A "symptom of dementia?"

William Hester, CFA
November, 2004
All rights reserved and actively enforced.

John Brooks , who chronicled the late 1960's stock market bubble in his book The Go-Go Years , wrote that there are certain "symptoms of dementia" found during stock market bubbles. He particularly warned of giddy action in initial public offerings. "If one fact is glaringly clear in stock-market history, is that a new-issues craze is always the last stage of a dangerous boom - a warning almost as infallible as Cheyne-Stokes breathing is a warning of impending death."

The activity in the new issue market can help measure the 'gambling mood' of investors. Companies selling stock for the first time often have short histories and unknown management. A few grow up to be blue-chips, but most eventually idle away as small companies or go bust. Stacks of academic research show that new issues tend to be poor long-term investments.

When investors fall over themselves to buy IPO's, it's usually a sign that they're feeling speculative.

So investors might do well to notice that the shares of companies who have had an offering in the last year climbed 30 percent over the past three months, according to a Bloomberg index. This is three times the gain in the S&P 500 and comfortably above newer companies' typical sensitivity to moves in the broad market.

An abrupt change in the speculative mood of investors rarely has just one catalyst. But the most recent rally in new issues kicked off just two days before Google sold shares to the public for the first time. After stumbling out of the block, the shares of the leading search engine have soared.

But investor excitement goes beyond just Google's business. Sixteen companies in Bloomberg's IPO index have more than doubled this year. Thirteen of those have outpaced Google's gain.

Investment bankers have been quick to notice the better environment. There were 41 IPO's done last month, the most of any month since August, 2000. This year's tally of 268 first-time offerings is the highest since 2000.

Internet companies are benefiting from this window of increased risk-taking by selling shares. In 2003, of the 146 companies that sold shares on US exchanges, five were internet companies. In the last three months, 10 of 67 IPO's were internet-related companies.

The valuations imply that investors are especially enamored with the prospects of Web companies. The best performer is eCost.com, an online discount store. Think Amazon.com with blue-light specials. The company had $110 million in sales in its most recent fiscal year. Analysts forecast that the company may earn $.03 a share this year. Trading at $16, that puts the forward P/E ratio at about 500.

Interchange, the second best performing IPO during this period, helps companies get listed by search engines. The company had $8.8 million in revenue last year, and $.06 per share in earnings. It's shares trade at over 400 times profits.

Of the top ten best-performing IPO's in the last three months, six are Web companies. Two of these are internet companies that do business in China - a perfect mix for the speculative crowd this time around.

A company called 51job is based in Shanghai and offers worker-recruitment services. Its shares have climbed 120 percent since its September offering. Beijing-based eLong is a travel service company whose shares have risen 55 percent in the three weeks since its shares began trading.

It's not just newer Web companies that have advanced. The Dow Jones Composite Internet Index has climbed 35 percent since Google's offering. Leading the way is Ariba, which sells spending-management programs and has had yearly losses since 1997. Its shares have gained 110 percent in three months. Overstock.com, a discount web-retailer, has doubled.

It's not impossible that the IPO market could get hotter from here. Brooks, the author, talked about "shooters". These were companies that doubled the first day of trading.

Investors active in the late 1990's remember those. But they should also realize what a unique period that was. From 1980 to 1994 only 10 companies doubled in value on the first day of trading. From 1995 through 2000, the shares of 223 companies - 119 in 1999 alone - doubled, according to Jay Ritter, a professor at the University of Florida.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).