Thar She Blows

Think you're safe from tech's big bubble? Think again.


DURING THE LAST YEAR, the nature of stock-market uncertainty has changed, and so have the fortunes of all of us who play stocks. It has always been hard to predict the future direction of the market, and I have been brave or foolhardy enough to try. The minicrash of early April could have gone either way, turning cataclysmic or laying the groundwork for the Nasdaq composite to double yet again. (I'll get to that later.) Back in the olden days, in mid-October of last year, before the Nasdaq doubled in six months, there were still reasonable ways to avoid volatility and still bet on stocks. The tech sector was something spectacularly separate, a place where high rollers were having a gas with risk. The rest of us could either watch them or join them. What's different today is that we are all high-risk investors, whether we want to be or not, because in large part, the riskiest sectors of the market are taking over the market as a whole.

A year ago, I talked to some of the smartest people on Wall Street, and they were almost all predicting then that the Nasdaq's candle was about to burn out. Instead, it was those smarties who got snuffed. Take Gary Brinson, the brilliant number cruncher who has done his share to define modern management. Brinson is the kind of guy old money used to like. He smokes a pipe, wears pinstripes, a gold watch chain, and suspenders, and holds forth in posh offices with wing-backed chairs and Oriental rugs. Until recently, at Union Bank of Switzerland, Brinson was point man for more than $300 billion, the world's largest pot of institutional money. Six months ago, he lectured me bitterly about the hyped stock market. Bonds and good, solid, undervalued stocks were the way to go.

Undervalued stocks! What a quaint concept! Brinson's institutional clients got the same advice, and, apparently, they didn't like it much. They would have rather doubled their money like young, dumb investors in T-shirts who bet on Nasdaq highfiiers. In February, the $89 billion New York State Teacher's Retirement System put Brinson on its watch list, the equivalent of probation. The Kansas Public Employees Retirement System, sick of low returns, moved $250 million elsewhere. In March, Brinson, at age fifty-six, retired. His flock wanted someone more wolfish.

In trading rooms and sales offices everywhere, investors big and small have demanded that their moneymen add oomph to their portfolios. Donald Yachtman was once anointed Fund Manager of the Year by Morningstar Mutual Funds, the respected ratings service. Yachtman, too, is a value investor who likes undervalued, out-of-favor stocks. He's one of those who worship at the altar of Ben Graham (long dead) and Warren Buffett (once oracular), believing that long-term investing and company fundamentals are the touchstones of wealth. In an era when record amounts of money are flowing into mutual funds, his has been drained down from $1.1 billion to a measly $88.8 million. In March, the onetime champ was named Flop of the Year by Mutual Funds Magazine.

Every money manager now knows that if he doesn't reach into more speculative realms, his days may be numbered. The once staunchly conservative Neuberger Berman, a shop built up as a value manager, took stock of its abysmal performance and launched its own tech fund. The legendary Julian Robertson shuttered his once high-flying and more recently crash-diving Tiger Fund, complaining that the markets were now beyond his comprehension. The cheap but high-quality companies he bet big on were losers.

Charles Pradilla, the chief investment strategist at New York's SG Cowen, told me that managers today "don't think it's prudent to avoid new-economy stocks. The pressure on them is from across the board." Pradilla says that as the most reluctant institutional investors are dragged into the tech sector, they create the most predictable of stock-market patterns, the "late rally" and then the "whack." For that lot, April was the cruelest month. Especially if you straggled into the sector late. The early birds--those playing tech for a year or more--still tally two- or threefold gains. That's why, despite the periodic corrections in techs, there has been no clamoring to bring back the fossilized value investors, who look smart for a couple of weeks when their doom and gloom makes sense, but over the longer run still look like losers.

While some professional investors may be conspicuous late entrants to the volatile tech sector, any investor with a broadly diversified portfolio is now exposed. That makes the very strategy that diversification is designed to avoid suddenly far more risky. The dynamic that makes this so is the velocity of the tech sector itself.

Today, tech stocks make up nearly 30 percent of all stocks in the Standard & Poor's 500 Index, the benchmark that tracks the market's biggest companies. Since the S&P is composed of those companies that are richest when measured by share price multiplied by total outstanding shares, the highfiiers--like Cisco Systems--have earned a place.

The dynamic isn't hard to understand once you consider that in 1999 the tech-heavy Nasdaq rose more than any broadly based index ever, with the tech portion up 50 percent more than the rest of the Nasdaq. Buy a mutual fund based on the S&P index, or any other fund that measures its performance against it (nearly all stock funds do), and you're already loaded up. So is nearly every major portfolio in the market today. And they haven't just embraced the big new companies, either. The smaller, very speculative companies are swimming in the mainstream, too.

"The market started to embrace smaller-cap stocks in the second quarter of last year," notes Christine Benz, who analyzes tech mutual funds for Morningstar. "That's when portfolio managers started fiddling with their matrix of stocks. I wish I had a dollar for every manager who told me, 'I'm getting away from the traditional price-earnings ratio and getting more generous with my evaluations.'?"

At a time when more and more people are buying into funds (February saw the greatest influx into funds ever), Benz fears most investors have no idea of their new and deep exposure to these stocks. "The average growth fund had 40 percent tech stocks already, and they're loading up even more. That will come back to bite them if the stocks do poorly." One particularly perilous problem with many portfolios is that investors buy tech funds for diversity, and then their other funds also turn to tech, and the individuals end up more concentrated and vulnerable than ever.

The mainstreaming of the market's most volatile sector means that the rest of the market must to an ever larger degree share tech's fate. We've all seen the beauty of the upside and felt the pain of a heart-stopping but expectable momentary setback, but there's still the fearsome possibility that a steeper, more intractable descent is coming. Brian Ziv, head of research at Morgan Stanley Dean Witter's Graystone unit, offers a few scenarios on how things might get ugliest.

"The 'first mover' advantage is the Holy Grail in the tech sector," he says, pointing to the phenomenon that boosted the fortunes of companies like AOL and Amazon, giants that plied their niches early. "What would happen if being the first mover provided no advantage at all? If eBay, Yahoo, and Amazon all started losing market share? That could be a disaster for tech stocks.

"What if new accounting rules start to send a lot of companies down the tubes?" Ziv ponders further. "Or if Alan Greenspan raises interest rates three or four more times? Whatever happens probably won't happen quickly. It will be death by a thousand cuts."

Whether it's a rapid drop or a long, slow descent (in the mid-1970s, it took two years for the market to halve), when markets do turn down, we will all pay for the hysteria in the tech sector. For ardent optimists, there is some comfort to be had even when markets shake out.

Edward Kerschner, PaineWebber's top market analyst, has been a cheerleader for new-economy stocks since the long rally began. Lately he has grown leery of the mania for what he calls the "new new industrials," such as Amazon, Ariba, and Broadcom, whose prices he feels defy sound logic. He distinguishes them from the "old new industrials," such as AOL, Dell, Intel, and Oracle, which can be valued using more traditional analyses and which have real earnings.

"You have to ask what is a rational resolution to the imbalance between the high levels of the new new industrials and the more rationally priced old new industrials," Kerschner says. "When the market corrects the imbalance--and it will--investors will wake up. The market overall will continue to grow strong, and an important lesson will have been learned."

Yet, if the mainstream fund and institutional managers who needed to be beaten up to change their ways are as slow to react to a market drop as they were to its rise, school will prove very expensive for most of us.


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