Decline of Hot Growth Issues Fulfills Prophecy of ‘Shorts’
The engines have gone dead on the highest-flying stocks of 1993.
From telecommunications equipment to golf clubs to coffee shops, investors suddenly are fleeing the “emerging growth” industries that generated wild excitement on Wall Street for most of this year.
And, if you believe the “shorts”--professional traders who make a living (and sometimes a killing) betting on market declines--the worst is yet to come for these and other allegedly overvalued stocks, even if the bull market stays alive.
On Thursday, the Dow industrial average fell 19.01 points to 3,685.34, as the market yawned at the House of Representatives’ approval of the North American Free Trade Agreement. That 0.5% drop in the Dow masked horrendous declines in many of this year’s former growth-stock stars.
San Diego-based Qualcomm Inc., whose claim to fame is a controversial digital cellular phone technology, tumbled $7.25 to $55.25 on Thursday, a 12% drop. People’s Choice TV, a fledgling firm that sells cable-style programming over the airwaves, slid $3.125 to $32.25, an 8.8% loss. Callaway Golf, the leading name in the oversized golf club craze, slumped $1.75, or 3.6%, to $47.25.
More significantly, the dumping of these once-hot issues on Thursday accelerated a selloff that began in October. Qualcomm, for example, has plunged 36% from its all-time high of $86.75 a share, reached in mid-October. People’s Choice has tumbled 25% from its peak price, and Callaway is down 28%.
To the relative handful of Wall Street pros who argued forcefully against most stocks this year--saying that prices were way beyond the fundamentals--the carnage in growth stocks was a long-awaited vindication.
To a particular subset of those pros--the short sellers--this is also payoff time: After losing money for most of three years while stocks soared, the shorts are back in the black.
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“I really believe this market has topped out,” said a jubilant Marc Perkins, head of Perkins Capital Advisers in Palm Beach, Fla., and an active short seller. “The signs are everywhere,” he said.
Not only are the new growth stocks plunging, Perkins said, but stodgy electric utility stocks also have slumped badly since late August. A drop in the utilities often is a precursor to a broad market decline, since a utility selloff frequently rising market interest rates.
What’s more, Perkins said, the extreme speculation in the new-issues market is an unmistakable sign of a market that is rapidly overheating. Last week, Boston Chicken, a chicken fast-food chain, went public at $20 a share--and saw the price zoom to $48.50 the same day.
“What we have now is a mania (for stocks),” Perkins said. But, as history demonstrates, he added: “All manias eventually correct themselves.”
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Indeed, whether this growth-stock retreat represents a short-term correction or a bull-market killer, the shorts say it proves the point they have been trying to make: that overvalued stocks can’t stay that way forever.
Short sellers are a rare breed, despised by many investors and misunderstood by most. Rather than make money the old-fashioned way, simply buying stocks and hoping they go up, the shorts play the opposite game. They pick stocks that they believe to be drastically overpriced.
In a short sale, a trader borrows stock on the open market (usually from a brokerage’s inventory of shares) and sells it. Eventually, the trader must repay the borrowed shares, hopefully with shares purchased later at a much lower price.
To illustrate: You borrow 100 shares of Overpriced Growth Inc. and sell them in the open market at $60 each, the current price. You collect $6,000. If the stock plunges to $30, you can buy back 100 new shares on the market for just $3,000, and replace those you borrowed. You pocket the difference--in this case, a tidy $3,000 profit.
It sounds great . . . except that when the stock you sold short rises instead of falling. If you sold 100 shares at $60 each and the price rose to $90, you would suddenly have a $3,000 loss on your trade instead of a $3,000 profit.
For many of the shorts, that has been the painful story since 1990. As the accompanying chart shows, the typical short seller has lost money in eight of the last 12 quarters, according to an index of short-sale accounts tracked by money manager Michael Long of Rockbridge Partners in Charlotte, N.C.
It isn’t simply the longevity of the bull market that has confounded the shorts. They were able to make money during the bullish years of 1986 and 1987, Long noted. The problem for many of the shorts since 1990 has been underestimating the risk of red-hot stocks becoming white-hot, or even a degree beyond that.
“We’ve found that companies that are overvalued can easily go to double-overvalued,” said Russ Faucett, whose Century City-based Barrington Partners is a veteran short-selling firm.
Qualcomm, for example, was a $23 stock early this year. As it rocketed to $40, then $50, then $60, many short sellers continued to lambaste it. They said that the company’s cellular technology would never become the “new standard” that the company’s supporters had advertised. But that didn’t stop the share price from zooming to $86.75 by mid-October--a rally that forced many short-sellers in Qualcomm to bail out long ago, at deep losses.
With the stock now back to $55.25, the shorts naturally believe they were right all along, though it remains to be seen if the company can deliver on its technology.
Most short sellers say the real issue in this market, as always, isn’t whether a company deserves to be in business, but how high the market should value the stock. A price of 20 or 30 times earnings per share might be justifiable for a growing new company if shareholders can reasonably expect above-average earnings growth over the next few years.
But with many so-called emerging growth companies boasting of price-to-earnings ratios of 40 to 50 or more--even after the recent decline in the stocks--the shorts still smell blood.
“You always regress to the mean in the stock market,” Perkins said. “Everything returns to normal.” The current valuations of many growth stocks are simply abnormal.
