The view from the top of Wall Street
By Aaron Patrick
There comes a point where the cost of capital removes the incentive to generate profit. That point is zero. And it has been reached in the new economy. The technology revolution has been more insidious than many have realised. As capital from around the world flowed into computing, internet, telecommunications and media stocks, the old economy was left gasping for air. The money had dried up.
In a kind of collective psychosis, investors discarded stock-picking theories that had worked since the introduction of discounted cash-flow valuations. Huge investment institutions chased mega-returns. Mainstream fund managers reported annual returns of 500 per cent.
The Nasdaq Stock Exchange, a young, electronic market based on over-the-counter stocks, became the focus of the investment world. While universities were teaching that long-term stock gains averaged in the teens, the Nasdaq Composite had a one-year gain of 85.6 per cent last year.
As Punky Brewster, an obscure children's TV character from the early 1990s, lined up a float of her website, the most widely held company on Earth, MetLife, was forced to cut a capital raising in half because nobody was interested in a boring old insurance company.
Byron Wien, one of Wall Street's old guard, believes investors abandoned logic because they had to. "They act rationally, and it proves unrewarding," Wien says. "Finally they say, 'I don't understand this any more, but I am paid to participate'."
The dislocative effects, of course, have extended far beyond the fortunes of those buying and selling stocks. They have permeated the world's financial markets, into currencies, interest rates, countless businesses, bureaucracies and the behaviour of a million individuals.
The recent retreat to the old economy hasn't redressed the imbalance. Nasdaq stocks continue to be valued around 200 times earnings, while among the leaders of the New York Stock Exchange the figure is in the 20s.
Given the breeding ground for the new economy has been the US equity markets, The Australian Financial Review decided to ask four key figures on Wall Street what was going on. On its historical significance, they have broadly similar views. Deutsche Bank's chief economist, Ed Yardeni, rates the developments of the late 1990s and early 2000 as a "10", putting them on a par with the Industrial Revolution.
Wien, the head of equities strategy for Morgan Stanley Dean Witter, says they are a "psychological 10" and possibly a "practical 10".
The chief quantitative strategist for Merrill Lynch, Richard Bernstein, rates recent events as a six or seven, though he compares them to the invention of the telegraph. "The market is treating it like a 25," Bernstein says.
Goldman Sachs' US strategist, Abby Cohen, declines to give a number but says advances in computing and telecommunications have been as important as the discovery of electricity. When it comes to tying down exactly what is the phenomenon, however, they have very different answers.
Was it really about computers and the internet, we asked. Or was it an issue of capital allocation? Perhaps it was the effects of economic liberalisation? Yardeni, for one, believes the answer is simple.
"There is a tendency to create a mystery around the global and economic financial situation by creating some lingo that is not very insightful," he says.
"Using the term 'new economy' doesn't explain very much. As a matter of fact, it creates this aura that it's something different that nobody understands just yet, and we're all kind of struggling to keep up with it.
"Let's just call it the new global economy. We should really start out with the global economy and work backwards to how our national economies fit into that picture.
"And I think that rather than use the phrase 'new paradigm' - because it doesn't explain anything other than create a mystery, of 'there's something new out there', and 'new' suggests improved - I think it's really not a new paradigm at all. It's a very old one that goes back to my hero here, Adam Smith, and [his 1776 treatise] The Wealth of Nations."
At this point, Yardeni leans back and pulls out the economic treatise from a shelf behind his chair. Holding it up for effect, he explains how the internet, free trade and globalisation of capital markets are unleashing the economic forces described by Smith. Supply and demand curves are finally being given free rein.
In Yardeni's mind, it is a capitalistic revolution, not a technological one. "The model says there are three characteristics to a competitive market-place. [First,] there are few barriers to entry into business. How realistic is that description of the current economic scene? Better than in the past.
"In the past, if you were an entrepreneur and you had a really wild, hare-brained idea that you wanted financed, you had real trouble getting money from a banker, because they are conservative folks. Now, with the junk bond market changing all that in the 1980s, a lot of money is being raised on the capital markets. The barriers to entry are becoming fewer.
"The second characteristic is there is no protection from failure. If you can convince your venture-capital friends that they should give you one or two more tranches of financing as you burn their money on advertising trying to survive as a dot com, for example, you don't immediately go out of business. But if you burn enough cash, at some point the venture capitalists say, 'this is enough, we're moving out'.
"The third characteristic of a competitive market is information is costlessly available to everybody. So, when we talk about the new economy, let's call it the new global competitive economy. And let's not say it is run by a new paradigm; let's agree it is based on an old paradigm and now has become very realistic."
Whatever you choose to call it, the new economy is being taking extremely seriously in the US. Two weeks ago the President, Bill Clinton, held a conference on it at the White House. (In a historical sidenote apt in the present market, the President apologised for sending biotechnology shares into a tailspin with a misinterpreted statement on genome research.)
Speaking alongside the President and the chairman of the Federal Reserve, Alan Greenspan, was Cohen, her presence reflecting her weight as a market forecaster. In the early 1990s, Cohen pronounced the US sharemarket "undervalued". On March 16 this year, she said technology stocks had caught up: "They finally got the respect they deserved."
A few days after the White House conference, she told the AFR the juxtaposition of new and old economies was artificial - traditional business had been exploiting technological advances for many years.
"For more than a decade now there has been a significant impact on business management techniques associated with these computer systems," Cohen said. "For example, we have outstanding inventory controls. That sounds like a rather mundane subject, but it is critically important because it helps explain one of the key reasons we have not had the usual rough edges in our economic expansion. The inventory/sales ratio in the US is the lowest we have ever seen it. Inventories are no longer the tail that wags the dog.
"There has also been a dramatic impact in the US in terms of management information systems. We have had a significant improvement in communication - companies between their suppliers and themselves, and also between their customers and themselves.
"And this is something we think is ultimately going to find its way into other parts of the world. US technology companies do about 50 per cent of their business outside the US with non-US customers. Many US companies are global in scope, so they will be introducing these techniques that are technology-dependent in their own operations.
"I think that it is a mistake to say that something wonderful happened over the last six months. Something terrific has been happening in a very gradual way for many years. I do not think it's over."
Cohen isn't talking tech stocks down, but says the huge recent gains won't be repeated. While she's broadly comfortable with tech prices in the S&P 500 Index, which includes companies such as Motorola and Microsoft,Cohen won't even talk about Nasdaq valuations. And it is among Nasdaq's internet, telecommunications and computing companies that huge expectations have been projected.
Take fibre optics company JDS Uniphase, headed by the Australian-educated Kevin Kalkhoven. The Nasdaq-traded stock has a market capitalisation greater than Chevron's, though its sales are one-half the petroleum refiner's earnings. As one of the new economy's high-fliers, it didn't even met the revenue requirements for a NYSE listing until last year.
The valuation disparities are so wide that some analysts believe tech stocks are part-way through a $US2,000 billion fall.
Among the old economy flag bearers is Morgan Stanley's Wien, who argues that a "shock" correction is needed to restore the traditional valuation regime. "The market is pricing these companies as if we are going to live a virtual rather than a real life," he said.
"You are not going to spend all day in front of the screen. Eventually, you are going to have to go out and have a meal, find a place to live, drive a car, get married, have a family, and all of those things are going to go on pretty much as before.
"One of the reasons that business-to-business stocks are suffering is that they were priced as if 100 per cent of the savings was going to accrue to the service provider, but in fact the savings will be split among the service provider, the company itself, like General Motors, and the consumer.
"This is probably as favourable a period as we have ever had. What is the effect of it? The effect is that . . . investors are approaching the stockmarket as if there is no risk. Most people think nothing bad can happen to them.
"My criticism . . . is not that the fundamentals are being misinterpreted . . . They are just being overvalued."
Merrill Lynch admits that its pricing theories stopped working last July. According to Bernstein, that's when the market "really starts deviating from reality".
Just as US profits were making a broad upturn, capital started flowing into one sector. Investors' appetite for exposure was so great that profits ceased to matter. The effective cost of capital fell to zero.
"Why wasn't all that technology coming to the market four years ago? It's not like it wasn't being developed. Now everybody is throwing capital at them and they can do whatever they want," Bernstein told the AFR in his office at New York's World Financial Centre. "Why aren't a lot of these companies profitable? They have no incentive to be profitable. They come back to market and issue more stock. It's free."
Bernstein has reached a similar conclusion to Cohen, but from a different premiss. He, too, sees technology restructuring traditional business, but argues capital allocation is forcing change. In economic terms, it is the process of creative destruction.
"The technology sector is sucking capital away from all other industries in the US. Let's take commodities. You are seeing an increase in global demand because the global economy is heating up. Normally the companies, at this point in the cycle, would expand capacity, and they'd ruin the whole thing. They would overproduce. But they aren't doing it this time.
"Why? If they wanted to get external financing, they couldn't. How many metals companies are doing equity offerings these days? Even on the debt side, they are getting squeezed out. In most cases their cash flows are strong enough to internally finance expansion. But when they do the decision, 'build versus buy', the valuations of the sector are so depressed that the analysis comes back saying 'buy'.
"So you are getting all the mergers. In the paper [manufacturing] industry, you are practically getting a merger a week. You have got, in the commodity areas, the unique combination of rising demand and constrained capacity. How often does that happen? "This is something Wall Street has wanted the base industrial companies to do forever. Now they are doing it, and nobody cares. To me, that is very ironic."
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