The End of an Era
(c) Felipe Rodriquez - 13 February 2000


							
SUMMARY

When public perception about the Internet becomes pessimistic,
an era of supposedly unlimited growth and extremely high valuations on the
stock markets comes to an abrupt end.



Introduction - The valuation of a company

Equity valuation is a process that requires an objective and a subjective
assesment of a company. The objective part in the calculations are based on
current earnings and cashflow of a company and on the 30 year bond rate. The
subjective part of the calculation is based on an estimation of future
growth, the length of future growth, and a risk discount factor.

If equity analysis would be an entirely objective process, then stock
markets would be efficient and predictable. In such a case everything about
a company would always be known, and would be processed in the valuation.
Therefore there would never be any over- or undervaluation in the market.
This is also what the (in)famous efficient market theorie predicts.
Unfortunately the precise value of a company at any time of its history
cannot be accurately predicted, there's always the subjective influence of
the hopes and fears of people.

Any mathematical valuation of a company uses subjective elements of future
expectations. Subjectively the investor tries to establish a growth rate of
a company, or tries to make an educated guess on the amount of years that
growth will continue. The investor also estimates the risk of an equity, and
discount such risk accordingly in the future. The optimistic subjective
estimations of millions of people have caused technology stocks to be
extremely expensive. By paying such a large price investors are expecting
high growth and an almost unlimited timeframe of future growth.


The new paradigm is shaking - negative perceptions..

The optimistic investor believes that the Information Era is the start of a
development that is as important as the industrial revolution. _And_ that
this development will create more productivity, and unlimited progress and
growth. The illusion of unlimited growth is a vulnerable and dangerous one.

Certain events can change this perception of unlimited growth. For example
the realization that the technology and infrastructure of the Internet are
still immature and unreliable. The Internet is sensitive to sabotage,
information warfare, and terrorism. Teenage hackers are capable of hacking
into websites of large companies and the pentagon. Trojan horses are spread
every day through Email, to exploit the the host system. And recently a
number of important Internet commerce sites, Internet icons like amazon.com
and yahoo.com, where shut down for hours by electronic sabotage.

Another fear factor that will sometime change perception is that modern
military strategy is based in part on information warfare. Doctrines have
been written about this topic by various countries like the USA and China.
Complete attack/defence schemes have been developed. And at some point in
the future these information warfare doctrines will be used in warfare
between nations.
The USA, and any other country that depends on information technology, are
extremely vulnerable to attack in the information infrastructure. An enemy
of the US, such as a group of skilled information terrorists or a foreign
nation, would seem to have no problem shutting down the critical business
operations of internet companies like Amazon, Yahoo, E-trade and others for
an unlimited time. Information warfare can be used effectively as economic
warfare.

Companies like Amazon.com have negative profit margins, despite the fact
that they are by far the largest merchant on the Internet. Future profit
margins are expected by most investors, but how can we be certain there will
ever be a positive profit margin ?
Amazon.com, and other companies, gamble on a branding strategy that focuses
on becoming the most important merchant on the Internet. By increasing
market share, and sales volume, merchants hope to earn some money in the
future. But in the future we may not need to know _who_ sells the book.
Assuming we'll have intelligent agents that automatically find the cheapest
books for us, at the best rated merchant, and with the lowest shipping cost.
Our entirely rational shopping agents of the future will not be impressed by
a strong brandname like amazon.com. Conclusion: no future profits are
guaranteed.



Performance = Perception = Performance

Positive performance in the market is caused in part by perception of the
very positive performance. And vice versa.

Perception and performance influence eachother. Strong positive performance
creates an optimistic perception of the future. Many investors buy shares
because they have only been going up. They believe they will go up some
more. The perception becomes the performance.

If either performance or perception change negatively, they affect the
eachother negatively. If the perception of the future of opportunities on
Internet changes negatively, the price of Internet stocks performance drops,
because people start selling their shares. That reinforces the negative
perception, and people become more pessimistic. The current optimistic cycle
is easily reversed into a negative perception cycle.

What the wise do first, the fools do last. Many of the last movers in the
optimistic market are heavily margined. Highly margined investors are often
forced to sell shares when the market dips, pushing prices even lower,
thereby forcing more margined investors out of the game.


Interest rates and inflation

The always changing subjective perception of events is accompanied by
interest rates that are in an upward trend. Central banks are preempting
future inflation by raising interest rates and tightening liquidity.

Long term interest rates are an objective number in equity valuation. A high
interest rate affects the intrinsic value of a company. Discounted cashflow
valuations discount the value of future cashflow with the long term interest
rate, and an additional risk premium. As interest rates go up, the intrinsic
value of a company goes down. Intrinsic value works like a magnet on share
prices. When the intrinsic value of a company drops the share price drops
too, eventually.


Conclusion ?

The current bull cycle of the market is driven by technology companies. The
shares of these companies often have insanely high valuations. These
valuations reflect interest rate and the optimistic future expectations of
the investors that buy these shares. Optimistic perceptions have changed in
past eras because presidents changed, or because of war, or because of
inflation, or because of higher interest rates. Or because of a combination
of such events.

Perceptions will change, they always do. We cannot be certain that the
Internet can and will grow indefinitely, or that the Internet is an optimal
business environment where profits will always be high. It is only now
becoming clear to investors that the Internet as a business infrastructure
is far from mature. Computers and businesses on the Internet are vulnerable
to attack, or other hostile activities. It cannot be expected anymore that
the Internet provides a safe and sound environment for electronic commerce.

If investors collectively change their perception into a negative one, a
selloff would occur, naturally driving down share prices. That in turn
reinforces the negative perception, and drives down prices even further.
With margin levels at an historic high, a dip in the market could cause a
massive amount of margin calls, squeezing more investors into selling off.

A longterm harmful side-effect is that call options would have substantially
lower valuations. Many employees, especially in tech companies, are
compensated with stock call options. The price of these options directly
relate to the share price of a company. Higher share price means higher call
options prices. Lower price means lower call  option prices, until at some
point the options become worthless. As options become less valuable, less
people will be inclined to work in the tech sector. That would push wages up
because these companies have to start paying employees hard currency,
decreasing the earnings of the company. Lower earnings usually means lower
stock price, reinforcing the downward cycle.

When our collective perception about the Internet becomes a little bit more
pessimistic, an era of supposedly unlimited growth and extremely high
valuations could come to an abrupt end.

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