In our last column in October, we said that if there was no severe fall correction, the market would soar to new record heights by the end of the year. Here we are in December and indeed, the NASDAQ has been on a record tear, surging past the 3500 level on December 3, 1999. The rise is a record of another sort—1999 is set to become the best year ever for high-tech stocks, with the NASDAQ up about 60%. There’s a reason why this is happening but we’ll come to that later.

How is our high-tech portfolio doing? Extremely well. Some of this is dumb luck. In September, we jettisoned one of our underperforming stocks, Inacom, just before they announced an earnings disappointment that sliced 50% off the stock.

But the best news is that some of our long standing holds have paid off handsomely. Texas Instruments, Analog Devices and Nortel Networks are up 200% over two years. Analog Devices last mentioned at $14 in September 1998 is now almost $70, up a satisfying 400%. The great rises in our recent picks, especially the two-month 100% return in DSET and the 40% return in AMD are welcome but have yet to be tested.

Ironically the stocks we added to the Loser List in September have also being going great guns. The three stocks were Critical Path, Go2net and Infospace. Infospace announced a stock split, which these days is an immediate licence for a new high. Having sold short some of these stocks, the result has been personally painful. However, in recognition of one’s mistakes I am going to remove these three stocks and Inktomi from the Loser List. I still believe they are wildly overvalued but they may go up a lot more before they crash. We add one new stock to the Loser List and that is Parkervision (PRKR).

The market is caught in a speculative tidal wave. The amount of money moving into technology is mind-boggling. A billion shares trade daily on the NASDAQ. Some companies have trading volumes so high that every single one of their shares will change hands in less than a week. Stocks go up by tens of dollars and even hundreds of dollars in a single day. Take the initial public offering of Akamai Technologies. The company has $1million in sales. In its first day of trading in late October it sold 9 million shares at an offering price of $26. The stock closed at $145, valuing the company around $16 billion. And yet this 458 percent increase ranks it only fourth on the list of best first-day IPO performers.

Unfortunately speculative fever has a history of grave disappointment. In the early 1960s, it was the electronics craze. There was Vulcatron, Dutron, Ashtron and Transitron. In the 1970s it was the Nifty Fifty. In the 1980s it was biotechnology—the likes of Genentech, Amgen and scores of now-forgotten "gen" companies. All of these episodes started with a seed of genuine technological innovation, moved quickly into a phase where huge premiums were paid for nothing much at all, and ended abruptly with a collapse.

I am sceptical of claims that the Internet boom is different. But I will grant one thing and that is the Internet boom is bigger than anything we’ve experienced this century, including the ill-fated euphoria of the twenties. The high-tech darling of the 1920s was Radio Corporation of America (RCA) which sold at a pre-crash price-to-earnings ratio of about 100. The dot.com darlings of today can easily sell at twice that. In the 1980s, some biotech companies sold for 50 times their sales. But that’s dirt cheap compared to our friends at Akamai Technologies who are happily selling stock to a hungry public at 16,000 times sales.

(Lest I leave you with the impression that IPOs are the way to profits, consider this: The record holder for the best first-day IPO performance, one that beat out Akamai, was theglobe.com. This stock soared over 600% in its market debut last year, at one point reaching $97. Where is it today? It trades around $22 pre-split. So it goes. A tidal wave raises all ships, but the ones that are made of lead don’t stay afloat once the excitement passes. Other lead dinghy IPOs include Earthweb and Cyberian Outpost both down about 50% from their IPO glory days.)

The uncomfortable conclusion is that when the bust comes, it will be bigger and nastier than anything within living memory. Some commentators think that a severe correction in technology will be good for the overall market. I believe the opposite. An implosion in the technology sector will take the broader market down with it. A bear crunch in technology means margin calls will force the liquidation of conservative stocks.

The Long List (prices as of December 3, 1999 in US$)

How do you surf the tidal wave without getting wiped out? Ten thoughts:

1. Recognize the difference between gambling and investing. You are gambling if you buy any stock with a price-to-earnings ratio that is higher than its earnings growth rate. Ditto if a stock is sporting a price-to-sales ratio which is over 20 and sales aren’t growing in excess of 100% a year. You are gambling if you cannot name two competitors of the company you’ve invested in. Should you gamble with your children’s education money or your retirement fund? That’s up to you. But don’t fool yourself into thinking you’re investing.
2. Don’t buy hope, buy businesses. Hope is peddled everywhere on Wall Street. Buy businesses with real products, real sales, real earnings and real prospects. And if some wild-eyed buyer shows up looking for hope, you be the one to sell it to him because the price of hope is at its highest price in decades.
3. Don’t treat paper profits as found money. Here’s what happens when we’re flush with success in the market. Say we’ve made $10,000 in paper profit in Nortel. We spot a speculative no-name that everyone says will be the next hot stock. A big temptation is to think of our $10,000 in Nortel as free money to play with. The likely result: losing that $10,000. If you have a paper profit, treat it with as much care as your paycheque dollars. Ask yourself this: If you didn’t have that profit in the first place, would you even consider going on that speculative bender? If the answer is no, then you shouldn’t do it.
4. Draw up your exit points. At this time in the bull market’s life, it’s critical to draw up a plan. What do you do when prices move for or against you? Here are some guidelines: We don’t know how high this tidal wave is going to get, so don’t nip your profits in the bud by putting limits on the upside. Instead put limits on the downside. Put in market or mental sell limits at price points 10% or 20% below market. If you’re afraid you might get sold out of the market on temporary dips, then adjust these percentages. If prices continue to go up from here, you raise the exit points to follow. Keep in mind that exiting the market can be done gradually. We’ve set exit points for some of our portfolio’s stocks in the table above. We will raise the sell point 10% each time the stock price goes up by 10%.
5. Embrace uncertainty. I don’t try to predict a value for the Dow or the NASDAQ a year from now—it’s impossible. Instead I use scenarios, thinking about the range of what could happen and guessing probabilities to each outcome. There will be times when I will have no idea what the probabilities are—hopefully I’ll be wise enough to know when that is. If you can’t embrace uncertainty, now is the worst time for you to be in the market.
6. Get to know the bear. If you have never been through a bear market, imagine an amputation without anesthetic. To help prepare, read A Short History of Financial Euphoria by John Kenneth Galbraith. Another good book is The Bear Book by John Rothschild. But no book can substitute for the actual experience.
7. "Buy and hold" is a slogan not a strategy. Despite conventional wisdom, most investors will not be successful buying and holding because they do not have an overall plan. In the technology world indiscriminate buying-and-holding is not a road to success. Fact: less than one in ten high technology companies will be successful ten years from now. As this boom has worn on, the quality of new issues has fallen. So expect an even higher mortality rate for the recent flock of Internet IPOs. If the stock price of your company has already factored in earnings for more than five years, it’s time to think about selling.
8. When others are obsessed about price, you should think about value. Because of human psychological myopia, value investing is still the only way to win in the long term. One factor at work now is what psychologists call anchoring. This is the powerful tendency that we all have of fixating on recent numbers. When the NASDAQ was at 2000 there were worries that it was overvalued. Now with the NASDAQ at 3000 we still worry about overvaluation but suddenly 2000 doesn’t look expensive anymore. But the original concern about 2000 may still be valid. Anchoring is one reason why you see analysts forecasting "more of the same" when they make their stock market predictions. It also makes people pay higher and higher prices during a bull run. The winners are the ones who spotted the stocks when they were relatively cheap (i.e., the value investor).
9. Avoid leverage. Leverage is the cocaine of the bull market masses. You may feel good but the long-term consequences may be more than you bargained for. Leverage is always most popular when it is most dangerous, i.e. at bull market peaks. (Reality check: the best time this century to use leverage was in 1933 during the Great Depression.)
10. Keep in balance. Some people are letting their lives revolve around the stock market even though it’s the last place they should be. Beneath the euphoria of the bull, lies a sad undercurrent of envy and desperation. Some people believe the market is going to solve their problems. The market has never done that in the past, and it won’t be doing it now or in the future.

What’s Ahead?

The reason why the market is hitting new highs is that we are in a phase of pure psychology now. The frantic momentum investing that used to be confined to IPOs has spread to the technology market at large. A market transfixed by momentum investing cannot rest. Huge amounts of money are ready to move the instant any stock shows some movement. That money wave makes for huge self-reinforcing surges in price levels either up or down. At the same time, the seeds of its demise are being sown. There are investors out there using high leverage to capitalize on these swings. When the momentum turns downward, we will get severe liquidation as their margin loans get called.

Some scenarios worth planning for: The NASDAQ can easily see another 30% increase in the next year which would bring it to 4500. At the same time there is a high chance of a collapse of 50% from its current level to 1500. The most likely scenario is a combination of both—a rise to 4500 followed by a 70% collapse to 1500.

If you don’t mind the danger, grease up your surfboard. Don’t forget your lifejacket.

Wynn Quon

© Canadian MoneySaver, PO Box 370, Bath, ON K0H 1G0 613-352-7448 - Published January 2000