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Google's Soft Underbelly Contagious

Weakness in the Internet search giant weighs on major averages amid weak economic data.
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Lose your dreams
And you will lose your mind
Ain't life unkind?

Goodbye, Ruby Tuesday. -- The Rolling Stones

The market learned some precious lessons after the bursting of the tech bubble. One important one: that you couldn't expect ever-rising exponential growth from the Internet -- no matter how promising it might be over the long run.



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candid admission Tuesday that this rule also holds for the No. 1 Internet search engine came as a surprise to Wall Street. After Google CFO George Reyes told a Merrill Lynch conference that "clearly our growth rates are slowing," the stock plummeted $52, or 13%, from $390 to $338. It trimmed the losses by the close to finish at $363, down 7% on the day as Google's fans on Wall Street came to the rescue.

The market followed Google lower, with the

Dow Jones Industrial Average

losing 104 points, or 0.9%, to 10,993. The

S&P 500

fell 1% to 1280, while losses were, of course, heaviest in the tech-heavy

Nasdaq Composite

, which lost 1.12% to 2281.


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fell, even though the tech star

announced its new Mac mini computers, which use


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Part of the market's surprise was that Google has been notoriously silent about providing guidance. The company's earnings miss on Feb. 1 had shocked Wall Street, but the firm attributed the shortfall to unexpected taxes. The stock then dropped 26% to $342.38 on Feb. 15, 27% below its all-time high of $471 reached on Jan 11. But it had recovered $48, or 14%, through Monday's close.

Baked in the price, it seems, were expectations that Google was immune to the laws of diminishing returns.

Morningstar analyst Rick Summer, who is still a fan of the Internet search engine, puts the stock's fair value at $285 and wouldn't consider buying it until it drops to $219.

"We expect revenue growth to slow from the mid-40s in 2006 to less than 20% by 2010 on the back of continued growth in online advertising," Summer wrote in a recent report. "However, we believe operating margins will decline to just under 30% because of an increase in marketing, customer support, and research-and-development spending in response to aggressive competition" from the likes of





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That's pretty much what Reyes told analysts and investors Tuesday, noting that the company getting larger and larger necessarily meant slowing growth at some point. "You can see that each and every quarter," he said. "We are going to have to find new ways to monetize the business."

That Google is getting too big for its own good was the last thing Wall Street wanted to hear on Tuesday, especially following weaker-than-expected economic reports.

Not only did existing home sales drop more than expected in January -- and consumer confidence dropped in February -- but there were also signs of weakness in the manufacturing sector over the past month.

The Chicago Purchasing Managers Index of business conditions slid to 54.9 in February, while economists expected the index to remain steady at January's 58.5 level.

As stocks slid, bonds advanced Wednesday. The benchmark 10-year Treasury bond gained 12/32 and its yield fell to 4.55%.

That consumption will slow this year along with the housing market is already discounted by the market, according to Owen Fitzpatrick, head of the U.S. Equity Group at Deutsche Bank. "But the market is nervous about signs of things slowing on the business side."

Why so much concern about business? Wall Street economists have been bullishly claiming that business spending will come to the rescue of economic -- and profit -- growth this year, should consumers start faltering amid rising energy prices and declining withdrawals from their home equities.

There is reason to hope. It took years to digest the overcapacity of the tech-bubble era. But business investment did rise 10% last year, and it's still expected to rise in 2006, according to many economists.

Wednesday's national report on manufacturing in February by the Institute of Supply Management is expected to show a better picture than the Chicago report, which was heavily affected by the downtrodden auto industry. The report might even show a pickup in new orders, a sign of healthy business spending.

But widespread expectations on Wall Street that such spending will offset the impact of a slowing housing market on consumption and the economy this year are close to what former Fed Chairman Alan Greenspan called "irrational exuberance."

"Consumer spending and housing together account for about 70% of the economy, leaving 30% to government spending and business spending," says Mark Vitner, an economist at Wachovia Securities. The latter "would have to pick up quite a lot" to offset a slowdown in the former, he says.

Yet, Vitner expects business spending to grow 9.8% this year, slightly less than in 2005. Businesses have been sitting on piles of cash during the latest economic recovery and there are still many other things, besides boosting spending, that firms can do with their money. When they've put it to use over the past few years, they've tended to lift their dividends, buy back their shares, or purchase other companies.

In 2006, Vitner predicts there is going to be another major source of competition for the cash. Baby boomers are expected to start retiring

en masse

and many firms will have to shore up their massively underfunded pension funds.

In March, Congress is expected to vote on a legislation that would induce them to do so or pay higher premiums to the Pension Benefit Guaranty Corp, the government-run insurer of private pension plans.

Meanwhile, a business spending boom in 2006 seems as likely as Google reaching $500 anytime soon.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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to send him an email.