11/14

  For what it is worth, we will be eliminating the 1999 Market Observations Archives from the site as of this weekend.  A little site cleanup and server space conservation exercise.  Oh well, there goes EMC's next quarter.  So much for storage demand.

THE WEIGHTING IS THE HARDEST PART

Lately I've Been Runnin' On Faith...Clearly, the tech sector is addressing and adjusting to the growing problem of a capital spending led slowdown in tech revenues and earnings.  And not just domestically, but globally.  The dreams of the new era are being challenged daily at the opening bell.  As you know, the process of adjusting what have been linear growth assumptions (and concurrent valuation assignments) to a newfound cyclicality is not without pain.  On Wall Street, dreams often die a thousand deaths in quiet desperation.  One investor at a time.

Earnings are but one of the worries of the tech sector.  Main Street is now being treated to the education that for many tech related companies, earnings will indeed be cyclical.  They are not necessarily going to zero, but their growth rates will fluctuate.  Up and down.  The big kahuna double whammy in the current "education cycle" is that tech weightings in most portfolios are too heavy.  Both in professional and personal portfolios.  Not only will tech issues labor under the weight of decelerating earnings growth, but also under the weight of shifts in asset allocation.  Let's look at Wall Street and Main Street.

OFF THE WALL

Off The Bench-mark...For the past multiple decades, investment professionals far and wide have grown increasingly resentful of the S&P 500.  The rise of the index funds and their attraction of "lazy" capital spawned a perpetuating circle.  The more money the indexed S&P fund attracted, the better it performed (continually re-buying its own holdings in weighted fashion).  The better it performed, the more money it attracted, and so on.  This virtuous circle also fomented the belief that passive index investing was superior to active equity investing as the S&P magically bested the performance of most of its actively managed mutual fund peers over the past decade.  From almost nothing to a little over $100 billion in assets in a little more than a decade, is it any wonder why?

To the point, the investing "game" on the Street over the past "X" years has been to sector benchmark against the S&P to try to match its performance.  Since investment managers were increasingly being measured against the S&P for performance reasons, why not join it as opposed to fighting it.  Better yet, to beat the S&P at its own game, managers increasingly began to overweight the best performing sectors of the S&P to turbo-charge the performance of their own portfolios.  Of course, we all know what sector has been the best performer over the last five plus years.  That's right, it's tech.

To add fuel to the fire, as tech performed relatively better than most of its non-tech sector peers, tech became a larger and larger percentage of the S&P.  To keep up the performance game, investment managers had to continually up the tech weighting ante in their own portfolios to keep up with and try to surpass the S&P.  To what eventual effect?  Well the following effect, as you would imagine:

The tech weighting in the S&P was driven not only by the factor of absolute performance of tech specific issues, but also by the rebalancing of the S&P over time.  As companies were acquired (bought out of the S&P index) or left the index, a good number of tech issues took their place.  Hence, over the past decade, the technology sector as a percentage of the total S&P grew from 7% in 1990 to a high of 34% earlier in 2000, to now rest at approximately 27% of the index weighting.  Maybe it's now meaningless, but the average S&P tech weighting for the past decade is 12.4%.  We're probably not going back there anytime soon, but is a move to 20% or below out of the question?  Certainly not.  For what it is worth, energy stocks in the S&P totaled close to 33% in 1980.  Twenty years later the weighting is closer to 5%.  Anything can happen.

In a performance driven world where the only real worth of a singular mutual fund in a sea of competitors is the investment result it delivers quarterly/annually, what's a poor portfolio manager to do when tech is hitting the skids?  The obvious.  Underweight tech relative to the S&P and its peer funds.  There is no question in our mind that asset reallocation has begun and there is most certainly a very a long way to go towards ultimate normalization/reconciliation.  Last portfolio manger out is a rotten egg?

Lately I've Been Talkin' In My Sleep...We've prepared the following tables as a little exercise in perspective.  Most of the portfolio allocations are dated, but important nonetheless.  Tech weightings may be down from these dates, but most certainly still meaningful by any stretch of the imagination.  With all of the gaping in price action (volatility) we experience, just how many of these funds do you think lightened near the highs?  That's right, not many.  The next time one of the talking heads proclaims that tech is a wonderful buy after the 40% NASDAQ "correction", think about these tables.  Remember who may just be on the other side of the trade.  For a great while to come, we might add.  As you would guess, all info is directly from Morningstar:

As of 7/31, Morningstar's average Growth mutual fund was carrying 43.9% tech sector exposure as a percent of total portfolio holdings.  Most of the weightings shown in the table above are simply staggering.  Of course many reports are near the top of the market.  Nonetheless, are these funds diversified equity funds?  Our characterization would be anything but.  Clearly gaming portfolio performance was taking top priority in the strategic management of these pools.  Does the general public really realize what they are buying here?  As you can see, tech earnings may just be the tip of the future tech stock performance iceberg.  Overweighting in institutional portfolios is perhaps the bigger issue.

Very quickly, this next table is what Morningstar categorizes as Large Cap Value.  Oh really?

There is possibly another interesting wrinkle at work in current market tech stock action.  Remember that the fund complex closes its tax books on Oct 31.  As you may recall in a piece we wrote a few weeks back regarding embedded capital gains within the mutual fund complex, realizing additional gains in what is currently a pretty nasty down year was not a recipe for warming the hearts of fund holders far and wide.  Now that Oct 31 is past, it's easy for fund managers to again sell tech as they have an additional 13 months until currently realized gains will be passed out to holders.  Right now it's about performance, not taxes.  What stocks are most vulnerable assuming taxes are not a concern and there is a pressing need to reduce aggregate tech exposure?  You guessed it.  The large, liquid tech names.  SUNW, CSCO, ORCL, INTC, MSFT, JDSU, etc.  Need we go on?  Selling these issues are the simple and most efficient way to reduce tech exposure.

The last comment on Street exposure is that the Street was willing to bestow capital on tech names almost right up to the point where these stocks seriously hit the Wall.  The following chart is a bit of testimony to that statement:

The biggest piece of the IPO pie by far for the 6 months ended August was dedicated to tech.  It's no wonder future shifts in asset allocation ahead are a very serious question for forward tech sector performance.  There is no doubt that revenues and earnings are important.  But, so are the actions of the crowd.  For longtime readers of Contrary Investor, you know we have argued until we were blue in the face that reallocation of tech holdings would at some point be anything but orderly.   Welcome to disorder.  By the way, the color is returning to our cheeks quite nicely, thank you.

PUBLIC AWARENESS

When We're Runnin' On Faith, All Of Our Dreams Will Come True...A lot of "professional" investors may have loaded their portfolios with tech over the last few years to "beat the averages", but what about the mom and pop America investor?  While aggressive growth, growth and sector funds were loading the boat with tech stock picks, it just so happens that Main Street was loading the boat with aggressive growth, growth and sector fund purchases of their own (Table data source: Investment Company Institute):

Here's a lay up for you.  How does Main Street cut back on tech in addition to parting with their beloved Intel, Cisco, Sun, AMAT, Oracle, etc.?  They simply sell their aggressive growth, growth and sector funds.  Where do the investment managers of these funds get the money to pay back mom and pop redemption candidates?  By selling the one group in which they are overweighted - tech stocks.  As you know, net net, Main Street has not yet asked for its money back quite yet.  Imagine what tech stock performance would be like if mom and pop investors did redeem (even a little of their holdings).  On second thought, maybe you don't really want to know.

Having described what we believe is a very serious asset allocation problem regarding institutional and personal portfolios being overweighted in tech, we also have to point out that the tech stocks may be the very stocks that are "gunned" from time to time by fund managers as they still have every interest in the world to try to get prices back up.  Of course trying to sell these issues once they have had even a modicum of a move back up may be tough.  Sell?  To whom?  Possibly only the die hard new era adherents.  What this may suggest is that volatility is here to stay while this tech weighting imbalance exists.  Don't be surprised by price gaping.  There is clearly a reasonable explanation as to why this is happening.  And so frequently.  We'll just have to wait and see how it all plays out.  As you know, though, the weighting is the hardest part.

Picture This...If you will.  As many of you may remember or know, original Dow theory did not include the use of the Dow Utility average.  This year the utilities have performed very well on a relative basis given the raindrops that have been falling on Wall Street.  A bit of a special case in terms of meaning in the newer context of the Dow theory.  Excluding the utilities, just how do the Dow Industrials and the Dow Transports stack up?  The following charts will give us a bit of help.

The recently volatile Dow is really towards the middle of its range relative to the recovery high off of the initial April/May bottom and the lows experienced in April/May and October.  For the transports, there has been a recent rally in sympathy with what we believe is a head-fake rally by the broad "cyclical" stocks.  The key numbers are laid out in the charts.  The Dow needs to close above 11,500 and the Transports above the 2,950 area for the Dow Theory bulls to take charge.  Conversely, a fall below the lows seen in April/May and October will spell real trouble.

As you know, the real trouble this year has been felt in the NASDAQ.  The drop from the highs of over 40% is just about as bad an experience as any year since 1974.  Conversely, the YTD drop in the Dow and the S&P are pocket change relative to where these indices have come from in the last ten years.  If we are in the midst of a true bear market, the Dow and the S&P will eventually catch up with the NASDAQ, possibly not in severity but most likely in direction.

Despite the "recovery" in the NASDAQ and NDX 100 since midday yesterday (futures, futures, futures), the near and longer term charts look anything but healthy.  Don't you agree?

The S&P has likewise broken down through a very important longer term channel.

Remember, with so much at stake over the near term in terms of mutual fund tech holdings, don't let unprecedented short term volatility distract you from the view of the horizon.  Don't put faith in anything except your own observations and convictions.