Here is a message for investors in America's internet stocks: pay attention!
Look hard at the revenues of the companies you are bidding up to unsustainable highs. Think twice about how much America Online will really gain from acquiring Netscape. Make a calm assessment of how long it will be before e-commerce really transforms the way the world does business.
You may still conclude that companies with revenues of Dollars 20m justify market capitalisations of more than Dollars 3bn, or that AOL is worth 350 times earnings. But at least you'll be making those judgments on the basis of the stocks' fundamentals, not just because they're hot.
This isn't an argument based on the excesses of the market in net stocks, striking though they are. It's a more general case, based on past experience in a whole range of markets for equity and debt.
The most dangerous moment in any financial market boom is the one where the suppliers of funds stop paying attention. Investors or lenders start to take on trust the value of the assets for which they are providing the funds. They assume that a loan is safe because everyone else is doing the same thing. They look for the stocks that will go up because . . . well, because everyone knows they'll go up.
That's how the Asian crisis started. But, as a perceptive paper* by two International Monetary Fund economists points out, there's nothing unique about the way that region's crisis developed. Jorge Chan-Lau and Zhaohui Chen argue that when banks stop monitoring their lending properly, small changes in the economic outlook can first produce a surge in lending, then an equally sharp contraction. Lenders suffer from "capital flow inertia". They keep on pumping in money long after they should have scaled back their activity; then, when the penny finally drops, they rush for the exit simultaneously.
The authors think this came about because the costs of monitoring loans in Asia's underdeveloped financial markets was high. When economic growth in the region became irresistible, banks that wished to participate could only do so by abandoning attempts to keep tabs on their loans. But, they say, this isn't just an Asian problem. Similar effects were at work in Latin America and in the US Savings & Loans lending disaster of the early 1980s.
The IMF paper is confined to bank lending. But it can also be applied to equity markets. Whenever it is expensive or difficult to monitor the value of assets, but the opportunity costs of missing out on an investment appear too high to resist, the same switchback effect occurs. Investors stop monitoring the underlying value of assets; instead, they look for the reassurance of momentum, of herd behaviour.
In the case of internet stocks, monitoring costs are high, since getting a real handle on how the technology will develop is prohibitively difficult. But reassurance has never been greater. Hot stocks took a battering in August and September but have now recovered all those losses, and more. New companies continue to come to market, to a rapturous reception. Even when something occurs that is an unmistakable sign of failure - Netscape's decision to sell itself to AOL - it is treated as the technology equivalent of the second coming, pushing up both companies' shares and leading to widespread predictions of a new era for e-commerce.
In short, no one is paying attention. In the near term, this could well lead - through the "inertia" phenomenon the IMF authors noticed in Asia - to further gains. In the long run, it is likely to lead to a sharp contraction in flows of money into the internet sector.
The parallels with the Asian crisis should not be pushed too far. But the general lessons are clear enough. The seeds of future crises are sown in the good times, when providers of funds no longer keep an eye on where their money is going. That's what is happening now. Pay attention! peter.martin@FT.com.
*Financial crisis and credit crunch as a result of inefficient financial intermediation - with reference to the Asian financial crisis. Jorge A. Chan-Lau and Zhaohui Chen, IMF Working Paper WP/98/127, Washington DC. E-commerce stocks up, Page 25
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