A Rally Despite Cryptic Message From Cisco's Chambers?

By Kurt Kasun | February 07, 2008 | 11:46 AM | 0 Comments

Many are still clinging to the false hope that tech will find its footing and the glory days of the 1990s will return in short order. For example, the following is an excerpt from an article which appeared just a few months ago in July 2007 in the Financial Times, titled "New Era ‘to surpass dotcom boom:'"

The introduction of consumer-driven web 2.0 technologies into businesses is set to usher in a new phase of productivity growth which could surpass that achieved during the late-1990s internet boom, according to John Chambers, chairman and chief executive of Cisco Systems. "We are at the very beginning of the next phase of creativity that will last, I think, a minimum of 10 years, probably 15 years," said Mr Chambers, in an interview with the Financial Times. "But it will have more impact because . . . the power of [connecting] many to many allows you to do things at a dramatically different speed." The head of the world's biggest maker of data networking equipment said social networks, wikis, tele-conferencing and other technologies that allow interaction on a large scale could change entire business models. His comments come amid a period of intense interest in consumer-oriented social networking sites such as MySpace and Facebook, which allow users to share pictures, videos and other messages online.

At the very least, Cisco's latest earnings release indicates that the rosy long term view has hit a bit of a rough patch. In a telephone interview with CNBC earlier today (we certainly hope Cisco equipment that was responsible for the failed video feed) Chambers allowed, "we're in for some bumps", "it is unusual for us to see these kind of bumps in our sales forecasts" and "it is the first time in years we missed our forecast." I found the interview very strange. John Chamber's tone was very positive and optimistic, but it was filled with caveats and fraught with seemingly cognitive dissonance on his part.

Back to Web 2.0: This was always wishful thinking at best, or a total misunderstanding of the business that will result in the misallocation of billions of dollars in wasted capital at worst. The new applications of web 2.0 absolutely pale in comparison to the way the web transformed business and was adopted by consumers in the 1990s. Web 2.0 for all of its video and other forms of broader-band usage, will be much more highly-demanded by the consumer than the business user. This means less revenue and lower margins than Web 1.0. There was a temporary upgrade cycle which benefited a few companies, but this will not result in anything like the investment flow we witnessed in the 1990s into the tech/telecom sector.

This is especially true now that commodities and emerging markets are a better alternative for investment dollars. My advice to my fellow-West Virginian, John Chambers, would be to return to his state of origin and follow the path of Hong Kong-based Mongolia Energy. Until May this company was known as New World CyberBase, a telecommunications company that first listed in April 1991, reached a high of HK$63.56 in October 1997, and then tumbled 99.8 percent to its low of 13 Hong Kong cents by the end of 2005. Since becoming Mongolia Energy, shares have jumped 981% since February of last year, when it announced plans to buy a coal mine. In May, the company said it sold its stake in New World Mobile Holdings, a mobile Internet service provider. They took the proceeds and wisely purchased land and related mining assets in Mongolia to look for coal, iron ore and other non- ferrous metals. There is a lot of coal still to be developed in West Virginia and I suspect that they would gladly accept the billions of dollars Cisco currently holds in cash to develop new mines.

Turning a bit more serious and returning to the Chamber's CNBC interview, those long the market (this group is typically biased toward a positive view of the tech sector) clung to the Chamber's optimistic comments and the market turned higher: "We feel very good about our long term guidance", this will be a "relatively short term [transition]" but we are "starting to see business leaders become cautious." The positive long term guidance in light of the short term caution and forecast miss reminds me an awful lot like the language we heard from Cisco when the stock plunged from 60 to the low teens during the last tech bust eight years ago. I would suggest that psychology accounts for a lot of this. A lot of sectors in the US have rebounded sharply over the past few years since the last bear market, and investors are mindful of the success they enjoyed in these sectors in the 1990s. Tech is the best example, but you could also include other growth sectors-financials, consumer/retail, pharmaceuticals, etc. I think investors are relying on their most recent experience (10-20-yr period) to guide their decision-making. This is to be expected.

What they are missing is that the sectors which performed well in the last bull market are underperforming during this bull run, and that the laggards of the last bull market (1982-2000) are the leaders of the current one. There is another psychological factor at play and it is known as "home bias" where investors tend to skew their portfolios with names of companies in their home country. US investors are just now beginning to grasp that the emerging world is the new growth story and yet many still insist on investing in US-based multi-national companies who receive a portion of their revenues outside of the US (owning commodity names and foreign companies have proven far better ways to capitalize on this). The last psychological factor involved is blind optimism in the ‘good ole ‘USA. Unsupported optimism and hope make for a dangerous investment strategy.

The sea of red in the chart below strongly suggests that we are entering an almost across-the-board bear market--except for the sector at the bottom of the graph which is now leading all other categories in 1-yr, 2-yr, 3-yr, 5-yr, and 10-yr annualized returns. Most US investors have missed the boat on investing in gold. This trend will most likely end only after the last retail investor has finally bought into it. It also dovetails nicely with the challenging economic times on the horizon which I addressed in my commentary earlier this week.

Returning to psychology and wishful thinking, the vast majority appear to be hanging onto the hope that this recession will be "short and sweet" as the last two (1991-1992, 2001-2002) (again...of recent memory) were. Even if this comes to pass, there is a lot of bad recessionary news which we need to cycle through before the stock market can bottom and fully price in all of the bad news and anticipate an economic upturn. Having said that, I fully expect the market to rally over the very short term and to make a very strong push to test the new 5-yr resistance level on the S&P 500 of 1390. A successful breach would take us possibly to 1450 and present a beautiful opportunity to add to our "Short" ETFs.