By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Testosterone Pit.
The theory is this: if certain stocks plunge far enough, it’s a buying opportunity because they’ll go back up someday. Assuming you’re patient and liquid enough, that theory works marvelously for those stocks that do go back up someday.
But plenty of stocks don’t. Momentum stocks – with a few exceptions – belong to that group. Once momentum hisses out of them, they deflate for good. All the hype and smoke and mirrors and hoopla that the fawning media eagerly transmitted from Wall Street and Silicon Valley or Silicon Alley or whatever to the public suddenly look silly. And afterwards, the mere sound of their names causes a flurry of raised eyebrows and shaking heads and some wistful smiles.
To make momentum stocks fly, the promoters doll them up in newfangled metrics and “estimated adjusted future earnings per share,” or some such pro-forma nonsense, or even “adjusted earnings per share,” or earnings “ex-items,” which aren’t earnings at all, but fantasy numbers, though by now everyone is using them. And to heck with the old-fashioned metrics like revenues and actual earnings as reported under GAAP.
On November 6, just before Twitter’s IPO – which was shrouded in even thicker than usual layers of hype, smoke and mirrors, and newfangled metrics – the SEC warned about newfangled metrics. They were designed, Chair Mary Jo White said, “to illustrate the size and growth” of these outfits that lacked outmoded results, such as actual profits, or even hope for actual profits. She strenuously avoided mentioning Twitter by name, tough everyone knew that’s what she was talking about. She and her staff were particularly concerned that “the true meaning of the metric (or more importantly the link from metric to income and eventual profitability) may not be clear or even identified.”
Wall Street ridiculed the warning, and Twitter soared to $74.73 by the end of the year. Now reality has set in. The SEC has proven its point. There are no actual GAAP earnings in Twitter’s foreseeable future. And the stock crashed 55% from its high. But what is a company worth to its shareholders if it cannot ever make any actual profits and simply eats up investor money?
Twitter is just the tip of the iceberg. Entire sectors have been demolished over the last few months. But the hype mongers on Wall Street are touting Internet stocks as a buying opportunity, as if this ongoing fiasco were some kind of ephemeral dip, a unique opportunity to get in at the right price for long-term prosperity. In that spirit, Citigroup pumped internet stocks.
So the FDN Internet Index fund is down 16.2% from its peak on March 5. Citi’s own large-cap Internet index is down 18%. But here it goes, Citigroup analyst Mark May in a note to clients:
We believe the recent pullback represents a particular opportunity among large cap Internet stocks, with multiples having retraced to levels not seen for more than two years, with no/little change in fundamentals, and with investment profiles that sync well with what portfolio managers are seeking in today’s market.
Citi’s clients are presumably not day-traders trying to take advantage of short-term swings, but portfolio managers trying to build and maintain wealth through prudent investment choices. Among his favorites: Facebook (-17.6% from its high), Google (-11.9% from its 52-week high), Amazon (-25.3%), AOL (-30.9%, so it’s “particularly oversold”), or even LinkedIn (-42.7%).
These and hundreds of other momentum stocks have swooned while the Dow and the S&P 500 indices have set new highs. What will happen to these stocks when the Dow and the S&P 500 begin to swoon as well? And why would these stocks now suddenly be such great buys, after they’d been excellent buys all the way up, and at much higher prices, and then all the way down? Because analysts have a job to do: hype the stocks they’re assigned to hype.
“Despite the pullback in valuations, the fundamentals of large cap Internet companies haven’t changed,” May wrote. Sure, the fundamentals, as expressed in estimated adjusted future earnings per share and the kinds of newfangled metrics the SEC had warned about, may not have changed, but reality hasn’t changed either, and investors have started paying attention to it just one tiny bit.
This is like so 2000. Back then, even as the hot air was hissing out of momentum stocks, there were enough powerful rallies to infuse a sense of hope and allow some lucky traders to make some money. And these heroic analysts rode the market all the way down with their hype and encouraged people to lose 50%, and often much more, of their investments just so Wall Street could wring out its fees.
Once the hot air is gone, momentum stocks become shipwrecks. Some of them sink to the bottom of the ocean. Others stay afloat for years, listing, drifting, nearly worthless. Some of the survivors cobble together a functional business model, make actual money, and perhaps even thrive years down the road. And a few, such as some of the large-caps mentioned, have impeccable business models and actual earnings, but their valuations simply make no sense, not even at todays lowered prices. But analysts would likely be fired for even thinking that.