FOOL ON THE HILL
Are Investors Being Duped Again?

Whitney Tilson questions the recent technology stock rebound and the prediction that the economy will bounce back strongly in 2002.

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By Whitney Tilson
December 18, 2001

Terrorists are on the run and Osama bin Laden will soon get what he so richly deserves. The average recession lasts 18 months, so we're nearly halfway through that. Thus, fueled by 11 interest rate cuts this year and continued strong consumer spending and productivity gains, the economy will rebound sharply in 2002. This will, in turn, drive a continued stock market rebound, especially among technology stocks.

This scenario, aggressively promoted by Wall Street, sounds plausible, doesn't it? Don't fall for it! Consider the following (data from the latest Fortune and Fred Hickey's newsletter, The High Tech Strategist):

• In the third quarter, year over year GAAP earnings of 1,370 companies surveyed by The Wall Street Journal fell 72% (an improvement from the second quarter, believe it or not). For the year, earnings for the S&P 500 are expected to drop 45%. (Fortune)
• "GDP fell 1.1% in the third quarter, the sharpest decline since 1991. Exports plunged 17.7%. In the last 13 months the unemployment rate has soared from 3.9% to 5.4% -- a five-year high. Continuing jobless claims have doubled to 4 million, the highest level in 19 years. Over one million manufacturing jobs have been lost... Industrial production in October fell for the 13th straight month, the longest stretch of declines since 1931-32 (the Great Depression)." (Hickey)
• "Business capital spending is expected to lead the economy higher, yet factory utilizations are at 18-year lows, and the corporate financing gap is still near record highs (indicating that even current spending levels are being financed with debt, rather than free cash flows). There has also been little liquidation of the massive corporate debt built up in the binge years of the late 90s... The disequilibriums have clearly not been adjusted." (Hickey)
• There are "early signs of a credit squeeze as banks tighten up on corporate lending... Since the terrorist attacks of Sept. 11, many banks have turned hypercautious...The tougher credit conditions are affecting firms of all sizes across the country." (Fortune)
• "The business environment remains grim -- profit margins are at 19-year lows, there's excess capacity at every turn, and aggressive price discounting is rampant... The steep decline in business investment that began a year ago is continuing today. Real business spending on plant and equipment dropped 11.9% in the third quarter, and new orders for capital goods in November suggest a further sharp drop for the fourth quarter." (Fortune)
• Overall consumer spending has remained relatively robust largely because of 0% financing deals by automakers -- which are ravaging their bottom lines and hence aren't sustainable. Beyond autos, there is little positive news. The Conference Board's November consumer confidence index slid to 82.2, an eight-year low. Based on early data, retailers expect that this will be the weakest holiday season in a decade. Finally, consumers remain heavily indebted. In every previous recession, consumer installment debt as a percentage of personal income has fallen sharply. Currently it's at near-record levels. (Hickey)
• "The budget has plunged from massive surplus to deficit, and deficits are now predicted until 2005 or later, according to the White House budget director." (Hickey)

My point in citing all of this bearish data is not to argue that another Great Depression is looming. Inflation and interest rates are low, our banking system is sound, housing is remarkably strong, and the U.S. remains well positioned vis-ā-vis our international competitors. But it is not at all clear to me that the economy will bounce back in the near future, or that when it does finally rebound it will be strong and lasting.

Valuations
Given all of the economic uncertainties and the pullback in the stock markets over the past year and a half, one would expect stocks to be reasonably valued, if not downright cheap, but we're not even close to that point. Today, the S&P 500 trades at 29 times estimates of 2002 earnings. At the bottom of the 1990-91 recession, the S&P P/E ratio was 14, and in 1973-74, it dipped to 7. In addition, the market's total valuation as a percentage of GDP (a metric cited by Warren Buffett, discussed in my recent column) is 50% higher than at the major market tops in 1929, 1968, 1973, and 1987. (Fortune, Hickey)

The technology sector
While the stock market remains richly valued overall, the absurdities are greatest -- where else? -- in the tech sector. Demand is dismal and overcapacity, excess inventories and pricing pressure remain at alarming levels. Consider these facts (from Hickey):

• Telecom firms continue to cut capital spending. In fact, Ciena's (Nasdaq: CIEN) CEO claimed that telecom companies are racing "to see who can reduce capex the fastest." Yet the stocks of companies that sell capital equipment to the telecom firms are soaring. Go figure.
• John Loose, CEO of Corning (NYSE: GLW), admitted that "the long-haul fiber market is overbuilt for five to six years."
• The storage market is glutted, with many companies only using 40-50% of their capacity, so it's not surprising that, according to Storage Inc. magazine, "the price per unit of storage is basically approaching zero."
• It's a similar situation in computer server sales, where worldwide sales dropped 23% in Q3 (and 29% in the U.S.).
• U.S. retail PC sales were down 30% year-over-year in the first two weeks of November. Microsoft XP, the supposed savior of the PC industry, is a dud. Sales dropped 38% in the second week of release and another 50% in the third week.

Despite these factors, investors have bid up the Nasdaq by nearly 40% since its low on September 21st. I try to avoid making short-term stock market predictions, but I'm going to violate this rule: This tech stock rebound is the ultimate dead cat bounce, and the Nasdaq will soon be headed lower -- just as it did after the failed rallies in the summer of 2000, January 2001, and the spring of 2001. Corporate insiders seem to agree with me, as insider selling soared in October.

Amazingly enough, since earnings have fallen even further than stock prices, tech stocks as a group are trading at even higher P/E ratios today than at their peak. Investors are obviously expecting earnings to rebound to levels of the late 1990s, which might well make today's prices look cheap, but what are the odds of this? During the unprecedented tech/Internet bubble, companies like Cisco (Nasdaq: CSCO), Oracle (Nasdaq: ORCL), EMC (NYSE: EMC), Sun Microsystems (Nasdaq: SUNW), Nortel Networks (NYSE: NT), and Corning could sell everything they produced, at pretty much any price they wanted. Of course profits skyrocketed, but I would argue that this was a once-in-a-generation phenomenon.

Should these profits fail to materialize again, there's a long way for tech stocks to fall. Consider the six former market darlings noted above, which I've been warning investors about since October 2000. These stocks are down an average of 77% since then, but as this table shows, it's hard to argue that even one of them is even fairly valued, much less undervalued.

                Sales  Market   P/S    P/E
Company  Price (TTM$B) Cap($B) (TTM) (Future)
Cisco   $19.26  $20.2   $141    7.0    62.1
Oracle  $14.79  $10.5    $82    7.8    30.2
EMC     $14.75   $8.2    $33    4.0     n/a
Sun     $12.62  $16.1    $41    2.5    84.1
Nortel   $7.44  $22.9    $24    1.0     n/a
Corning  $8.51   $7.5     $8    1.1     n/a

[Note: Prices as of Monday's close. n/a means EMC, Nortel, and Corning are projected to lose money in 2002. Future P/E based on consensus analyst estimates for the calendar year ending 12/02.]

Let's look more closely at Cisco. Last quarter it reported a loss, sales were down 32%, and it has little visibility, yet the stock trades for 7x sales and more than 62x 2002 earnings. This is a buy? The only stocks on this list that appear somewhat inexpensive on a price/sales basis, Nortel and Corning, are projected to lose $640 million and $322 million, respectively, in 2002.

Conclusion
Ben Graham once said, "Wall Street people learn nothing and forget everything." I suspect these would be his words today if he were observing the current foolishness. Having been beaten like piņatas for more than a year, one would think investors in the tech sector would have learned to ignore Wall Street and practice prudence rather than speculation, but apparently not. Just make sure you don't get sucked in.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any company mentioned in the article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/