THE HIGH-TECH STRATEGIST Part 1
Published Monthly Since 1987
Editor: Fred Hickey
September 3, 1999
DJIA 11078.45'
Running Full Tilt Into Nuclear Winter
A year ago, several market research firms covering the computer industry issued forecasts that called for a serious downturn in the computer industry beginning in mid-to-late 1999. Their surveys found that corporations had accelerated computer buying over the past couple of years to prepare for the Year-2000 (Y2K) transition. One of the research houses, the Gartner Group, coined the term "nuclear winter" to describe the expected fall-off in computer sales in late-1999 and 2000.
Forrester Research predicted that U.S. PC revenues would plunge 14% in 2000 from 1999 levels, and then remain stagnant through 2002. Forrester's director of computing strategies told Electronic Business magazine that the PC boom will "abruptly turn into a bust at the end of 1999," and the bust will come at a time when PC production lines may be running full-tilt, and the resulting oversupply could cause a major price war.
These forecasts received a lot of attention in the September/October tech stock massacre last year, and likely contributed to the tech stocks' troubles. At the time, there were almost 500 days to go until the millennium. As of today, there are just 119 days left. If all these surveys of corporate MIS directors' intentions were accurate, we should be feeling the effects of nuclear winter now. In theory, tech stocks should be under great pressure, discounting the end of the computer buying upgrade cycle.
Yet, tech stocks today have never been more in favor with investors. The tech-heavy Nasdaq 100 Index at 2506.69 is 136% higher than its low point last fall. Semiconductors, as measured by the Philadelphia Semiconductor index (SOX), have more than tripled from last fall's low of 183 to 561. While the average stock is stagnating, or worse this year (the broad Russell 2000 index is up 2.9%), the big cap "nifty-techies" continue to grow faster than crabgrass in August. This year's Nasdaq 100 index gain of 37% comes on top of last year's enormous 85% surge. In contrast, the Russell 2000 index's tiny increase follows last years' 3.5% decline. For almost two years, investors have lost money in small stocks
The "Big 6"
The stock market's gains continue to be concentrated in just a few stocks, and the best performers are the mega-cap tech favorites. The six biggest capitalization tech stocks (Microsoft, Intel, IBM, Cisco, Lucent and Dell) are now valued at $1.65 trillion, up $460 billion this year to date. Since the beginning of 1998, the total valuation of these six has more than tripled.
Just the increase in the valuation of these six tech stocks over the past 20 months ($1.1 trillion) is more than what all U.S. stocks were worth in 1982. It's safe to say that no one is fretting about nuclear winter. Going back to the beginning of 1995, when it is thought that this long bull market turned into a mania at Dow 3834, the big six tech stocks were valued at $133 billion. They're up by a factor of 12.4 times in the last 4 2/3 years. Combined annual sales ($198 billion) for these six have less than doubled since the beginning of 1995. Moreover, growth rates for all of these companies have slowed in recent years, just as overall industry growth rates have moderated.
In 1995, semiconductor sales were $150 billion worldwide. They're forecast to be less than that in 1999. There's been no revenue growth in the worldwide PC industry in 2 1/2 years, with ASP declines more than offsetting mid-teens unit growth, despite the favorable impact of the Y2K upgrade cycle.
These numbers are more than mind-boggling. Just today, on September 3, 1999 the melt-up caused by the "favorable" unemployment report added $63 billion to the market valuations of the "Big 6." One day's gain. At their lows in late 1990, all of the stocks in my top-ten "nifty-techie" list (that I've kept for some years) consisting of IBM, Hewlett-Packard, Intel, Microsoft, Motorola, Cisco, Sun Microsystems, Texas Instruments, Oracle and Micron Tech could have been purchased for a grand total of $52 billion. Essentially, most of the technology industry in 1990 is an even swap for one day's gain of 6 stocks today. This is insane!!
The stock performance of these mega-cap techs has created a virtuous cycle. Since they're where most of the market's gains occur, performance driven investors (a.k.a "momentum" investors) keep pouring money into these same names. While mutual fund inflows are down year-over-year, they're not down in those funds that have a high concentration of mega-cap techs in their portfolios. The Vanguard 500 Index fund is seeing record inflows
A Crowded Trade
The stock market's leadership is getting narrower and narrower. The market's "breadth" numbers are horrible. With interest rates soaring, financial stocks have come under pressure. Investors' response is to move more money into the big-cap techs and semiconductors. Drug stocks have weakened, so even more money moves into the techs. Even the Internet group has come under pressure, after peaking last April. The momentum money that used to chase America Online is now pursuing Texas Instruments (up an incredible 105% year-to-date).
The massive concentration in large cap tech stocks is a classic "crowded trade." When we talk about the stock market bubble, we're talking about these stocks. When Fed chairman Greenspan uses the words "irrational exuberance (1996) or "extraordinary" and "inexplicable" (August, 1999) to describe the stock market's run-up, he's talking about the action in Microsoft, Intel and IBM, and not so much the vast majority of stagnating small stocks. When everyone thinks about the insanity of this market, they think of Internet stocks, with no earnings and (sometimes) no revenues, soaring into the stratosphere. Yet Microsoft's gain in market valuation since the beginning of 1998 ($350 billion) almost equals the combined valuations of every Internet stock in existence today. Amazon's idiotic $20 billion valuation is a symptom of the disease. Microsoft's and Intel's combined $830 billion valuations are the disease.
The market is narrowing and becoming ever more unbalanced. Foreign investors are losing confidence and have begun to sell the assets of what Japanese financial leaders call "Bubble.com" (the U.S. stock market). The loss of confidence and the enormous trade deficit is driving the dollar down and pressuring longer-term interest rates higher. Debt levels keep expanding to feed Americans' outrageous consumption of goods and their insatiable demand for stocks. The Fed is trying to "jawbone" down the stock euphoria without success and has resorted to hiking interest rates.
The whole economic environment has become destabilized, and coupled with the building fears of Y2K, it's become a tinderbox. Ironically, this uncertainty is leading investors to crowd even more into the few big stock names. A money manager described the thinking in an interview with Investor's Business Daily: "Big-growth names will do better than other asset classes in this environment because they're the largest, strongest and best-managed companies. They're better equipped to cope with all kinds of economic scenarios." In other words, buy IBM at 13 times book value, Cisco at 100 times earnings and Microsoft at 26 times sales for "safety."
At all major market tops, before the onset of bear markets, investors always crowd into the big-cap names. In Japan in 1989, the favorite was NTT. In the U.S. in 1973, the favorites were the "Nifty-Fifty." It's fitting that investors should be piling into a few big-cap tech names today, because technology is at the core of all the bulls' "New Paradigm," and "New Era" theories that dismiss traditional stock market valuation measurements.
1929 Deja Vu
The similarities to these periods are scary, but this market is most like 1929. Investors in 1929 also thought they were in a "New Era." The U.S. had experienced a period of unparalleled prosperity, with low interest rates and inflation. While the economic fundamentals of 1929 are almost a one-for-one match to today's, it's the psychology of investors in 1929 that's really frightening. The following is a brief excerpt from the book Wall Street Stock Selector written in 1930 by William D. Gann, a great market technician of his time. In a paragraph titled "1929 Wall Street Panic," Gann describes the mood of the day and the outcome.
"The cause of this panic was due to wild gambling not only by the people in the United States, but by people in the foreign countries. The whole world was gambling in the stocks of the United States. People were buying right and left regardless of price. Fortunes were made on paper in a short period of time. Everybody from the chambermaid to the multi-millionaire was in the stock market. People had ceased to work and were watching the stock ticker. New millionaires were being made in a short time. People had neglected their business because they thought it was easier to make money in the stock market. Never was there a time before in history where a speculative wave was more overdone than this one. Broker's loans continued to mount until they reached over 8 billion dollars. It has been conservatively estimated that the total loans on all stocks outstanding in the United States exceeded 30 billions of dollars. At the top, when prices were reached, the total value of all stocks traded in on the New York Stock Exchange exceeded 100 billion dollars. Bond prices started to decline in 1928 and money rates started to advance, which was the first warning that the bull campaign was nearing its end. Call money rates were as high as 13 per cent in 1928 and went to 20 per cent in 1929. Warnings issued by the Federal Reserve Bank went unheeded. The largest number of new securities were floated in 1929 of any year in the history of the New York Stock Exchange, all of which required large amounts of money to finance. The last stage of this great bull market had been so rapid that a reaction, an orderly decline, or an orderly wave of liquidation was impossible. When everybody had bought to capacity and started to sell, there was no one else who wanted to buy and a collapse was inevitable. The decline was the greatest in history and the public suffered the greatest losses. However, this was a rich man's panic as well as the poor man's and the multi-millionaire suffered along with the lamb. Profits of 5, 10, 25 and 100 million or more were wiped out in the short period of less than 3 months. The big traders were just as unable to get out of stocks as the little fellow, because there was no one to buy the stocks they had to sell."
In today's market we have instant Internet billionaires. We have millions of day traders and on-line traders, some of whom have quit their jobs to speculate in the market. Instead of a stock ticker, these traders watch CNBC all day. Stock market margin debt is nearly $180 billion (a record), up from $30 billion in 1991. Margin loans are only the tip of the leverage iceberg. As in 1929, today's investors buy regardless of price. Bond prices started to decline in the fall of 1998 and have suffered through one of the worst years in history. Warnings issued by the Fed (as well as from many other leading economists - Paul Volker, Milton Friedman, Paul Samuelson) have gone unheeded. Paul Samuelson, the Nobel Prize-winning economist compares today's massive stock market valuations to snow building up on the Alps in advance of an avalanche, according to a recent report in The Wall Street Journal. The Fed has now raised interest rates two times this year and mortgage rates and credit card rates have jumped.
While we know that history never repeats itself exactly, we also know "that those who ignore history are doomed to repeat it." Since seventy years have passed since the crash of 1929, there are few Americans around that have any memory of it. That's too bad, because we're in the process of repeating a previous generation's mistake. History is not repeating exactly, although we might have been better off it it did. There are differences in this mania. Stocks are at least two times more overvalued than in 1929. A far greater percentage of the population is exposed to the stock market than in 1929. We have a negative savings rate, bankruptcies are at record highs and consumer debt is unprecedented.
There is one other difference. We're heading into a millennium change, not just the turn of a decade. In 1929, like today, the pressures were building. But even today, there are great arguments as to what the trigger was for the collapse. We know that the market was exhausted and all the buyers were in before selling began.
Will There Be A Race To Get Out First?
I believe we're well through the stage where all the buyers are in and the short-sellers have been destroyed. While there was no visible trigger in 1929 that started the selling avalanche, in 1999 we know that within the next 119 days, some number of investors are going to pull their funds from the market due to fears of Y2K-related millennium turmoil. Some are already pulling out, though it is probably only a trickle. Right now, most people are still enjoying the last days of summer.
Over the next several weeks, investors will look at their portfolios, and decide whether the rewards of riding this market through to next year are worth the risks. Greed will hold many in, taxes will freeze others from action. Already, institutional investors have been taking steps to reduce their exposure. Risk premiums in the bond market have been rising. Interest rate spreads between short-term treasuries and riskier alternatives have been widening. Corporations have been drowning the bond market with supply due to Y2K fears. The treasurer of DaimlerChrysler, which recently issued $4.5 billion told The Wall Street Journal recently, "My fear is we're ready for Y2K, but will there be redemptions from mutual funds hurting liquidity in the market?"
A Gallup Organization poll completed midyear found that 42% of respondents expect ATM machines to fail, 38% expect checks to bounce, 22% think the whole banking system will shut down and 47% either definitely or probably believe that people will panic and withdraw all of their money from the bank. Anticipating these fears, the Fed is printing $50 billion in additional currency.
An Associated Press poll found that a quarter of the population will take money from their banks and a third plan to stock up on food, water and other supplies. A poll conducted by DeRemer & Associates and Prince & Associates of 1,000 mutual fund shareholders found that 39% were highly concerned about the impact of Y2K computer issues, while 14% said they will sell shares by December. A recent worldwide survey of 14,000 people conducted by the Gartner Group, found that almost two-thirds said that they plan to modify their investments. September and October are historically the worst two months for the stock market in the year. Will investors hold their ground through earnings disappointments?
The Y2K Noise Level Is Building
In two weeks, the State Department will issue an advisory listing countries expected to experience severe Y2K issues. The State Department's inspector-general told Congress in recent testimony that about half the 161 countries examined by the State Department have a medium to high risk of experiencing failures in their telecommunications, energy and transportation sectors. The inspector general said, "In some countries, these failures could be mere a mere annoyance, such as a malfunctioning credit card terminal, while in others there is a clear risk that electricity, telecommunications and other key systems will fail, perhaps, creating economic havoc and social unrest." "As such, the risk of disruption will likely extend to the international trade arena, where a breakdown in any part of the supply chain would have a serious impact on the U.S. and world economies."
While the U.S. may be reasonably prepared, that's not the case in much of the world. Many doubt China and Russia's preparedness. The Russian government recently admitted that only a third of its vital computers have been corrected for Y2K. A CIA report suggested that computer glitches could threaten Russian gas supplies to Europe in the middle of the winter. Petroleum buyers are concerned about computer problems in such oil-producing countries as Nigeria, Russia and China, among others, with potential failures in embedded chips in pipelines and crude oil tankers. Even without disruptions, the International Energy Agency expects oil supplies this winter to be the tightest in ten years.
These are some of the more serious problems facing the world. Then, there are all the crackpots that are going to get attention over the next several weeks. There are people building bunkers. Many are buying guns. Some believe that the world will end. A Canadian man was arrested two weeks ago for plotting to blow up the trans-Alaska oil pipeline with 14 bombs on New Year's Day.
A week ago, a major market strategist was asked on a national television business show what would turn him bearish on the stock market. He responded that a build-up in the "fear of fear" would make him bearish. The chairman of the U.S. President's Council on Year 2000 Conversion, John Koskinen told a conference in Singapore that "A growing problem confronting every country is the risk of overreaction by the public." "It's also clear in any country if millions of people change their normal economic activities all at once, we'll have significant problems, even if all of the systems work just fine."
Koskinen is trying to play down fears. But the whole world has to be persuaded that all's fine, since the U.S. is more dependent on foreign capital than it's been in its history. Some argue that foreigners, who already own a third of our Treasury debt, will shift even more money here due to having more confidence in the U.S.'s preparations for Y2K, than in their own countries.
Money may flow into U.S. treasuries, but will it stay in non-government backed obligations and stocks given that much of the world believes the U.S. (Bubble.com) is a disaster waiting to happen? Most foreign investors do not swallow this new era crap. The Economist, the Financial Times and other leading overseas business publications have been especially urgent in their warnings concerning U.S. equity markets. They know that this market is all about confidence. Investors are buying stocks today because they expect them to go higher, not because they find any value. If the confidence is broken, for whatever reason; whether it's fears of Y2K or even concern that others will get out first, they will sell and the collapse will be on. There's a lot of uncertainty about what the rest of 1999 and 2000 will bring. But there is one certainty. These stock market valuations cannot hold. If Y2K doesn't finish this mania off, I think I know what will.
Tech stocks are on a gigantic run based upon the perception that end-user demand for computer technology products is strong. They believe that surging PC demand is behind the pickup in semiconductor sales. While they do not know it yet, they are wrong!!!
In fact, the second-half "nuclear winter" slowdown in computer sales anticipated by market researchers is hitting with full force. At this moment, investors are too drunk with greed to notice it. Not that they've ever noticed a shift in spending in the past.
Dismal Forecasting Record
Almost all analysts and investors in 1995 believed that widespread semiconductor shortages and surging prices were a sign of huge Windows 95-related pent-up demand for computer products and peripherals. We all know now that the consensus was wrong. Windows 95 was a disappointment and the markets were flooded with excess PC components. The semiconductor (SOX) index crashed from its top of 300 in Q3 1995 to half that level in 1996. In 1996, investors and industry optimists again became excited about the second half shipment of Windows NT 4.0. The product didn't restart PC growth as expected, and the result was another inventory correction. In 1997, there was another run in semiconductors driving the SOX index to around 400. Again, second-half PC demand didn't materialize. Computer vendors such as Compaq, IBM and Toshiba stuffed the computer distribution channels with product in order to meet fourth quarter numbers. Remember my "channel inventory alerts?" The channel stuffing led to a brutal inventory correction in the first half of 1998. The Sox index peaked in Q3 1997 but then plunged 60%. In late 1998, there was another channel stuff, primarily by Compaq, which led to the ousting of Compaq's management this year.
Weaker than expected first-half PC demand this year, combined with Compaq's stuffing led to a collapse in PC-related component sales. Sixty-four megabit DRAM prices plunged from $10 in early 1999 to record lows below $4 on the spot market by the end of June. Micron's inventory soared. Micron had so much inventory that it cut special deals with PC manufacturers to incent them to add more memory to PCs. Disk drive prices collapsed at the end of Q2 in the worst pricing blood bath that long-time industry veterans had ever seen. Quantum and Western Digital announced thousands of layoffs in the current quarter. Quantum's CEO, Mike Brown pleaded with competitors to put an end to the "crazy" price cutting.
Intel missed revenue estimates in both the first and second quarters by $400 million. Last quarter's earnings were short by 2-3 cents per share. AMD produced 6 million K6 chips in the second quarter, but couldn't find a home for almost 2.3 million of them.
A Puzzling Development
In July, something very weird happened. Despite no apparent cause, DRAM prices began to firm. At first this was due to rumors of Micron production problems, which the company denied. Spot market DRAM prices kept running up, however. Recently, spot prices have exploded back over $9 and there are reports today that prices have even broached the $10 mark.
Strange happenings were occurring in the disk drive market too. All of a sudden, there were shortages in the popular 4 and 6 gig drives, and prices firmed. There were no production problems, so everyone assumed that PC demand had picked up. We know that in June and July, retail PC demand jumped after the introduction of the subsidized, so-called "free" PCs. As you know, I was skeptical of the attractiveness of these deals, and speculated that the initial surge of demand might peter out, as had occurred after other significant price drops.
According to our first report on August retail sales, I may be right. This week, Allison Boswell Consulting, a San Francisco market researcher specializing in retail PC sales reported that PC sales surprisingly fell 8.2% from July to August, despite expectations for strong sales due to the back-to-school buying season. Prices continued to fall, with 77% of PCs sold under $1,000, compared with 64% in July. "The trend has been consistent since the beginning of the year with unit sales and average price declining in a consistent pattern. It is apparent that no matter how low prices go, unit sales continue to decline in the retail channel," said researcher Allison Boswell.
Office Depot preannounced a significant earnings shortfall for the current quarter due to inventory write-downs of slow moving tech-related products. Sales in their business products group were also lower than expected. CompUSA announced 1,800 layoffs of commercial sales reps located in the CompUSA stores. As the result, CompUSA sees low double-digit negative same-store sales growth in Q3. Best Buy's stock yesterday was slaughtered (down 14%) after reporting lower than expected same-store sales growth for August. Best Buy also disappointed by not giving a positive earnings outlook. A PC mail order firm has seen very weak results in Q3.
It appears the "free" PC retail blip is mostly behind us. But let's examine the state of the business PC market, which is twice the size of the retail market. PC sales in July and August were terrible in the distribution channels. This is a stunning development, because the perception on Wall Street is 100% opposite to this. The largest PC distributors in the world are all suffering. Not only is there a raging price war, but demand is down significantly. Today, Ingram Micro, the world's leading distributor, with $24 billion in annual sales was downgraded by Robert Anastasi. He's considered to be the best analyst covering distributors. Another analyst also downgraded Ingram and the stock plunged 9%.
Ingram's Q3 business is very weak. The president of Ingram Americas resigned this week. This should not be happening. As of August 1, Ingram became one of only four distributors authorized to sell Compaq products in North America through its distributor alliance program. Thirty-five others were cut and will have to source through Ingram or one of the others. Ingram Micro told analysts that they expected an additional $4 billion in Compaq business annually as the result of the change. Ingram is not losing business to the Internet. Ingram is handling the warehouse and shipping for on-line retailers such as Buy.com. Ingram's CEO told Forbes magazine this month, "In two years, we're going to be the back room for the entire (computer web selling) industry."
The number two distributor in the world, Tech Data, saw its stock crater 20% yesterday due to concerns of lower margins and price wars. Price wars do not usually occur when demand is booming. Tech Data's CEO this week stated, "There is some raucous (pricing) behavior out there, even in the U.S. Some companies have been forced to give away product just to earn back-end rebates. In Europe, what we've seen (is) an out of control situation." Tech Data reported results for the quarter ended in July that just met expectations. Analysts had upgraded Tech Data's stock anticipating better-than-expected results. In the prior quarter's conference call in June, Tech Data pronounced that the quarter had started very strong, particularly in the U.S. Something happened in the interim. July must have weakened.
The third largest distributor in the world, CHS Electronics also held a conference call last month. The second quarter numbers were shockingly bad. Revenue was disappointing and the company experienced heavy pricing pressure, particularly in disk drives, their specialty. CHS management stated disk drive supply exceeded demand in Q2, causing the steepest price declines ever seen in the drive industry. The pricing was termed "insane" with product sold below cost. This was an interesting conference call. Because it was held halfway through the third quarter, management had a pretty good read on Q3. Stunningly, CHS reported that they were now experiencing "extreme" disk drive shortages, leading to improved pricing and margins. That's the sound byte that was picked up everywhere. Disk drive stocks soared, which added to the illusion that PC demand was also strong.
The Answer To The Puzzle
Yet, I did not see reported the most important data point that I heard on that call. CHS stated that third quarter revenues were "disappointing," with particular weakness in Europe. This specialist in disk drives is seeing shortages in drives, yet end-user demand for them is disappointing. The answer comes! The computer vendors (and others) are building inventories.
A fear-driven Y2K inventory build has caused the sudden demand for PC components, even as end-user PC demand slumps. Many companies in different industries have admitted to building inventories. Ford Motor and Phillip Morris told a congressional committee that they were stockpiling raw materials and manufactured goods in order to serve customers in the wake of potential Y2K failures. The interdependency of the entire supply chain represents the greatest risk to Ford," said an executive. A report out of England found that 60% of British corporations are stockpiling in advance of Y2K
The computer industry is completely dependent on parts from overseas, particularly from lesser-developed countries that may be at high risk to supply breakdowns. We've seen the impact of disruptions in the past. A few years ago, a Japanese factory supplying epoxy blew up, sending the semiconductor industry into a tizzy. Last month, there was a massive island-wide power outage in Taiwan due to an accident. We still don't know the full impact. Samsung Electronics' president blamed the DRAM price spike partly on that electricity disruption. Taiwan supplies 80% of all the world's PC motherboards and many semiconductor types. Many of the fabless U.S. semiconductor vendors rely on a sole foundry located in Taiwan for their production. If the Y2K fears weren't enough, there's also the saber-rattling of a threatened Chinese invasion of Taiwan. Taiwan is a major supplier of computer cases, keyboards, modems, power supplies, scanners, monitors, networking cards and hubs.
IBM sources a large percentage of its board and system-level products from Acer in Taiwan. A source with a contact in IBM told me that IBM is building inventories. Many disk drive components are sourced out of Thailand and Malaysia. |
