Running Up the Risk Curve

Does it feel to anyone else like we're moving our way toward some big showdown? Each day the highest-risk companies seem to march ever higher, bolstered by the unanimity of the fishwrap and bubble-vision folks that we are indeed in a "new bull market" -- that economic recovery is underway.

Meanwhile, as Matt Richey mentioned yesterday, gold hit its highest price in seven years, at $383 an ounce this week, and the Philadelphia Gold & Silver Index (AMEX: XAU  ) is up 24% on the year. Why do people buy gold? For as many reasons as they do equities, bonds, currencies, real estate, or any other investment. But gold isn't income producing, and a rapid rise in gold prices really only means one thing: There are plenty of folks who are battening down the hatches for an economic disaster.

Naturally, what makes a market work is the fact that there are constantly differing opinions. Whenever you buy a security, you are in effect saying, "This is the best place in the world for me to put my money at this moment." Wait, you're not saying that? Well, that's exactly how you should think -- it could save you from those instances when you're hitting the order button at your broker while thinking, "Wow, I hope this works out." Meanwhile, at the other end of the trade is someone selling to you. In that person's life, there is no better move than to sell the very same security you are buying.

Since there are varying reasons for buying and selling, it doesn't necessarily follow that either must be wrong. The seller could be exiting a security due to its not meeting his risk tolerance. If it continues to rise, it still didn't meet his risk tolerance. This is how the market works generally. It's also why it works. It's also why some people find value in watching sentiment indicators such as the VIX (a measure of implied volatility based on the S&P 100) and the Put/Call Ratio (trading volume of put options to call options) -- when they get out of whack and start to show either overconfidence or fear, traders use them as signals.

I don't share this enthusiasm and don't care in the slightest about bottoms or tops. What I do care about is expensive and cheap. And what I see is stuff that by all means should be cheap is getting more expensive. Obviously, as evinced by the rush into gold and other commodities, I'm not alone. The middle ground, just as it seems in politics these days, is a lonely, lonely place.

Bleeding edge, or just bloody?
That's the thing that makes the current environment so interesting -- everything is extreme. There has been a nearly unparalleled outperformance in the stock market by companies with deeply depressed, or non-existent, earnings. Unprecedented -- except for that maddening period between 1998 and 2000 -- that is. And many of the names involved in the latest run are the same. Network Appliance (Nasdaq: NTAP  ) , Micron (NYSE: MU  ) , Juniper (Nasdaq: JNPR  ) , Sonus (Nasdaq: SONS  ) , and Chinadotcom (Nasdaq: CHINA  ) have averaged an increase of 600% from their lows of this year, more than 300% in the last 52 weeks. The market has Applied Materials (Nasdaq: AMAT  ) pegged at 7.8 times sales. The company, for its part, has about doubled from its lows.

Reasonable people could argue convincingly that the lows were too low. Certainly, that's the signal the market is sending. But rather than just give my opinion on the prices of equities like those listed above, I'd rather discuss what should be undeniable: The market has priced these companies not just for growth, but for unbelievably fast growth, starting very, very soon. Any delay, or any underperformance, will send these shares plummeting.

Once upon a time, back in 1998, The Economist called the folks who focused on trading Internet stocks "casino capitalists," and further diagnosed that they were "stark raving mad" for paying whatever price was quoted for common stocks on the belief that there would be someone to come behind them to pay even more. It worked until it didn't. Take a look at the 1999 Sequoia Fund annual report to see contrarians dealing in the midst of the last speculative binge. They didn't fight it; they just pulled their sails down.

What is startling to me right now is the level of risk people are willing to take on. I include in this group the people who are buying overpriced equities counting on substantial growth and a high level of profit for long stretches of time despite the total lack of evidence that these companies are able to produce either, even in optimal conditions.

Although these things are generally only obvious in hindsight, there are several components that convince me that the conditions, far from optimal, are actually pretty grim. For starters, for all of the companies listed above, with the exception of Chinadotcom, there would need to be a substantial, long-term uptick in capital spending among corporations for them to have a chance at meeting expectations.

And yet companies are still beset with billions of dollars of debt taken on during the boom, and overcapacity in nearly every part of the economy is rampant. So while Applied Materials, Micron, and Intel (Nasdaq: INTC  ) investors can get excited about the recent uptick in PC sales and that channel's effect on their prospects, Fred Hickey of The High-Tech Strategist notes that this rise correlated with many American families' receipt of the child tax rebate checks this summer and additionally with the seasonal inventory buildup that generally takes place at about this time.

Revenge of the string pushers
The government and the Fed have done as much as possible to pump demand back up, but they're doing the proverbial string-push. In an environment of overcapacity and too much debt, there is no compelling reason for companies to borrow more. That's the point of lowered interest rates: to entice people and corporations to borrow since the cost of capital is so low. What we got instead was a massive refinancing boom that kept consumers in the green for the last two years -- a trend that is ending. The estimated $300 billion in cash-out refinancing over the last two years is still dwarfed by the amount of consumer debt carried by Americans --$1.77 trillion, or $17,000 per household. This amount, by the way, does not include mortgages.

Borrow more to spend more? Consumers are tapped, and so are their easy lines of credit. Frankly, given the easy source of capital in people's homes, I'm staggered that there are as many new bankruptcy cases as there are -- 412,000 in the first quarter of 2003 alone. In such an environment, exhortations to spend more seem destined to fail. This is the environment in which those incredibly high multiples exist. Investors are banking on enormous growth, and I can't for the life of me see where it's going to come from.

A wise gambler once said that table games were easy once you figured out where the 60/40 side of the bet was. Those who are chasing after ever-higher returns on companies that are short on profits and cash flows but long on potential and hype certainly have yet to figure out where these odds are. At the table, they're known as "suckers." In the marketplace, it's much, much worse.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

I saw a werewolf drinking a piña colada at Trader Vic's. His hair was perfect. Rest easy, Warren Zevon. Bill Mann owns none of the companies mentioned in this article. To find the kinds of companies Bill would consider owning, take a free trial of Mathew Emmert's Income Investor.


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