Revisiting the "New Economy"

In just eight or ten short months -- on January 14th of next year for the Dow and on March 10th and 24th for the Nasdaq Composite and S&P 500, respectively -- we will reach the tenth anniversary of the peak of the "dot-com" stock market bubble and the beginning of the spectacular collapse that followed (for a chart showing the beginning and end dates of that bear market, and other bear markets in history, see this previous blog post).

While those "innocent" days may seem like ancient history to investors who have just been through an even more ferocious bear market than that one, they are actually part of a continuity that investors should be sure that they understand.

After that bear market, those who had been critical of the optimism surrounding the talk of a "New Economy" in the 1990s felt vindicated, as Wired magazine's James Surowiecki pointed out in "The New Economy was a Myth, Right?"

That article, written in October 2002, at the very bottom of the dot-com bear market, cited a December 2001 essay by Harvard professor Jeff Madrick saying, "The new economy of the late 1990s was an invention of media and Wall Street [. . .]. By 2000, new economy rhetoric became a frenzy of half-truths, bad history, and wishful thinking."

While the 2000-2002 bear market seemed to vindicate such critics, Surowiecki argued that things had changed fundamentally over the past ten years, and he gave clear explanations of what had changed and how. Specifically, productivity had increased dramatically, due primarily to the impact of increased globalization and a revolution in information technology.

Almost eight years later, however, we can look back and wonder where the continuation of the promise of the 1990s went. Markets are roughly where they were in 2002 and in 1997 before that, and the stocks of technology companies that actually had legitimate business models and survived the crash are still well below their previous trajectories.

For example, the stock chart for network equipment maker Cisco Systems* clearly shows the tremendous runup of the stock into the year 2000**. Cisco was one of the darlings of the 1990s, and briefly became the world's largest company by market capitalization in March of 2000.

The chart also shows the earnings per share of Cisco, which is the solid line connecting dots for each earnings release, directly below the stock price in the chart. While there is clearly a severe "V-shaped" drop in the company's earnings during the period from the start of 2001 to the start of 2002, earnings growth resumed in 2002 and eventually surpassed their previous highs, even though the stock price never did (it continues on in a sideways direction and today is roughly at the same point that it ends up in the 2006 chart**).

In fact, if you look at the company's fundamentals from the year 2000 and compare them to the company today, a very interesting picture emerges.

At the end of July, 2000, Cisco's market capitalization was almost $454 billion. Today, it is just below $114 billion.

Then, the company's trailing twelve months of sales were $16.7 billion. Today, the trailing twelve months of sales amount to about $39.6 billion.

Then, Cisco's net profit margins were 16.4%. Today, they have risen to 19.4%.

In 2000, the company's trailing twelve months of operating earnings amounted to $0.47 per share. Today, the company's trailing twelve months of operating earnings amount to $1.40 per share.

Clearly, there has been a profound change in the way value is being assigned. Back then, the company was trading at a price-to-earnings multiple of 181.8. Today, the P/E is 15.6.

What is the lesson in all of this?

We would argue that investors should consider the following analysis. Clearly, a P/E ratio of almost 182 is a ridiculous valuation. We would argue that it is quite obvious in retrospect that part of the run-up of 1999 to 2000 should never have happened, not only for Cisco but for the stocks of many other companies as well.

In the chart above, for example, we have drawn one possible trend line in red and would argue that some portion of the stock advance above and to the left of that line should probably never have taken place (the portion marked with a red "X" for example).

We have written in the past about some of the factors that led to this misallocation of capital or malinvestment, such as in "The long shadow of the Y2K bug," written in August 2008.

Unfortunately, as we describe in that previous post, after 2002 there was a similar bout of misallocation of capital, this time into real estate, the financial sector, and briefly into commodities. Just as the tech bubble before it, the post-2002 housing bubble was caused by misguided attempts to "steer" the economy by the Federal Reserve, using inflationary monetary policy.

The misallocation of capital into housing, financials, and commodities sucked capital away from technology companies which have continued building on the promise of technology. Additionally, investors who had been through the tech bubble's collapse were "once bitten, twice shy" and had no confidence in the promise of broadband and connected computing that had been hyped so exuberantly during the late 1990s.

However, some of those companies -- and some new ones as well -- continue to create exceptional value, even if the market now assigns valuation far below what it is actually worth (just as before it had assigned value that was far too high).

In the chart above, for instance, you can see the trajectory of Cisco's earnings line marked with the blue curve. Today, their earnings are another 25% higher than where they were then, even though their price is at the same level.

We believe that the egregious mistakes that culminated in the wreckage of 2008 delayed the arrival of some of the technologies that are now reaching a real turning point. We have written previously about some of these promising technologies and the ways that they will change the landscape both for individual consumers and for businesses, such as in "The Unstoppable Wave," "Big Changes Coming part I and part II" and "Video is clearly the killer app here . . ."

This time, however, the companies producing revolutionary changes are available at much more reasonable valuations! We have used Cisco as an example, and it is a company with an important role in network technology, but there are many other companies that investors can find which are adding value and paving the way for revolutionary changes.

We believe that investors should carefully consider this much-overlooked lesson of the past ten years.

* The principals of Taylor Frigon Capital Management own shares of Cisco Systems (CSCO).

** The chart above, from the Securities Research Company, is a semi-log chart, which is the best type of chart for seeing relative market moves because it depicts percentage moves on a constant scale, rather than depicting dollar moves on a constant scale (thus a 10% move would be the same size on the chart whether the stock went from $2.50 to $2.75 or from $50 to $55, while an arithmetic scale chart would show the second move as being twenty times larger). We have depicted a chart from 2006 because SRC makes their business selling these charts, so that investors who want one that is up-to-date rather than three years old can purchase one if they desire from their website.

For later blog posts dealing with this same subject, see also: