Wall Street Tailors

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Wall Street Tailors

By A. Gary Shilling

CUT THE SUIT TO FIT THE CLOTH. THAT'S WHAT Wall Street has done repeatedly--and often disastrously--to make outlandish stock prices seem reasonable by using cleverly tailored valuation methods. Way back, stocks were valued in relation to their dividends, just as high-quality bonds are still priced according to coupons and current interest rates. But during the 1920s stock market boom, Wall Street pushed appreciation. With the 1929 crash, it was back to dividends as the norm. In the late 1940s stocks leaped in celebration of the end of the war, the dawn of the postwar business boom and the newfound U.S. global preeminence. So dividend yields fell below bond yields, which rose with postwar inflation and the end of wartime interest rate controls.

To compensate, Wall Street responded by substituting earnings for dividends. Investors started hearing more about price/earnings ratios and total returns, which combined dividends and appreciation. Then the Street began hawking present value. Now, I understand the discounting of future dividends to determine the fair value of a stock, since dividends are actually paid to the investor. But discounting earnings? Sure, all earnings are theoretically available for dividend payouts, yet companies worthy of growth portfolios pay few dividends, if any.

Nowadays, my puzzlement over that maneuver is of fading importance as dividend yields drop to 1% and P/Es reach the stratosphere. In relation to bond yields, stocks are now overvalued by about two-thirds.

Once again, the wizards of Wall Street have helped investors sleep at night. The authors of Dow 36,000 simply assume that stocks are no riskier than Treasurys, and therefore, should sell at prices that make dividend yields plus dividend growth equal to bond yields. Others shifted to "pro forma" earnings, "adjusted" earnings, "consolidated" net income and "operational" earnings that exclude anything that analysts want to eliminate to pump up the numbers.

Want to make crazy stock prices seem reasonable? Simply change the valuation methods.

For Internet companies with no earnings in sight, the Street creatively shifts to sales growth as the way to value stocks. And super sales growth is assured, their devotees believe, since all it will take is zillions of Web site hits, ignoring the need for infrastructure like warehouses, as noted in my Jan. 24 column. Amazon.com is living proof that companies can sell stock to the public, issue debt, acquire other companies, make billions for managers and shareholders, and dominate their market niches while losing increasing amounts per sale.

But even stock prices per dollar of sales can be too big to swallow. Rhythm NetConnections, an Internet access firm, recently sold at 539 times its annual revenues, and GLT PhotoTherapeutics, a biotech outfit, fetched 1,127 times its tiny $2.5 million revenues. In contrast, the S&P 400 index of industrial blue chips sells at 2.2 times sales.

If you can't stomach these price-to-sales numbers, then take it on faith, the Street assures us, since there's no rational way to evaluate Internet stocks. Of course, the absence of rationality is true of any speculation.

Researchers at Credit Suisse First Boston resorted to chaos theory, which looks for recurring patterns with no causality or theory in mind. And they found one--a high correlation between the logarithm of an Internet stock's market capitalization and the logarithm of its rank. A stock ranked 10th has 10 times the market cap of one ranked 100th. Investors buy the well-known, big-cap stocks and propel them to even greater relative size. That's just a new version of the greater fool theory.

You may have made a killing in Internet and other tech stocks, but I advise filling your ears with beeswax to resist the Street's siren songs of valuation inflation. Otherwise your portfolio may crash on the rocks, just as Japanese stocks did in the late 1980s. Then P/Es over 100 were explained away by the "Q ratio," which related Japan's stock prices to corporate assets--including soaring real estate holdings--and made stocks look reasonably priced, even cheap. Like U.S. Internet stocks today, Japanese companies strove for market share at the expense of earnings. But as the Fed did recently, the Bank of Japan raised interest rates in 1989. And the Nikkei index subsequently fell 63%.

Wall Street can always concoct a theory to justify any insane stock price. Recognize this nonsense for what it is, and try on the suit before you buy it.


-- Farouk Madjurian (fmadjurian@hotmail.com), February 18, 2000

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