Business Forum: After the Gold Rush

By Isaac Cheifetz
Published September 3, 2001

''There is no New Economy. It's the same old economy with new technology.''

-- Jack Welch, General Electric

The Nasdaq dot-com bubble burst in April 2000. Once again, a company's market capitalization reflects its potential to generate profits (or at least cash flow), not its metaphorical message.

What are the principles for successful investors in the next decade? A look to bubbles of the past provides some guidance.

In ''Devil Take the Hindmost: A History of Financial Speculation,'' Edward Chancellor paints the turbulent picture of the financial bubbles of the past 400 years. Financial manias are primarily psychological, during which investors' excitement about a stock's price overwhelm analysis of the value of the underlying business.

Historically, there have been two types of financial bubbles. The first happens when investors become excited about something frivolous. The second occurs when investors become overly excited about a technological revolution in the economy and overvalue companies representing that revolution.

These ''substantive'' bubbles tend to result in positive results for investors over time.

Bubbles in History 

The following examples help to distinguish frivolous bubbles from substantive ones:

Tulip Craze. The poster child of frivolous bubbles. In the 16th century, tulips came to Holland by way of Turkey and became enormously popular. 

Holland's robust seafaring economy provided excess cash for collectors, and then speculators, to drive up the price of tulip bulbs (that is, tulip 'futures') to as much as 6,000 guilders, which was 20 times the annual Dutch workers' wage.

 The bubble crashed in 1637 after two years, but did not bring down the Dutch economy. They still love tulips in Holland, but they don't bet their future on them.

Roaring '20s. Massive technological change, with cars, radio, utilities and airlines all coming to mass market in the 1920s, after having been invented 20 years before. Experts insisted that the market had hit a state of permanent stability and could only go up. 

The Dow Jones industrial average rose from 100 in 1924 to 386 in 1929, then fell to a low of 40 in 1932. The Great Depression followed.

Go-Go '60s. The U.S. economy grew red-hot in the 1960s, driven by consumer electronics, commercial jet aviation and the interstate highway system. The Dow rose to 995 in 1968, before falling to 631 in 1970. 

Conglomerates such as ITT and Gulf and Western were cobbled together through acquisitions, driven by accounting rather than markets. Even so, they were legitimate firms, in contrast to the corrupt holding companies of the 1920s. The economy slid into a mild funk for a dozen years but remained stable.

Japan 1980s. During the three decades of economic growth after World War II, Japan's urban real estate appreciated in value by more than 5,000 percent. 

By the late 1980s, Japan's overly cozy relationship of crossholdings between banks and corporations had led to stagnant growth of profits, with the inflated value of real estate now bolstering the valuation of companies. When the bubble burst in 1989, the Nikkei stock index fell from 38,915 to 14,194 in less than three years.

 Japan still is mired in recession, primarily because of its lack of political will to effect painful structural changes in the economy that would stress the social fabric.

Dot-com 2000. The Internet, personal computers priced as appliances and wireless technologies became standard in industrialized countries around the world, leading to a 'virtual gold rush' in cyberspace.

Substance and Corruption

Two key factors that determine the outcome of bubble economies are the degree of substance behind them and the financial corruption underlying them. Corruption, in this sense, refers not only to fraud and misdealing but also to a general lack of rigorous accountability and/or regulation.

By this test, the tulip craze was a speculative bubble with practically no substance and little in the way of corruption. During the Roaring '20s, revolutionary technologies grew alongside massive financial corruption. 

Japan in the 1980s represented a lack of substance as their Economic Miracle was slowing down on top of a Byzantine, ultimately corrupt financial system.

The dot-com era resembles the Go-Go '60s in one important respect: In the '60s, the bubble was technology-driven with relatively little corruption. Conglomerates, mutual funds and creative accounting did inflate the market capitalization of firms, just as day trading and dot-coms' 'flexible' definitions of revenue and profitability did recently.

The dot-com era also had some common characteristics with the Roaring '20s, with its new technologies and insistence that the market had hit a permanent high. But the '20s had far more outright financial manipulation than the markets of today, with no Securities and Exchange Commission to answer to.

So is the Internet a fad?

No more than the car, airplane or transistor. Revolutionary technologies breed bubbles of exuberance yet still have massive impact.

Stocks to Watch

How can you identify the winning investments of the next decade? Companies that boom in the downturn after a technological bubble tend to have these characteristics:

1. They have executives who are disciplined visionaries, with profitability as a near-term goal.
2. Their use of new technologies is revolutionary in strategy, simple in execution.
3. They use technology to reinvent distribution of their products.
4. They have an obvious, overwhelming revenue model.
5. Their product or service is recession-proof, a 'need to have' rather than a 'nice-to-have.'

Look for a Federal Express, which took advantage of jets and computerized logistics in the 1970s to create the overnight delivery industry; a McDonald's, which applied 'lean manufacturing' to restaurants to create the fast-food industry; an Electronic Data Systems, which applied outsourcing efficiencies to mainframe computing.