Reality as Told by the Trader, Part 3

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Editor's note: This is the third installment in a multipart series. Please check out Part 1 and Part 2. Look for Part 4 later today!

And who actually bought this merchandise? Ahh, now here is where the third fortuitous element comes in. It was right about at this time that the public, which had been watching the stock market and was increasingly excited about it, simply went nuts with joy over the prospects of making a fortune by buying stocks.

How could they not? A whole industry, backed by billions, was telling them that they could open an account online and make millions of dollars trading. In fact, they had to be idiots if they didn't. The money was being given away.

The traditional market simply wasn't ready for the onslaught. It did not know how to handle this avalanche of new capital. Thus, you got these ridiculous openings when individuals' orders got batched by brokerage houses that controlled the opening prices with market orders that overwhelmed the regular IPO mechanisms.

Believe me, it wasn't institutions that opened these stocks up at massive premiums, at least at first. It was the individuals entering orders online.

The brokers certainly were not in a position to exercise any discipline. The stock brokerage business had been a crummy business for a long time except for two profit centers: margin lending and initial public offerings. Suddenly, both caught on fire, as individuals who were new to the market and got involved via the Internet borrowed money and played every initial public offering. Why not? If everything went up, why not borrow money to play? Seemed like motherhood and apple pie to borrow and buy and, if necessary, hold. I mean, isn't holding the worst thing that happens?

The institutions may have been loath to play, but not the corporations themselves. If you recall, what really got things stoked was that the dot-coms all started buying each other, and the bricks-and-mortar folk, envious of what they thought were never-endingly positive markets for New Economy stocks, threw money at the dot-coms to justify the valuations.

So even though the mutual funds, or at least, the old-line mutual funds, ignored the stuff, the corporate buyers ratified all of it.

After that happened there was no reason why the mutual fund buyers couldn't play. Why not? They may be paper fortunes, but they paid out, and you could sell them, you really could, into the bids of others.

Next thing you know, the mutual funds that played this game, that bought into these valuations, began to get billions of dollars in. They were featured everywhere. They talked endlessly about how they could profit from the New Economy and that they knew the New Economy even as others didn't.

The unnerving thing was how right they were, as the individuals and mutual funds kept the stocks in the air propelling valuations ever higher. As they propelled valuations higher, and those valuations were instantly ratified by bricks-and-mortar folk, the temptation just got to be too great for all but the most dyed-in-the-wool value managers.

There was only one problem. All of this worked as long as there was easy money made available by the Fed. You needed the easy money because that's what the public played with. You take that away and you don't get the voracious IPO market that makes the whole game worthwhile. You raise the price of the money, and the public can't afford to borrow anymore to finance its stock portfolios.

Once the public can't afford to borrow, the insiders will see how the stocks can't stay up, and they will begin bailing. (Hence the giant secondary activity of the first few months of this year.) The psychology of can't-miss will change, and all anyone will feel is that they can't win. The dream will be over.

There is only one problem: a tremendous amount of merchandise was created during this period, a monstrous amount, all of which got valued through the same euphoric prism of easy public money paying absurd multiples to revenues. The companies that were created all incestuously kept each other afloat, so those revenues turned out to be one-off in nature. The dot-coms, even the ones with merit, were established to grow revenue, not earnings, but with the dream over, earnings mattered again.

Consequently, the stocks without earnings ceased to have multiples and traded as a function of the amount of cash they had in the till minus the amount they were losing regardless of revenue.

And the stocks with earnings began to be valued like any stocks with earnings, meaning that if they sold stuff that made the Internet economy tick, or tick faster, they sold at some level that is traditionally in sync with high-growth situations. If the companies are growing three times as fast as the rest of the economy, they get a multiple on earnings that will end up being three times as big. But not 30 times. If they had high growth in earnings off a small base, they would be valued even more skeptically.

That's this multiple compression ailment I keep referring to. Not everyone believes that this re-evaluation is happening. The venture capitalists don't believe it. But who can blame them: they would have to return all that money they raised and give back those huge fees. That's preposterous. Better just to keep acting as if everything is OK, lest someone big want his capital back.

The public doesn't believe it. There is still way too much margin, and believe me, that is almost all public money holding on to crummy portfolios hoping for higher prices that won't come as long as they are in debt. Others believe selling is sinful. They have jerry-rigged a Peter Lynch first-hand experience model on top of a buy-and-hold Warren Buffett model for things that may never make any real money. Ouch!

And most of all, the whole class of manager that I call Buzz and Batch doesn't believe it. These are the people who are still hoping that the old valuations are going to come back. They sincerely believe that Broadcom(BRCM Quote) should sell at 300 times earnings, because, what the heck, it once did. Even if it were a dream. They think that they can just stay in the game, taking in money -- and they know it is building on the sidelines because they see the data -- and walk stocks back to where they were because the floats are small and the prospects great.

Now, however, the floats are huge. Everything is off lockup. Everything is for sale -- either because it still sells above the value someone else might have paid for it or because it makes a nifty tax loss. And the prospects are small -- the dot-com world turned out to be big, but maybe not as big as the cell-phone world. OK, that's an exaggeration. So what. It's obviously much smaller than we thought about a year ago. And I don't think anybody thinks the cell-phone market is much smaller than we thought it was a year ago. It is all on the perception.

How do we get out of this fix? That's the real rub. We don't. Remember, the prices were all put on when, like in Dallas, we thought the action was for real. But it turned out to be a dream, with no basis in reality. Reality is stuff that trades on earnings, as a function of its growth rate, either higher or lower than the S&P. The rest is just part of the dream.

Oh, don't be so upset about it. I am not creating the new/old rules. I am just observing them and pointing them out. I grew up under the old regime and I am quite comfortable doing multiple analysis and comparables based on earnings. I was never comfortable with this revenue stuff anyway.

I think you will find that in my columns I have come to accept that the Buzz and Batch world, which I regard as visceral and real and palpable, will have to be destroyed before whole sectors of the market can advance again.

In the meantime, though, there are other areas that are performing outstandingly. They just were never part of the dream. Those are the areas I will keep pointing out and keep treading in. Because they made sense to me before the dream began and they make sense for me after it ended. If they don't interest you, I think you should rethink what you expect out of the stock market.

The dream is over. I don't expect another one to appear any time soon. Accept it and move on. If you are holding out for its return, especially if you are borrowing money and holding out for its return, you have my sympathies and my condolences.

Otherwise, let's go make some money in this old world. It is a lot easier to figure out, even as it might be more boring, and certainly, slower in its rewards. Slow, but sure. That's fine with me.