10/26

A RETURN ACROSS THE FIELDS OF GOLD - FROM HERE TO REALITY
(Part II)

Having described the bedrock pillars of this bull market that we believe are being called into question at the current time in Tuesday's discussion, we promised we would follow up with a few thoughts on navigating the market minefield ahead.  Do we know where this market is going day to day?  Where the NASDAQ will have an interim or a final bottom?  Of course we don't.  What we hope to illuminate are factors we believe will have a great bearing on general market activity ahead and what you may want to consider in your own investment activities.  Despite beginning or being in the middle of what may become the first real bear market in many a moon, structural characteristics of the broad financial market that took years to evolve will not be changed overnight.  These structural characteristics have had and will continue to have in the future significant ramifications for equity investors of all types.  We hope our interpretation goes a ways in explaining what has happened up to this point and will help you put future activity into perspective as we continue to traverse the financial minefield.

THE MANDATE OF MANY INSTITUTIONAL INVESTORS TO BE FULLY INVESTED AT ALL TIMES

As you know, the equity world we live in is not made up solely of mutual funds and day traders (although sometimes it may feel that way).  Institutional investors who handle pension money, foundation assets, etc. are a very large force.  One of the trends that sprung up in the institutional investment world more than a decade ago was the mandate that many equity-only managers be fully invested in equities for client accounts at all times.  Conceptually, plan sponsor boards, foundations, etc. and their investment committees, along with their ever present and "trusted" consultants, set overall asset allocation policy for large pools of money.  Managers hired to run equity and bond money are then mandated to stay fully invested in their respective asset classes (and of course investment styles) so as not to disrupt overall asset allocation of the fund itself.  Today, a significant portion of institutionally managed equity money must remain fully invested, regardless of the personal market opinions of the actual managers of the money.

This plan sponsor/consultant mandate has created a structural ripple in the equity market whereby equity money that may have gone to cash two decades ago when the market turned sour now must move to safe havens, defensive stocks, etc.  It can't seek out cash no matter how much it believes it to be the right thing to do.  It's a business decision on the part of the investment manager, not an investment decision.

Oh where, oh where has the scared money gone?  Here are a few obvious hiding places.

The utilities:

Crazily enough, the utility group has gone straight up since the peak in the NASDAQ in March of this year.  Coincidence?  Nope.  Utilities have been a historical shelter from the storm.  We've been amazed that the rising tide is lifting all boats here.  There is little discrimination being done between utilities with excess capacity, favorable cost structures, favorable regulatory environments, lack of capacity, etc.  This is institutional money mandated to be fully invested hiding from the boogey man.  Of significant note is the weekly MACD chart at the bottom.  Could it be that this group is rolling over?

The big pharmaceutical companies are another bomb shelter favorite:

Although the pharmaceuticals do offer a certain consistency in earnings growth over time, they are certainly not immune from macro economic conditions.  The submerging Euro is not a pleasant fundamental prospect for this group.  Just the other day, Pfizer missed its revenue numbers because of currency.  The group completely dismissed political campaign rhetoric regarding potential Medicare price caps.  Scared institutional money will decapitate a tech stock in the current environment for missing the revenue line.  For the pharmaceuticals, all is forgiven in a day or two.  (Boy, talk about the shoe being on the other foot.  We thought we'd never see the day.)

Other areas where institutional money can try to stay dry during the rainstorm:

     Aerospace/Defense
     Foods
     Energy
     Other health care
     REITs

Just to name a few.  The reason we bring this up is so investors will have some understanding that the move in these groups this year is not strictly due to fundamentals.  When institutional money is no longer scared, it just may be a scramble out of these groups.  Likewise, if we enter a protracted bear, undoubtedly, sponsors of large funds and pools of assets will adopt more conservative asset allocation postures where money will be taken from institutional equity managers.  Plan sponsor "redemptions", if you will.  Don't invest in these groups just because they have current momentum or relative strength.  Make sure you do your homework on the specific fundamentals of companies you own.  Don't get caught or be blindsided by the ebb and flow of large institutional pools of money.

THE EFFECT OF THE MUTUAL FUND  COMPLEX ON CAPITALIZATION ORIENTED EQUITY ALLOCATION AND PERFORMANCE

First, a repeat table that definitely helps make the point:

With the carnage in the big cap tech arena, it may seem logical that smaller cap value and growth stocks should now come into their own.  Not so fast.  We've argued this for a long time and still believe it to be as true now as at any point in time.  The concentration of mutual fund assets in the hands of a very few mutual fund families has dramatically altered the structural characteristics of the market.

You know that the big boy Fidelity Magellan hovered around $100 billion in assets at its peak.  Let's use something much less dramatic for example purposes.  Let's assume a small $10 billion dollar fund wants to purchase a 2% position in an equity.  That's a $200 million commitment.  Now, as you know, whenever institutional investors cross a 5% total ownership position of any singular company's equity, they must file an SEC 13-d.  Funds simply do not like to cross the 5% ownership position in any singular equity.  It's not just the SEC filing that is a pain, but owning so much of one company can create a liquidity problem (especially in today's market).  Just ask Janus how it felt to own 5.1% of Apple's total shares as of 6/00.  So, to stay under the 5% threshold for our little $200 million investment requirement, total market capitalization of companies in which acceptable investment positions can be taken must total $4 billion or more.  That requirement leaves a whole lot of companies off the radar screen.  That's just for a $10 billion fund.  The numbers get worse as fund size gets larger.  Likewise, duplicative holdings in multiple funds within one family are surely a concern.

To what conclusion is all of this leading us?  Despite some pretty severe corrective action in the markets recently, the large fund families are still forced to play almost exclusively in the big cap area of the market.  They simply do not have the time or the inclination to fill up their portfolios with hundreds of smaller capitalization ideas.  It's just not a practical use of their resources.  

Last comments.  Action this year has clearly demonstrated that the concentration of assets in the hands of relatively few large mutual fund families is ultimately a trap.  There is no orderly way out of the behemoth big cap holdings of these funds upon any level of fund holder liquidation.  God forbid the public ever lose confidence in equities.  There is no one to sell to.  We have the feeling that the fund industry will fight to its dying breath to keep their large cap holdings up in price.  That is, fight with your money.  Small and mid caps may not come into their own until large cap fund liquidation occurs.  In the meantime, liquidity is the single greatest risk to everything below large cap status.  Don't bet the farm on small and mid caps...just yet.  Likewise, the liquidation of the big cap fund holdings is far from over.

LISTEN TO THE BOND MARKET

Although this could be a topic for an entire discussion, we believe the exercise of "listening to the bond market" will be critical in the months and quarters ahead.  We won't bore you to death recanting the numbers indicative of soaring credit excesses during the decade of the 1990's.  You already know what has happened.  It appears to us that we have arrived at the peak of the credit cycle.  Spreads between Treasuries and everything else have been wide for some time now.  We believe part of the spread differential is the anomalistic effect of the Treasury debt buyback program.  But, it's not the total explanation.  Credit quality throughout the entire financial system is deteriorating as corporate earnings and cash flows contract.  Prices in the high yield market are plummeting.  Although defaults are rising, they do not constitute the entire rationale for price degradation.  Liquidity is the culprit.  Fear is in the air.

It's always been our contention that bond money and credit money is anticipatory.  Stocks can be supported by hopes and dreams, but bond and credit products are solely supported by cash flows.  It's not that bond money isn't emotional, after all bond managers and credit lenders are human beings.  It's just that bond research is or should be most intently focused on cash flow.  We are seeing a definite dearth of liquidity in the bond and credit markets these days.  It's not just the Xerox's of the world.  It seems to us that what we are seeing in credit land is just another step in the liquidity daisy chain.  First VC money for questionable business plans simply vanishes from the landscape.  Next to go is the high yield sector.  Money becomes unavailable.  The follow on is lower rated corporate paper in terms of liquidity drying up.  This is nothing new.  We've seen the cycle before.  One only has to look back ten short years to the junk bond blowups in the early 1990's.  We have one simple question.  "If liquidity to run actual businesses and finance actual enterprises is becoming constrained, is that something good for common equity which is lower on the payback chain than the actual debt?"  In our humble experience, we have yet to see stock holders get paid back prior to bond holders in a corporate liquidation.  Although in new era's, there's always a first for everything, right?

The greater fixed income markets are telling us liquidity is a clear and present problem.  If you are contemplating an equity investment, do yourself a favor and first take a look at the price action of the company bonds.  We believe looking at cash flow is more important than ever in that corporate America has become highly levered over the past decade.  After all, somebody had to pay for those high priced stock buybacks.

THE BUY AND HOLD MENTALITY

We happen to be of the opinion that the "buy and hold mentality" currently is and will continue to be put to the test in terms of the months, quarters and possibly years ahead.  Let's face it, we are in the midst of change.  We are in the midst of rationalizing dreams of unlimited technology earnings growth, excessive valuations on many of the favorite dominant stocks, and expectations regarding longer term investment returns from common stock investing.  We personally believe that barring the relatively low probability crash event, the rationalization will occur in a stair step fashion over time.  Again, possibly over a series of years.  The excessive credit, valuation and investment expectation build up took years to accomplish in the first place.  Will it truly be rationalized in a quarter or two?  Our bet is no.  Once again, we view it as a process.  The following chart is a dramatic example that although the secular direction of the equity market is up over the truly long term, by no means is it linear on an annual or multi-year basis.  As you know, the Dow has already been flat for about 18 months now:

Periods of excessive valuation and expectations such as the 1920's and the early 1970's took years to rationalize.  Over those "years", the market was a rolling sea of activity.  Outside of accumulating dividends (remember those?), prices point to point during those rationalization periods did not stray too far from a big flat line.  The only way to accumulate principal was to be willing to trade.  As you know, we are not talking about day trading here, we are talking about being sensitive to the ebb and flow of a rationalizing marketplace.  Sensitivity to mutual fund flows, stock sector valuations, macro economic, monetary and fiscal policy, etc.  Sensitivity to the human process of perceptual change.  Who knows, maybe we are all wet here, but we will be betting ahead that buying and holding stocks over the next few years will ultimately be a round trip to nowhere.  Sounds exciting, right?  Exciting if you can forget about tax issues, focus on total rate of return, and adopt a personal philosophy of flexibility.

As you would have guessed, we have offered no panacea or prediction for where the stock market is going tomorrow.  Hopefully what we have presented will give you some perspective in your own investment decision making as the market continues through what we believe is the rationalization process.  The return to a heightened state of realistic expectations.  A return across the fields of gold.

Deja Vu All Over Again?...We'll just have to see if it's different this time or not.  Tim has done a wonderful S&P retrospective for you.  A portion of the late 1998 S&P experience and the chart of current activity are just about dead ringers.  Is it time for another ringing rally, or do we just roll over and play dead from here?  The file is a bit big so we've put it on the Chartroom page.  Make sure you stop by for a peek.

Icarus Falling From The Sky?...We've been observers of bubbles popping all year long.  More correctly we should say bubbles in the process of popping.  First the Net stocks - POP.  Then the big tech darlings - POP.  Now it appears the optical high flying eagles are losing a few feathers - POP.  Are the biotechs one of the only groups left with some pretty hefty valuations to be reconciled?  Maybe.  Have a look at the following charts and you decide.