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By Jason Zweig
Nov. 13, 2014
I don’t often look back at what I’ve written and think: I nailed it. One of my columns, however, does seem to hold up pretty well more than 15 years later.
In May 1999, I looked at Internet stocks and counseled readers not to buy them. Knowing, as you probably do, that Internet stocks lost approximately 90% from their peak in early 2000 to their low point in 2002, you might think this column made points that had to be howlingly obvious at the time, but you’d be wrong. They weren’t obvious. Don’t let yourself be blinded by hindsight bias. The whole reason there was a bubble in the first place is that people really did believe Internet companies would grow faster than any other companies had grown in human history — and never slow down, let alone stop.
As I wrote in my annotations to Benjamin Graham’s The Intelligent Investor:
In mid-1999, after earning a 117.3% return in just the first five months of the year, Monument Internet Fund portfolio manager Alexander Cheung predicted that his fund would gain 50% a year over the next three to five years and an annual average of 35% “over the next 20 years.”
Like all bubbles, this one wasn’t completely irrational. When the potential growth of a transformative innovation is high enough, excitement about the future is what gets the idea funded. That has been true for almost every “new era” bubble in financial history: the South Sea in 1720 (transoceanic trade), the British railway boom, the craze for electric-utility and radio stocks in the 1920s, and so on.
The Internet was transforming the world, and it is even more pervasive today than many of its most enthusiastic boosters in 1999 expected it to be. The people buying dot.com stocks turned out to be absolutely right about the industry’s potential. But they paid too much to participate in it. History proves that growth rates are finite and that they decay over time. Just as growth is limited in the natural world — trees can’t grow to the sky, because they would collapse under their own weight long before they got there — it is limited in the financial world. No company, no industry, no strategy can grow far faster than average for long; if they did, they would run out of new customers and sources of profit. History also shows that the early leaders in a new industry often don’t turn out to be the long-term winners.
As Benjamin Graham wrote in 1934 about the bull market that peaked in 1929:
The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a…stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the preboom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell but even upon the price at which it would deserve to sell. This fantastic reasoning actually led to the purchase at $100 a share of common stocks earning $2.50 a share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.
In 1999, the identical reasoning was extended to companies that had no earnings at all, on the theory that their future profits were virtually infinite.
Pointing out, as I did here, that none of this made any sense made me about as popular as someone who eats too many beans right before a wedding. Every day for months, I received dozens of emails calling me a moron, a dinosaur, and a seemingly endless variety of anatomical obscenities.
Around the middle of 2000, those emails stopped coming.
The lesson I learned: When a transformative investing idea first emerges, the people who believe in it are regarded as crazy by everyone else. Once the idea takes hold and swells into a bubble, it becomes orthodoxy. And when those who question it are regarded as crazy, then the bubble is finally getting ready to burst.
Here’s the column. If you read it, let me know whether you think it has held up over time.
These color PDFs are large files and may take a while to load; you might need to right-click, Cntl+click, or hold down your cursor. The article is in two parts.
http://www.jasonzweig.com/from-the-archives-baloney-com/
