MARKET OBSERVATIONS

HIDING PLACES

MARKET OBSERVATIONS - 5/25

Zero Tolerance...We spoke earlier in the week about the effect of the institutional investment consultant community on driving the venture capital asset allocations of pension, endowment, etc. plan sponsors.  Well another neat trick dreamed by the the consultants, in addition to the investment straightjacket of style categorization, is mandating that investment managers hired by plan sponsors be fully invested at all times.

In the ancient era of the 1980's, mandating zero tolerance for cash among hired managers was almost unheard of in the institutional plan sponsor arena.  Today it is more commonplace than not.  If a hired manager actually holds cash, he or she could effect the overall asset allocation scheme of the sponsor.  Hence, plan sponsors (and their consultants) often require their hired stable of behemoth institutional investment managers to remain fully invested in the asset class for which they were hired.

So what?  Just where are we going with this?  We thought it would be informative to explore the hiding places that institutional equity managers have chosen to "hide cash" in times of overall market turmoil.  Since they can't actually raise cash itself, they need to hide in what they deem to be the next best alternative.  Two reasons for discussion.  Despite the fact that some of these hiding places have already experienced nice price moves as of late, IF we are truly moving into a longer term bear market, these sectors may just hold up reasonably well on a relative basis (no absolute prognostications made in this environment) throughout a stormy period.  Alternatively, if a sustained rally of almost any length is experienced, these sectors that have already attracted the first bits of institutionally scared money may give way or be decent short term short opportunities.  Regardless of future market direction, awareness of price dynamics will hopefully facilitate clearer investment thinking.

The Utilities

What an obvious defensive sector pick, right?  Let's have a look:

   Almost on cue as the tech stocks and a good number of big cap darlings were leaving the stage in early March, the utilities began an almost straight up 15%-plus move.  What's a bit more convincing is that Enron, one of the big breadwinners in the index, hasn't been a key driver of this move.  To us, this is one of the purest examples of scared institutional equity money looking to hide.  In a period where 75 basis points has been tacked on to short rates, the utilities seem an unlikely candidate for appreciation except under a very few scenarios.  For a group that usually moves inversely with interest rates, the recent ascent has been one of the sharpest of the past year. 

The REITS

Just when you thought that the patient had been officially pronounced dead, they suddenly snap back to life.

Much like the move in the utilities, the recent spike in the Dow REIT index seems counterintuitive.  Just how can rising interest rates be good for the REITS?  Of course the answer is that it can't, but that's not what matters in the current market.  What matters to scared institutional money is that it find some type of shelter from the storm.  It's been over a year now that real estate has been cheaper to buy on Wall Street than on real world Main Street.  Many REITS have sported double digit yields.  None of the valuation work mattered as many REITS hit decade low prices late last year.  Nothing has mattered until it began to rain for forty days and forty nights on Wall Street tech stocks.         

The Pharmaceuticals

It just so happened that the pharmaceuticals were all selling near 52 week lows as the broad market peaked in late March/early April.  They were cheap compared to valuations experienced in the last few years, but not giveaways on an absolute basis.  Here's how the story has unfolded, so far:

 Again, much like the REIT's and the utilities, the pharmaceuticals have recently experienced one of their sharpest runs of the last 52 weeks.  What is interesting is that the headwinds are starting to blow in terms of regulated pricing for the pharmaceuticals.  US states on the Canadian border have initiated and are contemplating initiating drug pricing regulations.  The availability of cheap drugs "across the border" has sparked a political debate over fair pricing practices.  The political drumbeats are also becoming louder as we approach the election.  What better way to woo the AARP vote?  Despite this cloudy political environment for the major pharmaceuticals, these days institutional money shoots first and asks questions later.  Especially frightened institutional dough.

The Financials

We've saved this recent "hiding place" for last as it just may turn out to be the most absurd.  Financials are cheap.  The Fed's done raising rates.  You've heard all of the bullish battle cries.  We've been quite surprised that institutional money has gravitated toward the banks as the tech bear market has waged on.  Have a peek:

Although the banks have not experienced a rally approaching old highs as have the utilities and the pharmaceuticals, they've had a decent run nonetheless.  What seems so ironic to us is that perhaps the banks have possibly the most to lose of all of the currently perceived defensive hiding places.  IF we are entering a true bear market and IF that is the spark for significant real economic weakness, then the current expectations for bank earnings are way to high.  The "E" estimates are vulnerable.  Moreover, in a sizable real economic downturn, bank balance sheets take on the characteristics of a mine field.  You never know when a bad loan will blow.  You can step lightly, but, unfortunately, many loans have hair trigger detonation mechanisms.  It's simply too late when you've found out you've stepped on one.  Lastly, higher interest rates and higher bank stock prices characterize a historical discontinuity.  These events usually do not go hand in hand.  We know that at some point financials will begin to discount lower rates.  It's just hard to believe that lower rates are around the next corner.

We view these groups as recent hiding places for institutional money that has been mandated to be fully invested in equities at all times.  We do not know where prices are going next week for these groups or the market as a whole.  We're just making the bet that price relationships do exist.  If the bearish market/index sun begins to set, we have the feeling that many new found friends of the bank, REIT, pharmaceutical and utility stocks will find new playmates in a hurry.  

Perspective...No two market peaks ever unfold in exactly similar detail.  In like manner, no two asset bubbles ever deflate in precise price erosion uniformity.  Despite our bearishness, it is a pretty low probability bet from a historical perspective that we have another 40-50% decline in the NASDAQ/NDX in the next month or two, as we have over the past few.  Could it happen?  Yes.  Will it happen?  The odds are low.  Remember, investing is about playing the odds.  We thought it would again be instructive to have a look at the super work of the folks at decisionpoint.com in their construction of this 1929 educational expose.               

The first leg down in this beast was a near 50%er.  Ultimately followed by the first real rally in the 1929 bear.  The market rallied from the first "heart attack" off the 1929 November low through to April of 1930.  An approximate 40% rally.  The deflation of the 1929 financial bubble so similar in character to what we see in the current market environment was a series of multi-month advances and retreats that took a number of years to play out into ultimate depth.  Of course we are not suggesting that 2000 will play out like 1929, but rather that there are really no examples in US history of a market falling approximately 75% in 2 to 4 months.  We would expect the NAZ 2500-2650 level to provide a good bit of support if we reach it.  After all, it was the blast off zone for the final euphoric NASDAQ top.  We just can't say it enough.  Remain flexible in your investing activities.  Our personal bet is that buy and hold is over.  Our expectations are for continued volatility for a good while.  

Although the US market faces structural dry rot over the intermediate term, in the weeks ahead we will have to face the possibility that a June Fed rate hike may be the last for a while.  Yesterday's trade agreement with China will continue to be trumpeted as a landslide opportunity for tech companies.  Month end is next Wednesday and the institutional temptation to dress up a few big cap tech windows must collectively be quite strong.  And very possibly, the public will refrain from liquidating even a portion of their stock mutual fund holdings...at least for now.  For short term traders, it's mandatory to remain a market agnostic.  We believe the character of the market has changed.  Sometimes you have to have a little patience while perceptions catch up.  The financial bubble we have created in this country was not built in a few months.  It took years to gather parabolic price momentum and confidence.  Shouldn't the flip side be true to some extent?

In discussing the bank sector above, we forgot to mention that a good number of institutions have come to rely on "investment portfolio" (venture) profits over the last few quarters to shine up their P&L's every 90 days.  Chase is a prime suspect in this game.  It's not just the banks.  Intel and a good number of their tech brethren also book venture and public company investment "profits" into their quarterly reports regularly.  Now that much of this equity has imploded in price over the last few months, earnings "flexibility" is being pinched a bit.

Being the believers in the new new thing that we are, we boldly predict M2M will become a much more visible investment theme in the months and quarters ahead.  Remember you heard it here first.

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