GAME OVER(Archive)

While the “tech wreck” in the stock market has grabbed all the headlines, a host of non-tech, large-cap growth stocks have also taken a severe beating so far this year. We’re talking the stalwarts among blue chip growth stocks. Merck is down 31%. Home Depot is off 33%. Coca Cola dropped 20%. Medtronic is down 25%. And the list goes on.
When we get past the fixation on tech’s demise, we can see the tech decline as part of a broader reorientation of investor preferences: In 2001 we’ve had a financial coup d’etat in which all the former leaders were killed. And the principle that defined those leaders was not so much the economic sector they belong to as their size and growth rates.
During the five years through 2000, large-cap growth stocks increasingly assumed a position of hegemony over the market. Twenty-five to fifty of the largest, fastest growing stocks in the S&P 500 accounted for the lion’s share of the index’s returns, meaning that the other 450-475 stocks went nowhere or even declined.
As this situation became more evident, investors increasingly focused their holdings on this handful of names. Managers sold off their smaller-company stocks and bought into large-cap growth, creating a self-reinforcing spiral: as the handful of big names did better, more people sold out of smaller-cap stocks and bought big-cap names, pushing the latter higher and the former lower. And so it was that large-cap growth became the only game in town.
The big news flashing across the market in 2001 reads like a giant video-game monitor. And the message is: GAME OVER.
As 2000 turned into 2001 the unexpected threat of recession punctured the high-flying expectations for the large-cap growth darlings. A rapid deflation in price ensued. Suddenly, the same stocks that everyone had to own became the stocks that everyone had to sell. And that is what this market is about: unwinding the highly concentrated positions that most investors’ portfolios had in this short list of names. This process has been self-reinforcing on the way down, as it was on the way up.
As investors sell down their huge positions in, say, Cisco Systems, they have to do something with the proceeds of the sales. As large-cap growth stocks aren’t doing so hot, they often look to smaller-cap stocks as homes for the newly available cash. But because these stocks are smaller cap, their price is more easily moved by an incremental increase in demand. So as investors sell Cisco, driving its price down, they buy TCF Financial or Whole Foods or Genzyme, driving their prices up even more.
In this way a new self-reinforcing spiral is set in motion, one that carries large-cap growth stocks to irrationally low valuations and smaller-cap names to irrationally high valuations. The result, which we have already seen, is a perfect reversal of the performance hierarchy that defined the market for the five years through 2000. If Big was Beautiful in the ’90s, it’s been ugly as sin in 2001.
So, what’s an investor to do? For starters, don’t do what the now-decimated legions of tech investors did a few of years ago. Namely, swing your portfolio’s focus exclusively over to the market’s current darlings. Lots of smaller-cap stocks have already been pumped up to irrational valuations. So don’t chase yesterday’s winners. And don’t eschew diversification.
Just as valuation was the key factor in determining when large-cap growth stocks had become overpriced, so valuation will tell us when smaller-caps are overpriced as well. More importantly, valuation will tell us what remains underpriced in the market, whether it be small-, medium- or large-cap names. Our strong sense is that the market going forward will be less monolithic, that the market’s winners will be more democratically distributed across economic sectors and capitalization tiers. Which is to say it will be a whole new ball game.