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The Long View: When bubbles burst
Published: April 20 2001 17:08GMT | Last Updated: April 20 2001 17:40GMT
The Fed's unexpected rate cut this week is a reminder that financial bubbles have real-world origins - and real-world consequences.
They usually begin with some genuine piece of good news in the real economy. This might be a transforming technological innovation - the railway, the car, the electric motor, the semiconductor, the internet. Or it might be a financial innovation: new lending powers for savings institutions, venture capital, the recycling of petrodollars.
The initial results of innovation are good; the long-term results may be overwhelmingly positive. But in between these two benign stages comes the cycle succinctly described by Lord Overstone, a 19th century banker: "Quiescence, improvement, confidence, prosperity, excitement, overtrading, convulsion, pressure, stagnation, ending again in quiescence."
Less melodramatically: early sellers of the innovation do well. Capital floods in; capacity rises sharply. Costs fall, but because of the new capacity, prices fall faster. Purchases leap. This leads to more capital, more expansion. At some point it becomes clear the industry has overexpanded. Capital dries up. Demand falls short of swollen supply. An industry built on growth suddenly contracts, with dire results.
This cycle explains why Cisco has lost three-quarters of its value in little more than a year, and why this week it forecast a 30 per cent drop in quarterly revenues and said it was sacking a quarter of its workforce.
Cisco is a textbook example of the connection between the real world and the bubble. Its cheap, reliable internet equipment was a key innovation that helped the bubble get started. Its stock price rise briefly made Cisco the world's most valuable company. And its slide in sales is a direct consequence of the end of the boom and the supercharged demand it created.
Now think back 70 years to the Cisco of the 1920s: General Motors. Everything we say about Cisco today - high-tech, entrepreneurial, innovative, tightly managed, acquisitive, skilfully marketed - applies to the GM of 1929.
Neither was an old company. Cisco was founded in 1986, and went public in 1990. GM's origins date back to the early years of the century. But the General Motors we know today was rescued from the 1920 recession by Pierre du Pont, the chemicals boss, and prospered under Alfred P. Sloan.
Sloan's GM introduced tight financial management and encouraged marketing innovations such as the annual model change. He integrated widely separate businesses into a coherent management structure and product range. John Chambers, the boss of Cisco, has implemented tight financial management, with instant reporting of profit and loss figures. His marketing innovations include pioneering high-value sales over the web. And he has snapped up smaller companies and merged them into a coherent management structure and product range.
For both GM and Cisco, the rapid rise in share price during the boom was triggered by developments in the real economy. US car sales rose from 1.5m units in 1921 to 4.5m in 1929, a level that was not to be reached again for two decades. Cisco saw the number of internet hosts rise from fewer than 200,000 at the beginning of 1990 to 109m at the beginning of 2001.
The slump in car sales might be attributed to the generalised depression that swept the US and the world in 1929-32. No such generalised depression is in prospect now, thank heaven. But notice that, though car sales stayed below their 1929 level for 20 years, motoring continued to grow. Miles travelled rose steadily, except in the two worst depression years. So did tyre sales and the number of petrol stations.
The underlying trend that had powered GM's stock price rise - rapidly growing use of the car - proved just as powerful as investors had expected, surviving the Hungry Thirties in fine style. But car makers failed to benefit in the years after 1929 to the extent that might have been predicted. GM's share price fell from $73 in September 1929 to $8 the following summer, and recovered only slowly.
The question for investors in Cisco, and the other internet technology suppliers, is whether they will suffer the same fate: watching morosely as the underlying trend in internet use continues steadily upward, but failing to see matching sales.
The Fed's unexpected decision to cut interest rates this week was made for much wider reasons than the travails of an individual high-tech company, no matter how symbolic. But it reflects a concern that the capital spending boom of the past few years, fuelled by high-tech investment, has come to an abrupt end.
Cisco is the symbol of that corporate investment surge, just as GM was the symbol of the consumer durable investment of the 1920s. That party's over - but for how long?
Contact: Peter Martin |
