ContraryInvestor - Market Observations

MARKET OBSERVATIONS

MARKET OBSERVATIONS - 5/23

VC See, VC Do...Everybody who's anybody wants in. It's an essential component of the "new era" paradigm. Phenomenal returns. The engine underneath the New Economy. A big piece of the reason for the supposed immunity of tech companies from higher interest rates. The following chart documents commitments to U.S. venture funds over the last two decades. The overall 20 year trend approximates that of the NASDAQ itself. Only with 20 years of retrospective does the current experience of the last few years appear geometric and parabolic in nature.

Source: Venture Economics, Inc.

Momentum as a pricing concept does not pertain specifically to financial assets. Real estate geographically proximate to tech business centers has been an exercise in momentum over the last 24+ months. Institutional asset allocation (largely consultant driven) has been increased for "alternative" or VC related investments/investment funds. Price momentum in private equity deals has escalated, at least prior to the recent Net stock shrinkage. Cambridge Associates (a major institutional investment consultant) estimates that a $2 million investment in a tech startup would have bought the venture dollar an 18% equity position in 1995 and today that same $2 million would only buy 4% of a deal. Clear price momentum in a bona fide "asset class". By default, too many dollars chasing a number of viable deals growing at a rate more slowly than the dollars chasing them ultimately results in diminishing returns for the incremental dollar invested. Welcome to the party all you new VC investors.

The gold rush mentality is the only rationale we can come up with for the desire of the institutions to participate in VC investment funds when there clearly seems to be far too many players and dollars on the field. The institutional gold rush mentality. One of the things we have noticed along the institutional landscape of past days is that the pension funds usually up their allocations to asset classes characterized by price momentum at or very near the top of the cycle or the move. This was nothing short of vivid with real estate in the late 1980's. What are we seeing at the current time? You guessed it. As the following chart depicts, pension funds were the largest "buyers" of venture funds in 1999:

Source: Venture Economics, Inc.

Not much has changed moving into this year. Just recently, behemoth CALPERS announced an incremental uptick in allocation to venture. In the late 1980's, many of the large public and private pension funds were tripping all over themselves to increase their investment allocations to real estate. Right into the price peaks. They were hiring specific managers to dedicate money to office buildings, multi-family apartments, warehouse properties, retail space, buy and fix operations, etc. They literally caught the peak at that time. More properly, they put in the price highs. In the downturn of 90-91, much institutionally owned property was sold off to the vultures such as Sam Zell. The vultures later bundled their real estate pickings from the institutions and sold them off to the public in the wave of REIT offerings in the mid-1990's. Are the institutions making the same mistake with tech oriented venture money? You'll be happy to know that our resounding answer is emphatically NO! The mistake is possibly worse. At least with real estate, there is a physical asset. Unfortunately for today's tech venture enthusiasts, the physical assets at Net companies simply blow out the front door just as soon as their stock option packages go bust.

It's the folks like Cambridge that we believe have a big influence on the pension funds. Many a public and corporate pension executive is "measured" against his or her peers in the plan sponsor management club. If other institutions are "purchasing" VC fund investments with success, the pressure is all of a sudden heavily on those who have not taken advantage of this wonderful opportunity. The cross fertilization of institutional investment consultant influence across many of the large funds also drives a commonality in action. Like the pension plan executives themselves, investment consultants are often measured against their like company peers. It's not hard to see how VC investing can begin to gather and sustain momentum. Has the pendulum swung about as far as it is going to go in this cycle? We'll just have to check in with all of today's new investors in about two years to find out.

Is The VC Investing Game Changing?...Just maybe. As you know, tech and Net IPO's have been all the rage for the past few years. A ticket to fortune and riches. The end game of the VC process. Realistically, the public and professional (with the public's money) infatuation with "new era" company IPO's in the past few years has been the escape hatch for VC's and the major support mechanism to the outstanding investment returns of this asset class. Venture capital needs an increasingly steady flow of retail end-buyer interest to sustain its performance record. This is what may be changing ahead. To all those who have recently lost substantial sums on once hot Net investments, the VC community thanks you for bailing them out, providing them outstanding investment performance records, and allowing them to attract oodles of new capital on which to charge fees. The appetite for IPO's is already on the wane. Last week's New Focus (optical hardware company) deal was the first in many a moon to double at the open. Public and professional investors need to regain confidence in IPO's or the investment return in the VC game is about to change. Of course, no one seems to have told the pension funds this yet.

School Daze...It's interesting to note that a good number of America's respected economics and finance professors are, shall we say, less than bullish. It's not just Shiller trying to sell a book, but others who could never be called perma-bears. Although Shiller's included here, have a look at what a few of America's best and brightest academic economists and finance professors have to say while recently quoted in the press (thanks to Jim Moltz of ISI for these sightings):

Franco Madigliano (Nobel Prize winner)

He says he thinks the Dow Jones industrials could fall to 8,000 or 9,000, but the technology stocks are far more vulnerable. "In the case of the Internet, it is so hard to establish fundamentals, to understand how much is a bubble," he said. "In my view, it is very much a bubble."
And then? "There is no bubble that quietly deflates. A bubble by its nature will burst. I don't know when. But it will happen, and the pain will be greater if the bubble has grown." He says the Federal Reserve is right to raise interest rates, but may be moving too slowly.
New York Times 3/31

Burton Malkiel (Princeton)

"So what happen next? Is this the end of the NASDAQ's big rise for the foreseeable future? No one knows. I have followed markets for a lifetime and know enough to understand that while valuations of NASDAQ stocks are still far from cheap, stock prices are essentially unpredictable.
But I am also persuaded by the wisdom of Benjamin Graham, author of Security Analysis, who wrote that in the final analysis the stock market is not a voting mechanism, but a weighing mechanism. Valuation metrics have not changed. Eventually, every stock can only be worth the value of the cash flow it is able to earn for the benefit of investors. In the final analysis, true value will win out."
Wall Street Journal 4/14

Robert Shiller (Yale)

Right now, he says, the indexes are reaching a peak, for the fourth time since 1901. And if history is a guide, this latest peak - the highest of all - will be followed by a decline that might last for years before stocks turn up again into a new bull market. Just when the next downturn will begin and how it will unfold, Mr. Shiller says he does not know. He is confident, though, that after the fact, the experts will offer all sorts of rational - and incorrect - explanations.
New York Times 3/26

Jeremy Siegel (Wharton)

"What does all this mean? Our bifurcated market has been driven to an extreme not justified by any history. The excitement generated by the technology and communications revolution is fully justified, and there is no question that the firms leading the way are superior enterprises. But this doesn't automatically translate into increased shareholder values."
Wall Street Journal 3/14

These are the current views from some of the best and brightest. You may remember that people like Siegel were actually extremely bullish a few years back. As author of "Stocks for the Long Run", Siegel at one point waxed poetic about the benefits and risk diminishment of long term stock investing. Obviously he's not quite so poetic anymore.

Hey, Ralphie Boy...The virtually perfect contrary indicator, Ralph Acompura, yesterday gave the signal that tech stock prices are heading lower. This wonderful pronouncement hit the wires quite near the intra day low in the NDX and the NASDAQ itself. Right before a 2+ hour 7% rally in the NDX. Tech bears beware! You've been warned by the inverse market timing champion of 1999. (And, so far, leading contender in 2000.)

Bonfire Of The Currencies Part II?...In case you haven't noticed, many a global currency is melting away relative to the dollar these days. What seems to have gone unnoticed is that a good number of currencies of smaller Asian countries are simply not faring well. Is this why the Nikkei has hit the skids? I this why the Taiwanese and Hong Kong government's are considering using government resources to support their respective markets? The US needs a strong dollar to support the trade deficit and attract recycled trade dollars into US financial assets. So far, so good (for the US, that is):

Imagine what would happen if our happy dollar investing trading partners decided they needed to repatriate capital to support their own currencies and financial markets. The bonfire of the global currencies to support foreign country domestic economic growth (Euro, partially the Yen, Peso, etc.) cannot continue for long. Does anyone remember the Asian experience of 1997? Don't all raise your hands at once. Plain and simple, the dollar is vulnerable.

The Body Count...No, not the Clinton conspiracy files. We're talking about the .com body count. We told you about Boo.com and Entertainment Network last week. In the last few days, Craftshop.com filed and Toysmart.com "ceased operations". This time around a few of the "big boys" were stung. Craftshop.com is/was an affiliate of CMGI's AtVentures unit and Toysmart.com is majority owned by Walt Disney. Clearly, even the heavy hitters won't pony up capital to keep these new era business models afloat. We smell writeoff. And this is simply just the beginning.

Watch Out For Falling Rocks...Driving up the NASDAQ mountain, there were plenty of signs warning of the possibility of "falling rocks". Since there were no documented cases of stock car drivers actually being hit by falling rocks, the warning signs went unheeded. Now the rocks are falling. Our forbears who built the road tried to warn the innocent. Alas, in vain. As you know, the NASDAQ hit a new low today. A perfect series of declining highs from the top. It appears to us that we have arrived at the crossroads of confidence. Which way from here? Behold:

What is apparent in current market action is that the big mutual funds, hedge funds and Mo players have not been able to get out of their overweight tech positions. The volume, or lack thereof, clearly documents this over the last few weeks. They are stuck, plain and simple. Likewise we have been detailing to you that equity mutual funds have been experiencing inflows. Remarkably, flows into aggressive and tech oriented funds last week were strong. The public has not sold anything. How does the public, the hedge crowd, the MO players and the mutual funds (which really represent the public) all get out if the going really gets rough from here? The simple answer is that they don't. "Sell? To who, you were the buyer."

For the near term, we believe a bottom in the NASDAQ can only come about in a small number of ways. A climactic sell off done on stupendous volume. A moon shot increase in bearish sentiment. Dramatic breadth improvement done on heavy advancing volume. So far, none of these characteristics has presented itself. In fact, the way things are going, our humble advice is don't hold your breadth.