The New Economy

"Now the internet is a very significant change, but it's a technological and social change, this does not mean that is is going to generate a lot of profitable businesses."

Frank Veneroso is head of Veneroso Associates, a global investment strategy firm. Formerly he was a partner of Omega Advisors, where he was responsible for investment policy formulation. Mr. Veneroso has been an economic consultant and investment strategy advisor to governments, international agencies, financial institutions, and corporations around the world. His clients have included the World Bank, the International Finance Corporation, and the Organization of American States. He has been an advisor to the governments of Bahrain, Brazil, Chile, Ecuador, Korea, Mexico, Portugal, Thailand, Venezuela, and the United Arab Emerates. Mr. Veneroso graduated from Harvard University and has authored several articles on subjects in international finance, including publishing the 1998 Gold Year Book.

Mr. Veneroso kindly spoke with Philip Judge from the World Gold Conference in Western Australia, this year.

JUDGE: Mr. Veneroso, if we could start by looking at the recent volatility in the stock market and particularly in the high-tech sectors. Do you feel the stock market, both in general but particularly in technology stocks, is a financial bubble due for correction; and if so how significant might this correction be?

VENEROSO: I’ve written a lot about this, and I’ve just finished two pieces particularly relevant to this; one asking why the volatility?

I defiantly think it’s a bubble, but I not only think it’s a bubble, I think it’s the biggest stock market bubble in the history of all of the industrialized countries.

The market-cap to GDP ratio is probably higher in the US today than it was in Japan at the peak. My guess is that the overall stock market overvaluation is comparable. Japan’s P/E ratios were higher, but they had more conservative earnings, and the companies that went up as much as they did, were for the most part real businesses, substantial businesses, selling at 100 times earnings. There were a couple that were selling at 300 or 400 times earnings, but at least they had earnings.

In this particular market we now have a split market. The aggregate market capitalization is about as high, relative to the average national wealth and income, but its got a component which is the high-tech sector, which is far, far more overvalued than anything of significance was in Japan.

You never have had, in any major industrialized country, in any point in its history, literally dozens and dozens of companies selling for market-caps in the order of tens of billions of dollars, that have virtually no revenues let alone earnings. Of course you have to relate their market-cap to GDP and the overall market-cap. I mean these things sell for 1,000 or 2,000 times revenue sometimes.

Then the accounting is very, very liberal, you just never had anything like this, so the high-tech sector bubble in the US is clearly the greatest bubble in the history of stock markets in Industrialized world.

Now the overall stock market, because of this component, is probably as overvalued as any market has ever been in any major G10 country.

JUDGE: Early in 1982 you were asked to advise on what you have described as the greatest stock market bubble in all time, and that was in the Persian Gulf. Can you explain for our listeners a little about what saw there in the early 1980’s and how it may relate to today?

VENEROSO: Well that was really crazy, that was much more extreme than the US market overall, but I would say that there are some real similarities between the really fringe part of high-tech, like parts of the internet, and what went on then.

There you had companies that had no business, or very meager businesses, that were really created simply for the purpose of stock speculation. Their market was completely and totally speculative, there were no underlying fundamentals whatsoever, valuations were unimaginable; so the dynamics were very similar. It’s the only thing that I have ever seen, and like I say I saw this thing first hand, that I can relate to what’s going on today in the more speculative part of high-tech.

Really we have two problems. We have the nifty fifty, like in the early 1970’s, with the high-tech blue chips, you know the Microsofts, the Dells, Ciscos, and Oracles and these kinds of companies. Accepted valuations here are much higher. In the early 1970’s Polaroid didn’t quite make it to 100 times earnings, most of them then were around 50 times earnings. Today they average around hundred times earnings and some of them are more than that. The accounting then was much more conservative and as I’ve said, the accounting now is very liberal. Then you have all the dot com companies and the suppliers to the internet, where we are talking about companies that are selling many hundreds or even thousands times revenues, and it’s this latter part that has no historical precedent.

JUDGE:Yes, when you look at the NADAQ there was something like 4,800 stocks listed last year, and only 65 of them, which is just 1.3%, generated the colossal growth we saw in the index last year. That is not a healthy breadth in a market?

VENEROSO: That’s absolutely true, but the breadth in this market has been absolutely terrible for two years.

JUDGE: Frank, is there any merit to this new paradigm philosophy or what people label the "New Economy"?

Look I think the whole thing is very, very exaggerated. Is there a technological change going on? Yes. Is it more rapid than in the past? Maybe, maybe not.

When I had my first job as a high tech-analyst in the very end of the 1960’s, at the peak of the last high tech bubble, and I can tell you that was nothing like this one, but then you really had a revolution. The transistor was in mass application for the first time, computers were being built and applied for the first time. We were starting to develop integrated circuits for the first time. That time really was important.

Today we have had computers and semiconductors around for a long time. These are mature industries. IT as it is called is maybe 5% of GNP, broadly defined. That’s a large part of GNP. When you are that much of GNP, you cant grow much more rapidly than the general economy, you are already a big part of the economy, whereas back in 1969 IT was maybe 1/10th of 1% of GNP.

So today it is more pervasive, but is the rate of change any greater at the technological frontier?, I don’t think it is any greater than back in 1969, but because of the current stock market, people are making a great deal of it.

Look, lets take these nifty techies, the big blue chips like Dell, Oracle, Intel and the like. Now look at the growth rates of the industry revenues that most of these big cap stocks are in; they are in the PC and semiconductor industries. Their growth rates were 20% per annum in the 70’s and 80’s. In the first part of the 90’s they were in the low double digits and in the second half of the 1990’s they have been in the high single digits. That’s not very rapid growth for global revenues for these big IT industries. They certainly don’t warrant hundred times multiples; again, these are now mature industries.

Now the internet is a very significant change, but it’s a technological and social change, this does not mean that it is going to generate a lot of profitable businesses. When we have analyzed this sector we have recognized that over 90% of these companies lose money, of the ones that do make money, most of them make just marginal money, part on their IPO, but very few of them show any profits from their operations. In all these cases you have to question what you see because, again, the accounting is extremely liberal in a way that accounting hasn’t been before.

JUDGE:OK, explain what you mean by "the accounting is more liberal now"?

VENEROSO: Well for instance, they don’t cost stock options; and that is how they remunerate, to a great degree, their employees. They do a lot of other things that overstate revenue and profits. We have seen more and more instances of this and more comments on it.

Ask yourself, how can a new innovative industry not generate profits? Economic theory says that the innovator has a monopoly position, at least for a while, until other people copy him and compete, and therefore he, the innovator should earn monopoly rents. Instead, these companies lose money.

Now the new era theory has it that the structure of the economy is different. Investment isn’t in physical capital anymore, instead it is in intellectual capital. You have to spend a lot of money up front to get that position. You should, in these intellectual capital investments, seek to get as many people to utilize your intellectual property as is possible, because the person that gets the first mover advantage and dominates the market, will wind up generating a network. A network is of more use to its users, the more people that are in that network.

The more people in a market for example, the broader, deeper and more liquid that market is, and therefore, the more value it has to the participants in that market. People will gravitate to the bigger market rather than the smaller market. The same can be said for a telecommunications system, the more people you can talk with and the more places and so forth, the more useful it is to you. There is a tendency, so the theory claims, for these kind of industries to develop into natural monopolies.

The paradigm for all this is always Microsoft, where they did not build the best operating system and software, but it was the most widely used because it was tied to the IBM computer. Because of that it became the standard, once it became the standard, it had a locked market and was able to charge a monopoly price and then earn a monopoly return.

Now all these internet companies are trying to tell you that that is what they are trying to become. They are spending a lot of money to gain that first mover advantage, so that they, the network, the standard and that the profits will come latter. Now when we look at these internet companies, what we see is that, for the 90% that reported for the third quarter of last year, their losses grew more rapidly than their revenues. Their revenues increased 100% on average year-over-year, but their losses increased 200%. We don’t see any tendency for increasing returns.

Even for a company like e-bay, which had a real good chance of being a network, it was the first online auction, has experienced a decline in profit to revenue ratio steadily over the last two years. Somehow or another, even though it had a first mover advantage, we are seeing a lot of websites that service auctions market for various kinds of consumer goods, particularly at a specialist level.

We don’t see there is a technological revolution here that will generate a lot of viable businesses that is going to justify this current stock market craze.

JUDGE: Mr. Veneroso, thank you for your time today.

Philip Judge

Anglo Far-East Company