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What Investors See in the Cienas of the World

Justin Lahart

Thursday was a good day in optical-equipment land.

Ciena (CIEN Quote - Cramer on CIEN - Stock Picks) rose 15 15/16, or 9.8%, to 179 3/16 after besting analyst estimates for its fiscal third quarter and saying that the fourth quarter is looking strong. (TheStreet.com reported its outlook earlier.) Brocade (BRCD Quote - Cramer on BRCD - Stock Picks) tacked on 15 3/16, or 7.7%, to 211 15/16 after it reported blowout third-quarter numbers last night. Corning (GLW Quote - Cramer on GLW - Stock Picks) was up 14 1/16, or 5.1%, to 291 from its New York close on last night's announcement that it would split its stock 3 for 1. (Wednesday night, on the heels of the announcement, Corning ran up to 290 in composite trading.)

It was a good day in optical-equipment land and it has been a good year. While other highflying groups have fallen by the wayside, investors continue to enthuse over anything glass. As voice and data traffic explode, driven by the spread of the Internet, companies that make telecom networks are under enormous pressure to keep up with the demand for their gear. So in the thin-air version of market rotation, where money has shifted from e-commerce to business-to-business to biotech, optical is it.

Big Bets

"People are looking for where they can create better-than-average returns for themselves, and they start to hone in on a sector," reckons Tony Cecin, manager of Nasdaq trading at U.S. Bancorp Piper Jaffray. "It becomes self-fulfilling, obviously."

That really isn't all that different from normal sector rotation, where investors will shift to steady growers when the economy slows, move into cyclicals as things heat up, and so on. But normal market rotation involves companies that are pretty much known quantities, with histories that can help you gauge their future. Sectors that get white hot have limited histories -- and futures that seem endless.

"The flyers are generally dominated by companies that have more promise than current reality," says John Bollinger, president of EquityTrader.com. "They tend to be very, very early cycle businesses. You can't really say that fiber is an early business, but in terms of being a big business, it's a new business. If you take all the fiber that was laid down between when I was a kid and last year, we're probably laying that much fiber every month now."

As investors move into a hot sector, says Bollinger, a stock can become increasingly divorced from the company it represents. "Once you get a certain distance from the underlying reality, you need to deal with these as purely emotional phenomena," he says.

Scratch It Off

Santa Clara University finance professor Meir Statman, who does work on behavioral finance, goes so far as to suggest that hot stocks show similarities with lottery tickets.

"One of the things that lottery promoters have figured out is that they have to provide variety," he says. "People get bored with existing games, so they move to new games. And the same applies to sectors and particular stocks. Some stocks are in the news, they are the Harry Potter of the day. But soon everyone has heard about them and they move to the next one."

Yet on the face of it, the optical-equipment makers seem not to have reached the lottery-ticket stage. Proponents will note that, unlike e-tailers or biotech, these companies are well grounded. They make and sell something real now, and though valuations are extremely high, many actually have earnings. Moreover, this is not the same stock-market environment as late last year and early this year. Sure, the stocks are doing well, but none have shown gains like those of Qualcomm (QCOM Quote - Cramer on QCOM - Stock Picks) in 1999.

Still, the valuations are high -- so high that they seem to disallow the notion of competition; so high that they assume a level of use that might not be there. Rich Bernstein, chief quantitative strategist at Merrill Lynch, muses that it might be like railroads in Britain in the 19th century, where several competitors would lay lines between, say, London and Manchester. "Nobody ever thought, 'Is there going to be enough traffic?' " notes Bernstein. "The issue for some of these guys is, when all this stuff is down and it's usable, what's going to be the capacity utilization?"

But Bollinger warns investors off from what he calls "the contrarian trap," where someone will exclaim something like, "Even if they grew at the current rate they wouldn't come to a normal P/E in 12 years!"

"That's wrong-headed," says Bollinger, "because what you're trading on here is perception, not growth."