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Huge price swings in Internet stocks don't seem quite so intriguing when the direction is down. Amazon.com (EBAY) all fell about 10% as Amazon took its tumble. To be sure, a day of steep declines isn't unusual in these stocks, which have experienced many big one-day price moves in recent months -- albeit, usually up. On Jan. 20, they may well have been simply taking a breather before soaring again when some new bit of Net excitement materializes. But a 19% decline on a day when the overall market was essentially flat raises the question of what kind of ride investors will take when Internet mania ends -- as even the most irrationally exuberant Internet traders know that it inevitably will. Peter Coolidge, managing director of equity trading at Brean Murray & Co., likens the Internet stock trading frenzy to musical chairs. "Someday the music will stop," he says and fundamental measures of stock value such as price-to-earnings, price-to-sales, or price-to-book value will start to count again. "And I don't want to be there when it does," says Coolidge. "REDUCE YOUR EXPOSURE." As a rule, overvalued stocks tend to fall faster than they originally rose. But the trading dynamics of Internet stocks could make their slide especially swift. First and foremost, that's because much of the trading in these shares is done by individual investors making quick moves in and out of stocks, following the direction of the underlying momentum. It's also because these investors frequently use new electronic trading systems -- whether provided by an online discount broker or by a day trading firm -- that allow them to trade more easily, more cheaply, and more profitably than they could during the last comparable stock mania -- biotech shares in the early 1990s. The result is that price swings in Internet stocks have been so fast and dramatic that they stand to overwhelm the technical capacity of Wall Street firms to manage the activity. Many investors are probably relying on technology to get them out of positions when the slide starts, but that technology may fail them. In a steep correction, both online and electronic exchanges could see delays. Sell orders may not be executed as stocks fall. "I am alerting you to my concerns regarding this issue and suggest that you drastically reduce your exposure and risk in these issues," Marc Friedfertig, a managing member of Broadway Trading and author of The Electronic Day Trader, wrote to clients in a Jan. 12 memo. "Many day traders as well as investors will likely be humbled." In many ways, the huge success over the past year of so many inexperienced Internet investors may be setting them up for a fall, says Ari Kiev, a psychiatrist who coaches professional traders and who is the author of Trading to Win: The Psychology of Mastering the Markets. "It creates in many people a false sense of confidence, so they end up putting more and more money into the game," and they may not try to get out when they have the chance, he adds. HOLDING THE BAG? "I think that there is a perception by day traders and momentum players that they will be able to get out of these stocks when the stocks are no longer in favor," says Bernard L. Madoff, chairman of market maker Madoff Securities and chairman of a committee on trading set up by the Securities Industry Assn. "That is a perception that I think is wrong." Brokerage firms that thrive on individual investors trading stocks are now expressing alarm that their best customers may get wiped out when shares tumble. Or worse, the firms themselves could get left holding the bag as customers prove unable to meet margin calls. Several brokerage firms, including most prominent online discount brokers, have raised "maintenance" margin requirements on select Internet stocks, which essentially means investors can't borrow as much to make bets on them. Charles Schwab, for example, recently raised margin requirements on 22 stocks to 50% from 35%. The firms are also discouraging, and in some cases restricting, trading in new offerings. Merrill Lynch, for example, has been crowing to the press about how it protected investors from getting caught in the steep decline that followed the November initial public offering of theglobe.com. SCARCE MARKET MAKERS. Madoff's is one of several market-making firms that have stopped dealing in certain Internet stocks, period. "We feel that these stocks are trading in such an irresponsible manner that it is impossible for us to trade them in the way we are accustomed to," he says, adding that the firm's dealings in them has been profitable. A market maker's role on an exchange is to make trading orderly by taking the other side of the trade when there is an absence of buyers or sellers. For example, if an investor wants to sell shares of Amazon, the market maker would buy them in hopes of quickly selling them to another investor for a little more, making money off the spread. Market makers are increasingly wary about playing this game with Internet stocks, however, since they could get stuck holding stocks that minutes after they buy them are already trading 10 points lower. Smaller market makers have stepped in to take the place of larger firms that are opting out of making markets in Internet shares. But traders say these firms can't provide the same degree of liquidity. "You need to have the big boys in there," says Arthur Hogan, chief market analyst and trader at Jefferies & Co. Less liquidity means more volatility. "It eventually means that the price of the stock will be more volatile and that more people will be hurt," says David W. Tice of David W. Tice & Associates, which specializes in providing research reports to institutions on stocks it expects to fall in price. WHEN THE BUBBLE BURSTS. One reason prices rose so fast last year is because there weren't enough Internet shares around to meet demand from investors. But many more shares are becoming available. "We expect that a rush of new stock from IPOs and secondary offerings may satiate demand by the end of the quarter," analyst Keith Benjamin of BancBoston Robertson Stephens wrote in his weekly Web Report on Jan. 15. Several stock analysts are refraining from even putting price targets on stocks, even though they maintain "buy" ratings. Derek Brown of Volpe Brown Whelan, for example, doesn't have a price target on Amazon.com. CIBC Oppenheimer analyst Henry Blodget, who sparked a surge in Amazon with his $400 (pre the stock's 3:1 split) price target last month, apparently prompted the Jan. 20 slide when he reportedly declined to raise his price target above 133 post-split. "They have gone straight up," he said of Internet stocks on Jan. 12. It just gets scary. Even if they double from here, you don't want to risk a 40% pullback." How far could Internet stocks fall when the bubble does burst? Rick Berry, a technical analyst at J.P. Turner & Co., believes top Internet stocks will decline at least 50% this year. "Even at that point they will be overvalued," he says. Tice believes Amazon will lose 90% of its current value. "That doesn't mean it is going to go down tomorrow," he says. "It's just a matter of time." Regardless of when the expected bloodbath starts, investors should be ready for an Internet stock swoon that will be fast and painful. That way, they'll be able to regroup after the correction, to take advantage of some really cheap Internet shares. Stone is an associate editor at Business Week Online |
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