Pain Shows This Is Real Biz, Not Show Biz

It's entertaining to watch the market go bananas. But when the bottom drops out, what drama!
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Just as entertainment has become one of the nation's biggest businesses in the past few years, big business has ironically become one of our greatest entertainments. Nowhere is this made plainer today than at 43rd Street and Broadway in New York City, where the gorgeous, gigantic electronic billboard of the

Nasdaq

stock market competes for tourists' attention with digital confections promoting

ESPN

and

MTV

.

The crazy incongruity of our equal expectations of happy endings from entertainment and stocks has largely been hidden from new investors until the past week. My mail and online bulletin-board messages suggest that thousands of people in the market had not experienced the plunges as recent as in 1998 and 1997, much less 1990 and 1987.

After reading posts and strolling the perimeter of the Nasdaq market site in Manhattan over the weekend to gauge the depth of despair, I gathered that many would not be around for the next plunge, either. The unprecedented "Panic of 2000" in Nasdaq stocks, it seems, could leave lasting psychological scars on individuals even as the stocks themselves recover.

One of the saddest examples came to me by mail on Saturday from a very well-educated graduate student in the South, who wrote that he was an avid reader of my book and columns but had engaged in what he called "selective listening" concerning my recommendation that momentum stocks should make up 20% or less of any individual's portfolio.

"I have managed to lose almost all of my family's money, including money that was earmarked to take care of my aged grandmother and to pay for my children's education," he wrote. "I am a disgrace. I have squandered, through pure idiocy, what it took my grandparents a lifetime to amass. While the situation is bleak, I will support my grandmother myself and she will never know the difference, but I will know what I did."

Don't Lose Touch With Balance

The young man, who asked to remain anonymous, wanted me to warn other readers about his fate -- and beg that they not repeat his mistake. And here's what it was: He started with about a quarter of a million dollars worth of Flare-Out Growth and MVP Growth names from our SuperModels screens, and augmented those funds with heavy borrowing from his broker on margin. Before long, his stake had grown to $395,000, and he thought he was bulletproof. When the Nasdaq made its first 500-point intraday plunge in April, he bought even more on margin, thinking he was catching a bottom.

But he was wrong, and lost a lot of stock in margin calls. His stake shrank to about $110,000 in just a week's time. And, lest you think this is just a case of another crazy online trader who should seek professional help, my correspondent says he was working with a broker at a major Wall Street house who turned out to be just as inexperienced -- and failed to wave him off.

The young man says he'll soon be going to work at a terrific salary, and thus will be able to pay back his grandmother's and children's accounts if all goes well. I think this grim tale will turn out all right. But if you've been thinking of using margin to load up on our sort of growth stocks yourself during this downturn, I hope that his experience will serve as a good warning: Our SuperModels momentum, growth and value stocks -- selected entirely from historically tested screens -- are intended to be purchased in small, equal quantities for the limited purpose of adding spice to a portfolio otherwise balanced with core holdings or index funds. If these stocks grow over time to be a disproportionately large part of your portfolio, trim them back until balance is re-achieved.

Perhaps the most important lesson of the past two weeks, however, is that you should not let desperation, or the waning siren of temporary good fortune, seduce you into "averaging down" on -- or buying more of -- plunging stocks: That's not a strategy, it's attempted suicide. Stay cool, focused, moderate and mechanical in your approach to prevent any single set of events from dimming your financial picture.

Where Do the Dying Dot-Coms Go?

If you've ever wondered where dot-coms go to die when their wild west days are done, let me suggest a road map: Just screen an equities database for all small-cap stocks trading at less than one-fifth of their 52-week highs, and turn south.

There, at the crest of the financial community's equivalent of Boot Hill, the view is desolate and eerie. If you listen closely enough this week, you can still hear analysts pounding the table as the wind whistles through balance sheets as thin and fragile as tumbleweeds.

Almost a third of the stocks in this graveyard of greed -- technically, stocks with market caps less than $1 billion, prices greater than $1 and more than 80% off their 52-week highs -- are trying to make their way in the world by selling knickknacks, news or ads on the Internet. Many have courted fame as yuppie household names, yet the average company in this group has managed to wrest just $7.4 million in revenues from customers over the past 12 months, according to figures in our database, much less any income at all.

The scene is even sadder if you screen for all medium- and large-cap stocks in the market trading for less than 40% of their highs. Slightly more than two out of every five of those stocks -- technically, ones with market caps greater than $1 billion and prices at least 60% off their one-year highs -- are Internet names. There, too, are once-frolicsome firms where the revenue numbers are frightening: This brood has averaged a paltry $26 million in trailing 12-month revenues, according to our database.

The tombstones on this field of broken dreams show that the long-awaited Internet-company shakeout officially began, appropriately enough, around Halloween last year. From Oct. 30, 1999, to April 14 of this year, the Nasdaq advanced 12% while

eToys

(ETYS)

sank 92%,

MP3.com

(MPPP)

sank 79% and

iVillage

(IVIL)

sank 60%.

To be sure, a handful of the companies on this list could stage miraculous recoveries that will spark hope in others. But the disparity of returns -- a proxy for investors' belief in their business models -- between the Nasdaq favorites and flops suggests that most will nonetheless disappear in a cloud of dust: Expect mergers, layoffs and heartbreak over the next nine months.

If you own shares in any of these, think hard about the best possible result over that time frame. Complacency is your enemy if you think that a stock that's gone from $70 to $7 can't go any lower. Just ask the nice people who owned shares in well-meaning, well-regarded firms like

Peapod

(PPOD)

,

Day Runner

(DAYR)

,

Safety-Kleen

(SK)

or

North Face

(TNFI)

, all now trading for about $1 to $3.

And if you're waiting for a buyout to save the day, keep in mind that new owners of the failed business will strip its few tangible assets -- maybe its list of users and a few key personnel -- and ditch the rest. There probably won't be a premium for public shareholders or employees.

What's the lesson for investors? Terry Bedford, a hedge fund manager in Toronto, offers this view: "You should look closely at the action of the past few months to understand why 'story-stock' investing can be so dangerous. You fall in love with an attractive concept, but the next thing you know, it's an attractive story at half or a quarter or a 10th of the price," he said. "Prices are changing so rapidly today because they are all about sentiment -- how people feel about the future -- and nothing concrete. It's an unstable, untenable situation. You should always demand real, tangible quality in all your investments."

The good news is that the shakeout will lay bare the best fundamental stories. While many of my 100x10y portfolio names are admittedly very high-risk members of the story-stock family, all of my regular SuperModels portfolios house only stocks with serious revenues and even some earnings.

Pay most attention to the MVP Growth and Redwood Growth names, such as

Sun Microsystems

(SUNW) - Get Report

,

Network Appliances

(NTAP) - Get Report

and

PMC Sierra

(PMCS)

.

The market may occasionally wildly overshoot the right price for the shares of these firms, and take them down a few notches for one to nine months, but you can be quite sure they will never vanish in a cloud of smoke and mirrors.

Fine Print

We added a new QuarterTrader portfolio to our list of models at the start of April. This will help us understand whether it's better to rebalance SuperModel stocks monthly, quarterly or annually. Last year, the three-month rebalance beat the one-year rebalance by a solid margin. This year's QuarterTrader is off to a good start, which means it lost less in the downturn than the YearTrader.

We've seen this sort of bloodbath in the SuperModels every April for the past two years; maybe next year, we'll add a rule to go to cash for a while at the start of spring. Typically, the models rebound in May, slide in June and throughout the summer, and then rebound sharply in the fall and winter. They're meant to offer an almost trading-free way to own lively stocks, so we don't officially use stops ourselves.

At the time of publication, Jon Markman owned or controlled shares in the following equities named in this column or listed in the SuperModels portfolios: BroadVision, Digital Lightwave, EMC, Emulex, Gemstar International, Kopin, Maxygen, Microsoft, Nokia, Nortel, Oracle, Qualcomm, SDL, Siebel Systems, Sun Microsystems, Superconductor Technologies and Xcelera.com. He welcomes your feedback at

mctsc@microsoft.com.

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