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Markets value continues ascent, but just how high can it climb?

By Greg Ip -- THE WALL STREET JOURNAL

Jan. 18  The most-exciting business to come along in a century had sales of $30 billion last year, a bit less than Kmarts. But it lost billions, and will lose at least twice as much this year. Even giddy investors enriched by the surge in stocks now wonder how high is up  and, if the market teeters, how low could be down.

FOR THIS, THE PRICE TAG is a cool $1 trillion  more than the gross domestic product of Canada. That, in essence, is what investors in the Internet sector have bought: an incomparable business opportunity at an inexplicable price.

Euphoric valuations are hardly the preserve of the Internet. Fifteen technology stocks are today worth more than the entire market a decade ago. All stocks are together worth a record 172% of U.S. economic output, more than double the level before the 1987 plunge.

Does this make sense?

Even giddy investors enriched by the surge in stocks now wonder how high is up  and, if the market teeters, how low could be down. Doesnt this market scare you at all? asked one participant on an Internet message board recently. Last week, Federal Reserve Chairman Alan Greenspan pondered whether this period would be remembered as just one of the many euphoric speculative bubbles that have dotted human history.

It is impossible to say conclusively whether the market is overvalued, much less predict when it might tumble even if it is overvalued. Stock prices long ago broke all historic valuation records compared to earnings, dividends or any other traditional benchmark. They have kept rising long after skeptics first labeled the market a bubble  not surprising, perhaps, given the durability of strong economic growth, low inflation and technological advance that has fueled them.

But alarm bells have been set off anew by the Nasdaq Composite Indexs 60% moonshot in the past five months. It has recovered from a new year sell-off, closing near a record at 4064.27 Friday, five times as high as its year-end 1994 level. The Dow Jones Industrial Average finished at a record 11722.98 Friday, triple its year-end 1994 value. (Markets were closed Monday for the Martin Luther King holiday.) Most telling is that in many cases, Wall Street no longer even bothers trying to defend the valuations of Internet and technology stocks.

Erik Voss, a fund manager for Conseco Capital Management, describes being told by a Wall Street analyst covering Internet infrastructure companies,  The opportunity is so huge there, you just have to own these things. I said, Can we talk about valuation at all? And his response was, If you have to ask about valuation, you cant afford it. 

Concludes Mr. Voss, A lot of investing, at least the technology investing, has turned from fundamental analysis into mainly game theory: you make money by being able to sell to somebody at a higher price, and thats all.

Actually, outside technology and the Internet, valuations are far more terrestrial. Indeed, the average stock is barely higher today than two years ago. When it comes to technology, even the most bearish analysts agree the microchip and Internet are changing almost everything in the economy. Building a thriving company off that trend is another matter. In the past year, three online-travel services, five online-job recruiters, six online-music distributors, seven business-to-business e-commerce companies and 17 health-related Web sites have gone public and many have price tags of hundreds of millions, even billions of dollars. Yet they are fighting for a slice of a still-tiny market against more-experienced and often larger traditional companies also muscling onto the Internet, not to mention tens of thousands of private Internet companies, many financed by huge dollops of venture capital.

To give one example: Five online job-search companies are together priced at $1.2 billion, yet online-job advertising this year is projected at only $525 million, and already there is fierce competition for that money  from traditional companies that own the two largest job sites and from some hundreds of other sites.

Similarly heroic assumptions underlie the valuations of some traditional companies. Wal-Mart Stores has grown rapidly this decade to become the worlds largest retailer, but with a price/earnings ratio 2.5 times as large as that of other retailers, profit would have to match analysts bullish estimates of 14% annual growth for seven more years to grow into its valuation (with no change in its stock price). To achieve the nearly $400 billion in sales such growth implies, Wal-Mart practically would have to put every other general merchandiser out of business. Intel dominates sales of personal-computer microprocessors, but its $344 billion market value is double world-wide annual sales of PCs. Thanks to the high prices of such colossal companies, the Standard & Poors 500-stock index stood at 31 times trailing earnings at the end of 1999, double its 40-year average.

Some bulls dont even try to rationalize todays valuations, arguing the world has made such measures obsolete.

Its a new world order, says Robert Froehlich, vice chairman and chief investment strategist at Kemper Funds. He says investors should own Cisco Systems, Motorola and Intel at any price and not worry about the valuation. We see people discard all the right companies with the right people with the right vision because their stock price is too high  thats the worst mistake an investor can make. The people who have missed the bull market are the people who are on the sidelines trying to figure out how to value these things as opposed to getting into the market.

Those with long memories remember similar talk in 1972 about the so-called Nifty Fifty one-decision stocks  essential investments at any price. They collapsed in the 1973-74 bear market. Talk of new eras has prevailed at the height of most speculative booms, whether the 1920s in the U.S. or the 1980s in Japan. When bear markets hit, notes Fred Hickey, editor of the High Tech Strategist newsletter, tech stocks are hit hardest. From 1929 to 1932, Radio Corp. of America (RCA) fell 98%; from 1969 to 1970, 10 leading computer stocks including International Business Machines and Sperry Rand fell 80% on average. At their 1974 lows, Honeywell had fallen 90% from its peak, NCR 85%, and Control Data 95%. Even in the much-milder 1990 bear market, Mr. Hickey notes, in the space of 12 weeks Intel fell 46%, Compaq Computer 48% and Oracle 76%.

We see people discard all the right companies with the right people with the right vision because their stock price is too high  thats the worst mistake an investor can make.

 ROBERT FROEHLICH --- Chief investment strategist -- Kemper Funds

What is the value of a stock, anyway? The answer always has been part art, part science, so it is impossible to say conclusively whether todays prices make sense. Analysts agree on three paramount factors: profit growth, interest rates (or inflation) and risk. Depending on your assumptions for these three factors, you can come up with almost any value for stocks.

That said, examining these factors reveals a fundamental underpinning for stocks rise. Profits have gro wn steadily since 1992 with just a brief interruption during the 1998 emerging-markets crisis, and companies such as Microsoft and General Electric are growing at rates never seen for companies of their size. Interest rates, although they have risen in the past seven months, are their lowest in a generation, which increases the present value of future profits. With the bull market and, soon, the economic expansion both the longest in a century, investors have come to see stocks as a less-risky investment. These factors help explain why all stocks are highly valued, and fast-growing stocks such as in technology even more so.

Market-valuation levels have doubled from their historic levels, because investors feel extremely confident about the future, says Ed Keon, director of quantitative research at Prudential Securities. Therefore those stocks that have the greatest exposure to the future have benefited enormously and disproportionately. The S&P 500s 31 price/earnings ratio is misleading. The 10 largest technology stocks plus Yahoo!, together making up a fifth of the index, had a combined P/E of 74. Without them, the markets P/E drops to 26, according to Salomon Smith Barney. Half the companies in the index trade at 20 times earnings or less.

So rather than question overall valuations, investors need to ask themselves whether they are overpaying for growth stocks, in particular technology stocks. A good place to start is the Internet. The nearly 400 Internet-related companies compiled by CommScan LLC, a New York investment-banking research firm, Friday had a market value of $1 trillion. Their total revenue in the past 12 months was only $29.5 billion, according to First Call/Thomson Financial data. Next year, they are expected to lose more than $9 billion. For the same price you could buy every energy and basic-materials company in the S&P 500, S&P midcap and S&P small-cap index, including Exxon Mobil, Chevron and DuPont and get revenue of $753 billion and profit of $23 billion.

Clearly, America Online, Yahoo! and even Amazon.com have carved out leadership positions in a rapidly growing industry. Whether the hundreds of less-tested companies deserve the same valuations is more contentious. Online-grocer Webvan Group with $4 million in revenue and no hope of profit anytime soon, is priced at $4.2 billion, more than Winn-Dixie Stores, with revenue of $14 billion.

While growth stocks have always traded at far-higher valuations than the overall market, such as IBM and Xerox in the 1960s and early 1970s, never before have companies the size of Cisco Systems (third largest market value in the U.S. at $352 billion), Oracle ($152 billion) or America Online ($141 billion) sold for more than 100 times trailing earnings.

Intellectually, it is really hard to justify what has gone on in technology, says Roger McNamee, a veteran technology investor who is general partner at Integral Capital Partners, a Menlo Park, Calif., investment firm.

On the other hand, their growth rates are pretty spectacular. At its estimated long-term growth rate of 30%, Ciscos profit will double in 2 1/2 years, compared with five for Coca-Cola and 10 for Exxon Mobil. Todays companies can grow more quickly than their predecessors because they are more dependent on intellectual than physical capital, argues Michael Mauboussin, chief investment strategist at Credit Suisse First Boston. For an auto company to grow, it had to raise additional capital to build factories and equipment. For a software company or an online business to grow, it just has to print more CD-Roms or add more accounts. Thus, assuming the demand is there, such companies potential growth is unlimited, and it can come without an extra dime of capital from outsiders. Mr. Mauboussin says these superior economics can be seen in the higher return on capital for the 50 largest industrial companies today: 32% at the end of 1998, compared with 19% for the Nifty Fifty stocks in 1972.

Even if theoretically these companies can grow much faster than before, Mr. Hickey says the fact is many dont. Oracles P/E ratio in 1990, when its [revenue] was growing at 50%, was 50. Now its P/E is 100-and-something for 12% revenue growth. Sales growth straight down, stock price straight up.

Judging stocks today based on their historic valuations also can be a mistake because companies can change and none as quickly as a software or Internet company. All the pundits said 18 months ago, Amazon.com has to sell every book on the earth to justify todays value, it doesnt make sense, says Mr. Mauboussin. What wasnt fully appreciated was they could take that platform and do different things with it.

Furthermore, the potential market for an Internet or software company is far larger than that of an automobile or oil company, whose markets are growing no faster than the economy. Thomas Madden, chief investment officer at mutual-fund manager Federated Investors and former skeptic about technology valuations, recalls being told by a scientist from Carnegie Mellon University that if you plotted any Internet related factor on a chart, from users to network parts, it would be rising geometrically, that is in an almost vertical line. When an investor ... begins to believe that such growth may continue for years to come, it is easier to withstand very lofty valuations.

Some of todays tech leaders have spent most of their history growing in the face of doubt. Microsoft has been overvalued compared with the rest of the market virtually since it went public in 1986, but it consistently has beaten expectations and today is the worlds most valuable company, and one of the U.S.s most profitable. When Jonathan Cohen, now an analyst at Wit Capital, began coverage of the most-prominent Internet stocks in December 1995 for Smith Barney, he presciently rated Netscape a sell but he also rated AOL a hold, an ambivalence that cost dearly anyone who listened. AOL, which was at about $2.80 split-adjusted at the time, closed at $63.25 Friday.

The experiences of Microsoft and AOL are regularly cited to justify the valuations of numerous technology stocks today. But Microsoft enjoys a virtual monopoly on PC-operating system software and AOL holds a dominant market share in providing Internet service, a position it may strengthen with its planned merger with Time Warner. Few other companies boast similar virtues, yet many carry similar expectations. For Yahoo to retain its current stock price and trade at the same P/E as the S&P 500, it would have to maintain its estimated 50% growth rate for eight years without stumbling. Stumbles happen quickly. Four weeks after going public in the fall, business-auction site FreeMarkets achieved a market value of $12 billion. It lost a fifth of that in one day when a client, General Motors, said it was shifting its business to a competing auction site.

None of this discourages Wall Street from continuing to sell Internet stocks and their other-worldly valuations to the public. Some see a cynicism at work. Mr. McNamee says many institutions, including mutual funds, are buying into late-stage venture deals simply because they are almost guaranteed that once the company goes public (as most of them now do) the stock will skyrocket, adding a pop to the funds performance. People have gotten positive reinforcement for investment behaviors that are intellectually hard to support.

Even if the market is overvalued, that alone is unlikely to usher in a bear market. Mr. Keon notes that bull markets almost never end simply because of overvaluation; they need a trigger: falling earnings, rising interest rates or inflation, or war. With the profit outlook rosy and the U.S. at peace, the biggest threat, then, is rising bond yields as the Federal Reserve prepares to lift short-term interest rates to choke off inflation. By some measures, stocks are 67% overvalued relative to bond yields. Should rising rates eventually deflate the market, the greatest risk is that investors, who now have so much confidence in the future, abruptly lose it.

As Mr. Greenspan noted last year, History tells us that sharp reversals in confidence happen abruptly, most often with little advance notice... . Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behavior has characterized human interaction with little appreciable difference over the generations. Whether Dutch tulip bulbs or Russian equities, the market price patterns remain much the same.

-- snooze button (alarmclock_2000@yahoo.com), January 18, 2000

Answers

"The Big Bull Market"

http://hv.greenspun.com/bboard/q-and-a-fetch-msg.tcl?msg_id=000mbl

The annual unemployment rate for 1929 was 3.2%. Consumer prices in the summer of 1929 were only about 1% higher than they had been a year earlier.

-- Linkmeister (link@librarian.edu), January 18, 2000.

New paradigm, or just hot air? Who knows? All I know is, it is not prudent to enter or re-enter the market at this point. If you don't buy Cisco and Intel, you will miss a chance of a lifetime? I don't think so. Don't tell me some new opportunity will come along--AFTER the market has "corrected," or whatever.

-- Mara (MaraWayne@aol.com), January 18, 2000.

Don't know anything about the Stock Market. But it reminds me of kids playing Monoply, only they're using real money.

The kids are having a good time, but no matter what they do, it's still a game. I just wonder when is the game going to be over? How many times can Boardwalk be bought and sold?

-- Richard (Astral-Acres@webtv.net), January 18, 2000.

I agree with Mara, only people with cast iron stomachs should be playing the market right now. I'm sitting on the sidelines waiting for the dust to settle. You can't get back 100% of what you have lost even if it's a paper loss.

-- ~~~~~ (~~~~@~~~.xcom), January 18, 2000.

The way I see it, they're hoping to cash in on POTENTIAL here, getting in the ground floor. Yes, alot of these internet startups intend cater to global markets, which provide awesome earnings potential...or speculation, However, anyone who knows about venture capital knows that only a handful of IPOs will actually ever achieve their earnings potential. There was an article in Information Week's print publication a week or so ago (A Techie pub...more for managers/execs), saying that roughly 1 in 10 succeeds according to plan... I will try to find the article and post it by the weekend.

In essence, the venture capitalists fund a slew of internet startups, knowing that only a handful will only make it...but those that DO make it, make it BIG...enough to cover the loses for those IPOs that fail.

I am not condemning investing, only advising caution...do your homework, don't just act on a tip that you heard.

-- Tim (pixmo@pixelquest.com), January 18, 2000.

The move will happen and then all the "experts" in the media and at financial institutions will "find" some recent event to become...

Ta Dah.... The cause.

Then acedemics will debate this for years to come.

-- Squid (ItsDark@down.here), January 18, 2000.

Its simply more hype and frustration that we have to deal with. The smart money will off load their overvalued stocks , buy stable assets ( precious metals/ cash diversified foreign currency holdings( yen,euro) wait for the crash, and when the boottom falls out for these companies valuations and the price of foreign currencies and gold/silver increase in proportion to the decline in US wealth, sell your stable assets and repay your debts and buy the winners amoung the tech stocks that are still around and assemble a portfolio of investments that will carry you far into the 21st century. Which by the way starts next year.

-- cracker (Bubble@aol.com), January 18, 2000.