The Net Party Is Over

Our columnist returns with fresh perspectives on the Internet Valuation Sillies, the First Law of Internet Insularity and the Summer Dog Rule.
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While I have noted in several columns my ongoing struggle to avoid getting trapped in the day-to-day news flow, I have had little chance to do anything about it. Until, that is, the past two weeks, which I spent thousands of miles away from the laptop and the office.

That, in turn, enabled me to enjoy the benefits of perspective. And while I realize this sets me up for an experience from my college days -- when late-night thoughts of the utmost clarity and importance were reduced to bewildering banality by dawn of the harsh morning light -- I'll share with you some of the big thoughts that will be the basis of upcoming columns.

The first of these is how expensive big chunks of the market still are -- even after the drubbing of the New Nifty Fifty in the face of rising interest rates. It is truly eye-opening that almost all indices are still solidly up for the year in the face of a 25% move upward in long-term interest rates. This represents both a tremendous testament of faith in

Alan Greenspan

-- and at the same time a frightening prospect of just how much the world's financial markets are beholden in both the short and the intermediate run to the whims -- however conservative they may be -- of one man.

1999 is turning into another nice example of the eternal reversion to the mean. Or in lay terms, what goes around, comes around. The drugs, Internet-related and other "must-own" stocks are down 25% and much more from their highs, while last year's laggards -- value/cyclical/small-cap issues -- are steadily eating through the relative performance numbers like fat caterpillars munching their way through a leafy forest.

As study after study has shown, there is precious little correlation between trailing three-year performance and forward three-year performance. We are at the beginning of a painful debunking of the heroes and silly myths that have driven this market over the past few years, many of which fly in the face of basic common sense.

One of the biggest myths is that buying an

S&P 500

index fund is "indexing" the market. Wrong. It is a way to get low-cost representation in large-cap, high-growth stocks. As this group has begun to come back to earth, so has the index, which should be a pathetic punching bag for the next few years for professional money managers. (Three cheers!) Remember that when you hear your manager crowing about beating the S&P in the months ahead.

Even the most hardened value investor is drawn to the saga of Internet stocks like a June bug to a purple bug-zapper. At the risk of getting some juicy hate mail, here's my midyear take: It's over.

I am not saying that the Internet as a fundamental change in global commerce, consumer behavior, etc., is anywhere near over. I am saying that the Internet Valuation Sillies are finished. More than 100 Internet-related companies have filed to go public in the past six months, and May alone saw 35, a new record. Even if you concede that the top 10 will be grandfathered in and thus spared (at 70% below current prices, in my opinion), an entire industry created by a pathetic mix of Wall Street PR and Silicon Valley gold-seekers will be headed for the under-$5-per-share level as relentlessly as heat-seeking missiles.

After spending the past 10 days clearing my desk of financial publications and other excreta, my main thought is that I can't remember seeing such half-baked junk in 17 years in the investment business. Among my favorite items: the coming new issue for

quepasa.com

(PASA)

and a press release touting a new chairman of the board of

wannabe.com

, which noted that "already he has proved himself in helping forward the company's vision, as he himself is a visionary." I would also throw in that whatever is currently passing for

Marimba's

(MRBA)

business plan is not far behind.

Another manifestation can be found in the battle between

Global Crossing

(GBLX)

and

Qwest

(QWST)

for

U.S. West

(USW)

. This reinforces the First Law of Internet Insularity, which states that an Internet-related company can only merge with one of its own regardless of either stock's valuation.

As the abortive

USA Networks

(USAI) - Get Report

-

Lycos

(LCOS)

deal revealed, it is impossible for an Internet CEO to take the most rational course of action, which is to use absurdly valued equity to purchase real assets with demonstrated cash flow. The entire and severely insular psycho-feedback loop of venture capital firms, daytraders, tech funds and tech analysts punishes anything that strays from New Paradigm purity. So the fact is that the most intelligent use of Internet-stock-generated capital, using cyberassets to buy real assets, will not unfold despite the compelling economics. It's like owning three-quarters of the property on a

Monopoly

board: You can't use the rent money in the real world.

While I'm at it (and admittedly lacking the slightest shred of hard number evidence), I am hereby postulating the Summer Dog Rule. This generally states that if a stock is down big from its highs and has not yet recovered by mid-July, it will continue to be a dog for the balance of the year. The first reason (for all you

Gillette

(G) - Get Report

bottom-fishers here) is that the "first half is rotten, but we expect a strong recovery in the second half" story is one of the least reliable ways to make money. Why? Problems have a nasty way of taking longer to fix than anyone thinks.

Second, the calendarized ritual of unwinding stocks that have become an embarrassment at quarterly meetings is a fact of life. And third, don't forget tax-selling. All of these forces mean that by mid-July, a wall of selling tends to overhang the dogs with no letup until Oct. 30, the year-end tax date for many mutual funds. But that's not the end of the pain: Every accountant in the U.S. then tells his or her individual clients to sell the darn thing no matter what the price to take the tax loss.

This entire process offers some especially ugly implications for the Internet-stock world, given all the wonderful press about how individual investors are taking matters into their own hands and daytrading online. I will also postulate that, on this basis, we will have a doozy of a January effect at the end of the year.

Upcoming columns will also include a look at some terrific thinking coming out of

Credit Suisse First Boston

on new economy valuation work, a

Berkshire Hathaway

(BRK.A) - Get Report

valuation update, adventures in relative valuation theory and great Internet quotes of 1999. I hope you missed me.

Jeffrey Bronchick is chief investment officer of Reed Conner & Birdwell, a Los Angeles-based money management firm with about $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value fund. At time of publication, neither Bronchick nor RCB held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at

jbronchick@rcbinvest.com.