Anatomy of a Sell-Off

The stock market is incredibly efficient at digesting information and setting prices. But in the short term, it is significantly more volatile than it would be if it were perfectly efficient. (Significantly. In a perfectly efficient market, a stock price would move only when new information was being incorporated by the market, and there would be much less trading than there is today.) So even though today’s 138-point sell-off in the NASDAQ might feel like the end of something important–especially since it follows a week in which so-called growth stocks were trounced by so-called value stocks–it’s impossible to derive any deeper meaning about the future from today’s action.

Nonetheless, in the interests of not being boring, here are some things worth noticing about this past week’s sell-off:

While I hesitate to use the phrase healthy correction, which implies that the proper path for stocks is down, the downturn in Net stocks probably deserves that label if anything does. As one analyst said to me today–and he’s an AOL bull–“there’s probably something not quite right when AOL is one of the ten biggest companies, by market cap, in the S&P 500.” In the past couple of weeks, AOL’s stock has dropped more than 50 points from its 52-week high. That doesn’t necessarily mean its valuation is reasonable. But it’s certainly more reasonable.

At the same time, many of these Net stocks are still up significantly on the year, some more than 100 percent, and almost all of them are still higher than they were less than a month ago. CMGI, for instance, is down more than 100 points from its 52-week high, but it’s still a big winner on the year. No one expects Net traders to suddenly realize that 15 percent a year is a healthy return, but unless you bought CMGI at $330 a share, you’re not doing too badly. (Of course, there are plenty of people who did buy it at $330 a share.) Along the same lines, a 20- or 30-point drop for a stock whose price is near $200 a share is the equal to a 2- or 3-point drop for a stock at $20 a share. This is a painfully obvious point, but one that can be easily missed as you’re watching that minus-30 roll across the stock ticker.

The selling of the past week has hit almost all the high-multiple bellwethers, including GE, Wal-Mart, Pfizer, Microsoft, Cisco, and so on, in addition to the Net stocks. But the price-setting process in these two cases is very different. In the former case, only a small percentage of outstanding shares are being traded every day. In the case of Net stocks, where most companies have very few shares outstanding, a very high percentage of the shares are being traded. In both cases, the sellers seem considerably hungrier than the buyers. But the people who own Net stocks today are significantly different than they were a week ago–simple math tells us this–while the bellwethers have been punished more by traders. Actually, it’s probably more accurate to say that while a vast majority of the bellwethers’ shares are held by long-term investors, a minority of the Net stocks’ float is held by such owners. So traders are doing the punishing in both cases. It’s just that when it comes to Net stocks, most shareholders are traders.

Finally, what’s going on in the market does seem to conform to a classic sector rotation, in which high-growth, high-multiple stocks are abandoned in favor of low-growth, low-multiple stocks that seem to offer a better risk-to-reward ratio. If that is the case, then price is playing the role it’s meant to play. Eventually, even mediocre companies come to represent good values, as long as they offer some hope of earnings growth. On the other hand, the distinction between growth stocks and value stocks is, at heart, a false distinction. No one who’s really thinking about the question buys a “growth” stock even though they believe it to be overvalued. (People do do this, but they’re not thinking.) And no one buys a “value” stock if they don’t think it’s going to grow in the future. We know that markets can overshoot in the short term, and it’s possible that investors had come to overestimate the growth prospects of companies like Wal-Mart and GE and Sun Microsystems. But these are companies that will generate enormous value over the next five to ten years. One suspects that in the long run, their “growth” label won’t make a difference one way or the other.