Lessons from the NASDAQ Bust
Adam Hamilton April 26, 2002 4112 Words
Since those amazing high-flying days of early 2000 only a little more than two years ago, we have all been privileged to witness the exceedingly rare spectacle of a supercycle bubble bust unfolding right before our very eyes.
Privilege? Yes, it absolutely is. It may not be any fun watching the widely-held NASDAQ market darlings like Cisco plummet 80%+ if you were one of the folks who bought in above NASDAQ 3000, but it is incredibly educational for all speculators and investors.
Since these kinds of rare stock mega-manias that seduce and delude an entire investing populace only occur once every three generations or so, todayís speculators and investors are blessed with an amazing opportunity to learn generations worth of crucial investing lessons and wisdom compressed into only a few short years. Rather than merely reading about booms, bubbles, bursts, and busts in dusty old history books, we all have the wonderful opportunity to observe the whole fascinating process firsthand in real-time today.
Even though the mania psychology spilled over into all the major US equity markets and is not yet close to being fully purged, everyone realizes that the fiery nexus of speculative fervor hovered over the red-hot NASDAQ stock market. It was the NASDAQ that shot parabolic in a spectacular bubble blow-off, not the S&P 500 or Dow 30, even though these other two flagship US equity indices also traded and still trade in dangerous vastly overvalued territory.
As I watch the incredible carnage of the slowly-evolving NASDAQ bust continue to unfold with morbid fascination, I have been diligently trying to soak up as much information on the whole bloody mess as I can. Since we are blessed with the exceedingly rare privilege of witnessing a supercycle bubble bust firsthand, I want to ensure that I glean as many crucial lessons from this debacle as possible that can help me become a better investor and speculator in the future.
Learning from mistakes, oneís own and othersí, is absolutely essential in order to become highly successful in any endeavor in life, including investment and speculation!
The following lessons emerging from the depths of the NASDAQ bust have really struck me as profound and important. My list is certainly not exhaustive and is constantly evolving and expanding as time relentlessly marches forward and more information becomes available. As a start at least, I believe that all investors in all eras should really take the following eight key NASDAQ bust lessons to heart.
Valuation is everything over the long-term.
One of the key signature hallmarks of any mania, including the fanatical NASDAQ mania of late 1999 and early 2000, is that stock prices seem to almost magically decouple from underlying fundamental realities.
When this mania point is breached, rather than properly regarding equity ownership as merely a fractional share of a real living-and-breathing business that must make money to survive and thrive, stock certificates are commonly viewed as mere pieces of paper with no connection to reality, kind of like lottery tickets. When this peculiar situation transpires, as generations of investors before us have gravely warned, it is time to be exceedingly careful in preserving oneís scarce capital and not getting swept up in the hype.
Every publicly-traded company exists solely to make its shareholders money. They must all sell a product or service for more money than it costs to produce, with the difference of course being the profit. The whole goal of investing is to prudently deploy surplus capital into profitable business ventures so the owner of the scarce capital can earn a healthy return on his or her investments. An investor must be absolutely sure to not pay too much for his or her particular fractional share of a companyís future profit stream.
Contrary to NASDAQ mania hype, the price of a share of stock in and of itself is meaningless. Share price must be measured relative to the fractional share of a companyís profits that the share commands. If someone tells you that a stock is trading at $100 per share today and it used to trade at only $50 not too long ago, this bit of information is useless in determining if it is now a good buy or not.
This $100 share is only a good buy or bad buy in the relevant context of its true fundamental valuation, a reasonable multiple of the amount of corporate earnings it represents. If this share commands $12 of earnings, the stock is trading at a P/E multiple of 8.3, well under the historical centuries-old US equity market average P/E of 13.5, and is a great value. Consider buying it! If this same share, however, only commands $1 of corporate earnings, it is currently trading at a stellar P/E of 100.0 and is vastly overvalued, a horrible buy. Consider selling it short!
In order to have a real shot at buying low and selling high, the ultimate mission of successful investing, you must be sure to buy fractional shares of real businesses only when they are good values relative to the earnings they command. Stock prices for individual companies ultimately gravitate towards a reasonable multiple of the corporate earnings they can spin off over the long-term almost without exception.
In the future when you stumble across a market or sector trading at 50, 100, 150+ times earnings, remember the great NASDAQ bubble and know that a mania is raging. You should not delay in taking the necessary steps to protect your scarce capital. Either immediately sell out of the overvalued arena or buy put options as hedges to protect yourself from the crash that is almost certainly approaching.
The shameless NASDAQ hypesters eagerly told us in 1999 and 2000 that valuations were meaningless in the New Era. They were wrong. Valuation is everything over the long-term.
Earnings earnings earnings!
This is a critically important two-pronged corollary to the first lesson. As investing in stocks is really merely buying a fractional stake in a living-and-breathing business, not simply an abstract piece of paper, an investor must know how the underlying business earns profits and must know that the business model is proven.
During the NASDAQ bubble, unsuspecting investors were sold all kinds of junk companies that really had never earned any profits. Wall Street, in its frantic zeal to take advantage of the mania and fleece investors blinded by dollar-signs, rushed companies to the markets that had no record of successful profitable business operations. Investors did not understand the business models of these companies, since none existed, but they bought anyway because of the deafening cacophony of hype and the increasingly Ponzi-like upward spiral of seemingly endless increases in stock prices. And now we all know how it ended, badly!
When you are confronted with the ďopportunityĒ to invest in a company that has never earned any profits in real business operations, donít do it. Like Nancy Reagan said, ďJust say No!Ē These types of entities are, at best, high-risk speculations, definitely not investments. If a company has been hemorrhaging money for years, something is inherently flawed with its operations or business model and it should be avoided like the Black Death. With a vast universe of stocks out there to pick from, there is absolutely no reason to take giant risks with your scarce core investment capital in unproven ventures that shouldnít even be publicly-traded in the first place.
In addition to a solid history of profitable operations, as Warren Buffet continually drives home the business of any company you are considering investing in must be understandable. If someone canít explain to you in less than three minutes exactly what products or services a company sells at a profit and into what markets it sells, walk away. This kind of thing happened all the time during the NASDAQ bubble and even recently in non-NASDAQ Enron, where analysts continued to advise investors to invest in the dying company even though they admitted that they couldnít even begin to understand how it actually made money.
They say in real estate that location, location, location is the key. In stock investing the key is definitely earnings, earnings, earnings! Donít invest in a company that does not have a proven business model and has been losing money for years or a company that appears to have earnings but it is unclear how its business model works. The crushing NASDAQ losses would have been slashed by a huge percentage if investors had heeded this simple lesson.
Psychology is crucial in the short-term.
While earnings ultimately drive long-term share prices, investor greed and fear drive short-term fluctuations in stock prices. The spectacular bubble blow-off top of over 5000 on the NASDAQ was only possible because of a massive mania delusion temporarily perpetuated by the naked greed of the investing masses. As soon as cracks began cascading through the New Era NASDAQ illusions, the emotional tide shifted and the bubble crashed.
As a long-term investor you donít have to worry very often about emotion, only when you are buying or selling, but as a short-term speculator your continuous awareness of the general emotional state of the markets is absolutely crucial.
When you witness a situation like the NASDAQ in early 2000, where a stock or index is rocketing up in huge gains day after day and no one thinks it will ever end, then it is time to sell. In these anomalous situations of extreme greed and optimism, it is best to be the contrarian and play the short side when everyone else thinks the good times will run forever in a particular stock or market.
Conversely, if you find yourself in an environment filled with dark fear and dread where everyone thinks a stock or market is crashing to zero, perhaps it is the time to consider a short-term buy speculation.
Observing general market psychology is incredibly important in short-term speculation and a speculator must do the opposite of what the crowds are doing at the time in order to have a shot at winning the very challenging short-term trading game. Only a contrarian speculator has a real chance to develop into a successful trader over the long-term. Figure out what the vast masses of investors are doing at any given time and then take the opposite position yourself when you feel that emotional extremes are being breached.
NASDAQ investors should have known that greed was running way too high when shoe-shine boys at the airports were giving out hot stock tips and all that anyone ever talked about at cocktail parties was the NASDAQ. Observing market psychology is crucial for short-term speculation.
Your own emotions are lethal.
Speaking of psychology, watching other investorsí perpetual emotional struggle in coping with the changing markets is great and is necessary for contrarian investors and speculators, but heeding your own emotions can be absolutely lethal.
We humans are all inherently emotional creatures, which serves us well in most areas of our lives. In the unforgiving capital markets however, emotions are the kiss of death. Becoming enslaved by oneís own greed and fear is probably the easiest investment and speculation trap to fall into and it virtually ensures massive capital losses at some point down the road.
If, like NASDAQ investors in March 2000, you find yourself feeling absolutely euphoric about the continuing prospects of a stock you own that has been running up for awhile and is trading at very high valuations, you have a big problem. If you donít slay it, the greed inside of you will grow strong, devouring reason, and you will begin counting your winnings before you have taken your money off the table. At that point you are toast. You will start zealously believing that your stock can only go higher, a grave mistake.
Ideally, an investor or speculator wants to maintain complete emotional neutrality towards all investments. Investments arenít to be lusted after or feared, only to be strategically and tactically deployed as simple tools to build capital. You must capture and suppress your own inherent greed and fear before these dangerous emotions capture you.
When you attempt to make buy and sell decisions, leave your own emotions completely out of the equation. Donít be greedy, donít get scared, but analyze your decisions based on cold, hard, fundamental realities and logic.
Never grow emotionally attached to a specific investment. Be ready to buy or sell without remorse anytime. Never second-guess your own previous trading decisions. Make them, learn from them, and have peace with them, but never regret a rational decision you made on a non-emotional basis regardless of the outcome.
NASDAQ investors in the bubble became all wrapped up in their own emotions. They were hopelessly blinded by their own powerful greed and lost sight of crucial fundamental realities. And now they are being utterly destroyed because of their fatal error.
It is very important to observe the general emotional market psychology fabric at any given time for a contrarian investor or speculator, but make sure not to become enslaved by your own fickle human emotions. Other investorsí emotions are useful, but your own emotions are lethal.
A stock can always go lower.
One of the nefarious fables that has sprung up since the NASDAQ bust commenced regards the assertion that because a stock is off 50%, 70%, even 90% from its all-time high therefore it must be a good deal. This particular fallacy, just like the original NASDAQ New Era delusion, is total bunk and is extremely dangerous.
Just because a stock has already plunged 80% does not mean that it canít fall another 80% from its new level, and even another 80% after that! There is no fundamental difference between buying a $100 stock and riding it down to $20 or buying a $20 stock and riding it down to $4. A loss is a loss is a loss!
The only valid absolute long-term measure of whether a particular stock is cheap or dear is based on solid fundamentals like the earnings multiples we discussed above. A stock can only be overvalued or undervalued on a fundamental basis in light of the earnings it can spin off for the fractional owners of the business, its shareholders.
If you watched a stock tumble like a mortally-wounded duck from $100 to $20, and you are now interested in investing in the company, find out where its GAAP P/E ratio is running at the moment. Paying 100 times earnings for a company trading at $20 is just as foolish and silly as paying 100 times earnings for a company trading at $100. In both cases you are making a wild bet that, all things being equal, it will take a whole century for your investment to re-earn its purchase price, an absolutely foolish premise.
A big fall in a stock is meaningless in and of itself because the stock can always go lower. This week longsuffering Worldcom shareholders on the NASDAQ relearned this hard lesson. A beat up stock can only be declared a good value or not in light of its core business fundamentals, not its past share price performance.
Lies catch up with the liars.
As a man of honor, few things make my blood boil as much as being lied to. In my own life and business, I have zero tolerance for liars. If I find out that I have been lied to, I cut off all future business and personal relationships with the liar. Life is far too short to put up with liars who set out to intentionally mislead others.
Unfortunately the whole Wall Street hype community, as well as the shameless corporate cheerleaders who helped stir up the NASDAQ frenzy that led to the bubble, has been based on a vast sea of lies in the past few years.
Many Wall Street analysts continually and willfully lied through their teeth, as the just-announced SEC and New York investigations into certain analysts and firms has shamefully revealed. Some very high profile Wall Street analysts were recommending stocks as strong buys to the investing public while writing private e-mails to their friends and colleagues telling them the very same stocks were junk. This fraudulent practice is despicable and unconscionable. American dreams were shattered, retirements and college educations lost, because Wall Street liars put their own financial interests above their clientsí. May they rot in prison.
Similarly, overvalued US corporations which couldnít honestly earn enough profits to justify their stellar stock prices began to continually lie about their earnings through so-called pro-forma earnings releases. They would report one set of fantasy numbers to the investing public that would consistently beat analyst expectations by a penny. At the very same time they would submit official legal reports to the SEC with solid GAAP accounting numbers showing vastly lower earnings or even large losses. In my book this is lying, the act of intentionally misleading, and I have written about it with great fury in the past.
If you find yourself doing business with a Wall Street firm in the business of lying, or you own a fractional stake in a company that is continually lying to investors through deceptive pro-forma headline earnings releases, run away from these people with the utmost speed. Take your valuable business and capital to another honorable brokerage, dump your shares in the companies managed by liars.
The lies caught up with Enron, the lies caught up with Arthur Andersen, the lies are catching up with Wall Street, the lies sunk the NASDAQ, and the lies will eventually catch up with all the financial-realm liars. For US corporations that have been intentionally deceptive to investors, this often means a drastic and catastrophic drop in their stock prices once the inevitable day of reckoning arrives for the liars. Donít get trapped in this mess.
Sell any stock you own in a company that is managed by people who prove through their words and actions to be unscrupulous and dishonest. Why risk your own hard-earned scarce capital in a company run by rogues and thieves? Instead prudently invest only in sound businesses run by men and women of honor.
There is no short-circuiting a bust.
After the NASDAQ bubble burst, there was this almost universal sentiment and faith that if the Fed lowered interest rates, if enough easy credit was blasted into the failing system, that the Ponzi-scheme of the NASDAQ could be salvaged and reignited. There was a widespread belief that governments would never let markets fall because the political consequences were too awful. An influential cult arose calling for the resurrection and second coming of the tech bubble and began preaching its pernicious gospel.
Fortunately there is nothing like cold hard reality to smash popular delusions.
In 2001 our fearless market manipulators at the private US Federal Reserve headed by mega-inflationist Alan Greenspan put this fairy-tale to the test. They launched the most aggressive interest-rate slashing campaign in the entire 89-year history of the US Fed. The results of this last-ditch frantic offensive? All of the major US stock indices continued to mercilessly fall throughout 2001 and so far in 2002, almost as if the frenzied rate cuts never happened. To make matters even worse, Greenspanís outrageous attack on the savers further distorted the damaged capital markets. When viewed through the lens of stock investors the Fedís disastrous rate cuts of 2001 were a total and dismal failure.
History clearly shows that once every three generations or so a massive popular delusion takes root that has such great power and allure that virtually every investor falls for its seductive sirenís call. Vast amounts of capital are sucked away from other important sectors of an economy and poured into the mania area, creating an enormous speculative bubble.
Inevitably, 100% of the time, these great speculative bubbles fail and the consequences are horrific. The resulting bust ensues to painfully pry away all the speculative excesses and eventually return capital markets to their normal equilibrium state. The more capital that was misallocated into silly projects in the preceding boom, like dot-com companies with no real businesses, the worse the following bust will be in order to undo all these mistakes. The vast majority of capital thrown at the bubble is outright obliterated in the bust, never to be seen again.
My partners and I have diligently studied market history for a long time, and we still have yet to find a single historical example of a bust not ultimately taking stock valuations well below fair value. There is no short-circuiting a bust once it begins, the painful process must unfold on its own terms to completion.
Better off standing back and letting the raging bust run its full course than martyring your own scarce capital!
Never sell-out to an idea.
Finally, and perhaps most importantly, never sell-out to an idea.
The NASDAQ bubble occurred because investors chose to check their brains at the door and totally buy into this fantastic concept of a glorious New Era where the centuries-old laws of investing and economics were suddenly miraculously repealed. In physics terms, it was like abruptly declaring that gravity no longer applied! For at least a few months of the bubble the vast majority of investors actually believed that investing was easy and that all they had to do was buy anything and hold and soon they would be filthy rich and never have to do any productive work again.
Today, after the first two difficult years of the unfolding bust process this warm-and-fuzzy notion seems silly to us now, but we all know investors who absolutely believed this with all their hearts in 2000. The NASDAQ mania popular delusion was extraordinarily seductive.
Anytime that something good comes along, an appealing investment or speculation opportunity, always keep your wits about you. Never sell-out to an idea, believing on mere blind faith that some investment opportunity is going to change the world. Changing the world is exceedingly rare, as it has a lot of inertia!
Instead of selling-out to a seductive idea, read widely, do your own due diligence, and do not stake your future and fortune on a single particular investment notion or worldview. Be inherently skeptical when it comes to capital deployment, as it is far easier to lose money than to make money and there are legions of folks out there trying to separate you from your hard-earned capital. Many of these people even work on Wall Street!
There are lots of investing ideas out there, some good, most bad, so be extremely careful to never sell-out to an idea. Once you have lowered your resistance to a certain investing paradigm trumpeting a certain group of stocks to the exclusion of all others, chances are you will not be able to muster the necessary discernment to sell when it is finally time to sell. Stay alert and aloof in order to survive and thrive in the tough and unforgiving global investing arena.
Never rely on any single source for market commentary or opinion. Investing wisdom lies in a multitude of counselors, preferably with different experiences and worldviews. The broader the range of ideas you explore, the more knowledge and wisdom you will culture and the easier it will be for you to separate the investing and speculating wheat from the chaff.
As I have written in dozens of past essays, I still strongly believe the NASDAQ bust is far from over. This certainly doesnít mean that I am right, but I suspect we have another year or two of hard lessons before us. If past supercycle bubble busts are a valid guide, the NASDAQ itself will have to trade below fundamental fair value, a P/E of 13.5 or so, before this is all over. Unless current dismal NASDAQ earnings yielding a P/E of 65.6 dramatically explode, this kind of historical bust process will have to bludgeon the embattled index to well below 500 before the cannons are silenced.
It is hard to believe, but those who have already stubbornly rode the NASDAQ bust all the way down and lost 70% could easily lose another 70% from here before it is all over! Ouch!
All prudent investors today, whether they bear (pun intended) nasty NASDAQ wounds and scars or not, are presently being blessed with an exceedingly rare world-class historical opportunity to observe an actual supercycle bubble bust real-time and learn important lessons that will greatly benefit them for their entire investing lives.
I respectfully urge you to zealously study the evolving NASDAQ bust phenomenon and learn all you can because the knowledge and wisdom gleaned will prove priceless for all of your future investing and speculating endeavors.
Adam Hamilton, CPA April 26, 2002 Subscribe at www.zealllc.com/subscribe.htm