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Posted 12/5/2002
Contrarian Chronicles
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Contrarian Chronicles
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Beware the temptation to chase rising prices
When markets are rising -- whether its stocks or housing -- its so easy to chase the trend. More often than not, however, chasing the market is a recipe for disaster.
By Bill Fleckenstein
In the world of laboratory mice, it's easy to make a conditioned response disappear. Just take away the mouse pellets. The process is more complicated when it comes to the two-legged creatures that scurry on Wall Street. Conditioned by the mania to expect free-flowing rewards, they keep buying stocks, even though the aftermath continues to administer powerful jolts. This knuckleheaded behavior is most noticeable in tech land, where a dangerous risk/reward equation is no barrier for those who are hell-bent on gambling.
These days, people can take in the casino action from the comfort of their own homes. Or maybe I should say by using their homes as shingled poker chips. The bet, of course, is that property values will continue to rise, so just go ahead and borrow more against your house. Along that line, a couple of friends forwarded a stunningly clueless story in last week's Time magazine, titled "Cash Out Now." In a nutshell, here is what the writer had to say: "The wisest choice when investing is often the toughest choice. (That happens to be true.) Today, that means buying stocks, even if you have to mortgage the house -- literally."
That is the single most irresponsible piece of investment advice I have ever read. It's like telling people back in early 2000 that they should be borrowing against their stocks. Housing prices have risen, so this individual suggests that people should take out debt. Just leverage up against an asset that has been inflated, arguably, in a bubble, and go buy stocks because they're lower than they used to be. Anyone who follows that advice is almost guaranteed to be wiped out.
Recent commentary from The Wall Street Journal's Jesse Eisinger, on the other hand, consistently offers a realistic picture of the post-bubble times in which we find ourselves. In a story titled "The Eye of the Hurricane," he emphasized a point I have frequently made, about how imbalanced the risk/reward equation is: "As stocks race up, investors are no longer being compensated as much for the risk of owning stocks. Doesn't the recent spate of problems signal that all sectors are at risk? We only cared when stocks were falling. Investors don't care about corporate governance. They only care when they think other investors care about it." (The italics are mine.)
To that I might just add, the environment has become so warped, due to the long-running bull market that wound up turning into a mania, that people feel conditioned to chase higher prices.
The wrinkle in the pressed release
Of course, the frenzy of the chase can best be seen in technology. To understand what is wrong with technology specifically and the market in general, it can be most illuminating to first look at a company's earnings announcement and then do a bit of math behind the numbers. In that regard, Analog Devices (ADI, news, msgs) will serve nicely as Exhibit A. (By the way, I am not short the stock.) Last week, though its real earnings, "ex-items," were 9 cents, the company reported 16 cents, which was counted. Then, after the company finished lowering expectations for next quarter's revenues and earnings, it made an effort to hint at happy days by saying, "If the recent strength in orders continues, we can show some upside to our flat guidance." (Analog Devices keeps doing this, and then doesn't even make the estimate, not that anyone cares at the moment.)
This is an example of the little two-part dance that companies try to do. As soon as they give some bad news or realistic news, they like to say that business improved in the last 15 minutes, and things might get better down the road. For instance, recall that before Intel (INTC, news, msgs) lowered the boom during its last quarterly conference call, it talked on the prior midquarter update about how great a start the month was off to, though it was only a couple of days old. At the time, I called this for the game of hype that it was. So, companies continue to crank out the spin, rather than talk about the reality of the situation.
But that's not even the real problem. The real problem is price. Analog Devices trades at over 50 times earnings. When analyzing any stock, you have to ask yourself, what is the price discounting, good news or bad news? Has the price of the stock discounted a slowdown in the housing market, a tapped-out consumer, expectations of weakness in corporate spending, worldwide weakness, financial rot, or is the price discounting a new boom? When one looks at Analog, and stocks in general, it seems to me as though the risks have been forgotten and people are discounting a new boom.
Princely price for toad prospects
If one throws out the years surrounding the year 2000 -- which I think is an outlier, given the craze for technology hardware, both in the corporate world and for individuals -- one sees that for the most part, a realistic upside target for Analog might be 70 cents a year and a couple billion dollars in revenues. Or let's be generous and say that the company can do 50% better than that and make a dollar. At just under $30, the stock is still selling at almost 30 times what looks to be a generous upside projection for earnings, and at 55 times trailing earnings. But, if things were to go poorly, and a generous multiple of 20 were placed on its current earnings, the stock would trade for 12.
So, hopefully this little example will help people to understand what I mean when I talk about the risk/reward being all out of whack in technology. (The same case could be made for many other tech stocks and lots of stocks in Corporate America in general, though of course, not all stocks suffer from these problems.)
Growth in tech spending? What growth?
Stepping away from the math for a second, I would just like to share a frontline view of the trouble in tech land, via an e-mail that I received from a reader of my daily column. He runs the IT dept at a major Fortune 100 company that uses enormous amounts of technology, and here are his comments about IT spending and the latest tech rally:
"The one word I could find for the current Nasdaq rally is 'delusional.' I work as a technical architect for a large IT department, and I can give you a front-line view of what is occurring right now in regards to tech spending. What's happening is that final spending decisions are occurring on the money remaining in IT budgets for 2002. I have several sales and IT management contacts who have told me they are making some last-minute purchases of software and hardware (at bargain prices, no less). This happens every year at this time, and when it happened last year, it completely confused me as to why it sent the Nasdaq market into a frenzy (It was the little blip you saw in sales at the end of last year).
"Furthermore, we are not seeing any planned growth in our IT budget for next year. Right now, it is forecast as stable to down slightly. Most of the money allocated for next year, in fact, will just be on services for maintenance of existing technologies, as well as pilots for newer technologies (such as Web services). But this requires no new hardware, just consulting services, and again, bargain prices are prevalent everywhere, as we see undercutting by IBM, Dell and HPQ on virtually everyone else (and which you are seeing showing up in their increasing revenues).
"That is what confuses me about this current market rally. It seems to be focused especially on semiconductors, an area where I see no spending at all. People wonder where the replacement cycle is, but what they do not seem to get is that most IT people I know see no need to do a 'mass replacement' of PC's anytime soon. The only replacements occurring are in switching from high margin mainframe or Solaris boxes to low-margin Wintel or Linux boxes. Certainly, no replacement of existing network hardware is occurring, as the only network constraints we have right now are in bandwidth available. We can fill that at great rates due to the exceptional lengths that AT&T is going to woo corporate customers. Further, no requisition for new desktop PCs is occurring at all; only laptop replacement of desktops (although this is coming off the hide of desktop replacement).
"Overall, I am not quite sure where investors are expecting to see the semiconductor growth come from. The consumer? Internationally? Certainly, I am no market expert, but I get the sense that investors are again doing the 'hope ritual' with technology that they did last year. I have to tell them that unless a major natural disaster takes a huge chunk of IT equipment with it, they are just going to have to realize that the growth rates and replacement cycles of the past are not there. They will probably never return unless some new technology comes along that wows IT management into entering a new spending cycle. Until then, we are doing just great with the equipment we have, and even when we need to buy, the prices we can generate from bids are so low that I cannot see how these tech companies are going to grow profits all that much.
"That is why I bring up the word 'delusional.' It's one thing if the prices I saw for tech stocks reflected what I see at work every day. But they seem to be calling for some kind of boom cycle of spending. I am just writing to tell you and your readers, it's not coming this year or next year.
So, that is front-line view of an unbiased expert, and it underscores a point I have made frequently, that these tech stock prices are recipes for big losses.
The point about not pinpointing
Shifting gears, I'd like to make another point. Obviously, the market rallies and declines, and it does so on an irregular basis. Though I try my best to opine when either might be in the offing (Occasionally I get it right, and occasionally I get it wrong), that is not my purpose in the Contrarian Chronicles. I am not trying to pinpoint every rally, or catch overpriced stocks that might bounce 30% or 40%. That's not my forte.
I know it's no fun to sit by idly while the market careens wildly, especially when it happens in a short space of time and looks so easy. Being on the outside looking in is never fun. But hearken back to late 1999 and early 2000. It was very difficult to sit on the sidelines and watch that lunacy occur. And yet, that was exactly the right thing to do. Almost everybody who was sucked into that party wound up losing a ton. That's what happens to most people who chase the market action. They wind up losing far more than they think they will. So, every time you feel like you've been left behind because one of these epic rallies takes place, just think about how painful and yet how correct it was to sit out the insanity of the mania.
In any case, what I am trying to do is to paint the big picture so that people can gain some perspective into what is going on. My column is written for investors, not traders. People who want trading ideas should not expect to find them here. My goal is to help people at home to avoid large losses. To that end, I think this column has been quite successful.
Clarion contrarian call
I thought about stopping my daily column a year ago, in the wake of Sept. 11. One of the reasons I didn't was that I felt the need to speak out about so much of the misinformation that was being spewed at the time about a new bull market and an economic recovery. Last winter and last spring, I voiced my skepticism of the same. Just as not long ago, I shared my dim view of the sustainability of gains in the housing market. And I feel exactly the same way now about people's views that the current rally is the start of a new bull market and an economic rebound next year.
Until such time as sanity returns, the agenda that I have set for myself will be to debunk the myths and falsehoods that continue to permeate Wall Street. When sane valuations return, I will shift my strategies, and if I am lucky enough to find something I feel comfortable with along the way, I will recommend it, as I have found reason to do infrequently thus far. I hope this makes clear what the Contrarian Chronicles is all about.
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At time of publication, William Fleckenstein held a short position in Intel. Positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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