We See Dead Stocks

Certain glamour stocks are not ownable by us in a discipline that avoids maniacal stocks like most people avoid ghosts

Article's Main Image

Financial euphoria episodes are a common occurrence in investment markets and the U.S. stock market. When a new one comes along, market participants accelerate their enthusiasm toward the end, which makes the shares of companies involved dead to us. The new mania becomes comparable to prior episodes (see the chart below) and prepares to destroy the capital of those who extrapolate the existing trends and enthusiasm.

455160242.jpg
Source: BofA Merrill Lynch. Data for the time period Jan. 1, 1977 – Dec. 31, 2018.

One of our favorite movies of the last 25 years is the thriller, "The Sixth Sense." It is the story of a little boy, Cole, who is haunted by the regular appearance of dead people. He is visited by an expert psychologist, played by actor Bruce Willis, who hears the boy say, “I see dead people.” In the current stock market, we feel somewhat like the little boy because we see dead stocks. Dead stocks to us are ones which could spend 10 years or more just trying to get back to the highs of the euphoria episode.

We regularly revisit the agony that comes in the aftermath of manic euphoria episodes in the stock market over the last 60 years, because we have no urge to own stocks that make us hide in the bedroom like little Cole did in the movie. Therefore, is the decline in the most popular tech stocks in the last four months a temporary interruption in their long climb to complete dominance of the stock indexes and the U.S. economy? Or is ownership of them a ticket to future misery? Do violent rallies along the way tell you anything about whether the stocks are going to be dead for a while? Lastly, what does this mean for stock pickers like us and asset allocators who need U.S. large-cap equity exposure? Are you willing to be visited by ghosts?

There are two kinds of dead stocks late in a euphoric era. The first kind are the companies which gain heavy favor in the mania but end up being complete failures in their business, whose shares collapse completely. In the Nifty-Fifty mania of the late 1960s and early 1970s, the dead stocks that failed completely were names like Simplicity Pattern, S.S. Kresge (K Mart) and Polaroid. The dot-com tech bubble gave us Sun Microsystems, Lucent Technologies, AOL and a host of others which ended up in the dust bin.

The second kind of dead stocks are the share prices of the companies which succeed as businesses for decades to come, but the euphoria and excitement which became attached to them doomed the shares for 10 to 20 years. Among the Nifty-Fifty which fit this description were Disney (DIS, Financial), McDonald's (MCD, Financial) and Coca-Cola (KO, Financial). The stocks were dead for at least 10 years and saw their price-earnings ratios plummet from around 70 to 80 times to single digits in 1981-82.

The most successful businesses from among the glamour euphoria stocks of the tech bubble were Microsoft (MSFT, Financial), Cisco (CSCO, Financial) and Intel (INTC, Financial). The price-earnings ratio based on 2000 fiscal year earnings at the end of the mania on Microsoft was 65. Cisco peaked at a price-earnings of 222 and Intel topped out at 48 times profits of its outlier profit year, but it was 110 times the average of the three years surrounding its peak price. The profits and free cash flows of these survivor companies have grown massively over the last 19 years.

Those earnings stats, however, didn’t stop the common shares of Microsoft from declining 65%, while Cisco tumbled 89% and Intel fell 82%. To think numbers like this didn’t cause nightmares, leading index and growth investors to see ghosts, means folks have short memories. It took 16 years to get back to the old high on Microsoft and we have never been back to the 2000 high on Cisco and Intel! Have you ever heard of purgatory? Little Cole had some contemporaries.

If these stocks were dead in 1999, long before they peaked, how did investors stay sucked into their morbid vortex during the main part of the death spiral in 2000 to 2002? The answer was many violent bear market rallies in these stocks on the way down. Here is the chart for Microsoft during the worst of its decline:

129748469.jpg

Source: Bloomberg. Data for the time period Dec. 31, 1999 – Oct. 2, 2002.

On the way down, there were three bear market rallies of 25%, 33% and 40%. Two more rallies of 78% and 41% were included in the final bottoming process.

This takes us to Cisco, which was the largest cap stock in the S&P 500 Index on March 27, 2000:

1010126360.jpg

Source: Bloomberg. Data for the time period Dec. 31, 1999 – Oct. 2, 2002.

There were three bear market rallies of 38%, 71% and 94% on its way to the bottom. How could you have figured out that Willis’ character, the psychologist, was dead if he kept rallying like that in the movie? After all, he was giving the young boy great advice in his nightmares.

Intel was no exception to the rule. It had a 31%, 43% and an 85% gain intermixed with regular massive declines, which drove investors into a hiding place with a blanket pulled over their head. I can still see the tears of other people in the investment business who took the brunt of this abuse, and they didn’t even have Cole’s mother there to console them.

831964820.jpg

Source: Bloomberg. Data for the time period Dec. 31, 1999 – Oct. 2, 2002.

If today’s e-commerce glam stocks peaked last year, as the multi-bubble chart shows they might have, could this current rally in shares of Netflix (NFLX, Financial) and Amazon (AMZN, Financial) be one of the big rallies? Are these rallies part of the process of bottoming them for an extended purgatory period like the last tech euphoria episodes? Here are the charts of what has happened in these glam stalwarts since they peaked in 2018:

1079280060.jpg

Source: Bloomberg. Data for the time period Jan. 16, 2018 – Jan. 15, 2019.

After peaking at $2,039 per share on Sept. 4, Amazon has had rallies of 15%, 19% and 24%. Did we mention it was the largest cap company in the S&P 500 Index at the top?

Netflix has rallied 20% and 52% since it’s top on July 9, when it peaked at $419 per share.

1111265842.jpg

Source: Bloomberg. Data for the time period Jan. 16, 2018 – Jan. 15, 2019.

One of the ways we can see a repeat of the tech bubble episode is the boldness that numerous industry experts and stock pickers are showing by recommending and being optimistic about the e-commerce glam stocks. This is the same way that dot-com experts and analysts behaved back in 1999 and early 2000. Fortunately, for many investors, most of those experts have found new occupations. Have you heard anyone in the media lately say anything but positive things about the glam companies? Our rule is that if everyone is calling an up move a bear market rally, it is likely a new bull market. If they are all viewing it as a minor interruption in a bull market and touting how much these favorites are going to go up, you need to crawl into your bedroom and pull up the covers, or at a minimum put on your headphones.

Unfortunately for us, we aren’t as effective at seeing dead stocks as little Cole was at seeing and interacting with dead people. There might be new heights to this financial euphoria episode — even higher than we’ve seen so far. We remember going back and watching the movie the second time to see if we could figure out that the psychologist was one of the dead people. Even then it was hard. Regardless, these glamorous stocks are not ownable by us in a discipline that avoids maniacal stocks like most people avoid ghosts.

Disclosure: The information contained in this missive represents Smead Capital Management's opinions and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

©2019 Smead Capital Management, Inc. (Trades, Portfolio) All rights reserved.

This Missive and others are available at www.smeadcap.com.

Read more here: