The Meaning of the IBM Sell-Off

It’s hard to tell if this is still the Era of Stock Market Good Feeling or if a combination of Y2K concerns, rising interest rates, misreadings of Alan Greenspan, and conventional “October is a bad month for stocks” has brought it to a sudden end. What we seem to be living through right now is a strange time in which the market is simultaneously being excoriated as overvalued and hysterical and being described as being in a slump that forebodes bad things ahead. Can’t win for losing.

As evidence of investor hysteria, the financial media often point to things like the $40 billion market-cap hit that IBM took at the end of last week, after it announced that it would have two, and perhaps three, disappointing quarters in a row because its customers were cutting back on spending in order to take care of potential Y2K problems. Momentum investors pile into a stock, the narrative goes, and then pile out of it without paying any attention to the fundamentals, so that good buy-and-hold investors get whipsawed for no good reason.

But what happened to IBM on Thursday, far from being evidence of a flighty stock market, was instead a sign of just how discriminating investors have become. If stock prices really were being driven solely by inflated margin balances and the overconfidence bred by years of 20 percent plus returns, you’d expect investors to be forgiving. In fact, they are more punitive then ever. Investors are willing to pay high prices for companies that deliver consistent above-average cash-flow growth. But if there are signs that a company’s ability to deliver that kind of growth may be faltering–and IBM’s announcement was a Vegas-style neon sign to that effect–then the market will pummel a stock quickly.

The speed with which a negative earnings report can vaporize a company’s market cap is also sometimes held up as problematic. But here again, it’s no surprise that in a world in which trading costs are minuscule, the diffusion of information nearly instantaneous, and trading volume immense, prices will change very fast in the wake of significant news. This just means that markets are more efficient, not less, in the sense that they establish a new equilibrium price–or as close to it as they can ever get–in the space of a day, and not a week. IBM’s stock price bumped up a little bit on Friday, but stayed steady today, which suggests that Thursday’s sell-off was not some massive overreaction.

The most important thing about the IBM sell-off, though, was what it wasn’t, namely an impetus for a more general sell-off in technology. In the past (and even the recent past), we’ve seen announcements like the one that Big Blue made have a ripple effect on tech stocks across the board, as momentum and program traders bailed out of anything that might suffer from association with a big name’s blowup. But last week, investors rather quickly recognized that IBM’s problems seemed company-specific, and that companies that had reported excellent earnings during the week–like AOL–should be bought, not sold. In other words, investors rewarded the companies that should have been rewarded and punished those that should have been punished. Capital was allocated sensibly, rather than hysterically.

There are, of course, always going to be under- and overreactions, like the one that victimized Tyco or the one that sent the stock of Cisco (which I own shares of) plummeting on Friday after an unsubstantiated rumor that the company would miss estimates hit the Street. But what last week’s action suggested is that five (or 10, or 17, depending on how you’re counting) years of a bull market have not made investors careless or blinded by success. Eternal vigilance … Well, something like that.