Decline of Hot Growth Issues Fulfills Prophecy of ‘Shorts’
The engines have gone dead on the highest-flying stocks of 1993--in midair.
The wild excitement for shares of telecommunications equipment suppliers, golf club makers, coffee shop chains and other “emerging growth” industries has suddenly evaporated, and near-panic selling has set in.
And, if you believe the “shorts”--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. But 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 oversize 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%.
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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 is 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 as stocks have soared, the shorts are back in the black.
“I really believe this market has topped out,” said a jubilant Marc Perkins at Perkins Capital Advisers in Palm Beach, Fla., and an active short. “The signs are everywhere.”
Not only are the new growth stocks plunging, Perkins said, but electric utility stocks also have slumped badly since August. A drop in the utilities often is a precursor to a broad market decline, because a utility selloff frequently signals rising interest rates.
What’s more, Perkins said, the extreme speculation in new stock issues is an unmistakable sign of a rapidly overheating market. Last week, Boston Chicken, a fast-food chain, went public at $20 a share--and zoomed to $48.50 the same day.
“What we have now is a mania,” Perkins said. But as history demonstrates, “all manias eventually correct themselves,” he added.
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.
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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 target stocks that they believe to be drastically overpriced.
In a short sale, a trader borrows stock (usually from a brokerage’s inventory of shares) and sells it on the open market. Eventually, the trader must replace the borrowed shares. The goal is to repay with shares purchased later at a much lower price.
To illustrate: You borrow 100 shares of Overpriced Promises Corp. and sell them in the open market at $60 each, the current price. You collect $6,000. If the stock plunges to, say, $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 when the stock you sold short rises instead of falls. If you sold 100 shares at $60 each and the price jumps 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 just the longevity of this bull market that has confounded the shorts. They were able to make money during the bull years of 1986 and 1987. The problem for many shorts since 1990 has been underestimating investors’ willingness to bid stocks of iffy companies to outlandish heights, as interest rates have fallen to 30-year lows and as tidal waves of cash have poured into the market.
“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 $60, many short sellers continued to lambaste it, arguing that the firm’s cellular technology would never become the “new standard” that its supporters trumpeted. But that didn’t stop the share price from zooming to $86.75 by mid-October, equal to 100 times Qualcomm’s estimated 1994 earnings per share. As the rally progressed, it forced many short-sellers in the stock to exit early, at deep losses.
Most shorts 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. Historically, a price of 20 or 30 times earnings is justifiable for a young firm if you can expect above-average earnings growth over the next few years.
With many so-called emerging growth stocks still boasting price-to-earnings ratios of 40 to 50 or more--even after the recent decline in the shares--the shorts still smell blood. Faucett, for example, won’t say which stocks he is specifically shorting, but he readily lists the industry categories in which he finds overvalued stocks: computer hardware, medical devices and interactive media.
Could this downdraft in the new growth simply be a short-term correction? Maybe. But as Perkins noted: “You always regress to the mean in the stock market. Everything returns to normal.” Because the recent valuations of many growth stocks were plainly abnormal, they were bound to be fixed--the hard way.
