whole damn thing isn't going to the dogs -- and are eager to point out the upside of the downturn. "The good news and bad news," says Mary Meeker, managing director at Morgan Stanley Dean Witter, "is that now we are adjusting to more 'normal' times -- we will likely have more stability but less innovation and wealth creation." But Mr. Torvalds, ever the creative inventor, does not share her view on the short-term future of innovation: "Innovation is going to turn the economy around, and it will happen regardless of R&D budgets and economic slowdowns. All the technology that people were so hot on started in basements and garages. There still will be crazy people in their basements trying to change the world, and some of them will even do it."
Meanwhile, Ira Magaziner, President Clinton's Internet guru, agrees with Ms. Meeker's vision of a more conservative era. "I have always said that the vast majority of Internet companies that were being funded a few years ago were going to fail but that the Internet would still drive world economic growth for the next few decades," he says. "The markets have a way of learning. When the growth of the Internet economy resumes -- and it will resume -- it will likely proceed in a more prudent, though still entrepreneurial, fashion. But it's better that this learning is the result of market forces rather than government regulation."
U.S. Secretary of Commerce Don Evans says entrepreneurialism can flourish, even in a flagging economy. "You lead and you keep people focused on a vision out past the next quarter. You can't let the stock market make decisions for you. You have to stay focused on a long-term strategy," he says. His colleague in the Bush administration, Larry Lindsey, director of the White House National Economic Council, says that the inflated revenues for many companies in the last two years "still does not cloud the reality that the technology industry has some fabulous years ahead."
So where does all this leave the venture capitalists, those investors who play such a key role by breathing life into new technologies? The VC community is "going back to the pre-1996 days, where VCs are not going to go it alone anymore," says Gilman Louie, president and CEO of In-Q-Tel, the venture firm backed by the Central Intelligence Agency. "I'm seeing trusted funds investing together. Also, I'm seeing investments rationed out over time, $3 million to $5 million at a time. There's a real show-me attitude, whereby VCs want to see entrepreneurs deliver on milestones before giving them that next round of funding. As a result, entrepreneurs are much shrewder, tougher-skinned, and more focused on getting products to market than on hype and noise. Companies are seeking strategic investments from companies that could be customers, in order to survive."
"We've gone from a greed cycle to a fear cycle, and people are overtly pessimistic," says Vinod Khosla, the Kleiner Perkins Caufield & Byers general partner who created more multibillion-dollar companies than anyone except his partner, John Doerr, and who largely bypassed dot-com startups. At some point, fear will be replaced by hopefulness. By then, investors will have capitulated, earnings expectations will be reasonable, inventories and staffs will have been cut to the point where companies run efficiently, and everyone will accept the fact that the U.S. economy's fundamental indicators remain solid.
That's when venture capital funding, IPOs, and rising stock prices will return, and with them, company creation. Meanwhile, says Goldman Sachs analyst Rick Sherlund, "I think we are going through the scariest part of this process right now, which is the uncertainty of not knowing where the bottom is. That causes the most anxiety." But Clark Winter, chief global investment strategist at Citigroup, puts it another way. "The time to have benefited from being a pessimist ended with the Nasdaq high of March 2000," he says. "Now is the time to be a savvy opportunist."
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