Stock Market – Boom or Bust?

"Stock Market – Boom or Bust?"

by Ed Stroligo

Part I: What is Going On Here?

Even the biggest gamer takes a break from the old genocide generator once in a while to see how the rest of the world is doing. This year, a different kind of killing is occurring: in the stock market. Technology stocks have soared to record heights. Can this continue? Is this the new, sure, easy way to fame and fortune?

Don’t bet on it.

People buy stocks in company to make money. For its stock price to go up, companies normally need to be making money, and make more and more money as the years go by. Even if the company isn’t making money right now, that’s OK if it looks like it will make a lot of money in the future. The more money it looks like a company is going to make for each share of stock outstanding, the higher the stock price. However, if the company doesn’t deliver as expected, or it looks like it won’t, the stock price drops. A lot. Often quickly.

Eventually, any company has to make money in order for its stock to be worth much. A whole lot of money for it to be worth a whole lot. People like technology stocks and pay a lot for them because they think these companies will be making a lot more money in the future than they are now. Will they?

The problem with the stock market today is that many technology stocks have stock prices so high that most companies, even good companies, are unlikely to or simply cannot make the kind of profits the stock market expects it to make. It’s like paying $25,000 for an Athlon machine. It’s still a good machine; it just isn’t worth $25,000.

There is an easy way to figure out just how high a stock is priced. How much interest do you get from a savings account? Four, five percent? At four percent interest, you are investing $25 to earn a dollar every year. We can use that ratio to figure out how an investment is valued. The stock market calls it a price/earnings ratio or P/E. It tells you how much money you have to put in for every dollar of profit the company makes.

With our bank account, we have an absolutely safe investment with a P/E of 25. Stocks are not as safe as money in the bank, so you expect to make more in the long run for the chance you are taking the stock will go down in price or the company will go out of business. Therefore, you’d expect to pay less for every expected dollar of earnings, or a lower P/E, than you would putting your money in the bank. That’s been true in the long run. Historically, the average stock has had a P/E of about 18.

If you want to buy stocks that will be worth a lot more in the future, you just don’t look at what a company is doing right now; you try to figure out what they’ll do in the future. Some companies have more room to expand. For example, American computer sales have a lot more room to grow than American toilet paper sales. If I think a company will be making five times more money in five years than it does now, I’ll pay more for that company’s stock than a company I think will make only twice as much.

On the other hand, if the next couple years don’t look so good, maybe that toilet paper company doesn’t look so bad. People worried about spending money will stop buying new computers before they stop buying new toilet paper. Well, maybe not here, but most of the time. 🙂

Wall Street values many, many technology companies like they are guaranteed to do much better than make five times more money in five years, to make huge profits each and every year for five years or even much longer. Will they?

Once you’ve reached a decent size, it’s not too easy to make five times more money in five years, and the bigger you get, the harder it is. It’s really hard to earn 50% more every year for five or more years. Not even Microsoft has managed to do that any time recently.

If somebody is making a ton of money doing something, lots of other people want to join in the fun. Depending on the business, that may or may not be easy. If you want to go against Intel, you either have to spend billions and billions of dollars in fab plants, or pay somebody else who spent the billions and billions of dollars quite a bit to make your chips for you. Since Intel is pretty good at what they do, this is pretty risky. That is why not too many companies make CPUs.

Compared to that, it’s a lot easier to build an ISP, or an ecommerce site, or a Website, or a portal, or a distribution of Linux. This is why you see a lot more of those than you see CPU companies. When you have a lot of competition, prices go down, and so do profits. This doesn’t mean you can’t make money, or even not make a lot of money. It means it is unlikely you will make outrageous amounts of money, and outrageously more every year thereafter.

There were a lot of automobile companies in America around a hundred years ago. Most of them went out of business a long, long time ago, even though the automobile industry got bigger than anyone could have imagined back then. The first company to get into a race is not always the winner; usually, they aren’t.

Will computer-related industries become more and more important in the future? Of course. It’s inevitable it will become the most important industry in the world, and soon. However, that does not mean any particular company is certain to become much, much bigger, or much, much more profitable.

Even in the short history of the PC industry, there have been plenty of companies that looked like certain huge successes at some point in time, but things just didn’t turn out that way. Ten years ago, which were the best-selling word processing, spreadsheet and database software packages? WordPerfect, Lotus and dBase. They looked like they had their markets locked up. Did they?

Look at PCs themselves. Not so long ago, companies could make a lot of money easily making and selling computers. Then competition flooded in. The more competition, the lower the profits. Sure, there are a lot more being sold, but you don’t make nearly as much on each one anymore. How could you? You used to be able to make $500 or more on a computer, now you are selling some of them for that much.

Sure, a Dell or Gateway is doing fine, but an IBM or Compaq have lost a billion here, a half-billion there because they didn’t get it just right. You could have said that Packard Bell’s idea of selling a lot of cheap computers was a great one a few years back. Well, a lot more computers are being sold now, and they are a lot cheaper, but where is Packard Bell?

Remember that P/E of 18? Let’s take a couple companies that have track record of making money, a lot of money, in the technology field and see what their P/Es are. IBM has a P/E of about 25. Intel has a P/E of about 40. Microsoft’s is about 80.
Higher than that figure of 18, but all of them are pretty good at making more and more money as time goes by. If even the president of Microsoft says publicly his own company is grossly overpriced, just what do you call companies that have P/Es many times higher than Microsoft’s?

Email Ed

"Stock Market – Boom or Bust?"

Part II: Are They Worth It?

Let’s look at a few of these companies and see how sure it is that they’ll make tons and tons of money, and whether even that would be enough to justify their stock growth.

AOL has a P/E of a little less than 250. Yahoo is at 2000. Amazon and Red Hat don’t have P/Es because they have plenty of P but no E yet. However, to get around that P/E of 18, Amazon would have to start earning about a billion and a half dollars a year (about what they currently get in revenue), and Red Hat about eight hundred million a year (or about fifty times their current revenue; not profits, not earnings, revenue).

Over twenty million people use AOL, and are pretty loyal to it. However, if Microsoft offered free Internet access tomorrow (which they have mumbled about), how many people would keep paying $21.95 a month, and how many new computer users that would otherwise get AOL sign up with somebody else for free? AOL probably would have to become free, too. That’s a lot of money to give up.

Even if that doesn’t happen, in the next few years, millions will go to DSL or cable modem in the next few years. Based on what’s happening now, it looks like AOL will get less money for providing more bandwidth to a bigger and bigger proportion of their customers.

At least AOL makes some good money. AOL is not only an ISP, it’s also a big Internet portal. Yahoo is another. A whole lot of people use Yahoo as their starting point to the Internet. But how much money does Yahoo make from them? AOL at least gets paid by its users; Yahoo doesn’t. If Yahoo started charging while others didn’t, how long would people hang around?

Yahoo makes its money from advertising. Just how much can they charge? It’s a website, not the Super Bowl. How much money does it take to set up a website as opposed to a car or fab plant? Obviously not too much given all the portals out there. If Microsoft is giving millions free Internet access, don’t you think the price for that access is likely to be starting at www.msn.com, not Yahoo?

At least Yahoo makes a little money. Don’t make any money like Amazon, and your head bozo, sorry, Bezos, gets named Man of the Year. For what? Adding an “e” to “bookstore (not exactly drug-dealing when it comes to making money)?” I heard that the Man of the Year said Amazon wouldn’t make any money until 2006. Go to your bank and tell your banker that when you want a business loan. Tell your significant other or parents “I’m starting a business, but you’ll have to support me until 2006.” They’ll all call you something, but not Man of the Year.

At least Amazon gets revenue. How about Linux? Red Hat is now valued a little higher than Apple, more than Xerox. How much money can you make out of something that is based on the principle of being free? Something you can get free even from the company that is trying to sell it to you, without even a porno ad to pick up the tab? I know, they’re basically selling tech support, but if Linux is so stable, how much tech support are you going to need? If you’re a company, don’t you think you’ll just hire Linux people rather than Windows people because it’s cheaper than paying Red Hat every time you have a problem? How much money can you make before the Linux laborers of love writing code for free stop writing code for free?

On top of all that, do you really think Microsoft is just going to die the next couple years? Microsoft spends more on bribes, oops, lobbying than Red Hat gets in revenue. I don’t care if Bill Gates personally strangled the relatives of every judge all the way up to the Supreme Court; the U.S. judicial system will not kill Microsoft. They may punch out the two-ton gorilla, or split him up into a few 800-pound gorillas, but all you end up with is one or more pissed-off gorillas, and pissed-off gorillas don’t usually mope and whine and conveniently expire.

Why does “Revenge of the Nerds” keep running in my head when I think of Linux? You want to play Rebel Alliance against Darth Gates, you have to get Joe Six-Pack screaming for Linux, not PC Modem. There are a lot more Joes out there, and a lot more coming. So what if Linux is free? So is the software Joe “borrows” from work and his kid “finds.” Windows 2000 and Microsoft Office may cost too much, so but so does retraining every one to use a new operating system and applications. Unix for Wintel machines has come up every once in a while throughout PC history. Even Microsoft had one in the early days, but none of them ever got very far. Not saying Linux is a joke, but expecting it will overthrow the Evil Empire or even be a huge threat is not like expecting the sun to rise tomorrow.

These companies are not doomed to failure. A lot of them probably will be around ten years from now, and be solid businesses. But Wall Street treats all of them like it’s already 2005, and they’ve been wildly successful in between. There’s no guarantee or even great likelihood of that. They are all in pretty risky undertakings, and the current stock price is so high that they can do very well and that still won’t be good enough to justify today’s stock price, never mind tomorrow’s.

Sure, most of them are good companies. Sure, most of them will make money. Sure, many might pay more for their services than some No-Name company. Sure, most are likely to increase profits faster than IBM, but not by that much more. It’s like buying that Athlon system. You might pay more than $2,500 if you had to, maybe $3,000, $4,000, even $5,000. But not even Jerry Sanders would pay $25,000.

Email Ed

"Stock Market – Boom or Bust?"

Part III- How Much Money Can They Make?

Just what would these companies have to do to justify their stock price?

The number of personal computers sold in 2004 will probably be in the range of double to triple the number sold today (250-350 million a year). Assuming AOL can make the same amount of money per customer it does today (as we have seen, a very generous assumption), AOL would have to have eight times the number of customers it has now in five years for the price you paid for it to start looking reasonable by 2004. That’s about 180,000,000 users, or every American between 15-65. This has to happen for you to basically break even in five years. For it to start looking like a decent idea, AOL would probably have to have at least a half billion to a billion users in another five years.

That means AOL is going to have to convince a good chunk of the world that doesn’t necessarily like America or Americans to use it. The locals can set up ISPs, too, and have nationalism on their side. The locals aren’t too likely to make embarrassing cultural mistakes, either. If “You got mail” gets translated into some mortal insult, could hurt sales a bit.:)

Doing that looks easy compared to what Yahoo would have to do. Yahoo would have to make fifty to a hundred times the amount of money they make now to justify today’s stock price. If everything goes right, it will take them ten years to do that. Ten years of everything going right to break even, to make your investment look as good as Intel’s would today. Yahoo would have to make a lot more profit than the three television networks combined make now.

The only way they might be able to do that is to get people to pay them, get advertisers to hand out many times more money a hit; or buy companies that do make money. There just won’t be enough people on the Internet for the kind of growth and profits Yahoo would need from the way they do business now. Not exactly a safe bet.

For a current investment in Red Hat to get to the same P/E as Intel, it would have to make as much money as Microsoft did five years ago five years from now. Considering that it took Microsoft almost fifteen years to do that, and Microsoft didn’t have Microsoft to worry about, never mind free Linux fanatics, that’s a pretty tall order.

We’ve already been told by Amazon’s boss that it isn’t going to make anything by then, so who knows when they might start meeting expectations.

These prices just can’t keep up where they are, never mind continue to go up indefinitely. It’s like watching a soap bubble grow. You don’t know exactly when it’s going to break, and sometimes it can get incredibly big, but it will break. It always has before, and when it has, it leaves a mess, and the bigger the bubble, the bigger the mess. When stock prices go out of whack with expected earnings, the end of a bull market is near, and the stocks most out of whack will fall the most.

Nor is it just a couple stocks. It’s pretty hard to find a good technology company that isn’t valued at least as highly as Microsoft. Some will succeed and justify their price, but not all or even most of them. Nor is every shareholder acutely aware of what he or she has bought. Some of them don’t even know what these companies do. I know Intel shareholders who don’t even know what a PIII is, never mind Athlons.

They bought technology stocks because the stock was going up. Or because their friend said so. Or they heard it on TV. Or because technology, any technology stock, will make you money. Or because they made a lot of money on Yahoo, and expect to make a lot more, and by the way, what is it? Many, maybe most of them, have no memory of stock prices going anywhere but up. Many of those making a ton of money off all this stock trading aren’t risking strokes to remind them they can go down, either.

I’ve recently looked at quite a few stocks (including all those mentioned above) at one website that also provides analyst recommendations. I have yet to see one stock where even a single analyst has suggested you might want to sell any one of the stocks I looked at. Not a single one. That is just not normal. When there is no bad news anywhere, that is bad news.

One of these days, they are going to head down, and all of a sudden, in the minds of many of these people, stocks will turn from being a Good Idea to being a Bad Idea. People are going to panic, and since they had no idea what they had in the first place, a lot of them are going to think that any stock is bad, maybe even good, reasonably priced toilet paper stocks. Things could get really ugly, and the problem is, the stock market has been having a huge party for years. The bigger the party, the bigger the hangover, and if the party lasted for years and decade, so can the hangover.

A lot of employees in technology companies have taken a lot of compensation in the form of stock options. Wouldn’t you like to pay your employees out of somebody else’s pocket? So long as that works, that is. When the market takes a big tumble, a lot of employees are going to find they are a lot less rich than they thought they were, and when IPOs no longer make the janitor a millionaire, a lot of people are going to want more cash and less paper. This increases expenses and lowers profits, which by then the stock market, bankers, and other investors will probably pay too much attention to rather than none at all like now.

A lot of you will say “This is a new era, the old rules don’t apply, success speaks for itself.”

Sure, there are differences between now and generations past. On the one hand, it’s cheaper and easier and quicker to implement good ideas. On the other hand, those good ideas have a much shorter profitable life-span because it’s cheaper and easier and quicker for your competition to implement as good or better ideas, too. It’s true that accounting rules don’t account very well for the value of ideas. On the other hand, factory machinery doesn’t walk out the door at a moment’s notice when given a better deal, either.

Maybe a P/E of 18 is too low a value for a lot of these technology companies, but that doesn’t mean it doesn’t matter at all any more. Whether you are building widgets or plumbing into new realms of virtual reality, you still have to make money, and you still have to deal with competition. That hasn’t changed at all. You can move faster, you can even fly, but that doesn’t mean gravity no longer exists.

People have always been greedy, too, and they’ve always been attracted to making easy money. People have also always been prone to go from one extreme to another. We’ve seen successes like this before. The Internet stocks of today were the tulips of Holland and the South Seas companies of Britain in the eighteenth century. They were the American railroad companies of the mid-nineteenth century. They were the US electrical companies of the nineteen twenties, and the computer and conglomerate companies of the sixties, and technology and property-holding Japanese companies in the late eighties, and many, many others.

They all had tremendous run-ups in prices, just like now. They all became worth a lot more than any rational appraisal of their current or future worth, just like now. And they all crashed.

Let’s say everybody in America all of a sudden decided they had to have an Athlon system. The price of these systems would go way up because more people would want them than would be available. Pretty soon, people would buy them just because they thought somebody else would pay more later on. Today, it’s called “momentum trading.” It used to be called “speculation.” One day, you just run out of people willing to pay more, and suddenly, that price suddenly doesn’t seem worth it. So everyone stops buying and starts selling. Then they find out nobody wants to buy anymore.

How much is a Barney doll worth nowadays? How much will a Pokemon doll be worth three years for now?

None of this means that tons of money won’t be made from technology. It’ll just mean it will take longer, be not quite as lucrative, and more risky than people think it is today. Still pretty good, just not quite as good as it looks right now.

Beware.

Email Ed