January 21, 2001
Dow Jones Average: 10,588
S & P 500 Index: 1343
Demise of the Dot-coms
What a difference a year makes! Last year at this time
the stock market was gripped by one of the greatest manias of all time.
Investor appetite for technology related companies seemed to have no
limit. Shares in dot-com companies soared ever higher as mutual fund
managers capitulated and joined the buying stampede. Wall Street analysts
gave up even a hint of restraint as they issued 500 to 1000 dollar price
targets for Yahoo and other internet companies. Anyone who challenged
the new era was seen as a has been, someone stuck in antiquated investment
thinking. But we did take issue with the new market paradigm that put
the highest valuations on the weakest, money losing companies. In our
strategy update of January 2000 we said "the harsh reality is that companies
can not lose money for long without laying off staff and eventually
closing their doors. The market bubble will burst, as all have in the
past, when investors have exhausted their capital on overpriced companies."
As it turned out investors ran out of money in March of 2000 and many
dot-com companies starting laying off employees a few months later.
The magnitude of the decline in technology related
companies can not be overstated. It has been more profound and rapid
than even the most bearish prognosticators envisioned. In cosmic terms
we have witnessed the explosion of an intensly hot, luminous quasar,
leaving a black hole in its place. Investors in dot-com companies certainly
feel that their money has vanished into a black hole. In the most extreme
cases, companies that were selling for 250 dollars per share in March
of 2000 now sell for mere pennies per share. The larger, more established
internet companies such as Yahoo and Amazon have lost 90 percent of
their value. The demise of the dot-com companies has to be considered
one of the more significant events in stock market history.
Individual investors who have lost much of their life
savings in this market are looking for someone to blame. Angry postings
on internet message boards are directed at company managments for failing
to deliver results, Alan Greenspan for raising interest rates, and Wall
Street analysts for being too bullish. Rarely do these distraught investors
cite their own greed as a contributing factor in their predicament.
We agree that brokerage firms and their analysts contributed to the
mania and assisted in the ruination of many individual investors. The
billions of dollars in profit that Wall Street firms made bringing dot-com
companies public obviously clouded the judgement of the analysts.
Investment analysts who are viewed as experts by individual
investors have an obligation to offer opinions based on some kind of
reasonable logic. The premise that hundreds of dot-com companies could
exist, make profits, and be collectively worth trillions of dollars
all from internet ad revenue was preposterous. We said two years ago
that the little blinking ads on web pages seemed ineffective when compared
to 30 second TV spots, newspaper, radio, or magazine ads. Other people
we spoke to had the same reaction. But at the peak of the mania, the
market values of dot-com companies could only have been justified by
a huge increase in corporate ad budgets, with all that money going from
traditional media to web page advertising. It was a scenario that could
not happen and Wall Street analysts should have warned less sophisticated
investors. Instead they played on people's greed with forecasts of 1000
dollar share prices
Companies that provide services and equipment to the
dot-com companies have been affected by the shakeout. In a vain attempt
to become nationally known, hundreds of dot-com companies advertised
in the traditional media outlets that they hoped to someday replace.
It is ironic that the collapse of the dot-coms has hurt ads sales at
large newspaper companies and broadcasters. Companies that sell network
equipment and computers such as Cisco, Sun Microsystems, and Dell, are
also seeing fewer orders from dot-com companies.
Internet usage will continue to grow, but will not
be based on an advertising model. People will have to pay more for on
line services. In recent weeks both Yahoo and Ebay have instituted higher
user fees for certain services and listings. The days of free internet
services entirely supported by advertising are over. The internet will
increasingly be used by existing, profitable businesses and organizations
interested in disseminating information to suppliers, customers, and
the general public.
Recession Looming
Recessions are rather rare economic events. The uninterrupted
growth in the 1990's led many people to conclude that recessions were
a thing of the past. That opinion held until December 2000, a month
described as economic freefall by major companies. The speed and severity
of the economic slowdown caught everyone by surprise. The Federal Reserve,
sensing panic, slashed interest rates by 1/2 of 1% in early January,
hoping to forestall or shorten a recession.
While the U.S. economy has enjoyed eight straight years
of expansion, the sustainability of that prosperity is questionable.
Sustainable economic growth has to be based on spending and investment
levels that can be maintained. The economy and the stock market have
been linked in an increasingly unhealthy way over the past few years.
Enthusiam for stocks has translated into consumer sentiment and buying
patterns. As the stock market is inherantly unstable, one has to question
consumer spending decisions that are in part based on stock prices.
Purchases by American consumers typically account for
two thirds ( 67 percent) of the entire gross domestic product ( GDP).
Business investment in new plants and technology usually makes up 10
to 11 percent of GDP, governmnet spending about 16 percent, with the
rest of GDP going to savings. In recent years these long standing ratios
have changed dramatically. Consumers have been on spending spree financed
by credit cards, larger mortgages and home equity lines. Consumer spending
in the most recent twelve months made up about 73 percent of GDP. Businesses
spending on capital projects boomed as well as companies felt a greater
need to become technologically advanced. The portion of GDP made up
by business investment has risen to 16 percent. Government spending
continues to represent about 15 percent of total GDP. The combined total
of consumer, business, and government spending has passed 100 percent
of GDP. Something clearly has to give. Savings have been driven to zero
and the U.S. trade deficeit with other nations has ballooned to 360
billion per year. It seems likely that heavily indebted consumers and
businesses will be forced to retrench, bringing spending back down to
normal levels and savings back up to five or six percent of GDP. The
U.S. economy will endure a period of very slow growth or contraction
depending upon how quickly consumers rein in their spending.
The government will do everything it can do to keep
consumer sentiment and spending up. It seems likely that some form of
President Bush's tax cut plan will be enacted. The Federal Reserve Board
will continue to cut interest rates in an attempt to ease the interest
burden on indebted individuals and businesses. Whether all these stimulative
government actions will offset a depressing stock market is an unknown.
Japan tried all the same remedies after their stock market bubble burst
in 1990 and they still could not prevent ten years of economic weakness.
The sentiment of U.S. consumer, as tracked by various polling services,
is now at a two year low. The mood of consumers is something every investor
will be watching carefully in coming months.
