Monday Morning: The death of yet another new paradigm

The bad news is that the technology sector of the Standard & Poor’s 500 stock index was down 41% last year. The good news is that the price-earnings ratio of the sector, based on trailing earnings, was cut to 33 by yearend, from a high of 79 last March 27.

Now, that might not be a signal to plunge into tech stocks, but it is certainly a sign that some rationality has returned to the valuations placed on tech and Internet stocks by investors.

And the more reasonable valuations suggest that investors, including the Wall Street analysts who are supposed to guide them, again accept the traditional belief that stock prices are strongly connected to company earnings. And they acknowledge that the principle applies to tech and Internet companies also.

At the beginning of last year, more than a few investment professionals would have given you an argument on that point. The Internet, in particular, some argued, was a “new paradigm.” As a result, the old rules did not apply.

The collapse of the Internet bubble proved once again that one of the most dangerous phrases in the English language is: “This time it’s different.” I first heard it in the early 1970s, when the “nifty 50” stocks were the rage.

The nifty 50, made up of the technology stocks of the day such as IBM, Polaroid and Xerox, were called “one decision” stocks. They were stocks you could buy and hold forever, so the only decision you had to make was when to buy them.

The era of the nifty 50 was short lived, from early 1970 to May 1973. Then it fell apart. The prices of most other stocks had begun dropping in 1970. Though the nifty 50 defied gravity for a time, eventually they all succumbed.

The next new paradigm appeared in the 1975-80 period when it seemed that small-cap stocks would always outperform large-cap stocks. Academic studies showed that, historically, small-cap stocks had indeed outperformed large-cap stocks. From 1926 through 1975, small-cap stocks returned 9.8% compounded annually versus 9% for large-cap stocks.

That made sense, theoretically. Small companies were less mature than large companies and had fewer resources, so the stocks were more risky. Therefore, investors would get paid for taking that additional risk.

And from 1975 through 1980, small-cap stocks returned 52.8%, 57.4%, 25.4%, 23.5%, 43.5% and 39.9%, respectively. For those six years they returned 39.8% compounded annually versus 17.5% for large-caps.

Investors were convinced. Many plunged heavily into small-cap stocks.

Unfortunately, for the next two decades, small-cap stocks underperformed large-cap stocks. Large-cap stocks returned 17.2% compounded annually compared with 14.3% for small-cap stocks.

The Japanese stock market in the 1980s was another example of a failed new paradigm. At one point, the Nikkei Index topped 40,000, and the average p/e ratio of a Japanese stock was more than 40.

Investors in Japanese stocks were told the p/e ratio was not excessive because Japan was “different” and was operating in a new paradigm. In 1989, the Japanese stock market collapsed and still languishes around 14,000. So much for the new paradigm.

In many instances, that leaves tech and Internet investors with losses that will never be recovered. Other investors, if they have the patience to wait many years, may recover their losses and even make a decent investment return.

That was certainly true for investors who bought IBM in the early ’70s and held on.

And no doubt some tech and Internet stocks are “buys” now that the bubble has burst and their p/e multiples are more rational. The hard part will be identifying them.

Individual investors may be gun-shy about the sector now, but investment advisers can guide them to put a little money into good tech stocks or tech sector mutual funds that will pay off in the long run. And the long run is what investing is all about.

Mike Clowes is the editorial director of InvestmentNews.

Related Topics: Just Thinking