ContraryInvestor - Market Observations

MARKET OBSERVATIONS

MARKET OBSERVATIONS - 2/15

What's Your Favorite Stock?...Although our friends at Forbes have not gotten around to it yet this year, they usually publish an annual "big money" poll where institutional investors voice their opinions about their favorite stocks, sectors, etc. Ten years ago, the number one current holding and top pick among the smart guys was Philip Morris. (Hard to believe, isn't it?) Anyone who did not have the big MO in the portfolio, simply wasn't playing the game. In fact we remember that in the pre-IRAQ market meltdown, MO barely while the rank and file was gasping for breath. Today, that top pick has to be Cisco. Although Microsoft is the only behemoth with a larger market cap, Cisco is clearly the performance front runner. MSFT stock has been stuck in the mud for some time as Cisco has merrily tacked on hundreds of billions in additional market cap. Could it be that Cisco is the recipient of too much adoration? Cisco's valuation based on a multiple to earnings, sales, anything else is simply eye-popping. We're seeing articles flashing by proclaiming that Cisco is destined to be the first $1 trillion market cap stock. They are invincible. Growth is endless. Oh really?

It's not the car up ahead of you that poses the most danger, but the one speeding around the blind curve in the opposite direction that you always assume won't be there. In the Feb. 21 edition of Forbes ASAP, controversial (but too often correct) tech seer, George Gilder, describes the challenges Cisco faces ahead. It boils down to the fact that as we make the move to an all optical driven networking structure, Cisco's electronic/digital products will be largely obsolete. We could spend a page recreating Gilder's suggestion that all optical networks will kill off current SONET (synchronous optical network) routing hardware structures, but suggest you pick up a copy and read it for yourself. Not only is routing/switching technology changing, but we personally believe market dynamics are not working in Cisco's favor at the moment. As you know, Cisco is probably the ultimate technology rollup over the last decade. Is Cisco the technology development powerhouse the masses assume it to be? Far from it. Whenever Cisco has been faced with "technological development challenges" over the past decade, they have simply used their high powered stock to buy companies possessing the coveted technological prowess.

Cisco's prior acquisitions of technologies/companies have worked just fine. They have been able to pay 30, 40, 50, 70 + times earnings for companies and hide the potential dilution under the cover of their own highly priced currency. In today's environment, the jig is up. Optical networking companies already sell at well north of 200+ times earnings. No longer can Cisco so easily hide potential dilution in buying the optical technology of tomorrow. No longer can they afford to pay above market prices and easily integrate the acquisition on the P&L and balance sheet without certain analysts at least pointing out the excessive pricing. When Cisco bought Cerent a while back, it actually created 5%+ dilution. Of course in the current mania, no one thought twice. To continue to do this and worse would certainly raise some questions.

The last point regarding the changing times for Cisco is the bang for the buck question. In former acquisitions, Cisco has been the master of the R&D writeoff technique in creating above average future earnings growth. Very quickly, under GAAP rules, R&D can be written off as a one time charge in an acquisition as long as the products supported by that R&D were not "commercially viable" at time of acquisition. Of course assuming a complete writedown of costs associated with future products, once these very same products became commercially viable and began producing revenues, the attendant costs associated with these revenues had disappeared. Hence the P&L magic. (If all CSCO R&D writeoffs in the past decade were expensed in the P&L, CSCO would have generated close to no earnings over that period. Ah, the wonderful benefits of imaginative, but legal, GAAP accounting.) With the all but hurculean prices CSCO will have to pay to seriously get up to speed in top optical technology today, the effect/future benefit of potential R&D writeoffs relative to the acquisition price paid would simply fit on the head of a pin. Suffice it to say that the economics have changed drastically.

We're not saying Cisco has topped. To guess at that is simply folly. We are saying that one overriding constant in the financial market is change. Successful investors embrace change. Cisco may be "everybody's darling" today. Unfortunately, its current valuation says it better stay that way for at least the next decade. Are you ready?

Derivatives Redux...You may remember that a few weeks ago we presented you with the details of the 3Q 1999 OCC report on Bank Derivatives Exposure. Coincidentally, the dos-amigos, Greenspan and Larry Summers, sat before a Senate committee last week arguing that regulators should keep their hands off the derivatives markets. Specifically, the dynamic duo were addressing a committee focused on agricultural concerns, but some of the comments leave us a bit more than unsettled. As you know, Greenspan has publicly supported the expansion of and hands off regulatory attitude toward the broad derivatives markets for some time. It was only months after the LTCM blowup that Alan extolled the virtues of derivatives as having "improved the standard of living" for many. Clearly he must not have been speaking of bailout funding taxpayers. Here's a few choice Greenspan comments from the testimony:

"The risk of price manipulation of derivatives doesn't justify adding a layer of regulation. Even if the price of an OTC contract were somehow manipulated, the adverse effects on the economy would be quite limited. The professional counterparties that use OTC derivatives simply do not require the protections that federal law governing futures contracts provides for retail investors."

(After all, the professionals can always count on a government bailout, right? Who needs regulation, when moral hazard has worked like a charm...so far.)

Not to be outdone, Mr. Summers further opined, "We believe that these recommendations, taken together, would reduce systematic risk, promote innovation, competition, efficiency and transparency in our financial markets; would protect retail customers, and would maintain American leadership in OTC derivatives markets."

(The amazing part of this statement is that, at least in our humble knowledge, derivatives theoretically protect against unsystematic (or specific) risk. As you know, systematic risk refers to "market risk" as a macro concept. How do derivatives reduce overall market risk when they are designed to protect against specific risk - risk in the price of a singular asset, commodity, interest rate structure, etc.? Larry clearly knows something we don't. It's either that, or he doesn't really understand derivatives at all. Couldn't be, could it?)

Marginally Speaking...It just continues and continues. Higher and higher we go. Up we go, until we blow? Margin debt registered another record. The three month rise is now $61.2 billion. The 33.6% three month rise brings us to a grand total of $243.5 billion. We're simply getting lost in zeros. At some point we'll be drowning in them. Literally.

The Chartroom...For those of you who have been following over the past weeks, it looks like our friend TH's potential late February chart/S&P target has a good chance of being right on the money. Maybe the more proper term is "dead" on the money. All of a sudden it's lower highs and lower lows. Have a look for yourself at TH's picture perfect handiwork:

We all know options-X is at week's end. Expect the usual antics over the next few days.

We're Broadening Out...It's true. This market is broadening out...to the downside. Even today's feeble attempt at a semblance of a rally was done on simply rotten breadth. Just how long do you think today's rally in the cyclicals will last? For what it's worth, we're accepting bets in terms of hours, not days. New 4 1/2 year lows on the NYSE composite are simply supporting TH's late February target possibility.