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Posted 2/7/2005
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Denial sets tech investors up for a fall
Too many investors aren't facing facts: There's too much capacity in chips, computers and related hardware for the current demand. That spells trouble.
By Bill Fleckenstein
Hope and denial do not constitute a successful investing strategy. More money is lost by people listening to their emotions and ignoring facts than is lost because of just about any other influence. But no matter. That "strategy" has been operating full-throttle lately.
A case of mistaken extrapolation
Take last Monday, when investors decided to buy stocks because Iraqis had voted in large numbers the day before. Yes, the Iraqi election is a good thing for the world, in the form of seeds of a potential democracy being sown in that troubled country. That will be a good thing for humanity over time.
However, the election by itself does not mean an end to further chaos in Iraq, and it certainly does not preclude a civil war. (I am not forecasting this outcome, and I'm obviously not rooting for it. It is, however, a possibility.)
Even the best possible outcome -- that the election is a step toward democracy and a step toward undercutting terrorism -- is completely irrelevant to our stock market at this moment in time. Whatever good may accrue from positive developments in Iraq is quite a bit down the road and, in my opinion, not discountable by the stock market.
Just ask yourself this question: Do you know anyone who modified his or her behavior toward the economy or the stock market because of worries about the Iraqi election? I expect the collective answer to be an overwhelming "no," which shows clearly that the knee-jerk reaction of buying stocks is a classic example of decision-making driven by pure emotion.
Of end demand and heads in the sand
Where better to see this at work than in the tech-stock arena, where, for several quarters now, hope and denial have been doing their best to trump weak company fundamentals. Recently, however, fantasy ran headlong into sobering facts about end demand, in the form of earnings reports released on Jan. 27.
Problems have been reported across a broad range of tech sectors: PCs, via Gateway (GTW, news, msgs); networking, via Foundry Networks (FDRY, news, msgs); and contract manufacturing, via Sanmina (SANM, news, msgs) and Celestica (CLS, news, msgs). (The latter two, while not perfect indicators of end demand, can discuss what their customers -- who do contend with end demand -- are telling them.)
Gateway talked about slowing PC sales at Christmastime, as well as inventories in the channel. The company took down first-quarter guidance but, in a display of carrot-dangling, said its year would be fine. (To which I respond, "Yeah, right.") Since Gateway took market share, its competitors have a real problem. Hewlett-Packard (HPQ, news, msgs) appears set for a serious bruising.
Related news and commentary on MSN Money
As for Foundry Networks, the company said its customers have slowed their purchases. That jibes with the suggestion made by onetime highflier Broadcom (BRCM, news, msgs) (before GERQY -- Jim Cramer's shorthand for Google (GOOG, news, msgs), Research in Motion (RIMM, news, msgs), Qualcomm (QCOM, news, msgs) and Yahoo! (YHOO, news, msgs) -- there was BERQY) that more than just an inventory problem might be at work. That obviously implies slowing demand from its networking customers.
No fleeing the food-chain flu
Sanmina was brutally honest, saying business really slowed down in December, the worst month of its quarter. The company specifically noted that it expected its PC business to be down 10% to 20% in the first quarter. Given what Gateway and Sanmina said -- combined with the reports out of Best Buy (BBY, news, msgs), Circuit City (CC, news, msgs) and CDW (CDWC, news, msgs), and what we'll probably soon hear from Hewlett-Packard -- how anyone can conclude that Intel (INTC, news, msgs) isn't about to be caught with its pants down is beyond my comprehension.
For those who haven't been paying attention, capacity utilization at Sanmina and Celestica is in the 60% range (as it is at the major semiconductor foundries: United Microelectronics (UMC, news, msgs), Chartered Semiconductor (CHRT, news, msgs) and Taiwan Semiconductor (TSM, news, msgs)). That's after writing off hundreds of millions of dollars and sacking thousands of employees. Still, there's too much capacity.
Minimal mirth for Maxim
Following on the same theme, chip darling Maxim Integrated Products (MXIM, news, msgs) successfully played "beat the number" when it reported earnings results last Tuesday night. That is almost laughable, however, after getting a good look under the report's hood. Maxim's bookings were less than expected and declined. Its backlog is down. The company's inventory, which rose, is now up enough that Maxim can fill 40% of its backlog for the next 12 months just with the inventory it has on hand.
Obviously, Maxim's margins were helped by building inventories. But this company and others like it are wedging themselves into a corner: They'll soon face simultaneous shrinking revenues and collapsing margins, and there will be a veritable implosion of earnings. That cake is baked, barring an explosion in GDP or a miraculous rebound in demand for tech doodads, neither of which I see in the offing.
So, we see bulging inventories at the chip level, at the contract-manufacturing level and at the original-equipment-manufacturer level. And the big chip foundries are operating at roughly 60% capacity -- at the very same time that we're seeing a slowdown in end demand on the retail front.
If chip and chip-equipment stocks were at extraordinarily low valuations due to folks' concern about these problems, you could maybe make the case that they'd be interesting to look at. But of course, the opposite is the case.
Valuations are quite high on a price-to-sales basis, which is how you need to look at these stocks. If you just focus on price-to-earnings, they seem slightly less expensive, but that's because margins have been plumped up (and I believe margins are going in the other direction).
Denial: Accelerant for market dislocation
Denial is as intense as any I've witnessed in the last few years, to the point where it's actually hard for me to capture it in words. Let me put it this way: The market's role as a voting machine, spurred by hopes and dreams, continues to overwhelm its function as a weighing machine.
All in all, the data points end up in the same place: Too much inventory and slowing end demand. Combine that with all the denial that's gone on so far, and you have a recipe for trouble. A huge dislocation is coming in the stock market at some point. Whether it starts soon or six months from now, I don't know, nor do I know what will set it off. But given the crater that stands between folks' expectations and company fundamentals, that dislocation will come with a vengeance.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money. At the time of publication, Bill Fleckenstein was short Hewlett-Packard and Maxim Integrated Products.
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