FOOL ON THE HILL: An Investment Opinion
After a slew of earnings warnings from big companies and a general belief that the market is unlikely to race off again in the near future, the stock markets, particularly the technology-heavy Nasdaq, have slumped again. But you'd think that the Great Crash has already taken place by glancing over the headlines of most business news sources. Fact is, in some ways these news organizations are only telling us what we want to believe. The reality is that the U.S. economy is still operating at such a high level of productivity that the Federal Reserve is still looking at inflationary, rather than recessionary, evidence.
Nobody likes to think about depressions when the going is good. But come a downturn, it is suddenly tops on everyone's mind. When I wrote last month about expanding and deteriorating corporate debt loads being a potential harbinger for the next recession, my e-mail box got lit up, much of if by people who are terrified of where the economy is headed.
Why terrified now? Now that most Nasdaq stocks have given back much of their 1999 gains, are people worried about what's left? Surely the economy is falling to pieces, right?
No, it's not. This is what we expect to hear, because it will match how we feel. Investors are letting the stock market be their master, rather than forcing it to be their servant, as it should be.
I've got a news flash for you: The economy is fine.
You'd never believe it reading the headlines, though. Check out this sample of business stories I pulled off the wires last night:
"Priceline.com Affiliates to Shut down"
"Opinion: the Coming Internet recession"
"Ralph Lauren Closes 23 Stores"
"Wall Street Fall Led by Dell"
"J.C. Penney Sales Fall as Retailer Issues Profit Warning"
"Stocks Edge Lower as Earnings Worries Weigh on Market"
"Marimba Warns of Poor Results in 3rd Quarter on Missed Sales"
Oh sure, we've got problems. The cost of oil, some 200%-300% higher than a year ago, is going to cause a pinch this winter. Corporate debt is up, which is troublesome. And that woebegone pan-European currency, the euro, has dropped 35% this year. Let there be no doubt that any one of these factors would be enough to cause a weak economy to teeter.
In the past several months, Nokia (NYSE: NOK), Intel (Nasdaq: INTC), and now Dell (Nasdaq: DELL) have warned and lowered earnings expectations, along with a slew of other companies. Several sectors of the stock market, most notably Internet, telecommunications, and banking, have been hammered.
But did you know that oil is still cheaper in real dollars than it has been at almost any point in our history? This is a perspective that seems to be utterly lost in financial coverage. This perspective, more than anything else, is causing a fair portion of investors to get very nervous.
I had the opportunity to meet Lou Dobbs, former host of CNN's Moneyline, a few weeks ago. He told an anecdotal story about Ted Turner. Dobbs first met him just after he had captained the boat that won the America's Cup. They met at the ensuing press conference, and Dobbs figured out pretty quickly that Turner was intoxicated. Turner had a playboy image, and this reinforced Dobbs' perception that Turner was not to be taken seriously. Not long after that, Turner persuaded Dobbs to sign on with this crazy notion he had for 24-hour news coverage, something that would become CNN. The second Dobbs signed the contract, his perception of Turner changed from that of a boozer to "a winner who knew how to celebrate."
This same thing is going on now. Our perception is that the economy is collapsing around us, and this mostly has to do with our earlier perception that the rapid rise in the stock market was somehow based on realistic expectations. In fact, part of the pendulum swing may simply be a response to the incredible run-up in several sectors last year.
Warren Buffett once said, "Just because markets are often efficient, it doesn't mean that they always are." You've heard it over and over and over again: When you strip out all the gobbledygook, the market price of a stock is nothing more than the expected future cash flows discounted at an appropriate rate.
So was Mr. Market telling us last year that Nasdaq companies were, on average, going to have future cash flows worth 80% more than they were the January prior? Was it even saying that the average company was going to grow its earnings to justify an average P/E of 200? That's lunacy, and yet, that's exactly where we stood on December 31 of last year.
What we had was something euphemistically called "P/E expansion." This is not a bad tendency. It is a sign that its investors believe that companies will earn more money, faster. But eventually the companies must justify the higher stock price. Stocks cannot and will not remain high if a company's fundamentals do not support them.
But it's not like we're careening toward an imminent recession. The U.S. economy is still growing at about a 4% clip, interest rates are still low, and inflation is still largely in check. The jobless rate remains near 4%, and one glance at the weekend employment section will show that companies are still desperate to get some very high-paying jobs filled.
We are not left wanting for growth. Whether we like the stock market's performance or not, the Fed has engineered a soft landing for the overall economy, and it seems to be working. We are prosperous, and we still have amazing opportunities for wealth appreciation. So what's all this doom and gloom about? Why does the financial section make it seem like a bloodbath is going on out there?
Because that's what we, the aggregate mini-psychologies that make up the whole of the market, choose to see. Basically, we have lost 10 months of gains in the Nasdaq and 19 months of gains in the Dow and we're shell-shocked. The lessons of 1998 and particularly 1999 did not include the concept of treading water. But let's look at the big winners of 1999, and it's much easier to understand how investors feel as if they've been duped: The Nasdaq Telecommunications Index is down 30% year-to-date; the Nasdaq Computer Index is down 24%; and the Dow Jones Composite Internet Index is down nearly 50%. Obviously, this is a prime source for negative sentiment among investors, as these are the very same sectors that garnered such interest and provided such gains last year.
These losses are not a product of a doomed economy. They are a direct result of the crazy, stupid froth that was built into these very same companies last year. It is neither a hard landing, nor a soft landing. It is a hangover, one that a huge amount of individual investors are enduring after having been excited about all the same stocks at the same time. When economic reality steps in, our willingness to pay that much for future growth is exactly what hurt our returns. I look at the point in which Akamai (Nasdaq: AKAM), with negative cash flow and revenues less than $10 million (it has since surpassed this number), was valued at $34 billion, as high as General Motors (NYSE: GM), and I marvel that someone actually bought a portion of it thinking that it would still grow higher. Yet, a lot of us did.
If a stock price appreciates faster than a company's operational performance, one of two things must happen. Either the stock price will drop, or it will grow at a slower rate than the company. Regardless, the stock price is advised by the company's performance. So now, after a few months -- or in some cases, several years -- of the stock price running significantly ahead of certain stocks, the companies are playing catch up, and we are being punished for allowing our expectations to be too aggressive. Read the news -- listen to what the talking heads are saying. "XYZ today warned that it would not meet earnings expectations for the coming quarter." The trouble here is not the companies -- they're still growing at a healthy clip, for the most part. The problem, my friends, is us.
Bill Mann, TMFOtter on the Fool discussion boards