Momentum Investing Is the Nutty Craze for Internet

When the national pastime becomes playing the market, all sorts of things can happen.
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The way things are supposed to work on Wall Street is this: When a well-managed company's business is improving, its stock price is supposed to go up. That's why every worthwhile investment bank and brokerage firm on Wall Street maintains a research department.

But events on Wall Street have now reached a point where serious-minded people can begin to question whether stock research is worth the trouble. In the stock market's current manic mood, prices rise and fall (mostly, just rise) on the basis of little or no research whatsoever -- nothing more, in fact, than the buying pressure caused by huge numbers of small investors who've figured out how to spot rising stocks the instant they start to move.

What we're talking about here is known as momentum investing, and it has taken over the much talked about stocks of the Internet sector 100%, creating the biggest and most dangerous investment bubble Wall Street has seen in history.

For more than a year now, we've been documenting the growth and growing dangers of this bubble, both to investors and the market as a whole, yet no story highlights the surreal nature of what's been happening in the sector better than the wacky tale of a Texas fish-oil company,

Zapata Corporation

(ZAP)

, that has figured how to make its stock price double by simply periodically muttering the word "Internet" in public.

If Zapata rings a dim bell, that's probably because the company was founded by

George Bush

and a couple of his pals at the start of the 1950s. In those days, Zapata was an oil-exploration company, but one thing led to another and Zapata wound up in the fish-oil business. These days the company is headed by Avram Glazer, 38, who came to the public's attention back in May 1998, when, with $160 million in cash and a $10 stock, he announced plans to get out of the fish-oil business and take over

Excite

(XCIT)

, the Internet search-engine company.

Now, on the fundamentals, there was nothing terribly improbable about this. Just read

Cannery Row

and you'll know that anything is better than the fish business. Zapata itself was chugging along with $133 million in annual revenues and steady profits since 1995. The company had a strong balance sheet, plenty of working capital and equity of more than $200 million. Its stated target -- Excite -- had just about the same revenues (approximately $120 million) but no earnings or cash flow, and only about $70 million of equity.

In short, there was no reason to think Zapata's bid shouldn't have been taken seriously -- none, that is, except one: Wall Street was valuing Excite at more than $1.5 billion, whereas investors had put a price tag on Zapata of less than $300 million. In other words, it was a deal that, in the full scheme of things, had no hope of success.

Yet the mere fact that Glazer had said he wanted to acquire Excite was enough to put him on the map as an Internet player. When he announced not long afterward that Zapata would soon begin buying Web sites on its own (as in, Who needs Excite, anyway?), his stock quickly soared from $10 to nearly $23 per share.

But when the stock market stumbled in September and investor interest in Internet stocks cooled off, so did Glazer's plans to spend money for Web sites, and he began backing away from various pending acquisitions. In the process, Zapata's own stock began to slide back and back, until by December it was under $8 per share.

So what did Glazer do to get it back up? Why, he got publicly interested in the Internet again, putting out a press release on Dec. 23 saying Zapata thinks "the Internet continues to offer great opportunities" And with the certainty of the incoming tide, Zapata's stock price awoke from the dead and doubled to nearly $15 per share in less than a day.

Having said all that, let us step back from the particulars of a company engaged in financial management by press release and take a look at why things like this are happening in the first place: the explosive growth of the Internet itself as an investment medium for playing the stock market.

Through the Internet, millions of retail investors now have instant access to the stock market from their homes and offices, 24 hours a day. And through almost Pavlovian conditioning, they have learned that whenever someone with access to a public channel of communication rings a bell drawing attention to a company with a .com in its name or business plan, the only thing to do is go immediately to the nearest computer, log onto the Internet and an online broker and buy that stock.

Over the last two years, a whole range of Wall Street sharpies has capitalized on the ignorance of these robotized Internet investors -- from hedge fund operators to underwriters and investment bankers. But as they have grown in number, these investors have unexpectedly become a powerful -- and increasingly unpredictable -- new force in the market. They are, in a word, the ultimate loose cannons of Wall Street.

Back in November, the

National Association of Securities Dealers'

top regulator,

Mary Shapiro

, gave a speech in Florida that contained some astonishing numbers regarding all this. She reported that nearly half the households in America -- representing 125 million people -- are now investors on Wall Street, up from only 6% in 1980.

Shapiro described these people as America's "new investor class," but what they're really doing is pursuing America's newest -- and most profoundly engaging -- national pastime: playing the stock market. I like to think of myself as a well-rounded sort of guy, with friends in lots of different walks of life, but I don't know anyone who is not either "in the market" or at least cheering from the bleachers as an avid spectator.

This is happening in no small part because Americans in unprecedented numbers are pouring onto the Internet. Once there, they're discovering the one thing that the Internet was tailored to facilitate from the start: playing the market. By one estimate, there are already some 3 million such investors online, and Massachusetts research firm

Forrester Research

expects the number to rise to perhaps 15 million over the next four years.

It is hard to exaggerate the significance of what that means, for as Shapiro put it in her November speech, thanks to the Internet, everyday investors now have "the ability to trade for themselves, online, with no one standing between their fingertips and a financial commitment, much the way institutions have long traded."

That's great and everything, except that individual retail investors are not likely to be rescued from the folly of their actions in the way that the

Federal Reserve

orchestrated the bailout of

Long Term Capital Management

last autumn. When the Internet bubble pops, and stocks like

Yahoo!

(YHOO)

wind up losing 50 to 75% of their value overnight, institutional investors will get all the liquidity assistance they need from the

Fed

. Yet individual investors (what should we call them, the Internet rabble?) won't even know whom to call for help -- and wouldn't get their phone calls returned even if they did.

But the dangers of a collapse in Internet stocks is real -- and it grows worse every day. A year and a half ago, when

Amazon.com

(AMZN) - Get Report

went public, the Internet sector barely existed at all. As a force in the economy, it still hardly matters. But financially on Wall Street it has grown into a monster. It was just about a year ago when we began tracking this growth through the Observer Internet Sucker's Index. By last October, that index had swelled to $72 billion in value, equal to what seemed at the time an alarmingly large 2.3% of the

Dow

. As of Jan. 13, the index stood at $240 billion and was equal to fully 10% of the Dow.

Investors in huge numbers have been beguiled by the so-called "momentum trading" techniques of hedge fund gunslingers like Jeff Vinik of

Vinik Asset Management

. In momentum investing, you buy a stock not because it is any good as a business, but simply because others are buying it and the price has thus begun to rise.

Doing so successfully has been generating staggering payoffs. Consider what happened on Jan. 13 when, at about noon, an Internet chat room -- Trading-Places.com -- posted a tip that

Golden Books Family Entertainment

(GBFE)

, the near-bankrupt New York publishing house that was then selling for 34 cents a share, would soon be the target of a takeover bid by

Walt Disney

(DIS) - Get Report

. Investors in the chat room began to load up on the shares, and trading volume quickened to 41,000 shares in the next hour, or double the pace of the previous hour.

Then, at 1 p.m.,

Bloomberg Business News

carried a story quoting Disney chairman

Michael Eisner

as expressing interest in acquiring Golden Books, and within seconds the company's stock was overwhelmed with an avalanche of Internet buying orders -- nearly 1.4 million shares in the next 29 minutes alone. Finally, at 1:38 p.m., a spread-the-word tip materialized on a Web-site message board of Yahoo, and the fun really began as Golden Books' price rocketed to nearly 75 cents on volume of more than 5.1 million shares.

The next day, Jan. 14, was even wilder, as seemingly every Internet trader on earth piled onto the stock, sending trading volume for Golden Books past 27 million shares. Result? This essentially worthless, near-bankrupt company instantly became one of the year's biggest gainers (530% in just 48 hours).

Nutty outcomes like that are now a daily occurrence, as investment excitement stirred up by outfits like Zapata spread from popular and easily accessible sources of business news, like

CNBC

, into the ears of investors all across the world. Once they hear it, they instantly log onto the Internet to see if the shares are rising, then pile on if they are.

Thus, on Jan. 14 at 9 a.m.,

CNBC

reported that

Morgan Stanley Dean Witter

(MWD)

had upgraded a retailing company called

Sunglass Hut International

(RAYS)

because it had acquired another company that ran a retailing Web site. Within seconds, Sunglass Hut's stock was engulfed with orders, 900-to-one on the buy side. The shares ended 24% up on the day, with an unprecedented 15 million shares having changed hands, while the market itself was down nearly 230 points.

So how close is the end, really? Could be years off, and it could happen tomorrow. On the same day that Sunglass Hut's stock was soaring, several brokerage firms downgraded Yahoo and the other Internet search-engine stocks. One analyst, Bruce Smith of

Jefferies & Company

(JEF) - Get Report

, told

CNBC

that he'd have to "build a model 10 to 20 years out to justify Yahoo's price," and that he wouldn't be surprised to see the stock fall "50% to 75%" in the days ahead.

"I'm very concerned," said Mr. Smith. As well he should be ... as well we all should be.

Christopher Byron's column appears in the New York Observer, and he also writes a Wall Street and investing column for Playboy. He is the former assistant manager editor for Forbes, the Wall Street correspondent for Time and the Bottom Line columnist for New York. Byron holds no positions in any of the stocks discussed in his column. While he cannot provide investment advice or recommendations, he invites you to

comment on his column.