A New Paradigm – January 2000

January 18, 2000

Dow Jones Average: 11,561
S & P 500 Index: 1455


A New Paradigm?

With speculative stocks soaring to unprecedented prices market analysts are wondering if something really is different this time. Investment models that worked well in the past seem overly conservative in light of the boom in technology related stocks. Even the most aggressive growth stock investors have no theories that explain or justify the current price of the hottest stocks. The basic tenet of investing, the relationship of a stock price to the earnings of the underlying company, is dismissed as irrelevant by those who are driving prices higher. For the moment investing in companies is out of style, playing market patterns is in.

Two patterns that have become increasingly consistent and compelling involve stocks at opposite ends of the price spectrum. In years past investors shied away from paying huge share prices for stocks. It was rare to see stocks selling for more than 100 dollars per share. That has changed as stocks selling for more than 200 per share have gained an avid following. Most of these companies are nascent, money losing internet companies with products few people can fathom or explain. Even though the viability of the businesses is questionable the movement of the stock prices has become all but certain. It seems that every time one of these stocks breaks the 200 dollar price barrier it quickly moves on to the 300 dollar level. The pattern has become so consistent that investors assume it will automatically be repeated and their frenzied buying in the low 200¹s makes the prophecy self fulfilling. It matters little that the stocks seldom hold the 300 dollar or even the 200 dollar level for more than a few weeks. Millions of investors are riveted by the consistency of the pattern no matter how nonsensical or temporary the gains.

The other pattern we are seeing is the surge in penny stocks traded on the OTC (Over the Counter) Bulletin Board. These stocks are not listed on a formal stock exchange which frees them from the obligation of issuing pertinent financial reports. The lack of information sets the stage for the scams and fraud that are rife in this part of the market. But in spite of the obvious risks there is currently an explosion of interest in this sector of the market. The combustible mixture of cheap on-line trading, internet message boards, and CNBC, has ignited these formerly dormant stocks. Stocks that once languished at 20 cents per share now routinely rocket to 5 or 10 dollars per share. The market value of many former penny stocks now exceeds the value of some well established companies.

The common thread in current market patterns is investor fascination with new, mysterious companies. Mystery is so much more alluring than reality. The internet stocks selling for 200 dollars per share and the penny stocks at 2 dollars offer investors an undefined and therefore unlimited future. The fact that almost all of these companies lose money and have a slim chance of survival seems to trouble no one. As soon as a company begins to develop a business that can be analyzed, such as is the case with Amazon or eBay, the stock begins to lose value. The companies that have the least to say with respect to operations, the ones with no identifiable business, the ones that do not issue financial reports, are the ones people seem to like the most. The expression ³ignorance is bliss² was never more applicable to the market.

The refrain we hear from people investing in the speculative new age stocks is that they will get out before a devastating drop occurs. In reality very few people ever exit before the day of reckoning. There are untold billions of shares of stock outstanding and every share will be owned by someone when the big drop occurs. Most likely the shares will be owned by the same people who thought they would get out in time. The vast majority of people buying these stocks will find themselves at the end of a chain letter with nobody left to send it to. Call it a chain letter or lottery, the end result will be the same. In the final analysis there will be a few big winners and many people holding losing tickets. At the moment it seems that everyone who participates can be enriched simultaneously. If a high enough value is placed on stocks, real estate, memorabilia, art, or tulip bulbs a whole society can appear rich. But when even a small fraction of the people try to turn their holdings into hard cash the illusion of widespread wealth is shattered.

We take issue with the notion that this market is different from past periods of excess. The parabolic charts of certain internet companies mirror the gold price spike of 1979-80. The fascination with futuristic technologies reminds one of the biotech craze of 1991-92. The level of stock analysis is on a par with the stock tips Joseph P. Kennedy received from his shoe shine boy in July of 1929. Joe Kennedy exited the market shortly thereafter, only months before the great crash. The market dynamic we are currently witnessing is nothing new. It is simply an expression of the human desire to be untethered from the limitations of economic reality. The harsh reality is that companies can not lose money for long without laying off staff and eventually closing their doors. The market bubble will burst, as all have in the past, when investors have exhausted their capital on overpriced companies.

Current Strategy

While the riskiest stocks scale new heights hundreds of stocks remain at depressed levels. The divergence between the stocks in favor and the broad market has never been greater. The firestorm in the tech related stocks has sucked investor interest away from other industries, leaving many decent companies starved for buyers. Our investment methodology indicates that many stocks in industries ranging from food and finance to building materials and auto parts are reasonably priced. But before buying these stocks too aggressively one must factor in the impact of higher interest rates and the potentially negative effect of a collapse in tech related shares.

We are continuing to focus on capital preservation while judiciously buying a few high quality companies at depressed prices. In the most recent quarter we trimmed back on a number of positions, locking in substantial long term capital gains. Even though we are skeptical of technology stocks at this time we look forward to a time when they are more buyable again. Over the years we have made more money for our clients in tech stocks than in any other sector.

We continue to buy intermediate term bonds for clients as interest rates have moved to the seven percent area. Even though the marketable price of a bond will slip in a rising interest rate environment, the full value of the bond is restored if one holds it to maturity. We usually hold bonds to maturity and believe that the current rate on bonds is attractive when compared to money market fund returns.

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