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Thomas R. Peterson, the
Tom Hanks-lookalike who runs Bulls Eye Research is no Hollywood
lightweight. He is as targeted on the investment scene as the name of his
Vancouver-based firm implies. His service for institutional investors is
all about pulling triggers— and scoring. Which he does with impressive
frequency, by mixing razor-sharp technical analysis with a hefty measure
of rigorous economic and fundamental research.
KMW
Tom, one thing that sets
your work apart is the way you employ both technical and fundamental
analysis—and still manage to be quite comprehensible. Articulate, even.
Thanks. While some of
the biggest and best traders use technical analysis, they still don’t
particularly like to publicly endorse it—it’s their edge, after all.
But I have found it wise to combine my top-down macro-economic view with a
bottom-up stock selection process—and overlay it all with technical
analysis. Essentially, early in my career, I was a pure fundamentalist.
But after losing money in companies with apparently good fundamentals, I
decided to incorporate technical analysis—because I had noticed that
technical warnings often precede revelations of their fundamental causes.
A friend of mine, one of the best technicians I know, has pointed out to
me that towards the end of a bull market, a sort of superficial technical
analysis starts to work for momentum players, so everybody latches onto
it. Which only sets most of them up for great disappointment when it fails
to work the same way in the subsequent bear market. But that’s because
they don’t even understand that it is a bear market. Yet an interesting
thing about technical analysis is that in 1987, three people in particular
(that I know of) correctly forecast the crash. They were Ned Davis, Paul
Tudor-Jones and Marty Zweig. I
would assume that a good portion of their analyses, which led to those
forecasts of the crash, involved technical analysis.
As I recall, Steve
Leuthold and Justin Mamis also made great bearish calls back then. Neither
of them is a stranger to technical analysis, either.
But let’s talk about you. Your parents clearly did something
terribly wrong to set you on your career path.
I was abandoned.
On the doorstep of the
Exchange?
Actually, I have a
partially Scottish background, which makes me very wary of risk. I’ve
been risk-averse ever since I started out 20 years ago in sales with an
international underwriting firm. It carried over when I worked in venture
capital. I used to start my due diligence in the parking lot. What I found
was that there’s a strong correlation between entrepreneurs who are
successful and drive beat-up Volvos and also a strong correlation between
entrepreneurs who are not successful and drive leased German luxury cars.
But that experience taught me that no matter how much due diligence you do
on the fundamental side, there are all sorts of other risks that come into
play that you can’t account for. But one of the problems with venture
capital is that when you make your investment, you don’t know if
you’re going to be successful for many years. In the mid-’90s, I
decided that I really enjoy liquidity more than that. So I started
concentrating on publicly traded companies. And, as I said, after finding
out the hard way that the fundamentals weren’t telling me everything,
started embracing technical work too.
We should make clear
that you’re not talking about reinventing the wheel here. You use pretty
standard-issue stuff, for the most part.
Plain vanilla. It really
revolves around the work of Richard Wyckoff, who was a pioneer in
technical analysis at the turn of the last century and a very skillful
investor. After the ’29 Crash, he wanted to explain to the public how to
manage investments, based on what he knew. But he realized that you can
only tell people so much; they have to learn for themselves to really
embrace a concept, so he provided the technical tools—and it’s
essentially that very old-fashioned set of technical tools that I use
[Wall Street Ventures & Adventures Through 40 Years by Richard D.
Wyckoff.] Where I have updated them is by building my own proprietary
accumulation/distribution computer model. What I was looking for was an
edge that could tell me whether a stock was under accumulation or
distribution by people smarter than me.
A group you basically
define as insiders?
Not entirely. What I
found out from working in venture capital and doing due diligence on
companies public and private is that the most knowledgeable people about a
business don’t necessarily work for the company in question. In fact,
most would consider them outsiders. But customers and suppliers very often
have the best “inside” perspectives on their business partners.
They have insiders’
insights, and outsiders’ detachment.
Exactly. And what I’m
looking for, in employing technical analysis, is a match between the
fundamental picture that I see unfolding and the technical action of the
stock or index. I want to have confirmation. If I can get the two
conclusions to agree, then I know I’ve got a higher probability outcome.
It’s all about risk management. We’re just trying to define the risk
down to an acceptable level.
And your
accumulation/distribution model gives you a technical reading on what that
smart money is doing, by capturing and analyzing every tick?
Computers make that very
easy, which is a great advantage. What I’m trying to find—based on the
assumption that people who have superior intelligence about a stock or a
market probably also have superior resources at their disposal—are
technical indications in their trading that a large number of them agree.
Over a period of time, if a stock is really under accumulation, for
example, it should show greater advancing volume than declining volume and
volume should be growing on higher prices. The contrary is true, of
course, for distribution.
But then you also relate
that price and volume action to macro themes you see in the market—
Well, to be a successful investor, you have to anticipate changes in
trend. So what I try to do is look for facts that are unrecognized or
undiscounted by the market. Once they’re discounted, I move on. In the
current environment, I believe that what [David W. Tice & Associates’]
Doug Noland has called “the credit bubble” explains what we have been
seeing in the economy and in the stock market over the last several years.
Therefore, that’s the scenario that I’m working from. Because that view is
not widely endorsed by the Street, I know it’s not discounted yet.
When people do start talking about the credit bubble being a major
problem, we’ll probably be closer to an important low. But right now,
people are still hanging onto the idea there’s going to be a quick
recovery in the economy. I just don’t see how that’s going to be possible
because the debt bubble that was created is really crushing the economy.
You don’t see a chance
that the economy will at least muddle through?
I wouldn’t necessarily
say that. But I’d say that the country and the economy have some severe
challenges ahead. It will take time to work through the excesses, so we
have to be cognizant that the risks are still to the downside. We’ve had
a massive misallocation of capital. That was reflected in the bubble in
the internet stocks, the bubble in tech and telecom, the bubble in
consumer spending and now even the bubble in real estate. All of those are
symptoms, I think, of the greater problem, which is that there’s been
excess credit creation.
Don’t forget the
bubble in hedge funds.
If history is any guide
at all, what has to happen is that the credit has to be paid off. Or
rather, what I should say is that all that excess credit represents future
claims on assets—and those claims have to be paid.
Or repudiated somehow.
Inflated away—
Or defaulted. And
defaults are rising. What the existence of all that excess credit really
does is tie the hands of the policymakers, restrict the solutions they can
try to bring to bear on the problem. So until we can see signs that the
economy is turning around, we have to be cautious. As far as I’m
concerned, the No. 1 economic indicator is consistent growth in profits.
We don’t have that yet. In fact, we never had a profit miracle, as most
people think transpired the last part of the ‘90’s.
On that score, you agree
with Jim Paulsen [w@w 7/6/01]. Yet the profits miracle of the decadent
decade is an article of faith.
True enough. But from my
perspective, the investment management business is really the risk
management business. It’s a great business because it accommodates so
many different investment styles, but eventually it all comes down to
managing the risk. So that’s what I focus on. When you take the time to
go to the Department of Commerce web site and actually review the
statistics, you see that profits grew at barely more than the rate of
inflation in the 1990s. That’s really
a poor economic performance during a boom. And anyway I look at this
equation, I keep coming back to the “X” factor being excess credit
creation.
The excess funds naturally found their way into the liquidity
preference, found their way into the stock market, and particularly into
the flavor of the day (whether it was internet or telecom, or now, housing
or hedge funds). The valuations were pushed to extremes because there was
excess money available. Unfortunately, a lot (though certainly not all) of
that money has been lost now. But the obligations still have to be paid.
So I keep coming back to a problem of having a contraction that will
probably be exacerbated by the excess consumer indebtedness, as well as
corporate indebtedness that is at record levels.
Making it all the more
difficult to generate the profits needed to repay all that debt—
That’s true. The
mistake that most investors are making is that they’re looking at the
micro level and forgetting to step back and take a bigger picture view.
When you do that, you see that it’s not going to be easy to replicate
the portfolio growth of the latter ’90s. That is why stocks are so low
now.
Well, lower than they
were. But lots of stocks are anything but cheap. Look at the P/E on the
Naz, or even on the S&P.
Valuations are still
high, yes. But the loss of relative value has been huge. What I mean is
that a little over a year ago, there was a lot of talk about the Nifty 50
or the glamour stocks of the day, the handful of names everyone was
chasing in the first quarter of 2000. Today, those stocks, the Nortels and
Lucents, the Ciscos and Sun Microsystems, have had massive downward moves.
A lot of money was lost in those key names. Yet the market, unfortunately,
as you say, is still expensive on a valuation basis and it appears that it
hasn’t seen its low for this bear market.
You don’t think the
March low was the bottom? That’s not good news, considering how good
you’ve been at timing both the market’s highs and lows—
Thanks for saying that.
But I know full well that this is an incredibly humbling business. So far,
my forecasting model has worked pretty well for the last 6 years. I hope
it continues to do so. The way I view investment management, to be useful,
you have to be able to make accurate forecasts in both directions.
Okay, you understandably
don’t want to incur the wrath of the market gods. But I seem to
remember, for example, a very explicit warning you issued last summer,
after calling the March top and subsequent correction lows—
In the summer of last
year I became convinced that the leadership stocks in tech and telecom
were going to put in a high and start a long decline that was going to
really wipe out a lot of money. So last June, I started talking about the
rally into Labor Day 2000 being the “last stagecoach out of Dodge
City”. What happened was that the leadership stocks, like Nortel, for
example, went through a classic progression last year. Anybody with a
grasp of technical analysis could see that they had a change of character
and were putting in massive long-term tops. I was just following the
script that the market seemed to be indicating. Trying to minimize the
risks. And things I was seeing on the fundamental level only reinforced my
views.
Such as?
What gave me pause were
things like the way a lot of the semiconductor companies had started
piling into making chips for handsets—and the top five manufacturers
were all claiming that they would take a 40-50% market share. The same
thing was happening in optical fiber. All the guys laying fiber optic
cable were claiming that they would have 40-50% of the market, and the
same thing in telecom. So what you ended up having is a whole bunch of
corporations diverting far too much spending into areas that were going to
be extremely competitive.
Just the sort of
mathematical truth, and basic fundamental insight, that no one wanted to
hear.
It seems really simple
in retrospect. A time, I thought it was glaringly obvious. But it takes
time for the herd to—I shouldn’t say that.
Oh, go ahead.
Well, it just takes time
for information to flow through the economy, I guess.
Especially information
that is cognitively dissonant to the prevailing faith, as you pointed out
in a recent report. The maniacs discounted the math because they presumed
the pie would continue to grow exponentially—forever.
That’s true, and there
was a chance that those proponents could have been correct. I guess the
advantage I’ve got is that I could see distribution occurring in a
classical way in those top-name company stocks. And that fit the theory
that because there was all the building going on in those industries,
they’d become incredibly competitive. My natural conclusion was that it
was time to get out. By the same token, there will be correspondingly
positive action sometime in the future in those same names.
But I believe they have to go through an extended period of
retrenchment, first.
They’re not likely to
have much upside while their insiders are still bailing out, en masse.
I view that as an
interesting debating point right now. Some people think that corporate
insiders who sell are usually wrong and so insider selling now is a good
sign.
That’s a bull market
perspective.
Exactly. I would counter
that we’re still stuck in the bear market that started in early 2000 and
that you have to adjust your frame of reference to accommodate that. What
I’ve always found through my due diligence work, from a fundamental
perspective, is that corporate insiders are almost always bullish on their
business and on their industry. So when those people who should normally
be buying the argument for a turnaround are actually selling against it, I
think that’s important information. They’re also selling at prices
that are distressed compared with prices a year ago. And that information
is being backed up by actions of the corporations themselves.
Meaning?
For example, all the
leaders in the PC manufacturing area, in telecom, in optical fiber, are
not only repeating the same phrase over and over again (“there’s an
unprecedented slowdown in the business”), but they’re also laying off
employees. And you don’t lay off employees if you see a turnaround
within six months.
That is so basic, and
yet it’s being ignored by so many strategists, analysts and investors.
It is so expensive to lay off and then rehire people that any company
really expecting a fourth quarter rebound would be sitting tight.
Absolutely true. I would
say that people like Michael Dell, for example, are speaking very loudly
to the market about the future, when he not only lays off employees, but
specifically lays off people who work in Dell’s service centers, man
their help lines—their key customer relationship management personnel.
Another new age buzz
word, down the tubes.
When Michael Dell is
laying off people in key customer service areas, that’s very important
because he built his business on superior service. It’s just elementary
logic. But Wall Street is in the sales business. A lot of investors fail
to recognize that, or to consider that Wall Street will always present the
most optimistic view. But when it comes right down to it, a professional
money manager cannot afford to be optimistic or pessimistic, he has to be
realistic, and basically take what the market will offer at any time.
Right now, the bear market is only offering swing trades—and we
just have to work in the environment that’s available.
So that’s why your
focus has become very short term?
Yes. I’d prefer to be
able to just buy stocks and go to Tahiti for a couple of years. But I work
with a lot of traders and I provide guidance even on an hourly basis for
some. That’s tough to do, obviously, over a long time. I prefer to talk
about the overall scenarios. It’s just that this market now is probably
the toughest market in history. The volatility, with so many new
participants, is creating real challenges for money managers.
The toughest market in
all history?
Because you’ve had
record public involvement. You’ve got more access to information, so
you’ve had a totally new level of participation. Also, we’ve got the
worst economic backdrop in history. So
we’re trying to fight the battle of sorting out what’s important from
what is not; or what is noise. We’re forced to be very nimble. Perfectly
good stocks can explode overnight. Money managers don’t have the luxury
anymore of buying and holding. In fact, really for the last several years,
a buy and hold strategy has been a non-strategy. These markets are dynamic
and so money management requires a dynamic approach.
Are you suggesting that
the current economic backdrop is worse now than it was in the 1930s?
I would argue that Japan
through the 1990s is another pretty good example, and a more recent one,
of an awful economic backdrop. But if you look at the raw data today, it
is very sobering. You’ve got $6.7 trillion of debt in private hands and
about $4.7 trillion worth of corporate indebtedness. If you just look at
the first quarter numbers for this year, those totals are growing much
faster than the economy. In the first quarter, the economy grew at a
little over a 1% annual rate, or by about $110 billion.
If you believe the
government’s statistics—
And if you accept hedonic indexing as valid. But just accept those
numbers, for now. Compare that annualized $110 billion growth in the
economy to M3 growth in the first quarter, of about $240 billion
annualized. Or to the annualized growth in total indebtedness of about
$1.8 trillion. In other words, we were adding roughly $17 worth of debt to
the economy for every dollar in GDP—that’s frightening. Should sober
anybody up. And that’s why, I think, the stock market is in so much
turmoil. Because people are having to discount this environment.
It’s not that you can’t save the economy, it’s that it’s going to be the
biggest challenge in history to do so. I don’t believe that lowering
interest rates in themselves is the solution. Anyway you look at this
equation, you keep coming up with the risks being substantial and the
near-term rewards being very limited because there’s no profit growth. So
we have to try to be opportunistic in our money management style until the
economy proves that it has stopped contracting. We’re a long way from that
point, I believe.
So how bad does the
market get in the interim? Put some parameters around your bearishness.
Boy, you’re nailing me
to the wall.
Hardly. You make
projections all the time.
Well, I believe that
we’ll be lower by the end of the year than we are now.
Good God! You’re
starting to craft phrases as carefully as those famous strategists on
CNBC.
Well, I would say that
we’re going to make new lows by the end of the year. But let me put that
in perspective. I’d been anticipating that this spring’s rebound would
turn at 11,350 on the Dow and 1315 on the S&P. We hit those targets on
May 22 and we’ve had a normal pullback since then. Our lowest target on
the S&P for this retracement was 1170 and it hit 1168.4 a week ago
Wednesday—
Close enough.
Yes, for government
work. So we’ve completed a normal pullback and now it’s up to the
stock market to prove that it can build on that. So far, the evidence is
not compelling that we can go on from here and test the highs for the
year.
So you expect another
failing rally—one that won’t take out the old highs?
We’re forced at this
point, because of the choppiness in the environment, to look at our
accumulation/distribution data on a daily basis. What is interesting is
that we did not get the kind of accumulation that you would want to see on
the pullback from May 22. And the pullback went deeper than it normally
should go in a healthy correction—right to the “fail-safe” point. So
it’s not that accumulation can’t come in all of a sudden in coming
weeks and restore a more bullish perspective. It’s that so far the data
is not encouraging. So having been bearish from May 22 until last
Wednesday [July 11], we’re now basically neutral, because we’re really
in the middle of the anticipated trading range.
And got there,
essentially with another one-day wonder the very next day. Which is all
too typical of a bear market.
It sure is. And that
rally was not verified by the accumulation data that I saw last Thursday,
which was quite amazing. There simply was not any net new accumulation on
that rally, despite the huge increases registered by the indexes. What
that suggests to me is that there was distribution on the rally; that a
lot of portfolio managers were lightening up. Also that the rally was due
to technical traders who saw the same math that I did, as well as due to
short covering. It’s nice, don’t misunderstand me, to see the market
turn exactly at the points you’ve forecast. But we have to build on that
turn, if it’s going to be any good. And at this point, we have to take
it day-by-day unfortunately.
[On that basis, the S&P hit Tom’s
minimum retracement target of 1225 Thursday morning, and brought out
selling, as he expected. (See Chart) He looks for a deeper pullback to the
1190 area, with overhead resistance from 1225 to 1240. Since 1243 is also
the 50% retracement target, he says he’ll interpret any progress made
against that overhead resistance in the near-term as increasing the
probabilities of a rally breaking through towards 1260-1267 later. ]
To step back for a
minute here, if this turns out to be just another failing rally—
We’ll have very
important tactical information. Another point is that even the most
optimistic forecasters, who think that the Dow still might go to a new
high, would likely concede that the S&P probably will not. That kind
of divergence is another classic way of ending a rally and starting a new
downtrend. So my overall perspective is that we’re still trapped in a
broad bear market. And it will probably take a long time to finish going
down because, in coming months, we’re likely to see economic data that
somewhat supports the view that things are bottoming. But then, later in
the year, I believe, we’ll get a new round of data,
probably led by a decline in real estate prices, that will bring in
a whole new array of disappointments.
The ideal scenario, for investors, is that we can buy time by working
through a trading range that presents opportunities. And the way you
operate in that kind of an environment is to buy support and sell
resistance; try to bank winners and try to not ride out declines.
In other words, you
actually have to make sell decisions?
I find that a lot of
portfolio managers need to tighten their sell disciplines. Again, I view
everything as risk management. I’d only take on positions here where you
have liquidity, and where the risk/reward is at least 3-to-1 in your
favor. That’s just common sense.
What does having
“liquidity” mean to you?
Investment size is a
real issue for a lot of managers. Many, who would prefer to be more nimble
can’t be, simply because of the amount of dollars they’re investing. I
recognize that and I understand it. But there are a couple of ways you can
work with that. If you’re a hedge fund, you can hedge with the futures,
which is one of the preferred ways to go. If you’ve got a portfolio
exposure, you can hedge it by shorting sub-indexes or the overall indexes
and manage the risk that way. But one of the problems with the market is
that liquidity is taken for granted. That’s always been the X factor
when it comes to market meltdowns because bids disappear (as LTCM found
out).
Low-probability events
happen.
Right. I know a lot of
guys who are getting headaches in this market. Looking at the overall
scenario, there are two real alternatives here: Either we go up to
resistance and fail, which is quite likely, then we can go into a trading
range. Or after we fail on the next good rally, then we go down and take
out the old support. In either event, I really think that the Dow is
headed to test 7500 before it’s all over. And that might prove a very
optimistic view depending on how this whole debt bubble unravels in the
next couple of years.
Finally, a downside
target from your lips. So the only question is the slope of the path we
follow to that point?
The thing is, whenever
the decline gets very steep, like it did in March, you have to think that
it’s going to stop and turn. That’s why technical analysis is a great
advantage for people who want to measure the risk/reward in this kind of
trading range market. I think the upside versus the downside risk today is
probably equal, but as we rally towards resistance, then people should
sell. I think that raising cash on the next rally would be a smart thing
to do.
“In this kind of
trading range market.” Are those words inscribed on your quote screen?
One of the things I find
the most striking about this business is that most money managers don’t
take advantage of the No. 1 advantage they’ve got over every other type
of business—that is, that you can choose whether you want to be invested
and you can choose at what price and when.
A lot of them swear they
must be fully invested.
Well, then they’re
going to under perform. Again, coming from a venture capital background, I
find it a tremendous advantage to be able to change your mind within
minutes as a portfolio manager. I find that the best investors manage
their positions on an individual basis in accordance with the risk
management parameters that they set for themselves. If they take on a
position and it doesn’t work out for them within a short time, they
reduce it or even go completely the other way. The way I look at it, in
this business, we’re able to know whether we’re right or wrong almost
immediately. And being wrong is good information, too. If you’ve built
up a scenario you believe should work and it’s not working out, then you
should consider going to the opposite direction.
That’s just a mite
contrary to human nature.
That’s an interesting
point. Money management requires a very flexible approach today. I always
tell people there’s nothing very noble about holding onto losers. In
fact, holding onto a losing position is like telling the market what to
do, rather than admitting the mistake is yours. But if you get right down
to the smallest transactional level and manage your risk on an individual
position basis, then overall, you’ll probably outperform.
It is more and more true
that no matter how correct you are about the long-term fundamentals, you
can get your head handed to you in a countertrend move—one that you
won’t get bailed out of in an “acceptable” length of time.
That’s an interesting
facet of the business. Almost everybody will agree that the market is a
discounting mechanism, but when it starts disagreeing with their view of a
stock, they always say the market is wrong. For example, look at Nortel
again. When Nortel early last year showed a severe change of character;
dropped very severely from a new high, that was classic behavior. What
happened was that after having a huge decline from March until April of
2000, Nortel turned around and went right up to a new high in July.
That’s how positions are distributed according to classic technical
trading guides. Then, as it started to decline again, a lot of people
couldn’t believe it because the news wasn’t all that bad. They were
convinced that bullish view of Nortel was correct. If they had just
allowed themselves to be stopped out of those positions as the market told
them otherwise, they would have been saved a lot pain. If they had just
picked a point—like the 21-week moving average—and just said, “If it
goes below here, I’m going to get out and reassess the situation,”
they probably never would have gotten back in again. As
a matter of fact, after Nortel broke its 21-week moving average, it
then rallied back to just underneath it last October, in a classic move
which provided another short opportunity.
But what tends to happen is that
people stick to their beliefs even when they’re not getting confirmation
from the market that they’re correct. That comes back to that theory of
cognitive dissonance, which we’re all guilty of. That’s why it’s now
so important to have somebody who’s acting as navigator to say, “Well,
it looks like we’re going to drive off the cliff here,” and to tell
the driver to turn. That’s how you can save yourself from giving back
everything on a formerly great performer. Of course, by now, anybody who
is a long-term holder of Nortel has given back their performance
going back to ’97. As I said, this business eventually comes down
to managing risk. If you
don’t have a strong sell discipline, you’re going to have a lot of trouble
in the next couple of years. You’ve got to be willing to reduce your
expectations, take less of a return and be willing to be stopped out for a
small loss, if a stock is not behaving the way you expected.
Where the rubber meets the road is the actual execution of the action
plan. So I never enter into a position unless I know where I want to get
out both on the upside and on the downside. I constantly talk about
managing the risk because everybody knows what the upside could be. It’s
unlimited. But you have to deal with the nasty part, too, and be able to
admit you’re wrong. If you review the best investors in history, every one
of them preaches the same discipline. It’s nothing new, it’s just that
because human beings do get emotionally invested in their trades it’s very
difficult to actually do. Futures traders tend to be good at managing
stock positions because they’re religious about giving themselves a time
limit and a price limit to be right. The best traders I know take very
small losses but they take a lot of them. That’s how you’ll have a guy who
makes a lot of money talk about being right only 50-60% of the
time—because he’s including his losing trades. It’s just that his gains on
winning trades far exceed the capital lost on the losing trades.
Psychologically, a small loss is a lot easier to take than a big bath. We
were recommending Nortel as a short at 80. If you had sold it there, you
could have always bought it back later. But if you didn’t sell it and you
rode it down, every day it gets tougher to come to work. Every day it gets
tougher to admit you’re wrong. That’s where we are now. A lot of people
have overstayed their positions and are willing to grasp any glimmer of
hope. But unfortunately hope is not reality. We have to deal with reality.
I expect several false starts before we finish going down.
You’re just full of
cheer, especially for portfolio managers still overweight the old
favorites—or the indices that are themselves overweight in those same
stocks.
A lot of the volatility
we’ve been experiencing is a result of portfolio managers who for
whatever reason don’t want to buy a particular big-cap, say Coca-Cola,
but want exposure to that sector in their portfolio. So what they’ll do
is buy an index derivative and try to weight their portfolios that way.
That’s how you get explosive moves like we had last Thursday in the Dow,
in which underlying stocks
really don’t do that much. Too many managers are relying on index
derivatives as a way to be invested. Again, that’s not a healthy sign.
Okay, you say portfolio
managers have to take what the market is offering, which isn’t much more
than swing trades?
Yes, and it’s tough to do. But it’s more important to want to make money
than to want to be right in this environment. People who want to be right
all the time are afraid to make decisions. But people who want to make
money are willing to change their decisions to take what the market will
give them. Transaction costs don’t prohibit it. You know, in a classic
investing style, you build a position over time and you only add to your
position if it is moving in your favor. Look at Reminiscences of a Stock
Operator (the Jesse Livermore story). He says he always loves to pay more
for a stock as he’s building his position, because that tells him he’s
right.
In other words, there’s more demand than supply. Following that advice in
this particular market will save you a lot of problems. It will prevent
people from pyramiding into a bad situation and it’ll also require them to
only enter liquid positions. I also think we’re at the position in the
economy’s history where carrying a lot of cash in a portfolio is a wise
thing to do. Because stocks should get cheaper over time. So I see money
flowing away from portfolio managers who are too rigid in their thinking,
and towards flexible ones—whose charters permit them to carry a lot of
cash.
You’re talking about
an all-but-extinct breed. Haven’t you heard of consultants?
I hear you. But
ultimately I believe that outside of a pension fund, for example, most
individual investors want their money manager to manage as if it were his
own money. Which means taking less risk in a risky environment. If you
can’t buy good stocks at good prices, what you have to do is wait.
Because it’s a bear market, and they should come to you. Until it’s no
longer a bear market, people don’t have to overpay for a company. Or
worry about being penalized for holding cash.
Shorting is also part of
your game plan—
I wish everyone ran a
hedge fund. It would make their life so much simpler. This market is
vulnerable to further downside, which will be great for shorts, if they
can get a good rally to short against. Still, I haven’t advocated any
real wholesale shorting since last year. I published three big lists of
short sale candidates, one in February of 2000, one in March and one in
August. Since then, we’ve just been trying to hold onto the shorts
we’ve got. Some shorts you don’t want to take off —things like
Exodus Communications (EXDS). But others (like Nortel), have reached their
targets. Nortel could easily bounce 50% from here and then still go lower.
But at this point, the risk/reward on Nortel makes a short not worth
holding.
You want to keep your
short on Exodus because you see it headed to zero?
It’s possible. Again,
what Livermore would advocate, as a position moves in your favor, is
taking some profits. At this point, nobody should have a full short
position in any of these things, but there’s nothing wrong with having
some shorts, because they don’t look like they’re worth what they’re
trading at. If you want to try to pick another short, you could look at
Microsoft, which people just don’t understand. They think Microsoft is
the Microsoft of the ’80s and the ’90s and it’s no longer the same
company. They have some massive challenges ahead of them.
How can you say that?
It’s bringing out new Windows software in the fall.
Which is interesting
because that new software leaves a wide-open door for hackers to attack a
computer system. I think corporate IT managers will shun Microsoft’s XP
software until the bugs are fixed. In fact, XP has two fatal flaws. The
other is that it requires a very powerful computer to run it. A tremendous
amount of memory and computing power. Maybe Microsoft has a solution to
the hacker vulnerability sitting on the shelf that they haven’t unveiled
yet; but until that’s more widely known, IT managers won’t take the
risk. Especially because they don’t need to upgrade. So it doesn’t
matter if Microsoft does launch XP in October because they won’t see any
real sales from it until next year. And technically, the stock is not
under strong accumulation. So at this point it’s really in the hands of
the traders. Fundamentally, MSFT isn’t supported by the projections and
technically, it can’t go a lot higher without running into a lot of
selling pressure. I’d be surprised if the stock could get above 87. The
first challenge is for it is to get above 77.
Its recent
pronouncements were hardly the stuff of dreams.
Investors were swinging
from the chandeliers because Microsoft might, on a pro forma basis, have
1.5% better revenue than reduced expectations.
The key words there are
“reduced” and “expectations.” No one is comparing those results to
the quarter before’s, much less the year earlier’s.
It’s the old battle
that classically trained accountants have been fighting for a while.
Nobody—very few people look at the true numbers. They look at the pro
formas X’ing out anything that’s important or unpleasant. That will
change. People will take harder looks. But usually that stuff comes out at
the bottom. MSFT is still a market darling. For me to suggest that people
short the stock—well, it goes against mom and apple pie.
And one of the
best-performing techs this year.
Absolutely. When it got
down to the extreme low in December, it put in a classic technical
pattern—the coming turnaround was evident. But I still didn’t see a
lot of accumulation prior to the ending action on the downside, so it was
against my discipline to recommend it at that point. Microsoft now looks
like it has put in another little top, so we’ll see. All I know is that
it will have to get above 75 for me to be worried about shorting it. At
72, it’s a good sale. [After MSFT’s numbers disappointed and the stock
broke 70 like it wasn’t there in afterhours trading last night, Tom
added: “I think it will bounce off the 150 and 200-day around 62-63 at
first; then rally back to the 68-69 ice;
then get down to the low 50s. Then we'll see.”]
Where are you finding
good buys?
Well, I regularly
publish a top 40 or top 50 list of names that show good accumulation and
good fundamentals.
The performance of that
list has been remarkable.
It has, especially
because we don’t write off losers when calculating the returns—I just
mark it to market each week as if none were sold or stopped out. We tend
to, especially in markets like ’99 and 2000, constantly harvest gains.
This year so far, the longs-only list is up about 10% on a marked to
market basis. (Actually, including the stopped-out gains or losses, would
probably add another 4 percentage points to that total. And the gains on
my shorts-only list, as you might expect in this market, have been
spectacular.) I’m trying to set a very high bar for myself with the
longs-only list. What I’m
trying to say is that you should be able to buy these stocks and go away
for a week; not have to constantly trade them. Even on that basis, it’s
outperforming S&P handily.
What’s topping that
list?
In the last week or two,
auto-related stocks have been doing quite well [See table]. General Motors
and AutoNation are ones we’ve held for a long time. Delphi Automotive
has just been breaking out. Those
stocks look okay. The list is quite varied now, in contrast to times past,
when broad themes like technology, or telecom dominated—or biotech—But
now it’s a bunch of names that are not considered market leaders.
That’s another indication that the market is not ready to go anywhere
important on the upside until more work is done. Another is that over the
last couple of weeks, a lot of stocks have had new breakdowns.
Name a prominent one.
IBM. I recently said to short it on June 21 around 114. It was in a
trading range bounded by support at 110 at the time and then broke down
from there on July 6. That’s what Wyckoff would call “a fall through the
ice.” Now it’s just rallying back up to there. The classic move is to
rally to just short of that breakdown point. Wyckoff would call “a fall
through the ice.” You can see the same thing on the Nortel chart. It goes
down, comes back up to just below the point where it broke down—just below
the point where a lot of people would be able to get even—then short
sellers come in and force those people to sell at lower prices.
IBM is just a great example of what is happening in the market—it can’t go
anywhere important without going down and testing the low from
Tuesday/Wednesday first. It’s quite likely that it goes all the way down
to 100. So now you’ll have a failing pattern in a market-leading stock.
But IBM’s business model has changed. People are paying a massive premium
for a company that is really a body shop now, as Fred Hickey has pointed
out. Service companies just aren’t that profitable. They’re certainly not
worth a growth multiple.
Thanks, Tom.
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