The Great Dow Jones Massacre (Fool on the Hill) March 10, 2000

An Investment Opinion

The Great Dow Jones Massacre

By Bill Mann (TMF Otter)
March 10, 2000

Nasdaq 5000.

I'd yawn, because these nice round numbers don't mean a whole heck of a lot, but the action in the market lately is pretty remarkable. The Nasdaq Composite was founded 29 years ago as the exchange of choice for companies that were too small or too weak to rate listing on the Big Board New York Stock Exchange or the alternative, the American Stock Exchange.

That seems like crazy talk now. The two largest companies by market capitalization, Microsoft (Nasdaq: MSFT) and Cisco (Nasdaq: CSCO), are listed on Nasdaq, and happily so. For years the Big Board has kept the ticker symbol "M" available for Microsoft in order to lure them over, but Gates, Ballmer & Co. have stayed put. Their rejection of the NYSE is symbolic of the change taking over the entire world economy. Where the Nasdaq used to be the domain of the high-risk ugly stepsisters of the public marketplace, these same companies have now become some of the focal points of the global economy.

Even though there are several enormous technology companies that are represented on the New York Stock Exchange -- most notably AOL (NYSE: AOL), IBM (NYSE: IBM), Hewlett-Packard (NYSE: HWP), and, by way of an American Depository Receipt, Nokia (NYSE: NOK) -- the vast majority are listed on the Nasdaq. As such, the Nasdaq has soared with the advent of rampant technological change in our personal and commercial existences. The key measurements of the two indices are perhaps symbolic of their diverging trails. The Nasdaq Composite is taken from the performance of every single company on the exchange, while the only performance index of the NYSE that seems to matter, the Dow Jones Industrial Average, only measures the performance of 30 specific companies. And with the changes made last November, two of these 30 companies -- Microsoft and Intel (Nasdaq: INTC) -- are not even listed on the NYSE. They're on the Nasdaq.

I'm just waiting for the American Stock Exchange to rename the trust that holds all of the Dow stocks. Shares of the trust are currently called Diamonds (AMEX: DIA). Might I be the first to suggest the more appropriate Cubic Zirconium? Or how 'bout we just call them Stones?

You can't throw a rock without hitting some maven somewhere trumpeting the advent of the "New Economy." And I am guilty as charged. But there are some pretty interesting lessons in the overall performance of our markets, lessons that the individual investor would be wise to take note of. There are a few casualties of the 84% rise of the Nasdaq in 1999, followed by the 25% rise thus far in 2000. The first of which is the notion that the Dow, which has fallen more than 17% in the same two-and-a-half months, is a reasonable proxy for the performance of the overall market. But let's just say that the Nasdaq has some froth in its numbers. The Wilshire 5000, which measures the performance of every single company listed on the major American exchanges, is up more than 5% this year, a 22% divergence from the Dow. And The Motley Fool NOW 50, composed of 50 globally relevant companies and created specifically to respond to flaws in the Dow, has outperformed it by 15% year-to-date as well.

Is the lesson here that the Dow companies are doomed? I don't think so. But their role as being the focal point of the American economy, and by proxy the global economy, is finished. And I'd look at the market performance as only a symptomatic sign of this. More important may be the response of the Federal Reserve to the so-called "wealth effect" caused by the rapid rise in Nasdaq stock prices. One of the reasons that many of the Dow companies are being slaughtered is that their capital-intensive businesses are much more responsive to interest rate rises than the low-debt technology companies that have shown much of the growth.

Think about this for a second. Basically, the Fed has shown its willingness to sacrifice the performance of heavy-industry companies to control the growth of the high-tech companies. This course of events would have been unthinkable even a few years ago, as the belief was that as the Dow went, so went the market. The only tool the Fed has in its arsenal is to control the flow of money. When it comes down to it, they're trying to perform surgery armed only with a hammer.

Clearly the hegemony of the Dow is under siege. The Nasdaq, as well as the Wilshire 5000, would have to lose some significant territory to lessen the assault, and they would have to do so with some leadership from the Dow. But the prospect of International Paper (NYSE: IP) and Gillette (NYSE: G) taking the reigns of power away from the technology stocks of the Nasdaq seems slight.

The other casualty of the rapid rise of tech stocks and the divergence of the Nasdaq and the Dow is the notion of a true Efficient Market Theory (EMT). This theory, to review, postulates that the current price of the market takes into account all news available at that moment. The last assault on the EMT came in 1987, when the Dow dropped more than 40% in the course of a month, on fairly benign economic news. The question at that time: Did the environment or future prospects truly change so significantly over such a short period of time?

I'd make the same argument today. When we see such established companies as Rambus (Nasdaq: RMBS) explode by more than 300% in the course of a month, I've got to ask whether the company was accurately valued before the run, or if it is accurately valued now, or is it neither? This has got nothing to do with Rambus; there are hundreds of similar cases out there. Ciena (Nasdaq: CIEN). 3Com (Nasdaq: COMS). Echelon (Nasdaq: ELON). Ericsson (Nasdaq: ERICY). Celera (NYSE: CRA). These companies' stock prices have skyrocketed in the last two months, at a rate that makes the concept of an efficient market seem implausible. One need only ask: What has changed in the future prospects for profitability to warrant such dramatic moves?

The answer is: not enough. Either these companies were always imbued with spectacular potential for growth and people did not notice until lately, or they are completely overblown now, or both. But what is not possible is that Rambus' intrinsic value is 3X what it was in January. Long-term shareholders have every reason to be ecstatic; they also have every reason to be very, very careful. For what an inefficient market can suddenly give, it can also take away. Again, this is not commentary upon these individual companies, rather a notice that the vaunted democratization of information has not necessarily created a market that moves commensurately with the prospects of its component companies.

One last note. I thought for a while yesterday that I was going to have to eat a prognostication in record time. Readers of this column will recall that I predicted that the poorly hidden merger talks between Qwest (NYSE: Q) and Deutsche Telekom (NYSE: DT) would fail. Mere hours after I penned this opinion, it was widely reported that a merger agreement between the two, as well as U S West (NYSE: USW), had been reached. This turned out not to have been the case -- the talks were breaking down. In the end, I hope that Qwest learns a valuable lesson: The market does not take kindly to uncertainty and poorly conceived strategic moves. You have a merger deal with U S West; either complete it or break it off, but take care of business.

Fool on!

Bill Mann, TMFOtter on the Fool boards