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It's time to put up or shut up
After years of observing and writing about the markets, I'll be putting my best ideas to a real-world test when I leave Microsoft and launch a new hedge fund.
By Jon D. Markman
On my first day as a reporter, fresh out of graduate school and on a one-day trial, an editor at the Los Angeles Herald Examiner ripped a story off the Associated Press wire machine and barked: Here kid, see what you can find out.
A pack of insurgents on a South Seas island had mounted a violent rebellion against the local government, and the AP said they were backed by a shadowy U.S. libertarian organization called the Phoenix Foundation. I sat at a typewriter abandoned by a guy the paper had just fired and worked the phones, ultimately discovering that a University of Southern California professor had written the rebels constitution. Bingo! I drove to the USC campus a couple of miles away, interviewed the tweedy prof in person, then returned to bang out my first piece on deadline.
This was May 1980, and California was gripped by an anti-tax fever highlighted by its notorious Proposition 13. So, on a slow news day my article turned out to be a hot item. The newspaper bannered it the next day with the headline, Tax Revolt in South Seas!, and my career was launched.
In the 22 years that followed, I never had a banner headline again, though I worked on dozens of more high-profile stories. And now, it seems that I never will. For my formal career as a journalist will end Nov. 15, when I leave the full-time employ of Microsoft to enter the hedge-fund management business with quantitative, market-neutral investment strategies that Ive developed and explained in columns here and at the Los Angeles Times over the past decade.
A new role, new insights
I will continue to write a column at MSN Money for at least two years, but my main focus will change from simply speculating on ways that investors can take advantage of anomalous market behavior, to actually leveraging them myself for the benefit of partners. This inevitably changes my relationship with readers, as I will no longer seem as objective or unconflicted as in the past. Yet, with any luck, my new role will yield new insights to relate. So perhaps it will be a fair trade.
The new fund will systematically buy and short stocks in an effort to exploit themes familiar to my longtime readers, including stock-price seasonality, valuation, inside-ownership trends, price and volume momentum trends, sector trends and earnings quality.
This path will take me a long way from my old haunts at the Los Angeles Times in the mid-1990s, where, when I wasnt writing a column on stocks, I spent much of my last few years either underground or in the transportation bureaucracy reporting on the dangerous financial and working conditions of the citys bedeviled subway project. Many times, it was hard to tell which were dirtier -- the tunnels or the politicians offices. My new path also will take me away from the ideal mission of journalism, which is to afflict the comfortable, comfort the afflicted and serve the public by seeking and revealing hidden truths about public figures, companies and governments.
The decision to take this path was hard because I have always believed strongly in those ideals of journalism as a public service, and still do. But for the next phase of my life, I am going to test another, unwritten ideal: the one that says a financial columnist ought to be able to put his money where his mouth is. Its put up or shut up time for this reporter. I will avoid writing about stocks that I own in the fund, and will, of course, make full disclosure if a conflict is unavoidable. If you would like to comment, send mail in the next two weeks to jmarkman@microsoft.com; Ill have a new address in December.
Indicators of a recovery
Long/short funds generally tend to lag the market a bit during powerful bull moves since the shorts are inevitably a drag on performance. So, if the market goes straight up from here, the performance of the new fund is unlikely to beat a well-managed, all-long growth-stock fund.
I dont think the market is headed straight up, though Im not the raging bear of summer as it appears that the economy is rounding into a very modest recovery. Lets take a look at some key indicators.
Economist Lakshman Acuthan, whom I met for lunch at the University Club of New York last week, says his work shows that the economy, like Rodney Dangerfield, gets no respect even though it is on track to grow at an annual rate of 3%. That was considered a fine rate of growth until the hyperactive 8%-growth period of the late 1990s. Acuthan, who runs the Economic Cycle Research Institute, says that despite anecdotal evidence of widespread layoffs, the recovery in jobs in this cycle has outpaced the 1991-1992 jobless recovery, which culminated in the longest expansion in U.S. history.
His organizations Coincident Employment Index, which moves in step with employment cycles to summarize seasonally adjusted household and corporate surveys, bottomed in January 2002, bounced off that low twice more in the following months, but has risen sharply since August and is now at its best level of the past year. Data from the federal government show that while there are occasional months now in which initial unemployment claims have risen, the big trend is toward moderate job growth. Unless companies abruptly stop hiring over the next few months, its hard to envision how consumers will stop borrowing and spending -- those adorable habits that have kept the U.S. economy going while business investment has faltered.
Possible profit growth
New data points even suggest possible improvement in profit growth. Analyst estimates for earnings per share growth among S&P 500 companies fell steadily from January through the start of this month, but in the past two weeks they have ticked up, according to a First Call analysis, to 17.3% for the fourth quarter. That may seem high, but its a comparison with a dismal fourth quarter last year. Combined with a surprising rise in estimates for revenue growth as well, large companies could well end up shocking the Street with upside come the January reporting season. Analysts at International Strategy and Investment Group point out that the recent Business Week Nov. 4 cover story titled The painful truth about profits would, in that case, prove to be the contrarian cover-story indicator for which many jaundiced observers have waited.
ISI Group, for its part, expects gross domestic product to advance at a 4% annualized pace in the fourth quarter, and at 3% for the first three quarters of 2003 -- decent numbers that owe their strength to a record drop in industrialized nations short interest rates, rapid money-supply growth and a rebuilding of inventories. In the fourth quarter of 2002, ISI expects growth will additionally be aided by the dollars spun out of home refinancings and continued 0% auto loans.
One reason for the optimism in rebuilding inventories: U.S. real durable goods inventories fell to $188.8 billion in September, a level down sharply over the past 20 months to the same level first reached in 1979. In contrast, U.S. real durable goods sales are in a well-defined uptrend, hitting $124.5 billion in September. ISI contends that the divergence in inventories and sales is unsustainable, leaving lots of room for inventory rebuilding. As for the money supply, total bank loans increased to a new high and are now running at a 13% annual rate -- a bullish development absent from the spring of 2001 to the spring of 2002. And new home sales are also at record levels, with totals revised upward in August and September.
Moreover, ISI points out a bullish combination in commodity prices: The cost of oil is dropping while the cost of copper is rising. Falling oil prices are tantamount to a tax cut for consumers in our energy-hogging society, and rising copper prices indicate increased demand by business. ISI regression analysis shows that during the past 32 years, there have been 15 quarters in which oil prices declined while copper prices rose. The average growth in the real GDP in those quarters was 4.3%, with a range of 0.9% to 10.6%.
Considered together, the economy does not appear robust -- Acuthan calls the current period a sub-subpar recovery -- but neither does it appear that the wheels are about to fall off.
Once the current short-squeeze rally wears off, this scenario leaves investors in the sort of stock-pickers market they have faced since 2000. That means they face the task of buying stocks that are likely to grow their businesses or market share internally, without reliance on a generally rising tide, and to short stocks with modest capacity to grow without divine intervention. For the former, defense contractors like General Dynamics (GD, news, msgs) still seem like decent bets on the long side after a recent correction. And for the latter, biotech stocks like Millennium Pharmaceuticals (MLNM, news, msgs) seem like a good bet on the short side. Millennium has shown a stunning decline in free cash flow over the past few quarters, as it has been stuck with declining sales and excess inventory from Integrilin, its cardiovascular drug. The company also has an extremely high level of goodwill on its books stemming from an expensive merger in February with COR Therapeutics, which is likely to be written off in the near future. Millennium is one of the few stocks that have not participated at all in the October rally, falling from $9.06 on Oct. 10 to $7.45 on Oct. 28. A decline over the next few months to the $5 area should not come as a surprise.
Fine Print
The man widely credited with inventing the hedge-fund concept in 1949 was a Fortune magazine reoporter with no previous portfolio management experience: Alfred Winslow Jones. He is said to have managed his leveraged, long-short fund well but obscurely until 1963, when another Fortune reporter Carol Loomis -- turned a spotlight on his success. ... The most heavily hated, high-beta stocks among the S&P 500s Terrible $2s (click here for column) have continued to move up solidly in the recent short-covering rally. The 14-stock list that I proposed is up an average of 22% since Oct. 16, led by a 44% surge in Lucent Technologies (LU, news, msgs) and a 41% surge in AT&T Wireless (AWE, news, msgs). ... Last week, I said that of all the high-momentum sectors of 2002, gold was the least likely to push on with strength. The gold bugs are making me eat those words, as highlighted stocks Royal Gold (RGLD, news, msgs) and Gold Fields (GFI, news, msgs) have booked solid gains since. ... Speaking of mistakes, every one of the short sells that I listed from technical analyst Phil Erlangers newsletter on Oct. 7 has gone up instead of down. Bad timing for a list of shorts.
While Jon D. Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jmarkman@microsoft.com.
At the time of publication, Markman neither owned nor controlled shares in any stocks mentioned in this column.
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