Tech: The Weakest Link? Fred Hickey

(v. 3, i. 7 4/27/01)

Tech: The Weakest Link?
Independent, Fundamental Analyst Fred Hickey Warns Rally Will Fail

Fred Hickey would stick out like a sore thumb in SillyCon Valley. Which is okay, because he’s been editing and publishing his High-Tech Strategist newsletter from Nashua, NH since 1987. And yet no one I know follows the outrageous turns of fortune, not to mention the fundamental developments, in tech companies large and small more closely, or with more independence, than Fred. An accountant by training, he plied that trade for years inside a tech behemoth. But Fred had been bitten by the investing bug at a tender age and quite clearly revels in an independent streak rather too outsized for a corporate suit. Happily, it’s perfectly suited to an independent investment analyst. Especially one enamored of techs, one who has focused his research and investing efforts exclusively on computers, software, semiconductors, networking et al for better than two decades. And who calls them as he sees them, standing by his fundamental research, even when the market, for seemingly interminable stretches, cares about nothing so rational. Like now. Fred suspects investors may be in for a spectacular fireworks display in this rally. But he’s also convinced most will end up burned. KMW Fred, you must have just been gored by the tech bulls, but good. I’m okay, considering the week that I’ve been through. But my head is spinning. The volatility of this market is so intense, it takes your breath away. Isn’t that funny. Bears complain about upside volatility. Bulls, when it’s on the downside. What’s unfortunate is that I’m tired of being bearish. I just wish we could end this stupidity of money managers throwing everything they have into the market to chase momentum trends. I’m tired of “professionals” not considering valuations. It’s frustrating because the longer this insanity goes on, the longer I have to remain bearish. I don’t want to be bearish, but I’m looking for a great big buying opportunity—which by definition won’t come until all these people learn that valuations matter again. So it’s not that you’re a perma-bear, just a perma-contrarian? Absolutely. For the majority of my career, I have been a tech bull. All the way from 1979, basically into the mid-’90s, I was a tech bull. I only got short occasionally, for very brief periods. I remember, particularly in 1989-90, I couldn’t persuade anyone to buy techs—and that was when you had valuations that were fabulous, offered lots of upside. And I captured it. But I don’t know of many others who did, because everyone hated tech stocks at that point, after a long period of underperformance. More recently, of course, in the late ’90s mania, when valuations got way too high, I backed away. While I remained partially long through much of it, I got progressively more bearish, so that by 1999, I had no longs at all—and actually took a small loss that year. But my persistence paid off in 2000, which was a great year for my tech shorts—as all the work I recently had to do on my taxes proved. It’s an awful thing to do your own taxes, and no one else does it. But as an accountant, I feel if I can’t do it, nobody can. And I’m basically at the point where I can’t do it any longer. You are a masochist! Being a tech bear paid off last year, while I watched lots of momentum funds lose three years worth of gains within that span, dropping 70-90%. All of a sudden I didn’t feel so bad about missing those last couple of years of fabulous gains. But maybe you wouldn’t have overstayed the party— I just can’t play that game. My discipline is valuation-based and I delve so deeply into the fundamentals of the technology industry that if I see that world falling apart, there’s no way that I can stay in there and hope that some fool is going to buy the shares at a higher price. That’s just not going to happen. So even if we see the same thing again in 20 years, I’ll do nothing differently; I’ll step away too early all over again. I made that decision because valuations got too high, too dangerous and I didn’t have the sort of margin of safety that I like to have—that you have to have in the technology industry because its volatility is greater, the risk of loss there is greater than in any other area. Some folks argue that value in techs has nothing to do with traditional valuation measures. Or at least they used to— If you don’t apply valuation, then you have to use something else. Which is the greater fool theory. That was what was being used during the last three years of the mania—and is what we’ve been seeing, in spectacular fashion, with the Nasdaq up 33% and the Philly semiconductor index up 51% in 10 trading days. Let me take a wild guess. You’re not among those convinced the techs have bottomed? Bottomed? In the 1998 inventory correction, the SOXX index bottomed at 182. The recent “bottom” was at 450 or so and we took off and climbed 50% from that level. That leaves us with P/E ratios still in the stratosphere. Intel is still trading at 60 times earnings. What a bargain! My goodness gracious, I’m only going to pay 8 or 9 times sales, when Intel normally bottoms at 2 times sales. And that assumes you believe the wonderful forecasts coming from analysts who merely parrot the optimism they hear constantly from the company. So, impressive as it’s been, we’re merely in the midst of a typically head-snapping bear market rally? Sure. Remember what happened in January? Broadcom (BRCM) went from 70 to 140 after that interest rate cut. Then, over the next two months, it plunged to 20. That’s what is going to happen this time to the semiconductor stocks. The last time, the playthings of the momentum investors (which is virtually everyone, it seems) were the communications companies, the optical companies, the communications semi makers. Those stocks were run up at a time when their businesses were imploding. They soared and then investors looked down and saw no bottom. Panic ensued and the stocks collapsed. The same thing is going to happen here with the non-communication semiconductor companies that have been run up. The funny thing is, at least back in January, you could make an argument for a new era of sensational internet-led demand for optical communications. This time around, the rally is based on an expected fabulous rebound in PC sales, which just makes no sense at all. You see no glimmer of hope for an end to the “inventory correction” and a rebound in PC sales? That’s right. The facts I see just don’t support that. Gartner Group just reported that the first quarter saw the first ever decline in U.S. PC unit sales. IDC’s number was -10%. PC Data reported that weekly retail unit sales were down 20% in January, 24% in February and down over 30% every week in March. There is your “rebound.” Now, some of the stories going around had Taiwanese motherboard sales picking up in March—but no one is talking about what is happening now. What they aren’t telling you now on Bubblevision [CNBC] is that Taiwanese motherboard sales have been plunging in April. The largest Taiwanese motherboard vendors’ sales are down, in April, anywhere from 20-40%. But of course, we will never hear that when the bulls are trying to create a rally on the back of another rate cut. Okay, but PCs aren’t the only things that use semiconductors these days. Let me tell you about the CDW Computer Centers (CDWC) conference call—one of the dozens I listened to in the last couple weeks ago. It was very illuminating compared to some of these calls. For example, when I listened to the IBM conference call, I learned nothing. Spent 45 minutes listening to a script being read and a couple of minutes listening to them avoid answering questions. By contrast, when I listened to CDW’s conference call, I learned things. Most investors haven’t even heard of it. Don’t recognize it as a Fortune 500 company that sells $4 billion of computer and networking equipment directly to end users—or realize that only Dell does as well as CDW at selling PCs. This is a company that has a real insight into the business equipment market. So what did CDW say it sees there? CDW said that their sales (which grew at a 50% annual rate in Q3 of last year) had fallen to a 37% growth rate in Q4—and then plunged to 14% in Q1. They forecast low single digits sales gains in Q2. Virtually all categories of sales weakened. Networking equipment, storage equipment, servers, software and PCs. PCs represent 30% of their business and were the heaviest drain on the quarter. The good news was that their margins went up. But why? Because their PC sales imploded. Their notebook unit sales fell 22% in the first quarter. PCs had been such a huge, but low-margin, part of their mix that their gross margins improved. Now, some analysts on the call were fishing, as they love to do, for any kind of positive answer on trends, so they asked, “Didn’t sales pick up between January and March” The answer, of course, was, “Yes.” But then this company volunteered additional information, saying, “But sales always do that, seasonally. But the Q1 seasonal pick-up was weaker than normal.” They also said April daily sales were worse again. That was their basis for dropping their forecast for the second quarter. But the bulls didn’t listen to CDW’s conference call. They’ve been too busy claiming the bottom is in. They haven’t heard that Taiwanese motherboard sales are tanking in April, or that DRAM prices have again dropped to record lows. The analysts would rather go back and ask Intel (INTC) about PC sales, and then listen to its throwaway comment that, “This might be a bottom.” Despite its forecast that its next quarter’s sales would be down 25%, year over year. Could have been worse— And it will be. The bulls don’t want to look where they’d find the best information because they don’t want to hear things that don’t fit with the story they’ve been trying to concoct about an improving PC situation. The fact is, unit sales have been declining year over year all this year. But maybe—and only maybe—there was some slight pickup in the Taiwanese motherboard business for a week, and that was enough to spark a rally. You’re sure that the dismal demand trends are continuing? Last quarter Hewlett-Packard (HWP) warned that they saw severe weakness in their North American business but hoped it wouldn’t spread. Recently they preannounced that in the current quarter business had deteriorated around the world, particularly in Europe, but also in Asia. This was a shock to tech bulls. But to limit the damage, they also tossed in a throwaway comment about a possibility of a bottom. But you always get optimism from Carly Fiorina. Remember late last fall? HP was going to grow at 15%-20% forever! Now they’ve forecast a negative number for the current quarter. Here, the bulls are trying to paint the fundamental environment for real techs as good, when it is truly bad. As bad as we’ve ever seen and getting worse. There’s nothing that’s going to make it any better soon, either, not even the “Great Greenspan” and his magic wand. Yet that’s what lots of investors, quite clearly, want to believe. What does that tell you? That we aren’t anywhere near the end. Bill Gross, of PIMCO, put it best. “The belief in double-digit stock returns and their lack of risk over the long-term will persist until we experience evidence to the contrary, which means a deep and long enough bear market to replace the sense of greed with the least a semblance of fear in the minds of investors.” And we haven’t experienced enough pain yet? Watching trillions of dollars of market value evaporated on the NAZ? It hasn’t been deep enough yet, believe it or not. Even though the NASDAQ fell over 60%. That wasn’t enough to stop the speculation. There is still faith that a centrally planned government, meaning the Fed, can save us from any and all recessions. That just by lowering rates, Greenspan can increase consumer spending, even though consumer debt levels in February were 20% higher than a year before. People still have faith that stocks will always rebound and that Greenspan will always be able to turn the markets. Not to mention that stocks will always be up in the “long-run” (and most investors’ long-term horizons are actually pretty short-term). That faith has to be broken. Then they’ll stop speculating. Otherwise, every time we get a rate cut in the dark of night (or in this case, in the middle of an options expiration at 11 in the morning, after all the Fed members have said not to expect one)... You’re not implying that the Fed was going for maximum market impact? Well, it seems to me that whenever they were going to raise rates, they went out of their way to telegraph what was happening. This time, it looked like they went out of their way to mislead. And to time the move for maximum momentum. It just seems there’s a different style, depending on whether the market is going up or down. I hesitate to bring it up, but all of this reminds me of 1929, I’m afraid. I’ve been reading a lot of history about other periods when the market saw speculative extremes. The roaring market in the ’20s, the roaring economy, created tremendous over-capacity amid great technological revolution, low inflation, high productivity. And we all know what happened in the ’30s. When the market did break, in 1929, the Fed, which had been propelling the economy and the market with huge amounts of money through the ’20s, saw the solution as lower rates. They lowered them from 6% to 4% by the February, 1930, which created a huge sucker’s rally. And no one believed there was anything really wrong with the economy. No one doubted the Fed would succeed. Then the dollar broke. I think the same thing is going to happen here. It’s very interesting to hear the Europeans say, “We’re not going to follow you.” It appears they’re adamant. I guess they’re tired of being laughed at. Tired of hearing what a dolt [ECB head] Wim Duisenberg is, especially tired of comparisons with “the Maestro.” Or maybe they’re still fearful of inflation. For whatever reason, they’re not lowering rates. At some point, European rates may look a little more attractive than U.S. rates. Every half-point cut, I celebrate, because we’re getting closer to the day that rate cuts will not save the economy. But why not? The economy’s problems are not a shortage of debt. We have an excess of debt. Credit card debt. Corporate debt is massive, at a record. Only federal debt is at less than record levels. Sure. That’s because of capital gains taxes, thank you very much. But now there’s a question about how well they’re holding up, too. Capital gains receipts are not flooding into some states, apparently. Maybe not into the federal government’s coffers, either. Anyway, I don’t think the Fed lowering rates another half-point is going to enable AT&T to pile on anymore debt. Or that Winstar, which is now bankrupt, needs any more debt. Or that PSINet needs any more debt. Or that any of the telephone companies over in Europe can handle any more debt. Meanwhile, long bonds are falling here. Yields are going up, not down. Good point, the bond market isn’t following the Maestro’s beat. My point is that the Fed can cause bursts of speculation, but can’t quickly cure this overcapacity problem—which was built up by too much credit over a long time. We’re seeing the end results in the balance sheets of companies now, as demand has fallen off for many reasons. The implosion of the dot.coms, the wiping out of many of the thousands of ASPs we created over a year or two, the wiping out of all the CLECs, the cutbacks in capital spending by all sorts of companies. Even Sun Microsystems (SUNW), in a recent conference call said they were cutting back their own cap-ex spending. We’re seeing massive inventory build-ups. Such that Cisco (CSCO) saw its raw materials inventory grow from $145 million at the end of its fiscal year last July, to somewhere between $2-$3 billion in the last quarter. Which led them to write-off $2 billion of raw materials, $2.5 billion in total, because they would never be able to use it. Never be able to use brand new materials that you just bought in the last nine months? That’s right. Things like semiconductors and electronic components that you’ve just bought. This isn’t last-generation stuff. Even after the writeoff, Cisco has $1.6 billion of inventory on its books, a far higher level than they have ever needed. Meanwhile, their sales are plunging and they’re laying off thousands of people. Cisco is scarcely alone in that boat. Exactly. I never imagined the fundamentals could get this bad, this fast, even as bearish as I have been. Nonetheless, the bulls have again managed to separate the fundamentals from the stocks here. Isn’t it a relative thing? The stocks fell so much lower than anyone ever dreamed possible, that investors started looking at them as lottery tickets. Maybe. But what no one is considering here are the fundamental implications of last year’s activities. If Cisco has multibillions of inventory, that means they were buying it all last year—implying that all of their suppliers’ 2000 sales and earnings were inflated and artificial. All their earnings and sales levels were a mirage; not even to be considered when you estimate sales and earnings levels on the other side of this slump. I mean, consider that Xilinx (XLNX) wrote off $143 million of inventories—and they make programmable logic devices, meaning they could be used in almost anything—still, they wrote them off because their inventories grew from $131 million five quarters ago to $485 million. It’s rival, Altera’s (ALTR), have gone from $64 million to $315 million. By their own estimation, that’s 300 days’ worth of inventory. How are they going to sell that when customers like Cisco or Nortel (NT) or Alcatel (ALALF) have their own massive inventories to work off? The bulls think there’s going to be a big rebound here. But the numbers have only begun to plunge. By late this year, almost all the semiconductors are going to be losing lots of money. And there will still be mountains of inventory to be run off. Not just in the communications area. Look at Sun’s inventories. Intel’s inventories over the last five quarters have almost doubled. With their sales turning down, there’s a write-off coming there as well. Ericsson’s (ERICY) inventory went up by $500 million in Q1 to $5 billion, while their mobile phone orders fell 51% in the quarter. All of which points to more pressure on prices. In Q1 many semiconductor vendors were working off contracts with more or less fixed prices. As these contracts expire, prices are going to drop dramatically. Some companies are trying to wiggle out of contracts, now that prices have started to implode. You end up with cases like Alcatel, which just reneged on a contract with Advanced Micro Devices (AMD)—or at least that is what AMD is alleging. The upshot is that it is ludicrous to try to call the bottom here. Last year, we had a 90% increase in semiconductor equipment capacity, year-over-year. That new equipment is still being installed today. Utilization rates at the foundries are plunging. Charted Semiconductor recently put theirs at 40%. United Microelectronics (UMC) is in a similar situation. They’re big customers of the semiconductor equipment companies. Yet analysts are calling for the bottom in semiconductor capital equipment. It is unbelievable to have Applied Materials (AMAT) selling near a $50 billion market cap and to call that the bottom. Talk about jumping the gun. AMAT is higher here than it was in last August when no one even had an inkling there was a problem. It’s silly. Its orders are plunging now but it’s selling at 5 times last year’s inflated sales numbers. Normally, at a bottom it will sell for somewhere between 0.5 and 1 times sales. Yet analysts are saying, “Buy! The news is so bad we must own these stocks!” Can you believe AMAT’s market cap is more than the whole semiconductor equipment industry worldwide is going to do this year in sales? In word, no. It’s so stupid, it’s laughable. Yet fund managers are chasing these stocks as we speak. Their funds are contributed by individuals who put their pension monies in, their kids’ college monies in, and it’s being destroyed. They’re doing it because they can’t afford to underperform their peers who are also buying. From my perspective, it’s a crime. I’ve heard so many sad stories about people near retirement age losing all their savings in tech stocks. What we are seeing is a massive transfer of wealth. Many of these company executives making these optimistic comments are selling like mad, and have been for years. They’ve given themselves such huge options grants that they’ll walk away from this period incredibly rich. So of course they are optimistic. They’re not going to say, “Our business stinks and our products are rotten.” Or at least they won’t until the real bottom. But that’s not entirely fair. Some companies make an effort to avoid hype. Investors also tend to hear what they want to hear. That’s true. Recent conference calls have included lots of very negative comments. But those weren’t what we heard on TV. Or from the analysts. What we heard about was a comment or two about maybe, possibly, it might be bottom. And all of these poor suckers are coming in, just like they did in January. It’s sad. The economic damage is so great already and it will be greater; will have an impact on the capital formation process. People will go through a period of disgust, once they find out they’ve been completely fleeced. When we do get to the bottom, they will hate tech stocks. It will be ugly. People won’t be able to win financing even for good ideas as a result of this period of gluttony, Wall Street and corporate executives feeding off the stupidity of the average guy. That’s what really bothers me. I know this rally will implode, so the run-up itself doesn’t bother me a bit. So you’re a bear with heart of gold. But you’re not being paid to run institutional equity money. Don’t the people who are have an obligation to stay engaged–and try to better their performance in any rallies? You mean they have to “play” the game? I don’t think so. I don’t think that becoming one of the fools in the greater fool theory, works. Playing along with that theory implies you can get out. You’re so smart, you won’t get hit. But what we know is that virtually everyone gets trapped in these sucker rallies. People who were playing the momentum game earlier this year got killed. They’re going to get killed even worse this time. Historically, buying high and selling higher has never worked. Buying low with a margin of safety and selling high does. What you don’t want to do is buy a semiconductor company that has no orders, when its end market customers are completely saturated with inventory, and just hope that some greater fool is going to buy it from you. That’s your duty? I think not. A money manager’s duty is to buy them when no one wants them. When there’s an upcycle coming. When there’s some pent-up demand, when you haven’t just been through 10 years of an economic boom, with credit up the yin-yang. That’s not when you do it. If you’re buying now, it’s only because you believe other people are going to buy. You cannot justify these valuations, Micron Technology (MU) selling at $30 billion. A month ago, Micron had a bigger market cap than General Motors (GM), with a 40th of the sales. These valuations are beyond ridiculous. You are only buying them because you don’t want to be left out. Underperformance is not a career-builder. Look at the guys who were finally getting some accolades, before this interlude rally started. The value managers, who hadn’t gotten anything but scorn for years. Well, when this brief rally ends, they’ll get the accolades again. Those are the guys who win over time. Warren Buffett won’t touch this stuff. John Templeton says he wouldn’t buy anything in the U.S. for two years. All of the value guys who have done very well recently, I guarantee you, aren’t buying Micron, AMD, Intel or any of the other semiconductor companies at these levels, just to avoid missing a few points on the upside before they collapse again. But that’s what the bulls are doing. What makes you so sure this is a sucker rally? Historically, big bull markets do not end abruptly. You don’t have people change from being religious fanatics, certain of a new era or a new economy, to being agnostics overnight. It doesn’t happen. So you go through these patterns of sharp declines, and just as sharp rallies, but always with lower lows, lower highs. That’s what happened in the ’30s. They had that huge rally in 1930, bought the Dow back to 300 from 199. (The high was 381 in September ’29.) Then there was a sawtooth pattern, all the way down, something like 8 major rallies within that grinding bear market that kept producing lower lows. That’s how, over time, it finally ground up the belief that investors were guaranteed double-digit returns. No argument. Still, even some value managers had started nibbling on a few of the really beaten-up techs before this rally— Maybe some of the smaller, relatively obscure ones are buyable values. But not the big caps. Microsoft, Intel, Oracle, Cisco were all still very expensive, even before this rally started. All of them were trading at P/Es far higher than they’d ever had, pre-bubble. And the trouble with starting to nibble now even on the really small techs, is that you have to just hope that they can stay alive during the hard times. It’s dangerous. I mean, I’m willing to knock my head against the wall for years, if it takes that. But I won’t nibble yet. Usually, when we do reach the bottom, people won’t touch tech stocks for years afterwards. And we’re still at almost peak prices, not the bottom, in some of the tech stocks. It’s only when we are going through a period of disgust that I will start buying. I don’t mind being early, but I don’t want to be that early. I was willing to buy a bunch of tech stocks at the end of December for a trade, but I knew I wouldn’t hold them very long. I didn’t expect them to soar, but all the 16 did, up 50-100%. “Thank you, Mr. Greenspan.” So I sold. Most of them have given back most of those gains. But you didn’t anticipate this rally? I was starting to do a lot more work to identify companies to buy. Before this 50% run in the NASDAQ started, I had started to switch gears, get hopeful. This was the greatest bubble ever seen by mankind—and so we’re going to get the greatest opportunity to buy at the end of this bear, as well. But now that we’ve had this ridiculous rip-snorting intervening rally, it’ll probably take even longer to get to the point where I can be bullish. Or maybe it won’t. Maybe it’ll accelerate the ultimate decline. Anyway, I continue to do the valuation work on possible longs, but the real money to be made first will be by going against Intel at 60 times earnings, going against Applied Materials at $50 billion, against Micron at $30 billion despite ever-deeper losses as far as the eye can see. Those are the real opportunities out there. It’s too soon to bottom fish here. But are you also hinting that it’s too soon to short those big cap techs aggressively here? I’ve primarily been holding cash. What I have been playing on the downside has been very limited, minor. That’s why a huge rally such as this has barely dented me. It just doesn’t pay to be heavily exposed on the short side, because you can’t make a lot of money on the downside. I’ve had lots of 10-baggers by buying techs when they were cheap, and then watching them soar. But you can’t make that much on the dark side. Where your upside is capped and your downside unlimited. That’s why I never recommend trying to capture the downside to anyone but real professionals. Why I am waiting, by and large, for the opportunity to buy. Patience is the virtue here. So you will have cash to buy things that are really cheap at the right moment. I don’t feel under any tremendous pressure to chase a stupid rally. I’m very willing to accept my returns on cash equivalents and from just dabbling on the short side or with options. But the shorts you’re dabbling in are the big cap semis? Well, the best shorts after the January rally were the stocks that had gone up the most, like Broadcom. This time around, the stocks that have gone up the most are the large semiconductor companies in the SOX. That means going after the big names. Intel with has a market cap of $220 billion or so, and rapidly falling sales. It’s losing market share in a saturated PC market. Its end markets are terrible. In coming quarters Intel will be affected by brutal price wars in all its major products, including microprocessors and flash memories. Micron is just as absurd, a $30 billion valuation for a DRAM company whose sales went from $2.5 billion to $1 billion over the last six months. Whose margins last quarter shrank to 19% from 49%? I’ve always admired Micron, as a company, because it has survived battling tremendous competition while virtually every other U.S. vendor went out of business. But boy, it is in a miserable business and you’d better not be paying much for it. Yet the bulls in Micron can’t seem to get it through their heads that Micron never makes any money except periods of temporary shortages. Or that they have almost as many competitors today as they ever have had. Only now its rivals are governments overseas. Taiwanese foundries and the Korean giant Samsung are switching to making DRAMs, because their other products aren’t moving, just to get their utilization up a bit. So there’s no hope of Micron making any money soon, and if they don’t make money, they don’t sell at 8 times sales. They sell at 1 times sales. What about equipment makers, like AMAT? Almost every one of its customers is cutting cap-ex. There’s another announcement almost daily. Charted Semiconductor cut today. Texas Instruments (TXN) has just slashed its capital spending plans to $1.8 billion from $3 billion. Motorola (MOT) has gone from $2.5 billion to under $1 billion. STMicroelectronics (STM) just dropped theirs 40%. UMC, Taiwan Semiconductor (TSM) have cut theirs. Intel is holding to its $7.5 billion number, but they’ve already spent 36% of it in Q1. I suspect much of that didn’t represent spending on new equipment. Rather, it was the cost of shutting down construction projects. Intel has 20 of various types, from office buildings to fabs, on hold right now. I get the impression you think this rally could have legs, so you’re in no hurry to put on more shorts. You’re right. I am concerned that this intervening rally will last a bit longer than January’s. This week’s contraction on low volume is looking too much like a trap to pull in the shorts, for my comfort. So while I was tempted to put on some shorts at the end of last week, after evaluating the situation over the weekend and early this week, I decided not to add to any short positions just yet. Justin Mamis [see News Bites] has been pretty bearish, but he evidently sees staying power in this rally too. Well, I am definitely not a technician. But I do try to use certain indicators (VIX, put/call ratios etc.) to help with short-term trading decisions. And they tell me to be wary of getting too heavily short now. Additionally, we’re in what I call the “no news” period (after earnings but before preannouncement season) in which the bulls have a tendency to make up positive news that isn’t quite true. Historically, the preannouncements begin again in mid-May, and that’s usually a safer time to put on new short-type positions. So the fundamentals are awful and the valuations worse, but for now, I’m uncomfortably sitting on reduced short/put positions. (And I’ll probably regret it!) The fundamentals are that bad? Adjectives do not describe how bad this is. I cannot talk to anyone I know in the industry who says that this is anything but the worst they’ve ever seen. Nowhere close to bottom. The problem is obvious. Too much supply. That’s why we’re seeing such dramatic slashing of cap-ex budgets. With so much inventory, you obviously don’t need more plants. That’s the story, not just in PCs and semiconductors, but in cell phones. They were planning to build over 700 million cell phones this year; expected to sell at least 650 million. Ericsson just admitted it now looks like the total could be as low as 430 million. That’s a tremendous oversupply. There’s likely to be negative unit growth in the U.S. PC industry. The worst in history. And getting worse, going forward. Yet we have tremendous capacity, which is driving tremendous price wars. It’s going to take a long time to work through this capacity, so you’d better not be buying things at these prices thinking that we’re at a bottom. The only thing that will solve this problem is time. Yet investors are suddenly eager to look over the valley again. The funny thing is, nobody seems to notice that every time a company comes out with a positive statement, it announces laying off thousands of workers at the same time. Hewlett-Packard tripled the number of workers they’re laying off and said they were supposedly seeing a bottom? I don’t understand, if you see a bottom, why you have to lay off so many people. Nortel sees a bottom? Why is it laying off 22,000 workers? Intel is laying off thousands. No one wants to admit how bad things are. But watch their actions. They are writing off inventory. They’re laying off people. They’re cutting back capital expenditures. We hear stories about Nortel forcing employees to return RIM pagers and cell phones. I mean, that’s a problem. Telcom leaders are telling employees that telcom equipment isn’t essential. Everyone in the tech industry pretty much knows things are bad. But no one wants to admit that on Wall Street. Who won’t make it? There are hundreds of CLECs, 45 public, and I am not sure more than a couple will survive. We’ve wiped out over 300 dot.coms and there hundreds or thousands more to be eliminated. According to the applications service provider industry association, there are about 1,500 ASP companies in the U.S. Virtually all are losing lots of money. We were creating a dozen or so a day, each day last summer. One research house estimated that over half will be gone by yearend. The telcom sector is where all the debt is —and the obvious problems. In the Lucents, the PSINets, Winstars and Teligents. Most are in dire straits already. It seems likely that the Lucents of the world will have to sell off the crown jewels, just to survive. And then I’m not sure what is left. On the other hand, the Suns, EMCs and Ciscos don’t have a lot of debt and will make it. You mentioned IBM’s conference call earlier. It has seemed to move to its own drummer, both during the mania, and since the bubble burst. A lot of times I don’t even bother to listen to IBM’s calls. But this time, I knew that the first quarter comparisons were going to be an easy one for them—its business a year ago was very light because of all the post-Y2K spending freezes by the major corporations who are IBM’s customers. But I also know that if you’re a $90 billion corporation, as they are, bigger than everybody by a factor of two, there’s no way that you can be immune to an industry downturn. I also knew that many of their product categories weren’t doing well. So I thought that maybe, just maybe, they would have to admit to a problem. Even though I knew that Lou Gerstner would never want to rain on a stock market party. So I sat through the propaganda. But when they finally were asked about the second quarter, they said, “No comment.” Nothing. They’d only say, “We’ll only tell you that we will stick with our year-end numbers.” Which, of course, tells you there’s something wrong. We know everyone else has lowered their numbers. So I know IBM is going to run into some trouble here. But I also I know that much of their earnings are not generated on the front lines anyway. It’s the sausage grinding in the back. Hundreds of millions of dollars of pension gains, sales of plants to Solectron (SLR), AT&T, Cisco, etc. Reductions in the number of shares outstanding. Tax rate reductions. Changes in accrual rates here and there. In a $90 billion corporation there’s lots of room to do that. To manage its earnings, you mean. What IBM is actually earning right now, I have no idea. But I know it’s nowhere near what they report. A lot of what they have been able to do is a result of the bull market. Most companies in normal economies have to pay pension expenses. They don’t have pension income in the hundreds of millions of dollars per year. But IBM has been able to increase its accrual assumptions on the gains on their pension investments all the way up to 10% because of the bull market. Hasn’t it also reduced pensions payments to some former employees? IBM has done things to employees that I think are unconscionable. You know, when you change a plan in a way that affects many employees negatively and at the same time you take the pension calculators they used to be able to use off of your network, so no one can calculate what his pension will be—there’s something wrong. When you have to deal with angry employees, who are unionizing all over the country even though very few high technology companies have ever been organized, something is wrong. They’ve done extraordinary things to help the bottom line at the expense of their employees. But you can’t get away with that forever. You can’t not invest in R&D for very long. Nor can you can become a very successful services company in technology, which is what IBM is claiming to be now. You can’t? As Scott McNealy said, and I’m paraphrasing, “Services are where all the technology companies go to die.” Think about it. What did Wang become? A service company. Digital Equipment? Unisys? Services. Why doesn’t that work? Because if you are a services company, you’re a body shop. You’re not inventing the next router technology, on which you can charge a 70% gross margin, as Cisco did. You can mint money with a new technology—for a while. But you can’t do that in services. Body shops work on low margins with lots of competitors and aren’t generally accorded rich stock multiples. But no one has yet thought of giving IBM a service company multiple, apparently. Except you. When do IBM’s earnings comparisons get tougher? The third quarter? Actually, they start to get a lot tougher in the current quarter. But Gerstner doesn’t retire til yearend— Maybe, just in the nick of time. And he probably will have sold his every last IBM share by then, because he sells them after every analysts’ meeting. Usually about $70 million worth. He’s very consistent; made himself rich. Then he’ll be gone and some poor fool will be left $30 billion of debt, $18 billion in equity and $3 billion in cash. With all kinds of accrual rates that might not be sustainable. The piper will be paid. But these things can take a very long time. Meanwhile IBM’s market cap is nearly $200 billion. What I do know however, as a former accountant, is that when you’re playing accounting games, you’re not going to be able to hold it up forever. Even the mighty Cisco couldn’t. That’s the story of IBM. That’s sort of the story with Greenspan and the market. Play games. Hold it up as long as you can. But it doesn’t work forever. It didn’t for Lucent, it didn’t for Cisco. It’s not going to work for Greenspan and it’s not going to work for IBM. On that happy note, thanks, Fred. For subscription information on the High-Tech Strategist please call 603-888-3954 for details.		Illustration: Charles Powell




		"When we do get to the bottom, they will hate tech stocks. It will be ugly. People won't be able to win financing even for good ideas as a result of this period of gluttony, Wall Street and corporate executives feeding off the stupidity of the average guy."








		"What you don't want to do is buy a semiconductor company that has no orders, when its end market customers are completely saturated with inventories, and just hope that some greater fool is going to buy it from you."