Letting the Chips Fall Where they Must

By: Sean Corrigan | Thu, Jul 15, 2004
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riting in the New York Times, business correspondent Gretchen Morgenson tells us that the "high-tech balloon is going 'Ssssssssss'"

   Drawing attention to the spate of earnings warnings and negative mutterings emanating from technology companies, Ms. Morgenson remarks on the malaise being evidenced in a whole range of top name concerns - among them Siebel, Veritas, Webmethods, Filenet, BMC Software, PeopleSoft, Unisys, Ingram Micro and CDW.

   Naturally, all of this has been enough to put a severe dent in the stock prices of these and their sister companies, not only raising doubts about the tech sector itself, but also exacerbating mounting fears that the US economic recovery will fizzle out almost before it has begun.

   In the Times article, that noted observer of all things silicon, Fred Hickey, editor of The High-Tech Strategist, offers a plausible explanation of the industry specifics themselves by alluding to the "ballooning inventories on tech companies' balance sheets."

   "Already rising in the first quarter, these inventories will probably show a surge for the second quarter," Mr. Hickey said, going on to point out that, despite this growing stockpile of unsold goods, "few tech companies appear to have cut production in recent months."

   In the first reporting quarter of 2004, inventories jumped anything between one- to threefifths, the paper tells us, at the likes of Dell, Cisco, Intel and Texas Instruments, leading Mr. Hickey to expect profit margins to suffer and hefty write-downs to be taken in the coming months.

   Underlying these particulars, there may be readily understandable economic fundamentals at work; ones which may give us some insights into the likely path of the broader market.

   Firstly, it may well be that the sharp rise in the prices of a whole range of natural resources, such as coal, steel, natural gas, base metals and lumber, may be squeezing the amount of funds that companies have left to them, so they can devote less to replacing and upgrading their existing software and hardware, even though all these same firm's executives swear solemnly, when surveyed, to be looking more closely at increasing capital expenditures from the depressed levels of recent years.

   After all, we are constantly told that higher oil prices, for example, may be 'bad' for the sellers of consumer goods, since ordinary folk will be left with less discretionary income to spend, once they have run their A/C or filled up the SUV, but few go on to ponder the consequences for the 'discretionary income' of the nation's corporates.

   However, every extra dollar spent on raw materials or on energy inputs similarly represents the potential for one dollar less of income (where the firm is unable to pass on this cost in its own finished goods prices) to be allotted to the capital budget.

   High commodity prices, then, may very well be the culprit in the tech sector's seeming inability to profit from these inflationary times. Alan Greenspan may, ironically, be hurting Silicon Valley by running policy too loose, rather than too tight.

   A second factor at work is that those firms which are prospering - largely by servicing the needs of those two debt-wracked profligates, the US householder and his government master - may be bumping up into capacity constraints as a result of the recent torrid demands being made for their output, to the point that the immediate, pressing need for working capital (to pay suppliers, as well as to finance customers) is taking precedence over the deferrable schedules for maintaining and upgrading plant, equipment and software.

   Moreover, with wage rates, in general, failing to keep pace with rises in the prices of many necessities, it has also become more viable in recent months to hire men (perhaps on a temporary basis, where the otherwise hefty associated benefits are either reduced or not applicable at all) instead of buying in machines. This would be especially likely to occur in the traditionally labour-intensive areas such as the consumer goods and service industries and in construction.

   This second feature is what economists refer to as labour replacing capital. Added to this, is the pull being exerted on industry's overall capacities by the home-owners' credit card and by the government's treasury bill.

   In this latter, we have a case of what Austrian economists call the 'shortening of the productive structure' - meaning McDonald's and McDonnell-Douglas may be taking a bigger share of the pie than Micron Technologies or Microsoft.

   Finally, as with so many other considerations, there is a phenomenon overlooked by the mainstream when it soothes about the leavening which a little inflation brings to the economic loaf.

   Do you not think it strange that that prices, revenues and - yes - even profits in some lines are rising steeply, even as they are falling or stagnating at others? Is it not a trifle odd that there are still those who fret about an impending deflation, even as double-digit price rises become the norm and as the databanks of the world's finance houses hum with the record of new credits granted? Do you suppose that a well-adjusted world would be characterized by such wild swings in the prices of stocks, bonds, currencies and a whole host of other financial assets?

   If you answered, 'Yes' to any of these, would you be terribly surprised if an entrepreneur was similarly nonplussed and that, though he might talk a good game when someone solicited his opinion, he would keep a firm grip nonetheless on his bank book, striving to keep all his options open as he strained to peer a little further through the fogs of uncertainty which seem to swirl in unusual density about him?

   In other words, with many essential price signals - in both real and financial markets - so hopelessly confused by the debasement of our global monetary system, could we find it in ourselves to condemn the savvy businessman if he sought to minimize his commitments and to curtail outlays on things which, even in the best of times, could only be expected to bear fruit over a longer horizon?

   But, enough. If this theory holds up, what would we expect to see in the coming days?

   Well, to the extent that, aided and abetted by a still-lax Fed, the fiscally irresponsible stance of the government persists and, assuming that more hiring - albeit at wages which don't individually buy as much as they used to - continues to take place in those businesses where either the Musketeers or the Mortgageers spend both their earned and their borrowed dough, we would look for more of the same: namely, modestly more jobs appearing - but only in the lucky industries - rising prices overall, further woes for technology and, where they can't compete with the other Asians or the Germans in fuelling the China Boom, for all other makers of (non-defense) capital goods, in due course.

   If so, Mr. Hickey may be right to predict "some very ugly earnings comparisons in the third quarter", part of a scenario that, he says, "reminds him of late 2000, when demand from nascent Internet companies screeched to a halt," noting, cynically, that: "This industry is hopelessly optimistic. They always overproduce."

   But if the firms themselves always sport rose-tinted shades, what does it say about their credulous hordes of investors, for - perhaps in keeping with the zany California ethos which suffuses much of technology - this army of perennial hopefuls surely demonstrates that there decidedly is a New Age sucker re-born every minute?

   Surely the broader lesson we have to draw from this unfolding debacle is the one which relates to human behaviour and the inherent incapacity for learning displayed by people chasing instant riches in the stock market.

   Indeed, it could be said that, just as a nuclear chain reaction takes place when the quantity of uranium reaches a critical mass, then a paper-chain reaction can also be expected when the cupidity in investors' craniums reaches an uncritical mass.

   Consider that the average tech company--where not just an IPOsnake-oil vehicle, avidly peddled on the used-car lots of Wall Street - is a capital-intensive, highly cyclical, optionsaccounting, CEO-enriching, non-dividend-paying, short shelf-life entity, with its profits usually to be sought from declining product prices, yet to be sold at price-earnings multiples in the upper twenties, thirties and far, far beyond.

   One would have thought that the act of placing one's faith in one's ability to ride the market mania for such a group should have been irrefutably rejected as an investment policy by the Grand Guignol of the Internet/Telecom Boom of the late 1990's.

   Sadly, the fact is that, according to the eminent commentator quoted above, we are setting ourselves up for a replay of that delusion, just three or four short years later.

   Could anything else more clearly demonstrate that the malign effects of too much hot money are just as corrosive - and as corrupting - today as ever they were?

   Could anything reinforce the unremitting need to stop one's ears against the Sirens of the Street and unfailingly to exercise rational skepticism when committing one's hard-earned money to an undertaking?

   If so, we should certainly like to hear of it.


Sean Corrigan

Author: Sean Corrigan

Sean Corrigan

Sage Capital Zürich AG • Bellerivestrasse 55 • CH-8034 Zürich • Switzerland
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