When Supply Meets Demand in Fiber Optics

At college I took a class in economics about supply and demand. It was like a lot of classes I slept through at Harvard and I learned little. But I remember seeing an X on some piece of paper that showed that once supply came into balance, price comes down. Sometimes huge.

That class pays for itself every day in my business. Every day. Because it reminds me that, as long as the supply can't meet demand, pricing can be as out-of-control up as possible. But once the two fall into balance, there is no price that works. To the uninitiated, my views on things like fiber must seem so fickle, so stupid. Loves it one day; hates it the next. But to those who know supply and demand and have traded stocks through many cycles, you know that viewing it any differently simply isn't rigorous. It is stupid and it will cost you money.

Let's go over what happens again. You have 14 companies all expanding rapidly because of the "insatiable demand" for bandwidth. As I agree that bandwidth demand is insatiable, I buy into that notion. These 14 companies all borrow huge amounts of money at high rates to finance their purchases of these expensive pieces of equipment, mostly fiber-based, that give you massive amounts of bandwidth that copper can't give you.

They expect to get a return on it because they read about the "insatiable bandwidth" demands just like you do. That big return is how they justify the capital expenditures. There are suppliers of this equipment who only see these orders and see that the orders appear endless. They raise prices at will for the stuff, then they take the proceeds and they add capacity because, while they can make a ton of money keeping prices high, they can make much more if they have much more to sell. These suppliers don't know that much about the buildout. They only know that bandwidth demand is insatiable. They read the same stuff you do.

As the buildout gets done, the different competitors cut price to ribbons to get customers. They lure each others' customers. Despite the insatiable demand, customers don't have to pay that much for the bandwidth because there are 14 companies all providing services. So what happens when the 14 companies cut price and cut price and cut price on their bandwidth to keep you as a customer? The answer is they don't get a return on those capital expenditures. That would be OK if they hadn't borrowed money to buy the stuff. But they borrowed about $200 billion to do so. Mostly from mutual funds that own junk and from convertible bond arbitrageurs who shorted common stock and took in the bonds.

Neither wants to do any more lending. Neither trusts these guys anymore. And so the magnificent 14 are out of capital. But nobody told the suppliers. They were still pumping out and pumping out and pumping out the stuff for the 14. Now the 14 are cutting back just when the suppliers can finally meet all of the demand. That's when supply gets out of whack with demand and inventory builds and price gets cut by the producers.

We just crossed that line.

As long as we hadn't, these supplier stocks are longs because estimates are too low. Once we cross into balance and then, of course, oversupply, the estimates have come down. If you have learned on thing from TheStreet.com, it is that as long as estimates are rising, the stocks go higher. But once the estimates are about to reverse -- even before they reversed -- the stocks go lower. And lower and lower. That's where we are now.

Why does anyone play these stocks? Because that's where all of the performance has been. If you were in these stocks, you made fortunes and fortunes and fortunes. And as long as the junk-bond market held up and the companies hadn't done their network buildouts and the suppliers hadn't gotten all of the supply the customers needed, you were in a virtuous circle.

That's over now. Just ended. Doesn't come back into balance unless you go blow up the physical plant of 10 or 11 phone companies and all of the optical plants. Might as well be as if we opened the strategic optic reserve and we had billions of miles of wire in the reserve to sell. When it ends no one really wants it to end, except for maybe Herb. We play these cycles to the hilt. But once supply comes into balance, we are history. If not, we will be history.

That's what happened to Nortel (NT Quote - Cramer on NT - Stock Picks) on Wednesday. And the others, too. Which is why they have gone from strong buys to strong sells almost overnight.