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Look Out Below!

Election uncertainty, high valuations and tech's cash needs are some of the situations giving investors heartburn.

To repeat, now is a time to be extremely cautious with your money. Business conditions continue to deteriorate: The economy is slowing, interest rates remain high, and earnings expectations continue to disappoint. Price and volume measures remain woeful, with almost all of the market leaders having broken down below their various moving averages.

Vice President

Al Gore

continues his dangerous game of political chicken with Texas Gov.

George W. Bush

. And finally, many tech stocks remain well-priced considering all the uncertainty.

Cisco Systems

(CSCO) - Get Cisco Systems Inc. Report

continues to trade at about 60 times forward earnings, and

Nortel Networks


trades at a forward P/E of about 50.

You should not be shocked if the

Nasdaq Composite dropped another 10% to 20% from current levels. A level of 2000 on the Comp would be about 60% off the all-time high set on March 10 of this year. Sixty percent declines are not unheard of in major bear markets. And make no mistake -- this is a bear market for high-priced growth stocks, and tech stocks in particular.

Markets generally overshoot on the way up -- note the October 1999-March 2000 tech bubble -- and they tend to overshoot on the way down, too. The market top on the Comp was not some well-reasoned phenomenon. It was a case of bullish animal spirits and greed. So, too, when this baby bottoms, it will not be the result of calm, cool analysis suggesting that P/E's are unsustainable in the long haul. Instead, the trough will come when panic is in the air. Wait till we see the Comp drop 300 points in a day. We are not there yet.

Nonetheless, we are looking at the demise of the greater-fool theory of investing for this cycle. The notion that Cisco is a buy at $52 a share because you will come in and buy it next week at $72 has been found to be a money-losing bet in the current market. And it doesn't look like the greater fool school is coming back in vogue anytime soon.

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Here's why. The debt market has closed to any highly leveraged company with questionable cash flows. (For a discussion of how the equity market also has closed to cash-hungry Nasdaq companies, please read my colleague

Justin Lahart's recent story.) Even established companies such as



have recently been downgraded by debt analysts.

When you see moves like that at the top of the corporate food chain, it is not good news for more speculative technology companies. If bondholders, who have senior claims on the assets of a business, worry about getting repaid, then shareholders should not expect to see rising stock prices.

When debt-induced crises happen, they tend to strike quickly.

Say you have a company with an 8% profit or free cash-flow margin (profits or free cash flow as a percentage of sales). And say, interest expenses are 4% of sales. But what happens if revenue growth fails to meet expectations and the profit margin drops to 4% of sales? Suddenly, the company makes no money at all. Suddenly, it lacks the capital to invest in future growth. Financial leverage accentuates problems when the business fundamentals don't match prior expectations.

Business models that rely on unlimited access to the capital markets can be revealed to be deeply flawed in such cases. Take

(AMZN) - Get Inc. Report

, for instance.

Between 1997 and the first quarter of this year, according to

Lehman Brothers'

convertible bond analyst Ravi Suria, the bookseller generated $2.9 billion in sales but also had to raise $2.8 billion to finance that growth. Now, however, investors are finding that Amazon's off-line costs -- maintaining its Web site and picking and shipping the goods to customers -- remain higher than expected. The stock has suffered as investors wonder whether the company would ever reach profitability. If it doesn't, who will buy its assets at anywhere near its recent highs?

The debt crisis today is worst in the telecommunications services sector. The corporate bond market is denying additional capital to the telecom sector -- the CLECs (competitive local exchange carriers), data carriers, satellite ISPs (Internet service providers), Web hosters, wireless, cable, radio and broadcasting companies. (Last week, I wrote about a scary analysis by Suria of the

debacle in the telecom services sector.)

Without more money from Wall Street, many of these companies will go bankrupt. A dirty little secret of many New Era telecom services companies founded since 1996 is that they were never intended to survive as stand-alone companies. The ultimate ambition was always to sell out to some giant like


(T) - Get AT&T Inc. Report





Given the financial pressure bearing down on all the companies in the sector, high-priced bailouts for these companies' bondholders and stockholders appear unlikely. That is why telecom stocks have been routed in the past three months.

And the carnage continues. Monday saw

Level 3 Communications


drop $6.38 to close at $30.25 a share. The stock's 52-week high is $132.25. The problem? The company does not have enough cash to last through 2001 unless it gets more from the capital markets, and last week its existing bondholders started to fear that they might not get paid what the company already owes them.

Essentially, the stock is buckling because the company's capital structure is in question. If Level 3, with $7.5 billion of debt, does not get additional financing, the stock could go to zero.

The broader market implications of the debt-induced crisis at telecom companies like Level 3 should also concern investors. How sure can you be about continued fast growth for semiconductor and telecom-equipment makers if the Level 3s of the world are in such trouble?

The Ciscos and Nortels are dependent to some significant extent on capital expenditures by telecom-service providers. Let's say they see even a marginal slowdown in the demand for their products. Their stocks, which are still priced for high double-digit revenue and earnings growth even after their recent declines, could suffer mightily. You have to expect collateral damage from the debt-induced telecom disaster.

In the past five years, we saw an enormous transfer of wealth from bondholders to stockholders. If the corporate bondholder was getting 8%, the equity holder was getting 20% to 30% a year. It seems to me that the worm has turned. I'm not suggesting you sell your Amazon shares and buy Amazon bonds, unless you are a pro. But, you might want to raise some cash and avoid highly priced, highly leveraged tech stocks. We live in uncertain times.


Sgt. Esterhaus used to say, "Let's be careful out there."

Brett Fromson writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He invites you to send your feedback to