Use Caution When Following Trends

 | Apr 15, 2014 | 11:30 AM EDT
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I want to tell some more war stories from the period in which I started my career -- the tech bubble and bust. You know what? I have seen a lot.

I had early success trading my personal account, shorting some of the fluffiest fluff on the way down in 2000 and 2001. Even after I covered those shorts, those stocks kept going down. For a long time. That's the thing about trends; they just keep going.

Let's talk about Akamai Technologies (AKAM). I'm going to be honest and say I don't really know what Akamai does, but I don't need to because that's not really the point. Akamai went public in October of 1999. Good timing. A few months later, it reached an all-time high of $327.63. It would reach an all-time low in 2002 of about 70  cents. At the time of writing, it closed at about $53.

So what was the right price for Akamai? Was it $327.63? Was it 70 cents? Is it $53? The $53 is probably reasonably close to what Akamai is worth, at about a $10 billion market cap. So the market was wrong at $327 and it was wrong at 70 cents. In both cases, it was wrong by a lot (there is a lesson in here somewhere about market efficiency).

In the first case, the market was overly optimistic, and in the second case, overly pessimistic as the market was pricing in bankruptcy when it clearly had much better prospects. So on the way down from $327, why didn't it stop at "fair value," which is $53? Why did it go all the way down to 70 cents? Because markets overshoot. Markets overshoot on the way up and markets overshoot on the way down. This is very important to understand. It's not a difficult concept, but people forget it all the time.

I'm going to keep this very plain vanilla and say that we overshot on the way up, and that the growth/tech/biotech/momentum names will not correct to "fair value." They will almost certainly overshoot on the way down. People always, always underestimate how much stocks will overshoot to the downside. They will appear cheap, people will buy them and then they will get cheaper.

How does this happen? Think about Akamai. It was a screaming buy at three bucks. How much further can it go down? It goes down to $1.50. You lose 50% of your investment. Now it is even cheaper. What do you do? If you liked it at $3, you love it at $1.50. You buy it at $1.50. It goes to 75 cents. You lose half of your investment. Now what, buy it again? What if it goes to 37 cents?

Of course, 1999 was a magical time and it was the mother of all stock market bubbles. But I think we just experienced a much smaller version of that bubble. Yelp (YELP) isn't going to go to 70 cents, but it is entirely possible to go down 80 percent (it is already down 35 percent). It is possible for a lot of these names go to down 80 percent.

Not many people can withstand an 80 percent drawdown. I think this is the third time I've said this in RealMoney, but it's not normal for VCs to turn $8 million into $3.5 billion in two years. There was speculative excess. It won't be corrected in a few weeks.

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