PeakTrader.com

[administrator]

“There you go again!”

March 31, 2008

“There you go again” is a phrased lionized by Ronald Reagan during his 1980 presidential campaign, and we could not help recalling said phrase in anticipation of today’s release of regulations that will be the broadest overhaul of Wall Street since the Great Depression. Bafflingly, the recent measures being taken by the politicos – the Federal Reserve, the Treasury Department, et al – are occurring when the U.S. economy is not even in a recession, let alone a depression! Moreover, most of the time the powers-that-be try to “fix” something, the damage has already been done and the resulting collateral damage is legion. Case in point is the Sarbanes-Oxley Act of 2002 (Sarbox), which was enacted after the tech/telecom bubble had already burst, the marketplace was already cleaning up corporate America and Wall Street, and the equity markets were setting the “footings” that would allow the senior index to gain roughly 100%. As for Sarbox’s collateral damage, the increased cost of audit fees, board compensation, legal fees, etc. continue to cause companies to go private and is in the process of moving the financial capital of the world from New York City to London. So yeah, “There you go again!”

And here “we” go again, as this morning we reprise a report that we penned back in November of 1999. At the time, stock market participants were giddy with the notion that “this time it’s different” and that stocks would rise forever. We, on the other hand, were writing about the Dow Theory “sell signal” registered in September of that year and advised participants to not let anything go against them by more than 15-20%. For the most part, those warnings went unheeded amid the mantra that the “Internet is the greatest invention of all time.” To which we wrote (in November 1999):

The number of Internet users:
142 million worldwide in 1998
502 million worldwide estimated in 2003
That’s 72 million “adds” per year, or 197,000 a day

With numbers like these, the Internet has been heralded as the greatest innovation in history, a statement with which we take issue since its “footings” were begun around 1455 A.D. Indeed, higher civilization first emerged at the close of the fourth millennium B.C. in Mesopotamia with the Sumerians, who developed the first efficient writing system. The Sumerians were absorbed into the Babylonian civilization, as was their writing system, and the first information revolution began. The Sumerians’ clay writing tablets, however, were breakable and bulky. It took another 2,000 years for the Egyptians to turn the papyrus plant into a paper-like material, which still had a tendency to crack, but made long-distance communication possible for the first time.

The Greeks, who made parchment from stretched animal skins that could be folded, overcame the disadvantages of papyrus, hence the development of books. However, it took a monk over two months, and many sheep, to copy one manuscript, making said book an expensive luxury item. Around 1455 A.D., all of that changed. In approximately 1455 A.D. Johannes Gutenberg invented the printing press, with movable metal type, which was/is by far the most important innovation in history. The impact of Gutenberg’s invention led to an information revolution as it cut the cost of producing an additional copy of text by at least 99%. The result was that by 1500 A.D., Europe had produced about 10 million copies of some 35,000 different titles at affordable prices. This staggering accomplishment represented more material than was produced since the Sumerians invented the clay tablet writing system! Thus began the Renaissance, and with it the Scientific Revolution of the 16th/17th centuries, upon which the Industrial Revolution of the late-18th/19th centuries was based. Printing solved the problem of accurate and cost-effective information recording, which permitted the passing on of information from one generation to another. It also laid the groundwork for the newspaper revolution of the late-17th and early-18th centuries. This clearly advanced the dissemination of information leading to the scientific advances of the 19th century. Samuel Morse’s invention of the telegraph in 1837 was followed by Alexander Graham Bell’s first telephone in 1876. Then Marconi’s radio communication led to commercial broadcasting, and subsequently the television revolution, ushering in computers, software programs, and the Internet. But, all the groundwork was laid by Gutenberg’s invention, which dramatically changed the world and fostered the first communication revolution.

What we have tried to show is that the information/communication revolution has been taking place over thousands of years. Gutenberg’s invention, however, was the linchpin that accelerated the information transfer process bringing about the Age of Enlightenment. This led to one scientific development after another – communications, the telegraph, the telephone, the radio, fiber optics, the fax, cell phones, computers, etc. All of these technological inflection points were accompanied by boom/bust cycles in their respective stock markets. Radio Corporation of America (RCA) is a great example, as it rose from approximately $10/share in 1927 to a “mania high” of $114/share in 1929, only to collapse to $2.50/share by 1932. We can document that radios were as popular in the 1920s as computers are today. RCA was a true high-tech stock in its era, just like many of today’s Internet issues.

What one should not forget is that every successful technology eventually becomes a commodity type of product. Telephones, radios, televisions, etc. all were high-tech products that eventually became commodities. In each case, investors overlooked the threats caused by the entry of new competitors and, consequently, obsolescence. As in past technology “booms,” investors tend to underestimate competition from new entrees and better products. Furthermore, Wall Street tends to underestimate the impact of excess capacity . . . falling product prices . . . and the subsequent profit squeeze. Even legendary Bill Gates has suggested that only one out of ten Internet companies will survive the test of time. With many of the major mutual funds, driven by the momentum “performance derby,” currently loaded with these Internets, what happens if the “worm turns” and they decide to sell ‘em?

So, where do we go from here? Well, a mania is a mania is a mania . . . and when it will end is anyone’s guess. In the 1980 oil stock mania, oil was allegedly on its way to $100 per barrel according to the gurus of the day. Similarly, the Japanese market (Nikkei) was “cheap” at 39000, according to many market mavens in 1989, right before it lost 50% of its value. Manias tend to work both ways. On the one hand they create a demand for the product, but on the other hand they tend to reduce the length of the product cycle. Consider this; a century ago it might have taken years for a new entree to enter a market where attractive profit opportunities exist due to poor communications. Today, with instant communications, the situation is different. The flood of new Internet IPOs is a testament to this. Also remember that the longer a mania lasts, the lower the quality of the new issues become.

The fundamental differences between past high-tech manias and now is that previously the U.S. stock market was relatively inexpensive. Currently, that is not the case. The DJIA has roughly quintupled since the low in 1990, while the NASDAQ is up nearly 10 fold. Additionally, technology, and particularly the Internets, has outperformed the market by a wide margin, as it became the “only game in town.” In the past, such widespread popularity of a group in an extended market has seldom paid off. Is it really different this time? We are skeptical. Consistent with this, we advise participants to protect their profits in many of the Internet issues. With these thoughts in mind, we wish you a momentous new millennium.

The call for this week: This morning, we reprise our comments of nearly six years ago because just as we were cautious back then, we are currently short to intermediately bullish. Longer term, we remain cautious as we honor the Dow Theory “sell signal” of November 21, 2007. In the near term, however, the sentiment is about as negative as it was bullishly-skewed six years ago! Moreover, as the brilliant GaveKal organization notes, “The four great momentum trades at the moment are: 1) long U.S. Treasuries; 2) long commodities (including gold); 3) short credit [financials]; and 4) short the U.S. dollar/long the Euro. All of these trades are getting rather crowded, and, in our view, the fundamentals argue that they are due for a turnaround.” Plainly, we agree!