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The Speculator
Recent articles:
• Still bullish after the Crash of '02, 8/1/2002
• Dont bet the rent on technical analysis, 7/25/2002
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| | The Speculator
8 lessons from the summer slide
Stocks started August with a skid, a rare event that sets the stage for what's always a difficult time for us. Here are a few things we've noticed that might help you limit the damage.
By Victor Niederhoffer and Laurel Kenner
The sea captain Jack Aubrey, hero of the wonderful Patrick OBrian series of books well talk more about below, was in the habit of taking careful notes throughout his voyages. Every important detail was recorded -- depth soundings, the number of guns and men on a vanquished enemy ship, the date a barrel of provisions was opened. Weve found note-taking to be invaluable in markets and in life to help ourselves and others learn from and build on observations. We hope readers will profit from these notes and augment them.
The placid surface
To a man surveying the markets action serenely from Mars, the weekly moves in the S&P 500 ($INX) and the other indexes must seem remarkably tame. S&P futures closed at 844 on Friday, July 19; 853.70 on Friday, July 26; and at 865 last Friday, Aug. 2. From Friday close to Friday close, the market moved just 9.7 points in the first week and 12.30 points in the second. But the intra-week ranges were several times greater -- an 83-point rise from a low of 773 to a high of 856 the week before last, and a 59-point slide from a peak of 911.50 to a low of 852.50 last week. Thus, the mistress of markets is able to shake the tree, making weak hands capitulate at the wrong moments. A great reason for not trading over your head.
Has the cycle changed?
The stock market has been down on the first day of the month for the last three months. For the five years before that, it had been up on the first day of the month three-quarters of the time. In fact, when we studied the pattern for our personal speculations last March, we found you could have captured the entire point rise in the S&P 500 and Dow ($INDU) over the previous five years just by buying at the close of the last day of each month and selling at the close of the first day.
August, however, began with a 3% loss that widened to 8.5% over the next two days. It is always guaranteed to happen that whenever a relationship looks good, the cycles will change to the opposite the next time. Maybe the big institutions that used to put 401(k) money to work on the first day of the month have finally gotten wise.
The Ides of August
August is always the hardest month for us. Volume is down because many who own stocks are at the beach. The big hedge-fund boys spend the whole month at their estates in the Hamptons. The market makers are in Rome. When so few hands are at work, the food chain changes. Big moves occur. Little guys who go against the flow, like us, can get killed. In 1996, Trader Bob took the dollar up. In 1997, the markets took the Asians down. In 1998, Long-Term Capital nearly drowned as the sharks answered the bloodied funds calls for help, took a look at its books and then bit off whole limbs. In 1999, it was up and away in the Nasdaq. In 2000, we saw one of the most beautiful rallies of all time. This year, Brazil and Argentina are ready to go under. Japan is trading at 15-year lows. Germany is already down 20% for the year. One more key earnings report disappoints and the whole thing could topple like dominoes in a row. We wrote this paragraph in 2001 in an e-mail to some other traders. That year, the market obliged with a terrible August slide; the Dow and the Nasdaq ($COMPX) both fell 11%.
Things look the same or worse as we begin August 2002. An anti-business attitude has seized up the U.S. market. Bulls are being tortured on the rack. The Dow is about 100 points away from where it closed at the end of last September, after suffering a 2,900-point slide between March 19 and July 23. Germany is down 30% year to date. Japan is trading at the levels of 19 years ago. Argentina basically did go under, and Brazil is on the brink. As the supreme affront, the worst indignity, the ultimate illustration of all thats wrong with the market (here Laurel turns around three times to make sure Vic is out of earshot), Thailand is up 24% for the year.
An inopportune time for biotech
Amid the carnage, a reader writes to compliment us on our insights and politely ask if we ever sold out of the biotech positions we put on at the beginning of the year. (See "Real bargains at Nasdaqs after-Christmas sale" and "Sinking real estate means rising stocks.")
No, we never did, and were still long. (We sold a few stocks, as we said we would do, when insiders stopped buying and started selling. Those stocks were Varian (VARI, news, msgs) and Medicines Co. (MDCO, news, msgs), sold as a hedge, for 125% of the value of the investment.
Earnings surprise
Given all the pessimism about earnings, we were stumped when we looked up the actual numbers and found that 255 of the 433 S&P 500 companies to have reported second-quarter results through Aug. 5 had earnings gains. Average earnings per share are up 12.4% over the second quarter of 2001.
Of course, one wonders these days just how much of the earnings reported to the public are real. Weve been perusing tax data to see if the IRS has been getting a different story and will report in coming columns if we turn up anything of interest. Our curiosity was heightened by an acquaintance who noted that Indian companies in the mid-1990s used fake asset building, fake expensing and fake leasing to avoid paying taxes." When our friend's firm did a survey of institutional investors in 1996, he said it found fund managers were first looking for companies that paid decent taxes so "they were sure that the profits were genuine.
Recent figures from Enron (ENRNQ, news, msgs) and WorldCom (WCOEQ, news, msgs) lend support to the idea that paying taxes on a very small share of reported earnings may be followed by signals of distress. Both Enron and WorldCom both recently declared bankruptcy, much to our cost and that of others.
| 2 tales of trouble | | Earnings vs. Taxes | | | WorldCom | | | 2001 net earnings | $1.5 billion | | 2001 taxes paid | $148 million | | Enron | | | 2000 net earnings | $1 billion | | 2000 taxes paid | $60 million |
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It must have hurt so much for those companies to fork that money out, considering what we now know about the real condition of their businesses. But sometimes those pesky states and localities cannot be held at bay. And then, the window-dressing of paying a little tax rather than none can help keep away those overly inquisitive analysts and communitarian gadflies.(We should note that Enron filed for bankruptcy before 2001 ended and still hasn't filed an annual report.)
Corporate marriages and No Lizards Land
IBMs recent decision to acquire the consulting arm of Pricewaterhouse Coopers for $3.5 billion reminded us of so many other mergers that looked good on paper but failed to deliver the synergistic benefits promised. AOL Time-Warner (AOL, news, msgs), Compaq/DEC, now merged into Hewlett-Packard (HPQ, news, msgs), Disney (DIS, news, msgs) with Capital Cities ABC, Citicorp/Travelers (C, news, msgs), and J.P. Morgan Chase (JPM, news, msgs) all come to mind. Jack Tierney, a fine natural philosopher we are pleased to claim as a friend, looks to nature to explain why unions that appear so "natural" and bound to succeed wind up failing. Here is only one of the fascinating cases he cited.
"In the Rockies exist two species of lizards, one that lives above the tree line, the other below. Geneticists have determined they were one species at some time in the past. They are now separated by several hundred feet. Occasionally, one or both species will attempt to colonize this "no lizard's land." Whichever species provides the greatest number wins. However, within a short time the winners find it unlivable and return to their regular habitat. Since they cannot interbreed, there is no hope of creating a hybrid that could endure in either environment.
"The differentiating factor seems so minute as to be easily overcome. Yet it can't be accomplished. Corporations, too, have their own ecosystems with their own delicate balances. Perhaps corporations, before merging, would be better off spending less time on studying customers, clients and vendors and more on looking at their different cultures to determine if they're genetically compatible."
Summer reading
We are often asked to recommend a good book for speculators to read. We like the ones that teach about life, leave us feeling better and make us say, wow. Some of our favorites are "Monte Walsh" by Jack Schaeffer, "Atlas Shrugged" by Ayn Rand and "Don Quixote" by Miguel de Cervantes. We are also partial to books about the sea, including Herman Melvilles "Moby Dick" and Homers "Odyssey", as the lots of the fisherman and sailor seem so similar to our own -- terrible storms, disappointments, wanderings, soundings, long waits, shipwrecks, struggles for survival -- and, sometimes, the great catch.
This summer, we have a new favorite, the Jack Aubrey-Steven Maturin series of 20 novels written by the late Patrick OBrian. Based on the life of the daring 19th century British seaman Thomas Cochrane (as was C.S. Foresters Horatio Hornblower series), the OBrian books have justly been called the best historical fiction of all time. The friendship of the two heroes is comparable to the great collaborations of Sherlock Holmes and Dr. Watson, as well as Don Quixote and Sancho Panza.
Of particular interest to speculators are the numerous changes in strategy that Aubrey uses to win battles. He is a master of deception. In the climax of the first book in the series, "Master and Commander," Aubreys ship Sophie vanquishes a Spanish ship that has twice as many guns and six times as many men with some classic subterfuge. Before his men board the enemy ship from two sides for hand-to-hand fighting, Aubrey paints them in terrifying makeup. In the midst of the fighting, he pretends he has 50 more men on the way, calling otros cincuenta! and then calmly orders his bosun to lower the Spanish flag so that the enemy is fooled into surrendering.
Shifts in cycles, we never tire of pointing out, are endemic to the market. The S&P 500 was up Friday, Monday, Tuesday and Wednesday, then down Thursday, Friday and Monday. Up 9% in four days, down 9% in three days. And then (guaranteed to happen) a rally of near 3% on Tuesday. Always the change in strategy is relevant. Aubrey is the leading master of the same, and in each of his battles he shows it in spades.
Unlike most authors in the adventure genre, OBrian writes much about financial and investment matters. In "Master and Commander" and a later book, "The Reverse of the Medal", key sections of the plot revolve around insider trading. Aubrey is a masterful captain, but a fish out of water when it comes to investments on land.
Uplift in the mailbox
Weve been getting what wed like to consider a lifetimes worth of you guys win the broken clock award letters lately. So it was a relief to open the following e-mail and find a word of encouragement:
Being around technology 24/7 and managing instructors, it is truly refreshing to see a solid positive emotional posture being put forward, because -- as you all know too, too well -- the technology sector has taken a horrible beating. . .
I must tell you, I am thoroughly impressed with your recent positive stance on our economy, which truly is, and I think will be, an uplifting blast of energy and positive emotion for the Dow. Damn, I hope others have read this as well. . .
Thank you both for being strong optimists and faithful stewards for our potential recovery, which incidentally, holds true to the fact that this economic system is without question the most remarkable ever envisioned on earth.
Mike Harvey
IT Program Chair
ITT Technical Institute
Indianapolis, Indiana At the time of publication, Victor Niederhoffer and Laurel Kenner owned shares of WorldCom, and Niederhoffer owned shares of IBM.
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