Jubak's Journal
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Has your stock become a lottery ticket?
Frantic money managers are piling into some stocks now in hopes they can score big and boost their numbers by the quarter's end. See if it's time to bail.
By Jim Jubak
Why is everyone buying stocks now?
"Everyone meaning every professional money manager who has missed part of this rally.
During the first half hour of trading Friday on the Nasdaq ($COMPX), buying overwhelmed selling by about 30 to 1. Technical analysts commonly call any market "extreme" where advancing volume outnumbers declining volume by 10 to 1, so on Friday morning this market was genuinely off the charts.
Some of that was euphoria reflected the good news on the unemployment numbers. You see, Wall Street had been expecting unemployment to rise by 30,000 or so in the week, so the actual increase of just 17,000 was cause for celebration and justification for buying stocks.
But theres clearly more behind the markets behavior than a dose of good news. After all, stocks have moved up recently even on days like Thursday, June 5, when the news was stunningly bad. That day's report said that manufacturing orders for April fell by 2.9%. That was far above the consensus projection of a 1.9% decline . . . and a big reversal from the 2.2% increase in orders during March.
Still, the Dow Jones Industrial Average ($INDU) climbed a little more than 2 points to record another close above the symbolic 9,000 level on that day, and the Nasdaq Composite tacked on 11 points, or about 0.7%, as that index continued to lead the equity market.
So whats going on?
The lottery ticket stage
The stock market has entered one of those lottery ticket periods that come at the closing stages of all big rallies. Calculations of risk and reward that might have restrained stock prices become irrelevant in such a market. And stock prices are driven higher by investors who buy because they fear that theyll miss out on the big prize.
Like anyone who buys a lottery ticket, these investors know the odds are stacked against them but they buy anyway because the cost of not playing is just more than they can bear.
This kind of investor psychology makes the stock market extremely vulnerable to huge blow-off moves on the upside during lottery periods. And the sudden end to this psychology can leave investors just as vulnerable to big losses on the downside when the market decides to correct or consolidate.
Let me explain why I think were in the lottery ticket stage of this market and tell you what I think you ought to do about it.
The need to play a lottery ticket has grabbed those investment professionals who have been slow to jump on board this rally and now fear being left behind so badly that clients will notice at the end of the quarter. Let me use some examples from the mutual fund universe to show you how this works.
It has been a solid three months for many mutual fund managers. For example, of the 1,222 large company growth funds in our database, 590 have matched or bettered the 19.17% gain on the Standard & Poors 500 Stock Index over the last three months.
Of course, that leaves better than 600 funds trailing the index, and some of them trailing quite badly. The Berger Growth Fund (BEONX), for example, with $417 million of assets, has gained just under 7% for the last three months.
Even some funds that should have been in the sweet spot of this rally have trailed badly. The Van Wagoner Technology Fund (VWTKX), for instance, has managed to record just a 7.9% gain through May 31, even though technology stocks have led a good part of this rally.
Three weeks and counting
Those numbers from the mutual fund universe give you some idea of the problem facing many institutional money managers right now. Imagine that youre the lead manager of the growth stock position of a university endowment, or of a company pension fund, or of a state pension. Youre looking at the distinctly unpleasant task of having to explain to your clients why, after losing money for quarter after quarter during the bear market, the portfolio that you run has also trailed the indexes during this sustained rally. Your job could be at stake if the client is unhappy enough to fire your firm as one of its money managers.
Youve got just about three weeks -- until the books close for the quarter on June 30 -- to fix the problem or at least to make it as manageable as possible.
What do you do?
You sure dont buy Alcoa Inc. (AA, news, msgs), even though the aluminum companys shares should benefit from any second-half economic recovery. You sure dont buy Microsoft (MSFT, news, msgs) because the stock is among the cheapest of the technology stock after sitting out just about the entire rally. (Microsoft is publisher of MSN Money). You dont buy a defensive food stock like Sysco (SYY, news, msgs) because it will give your portfolio good downside protection if the second-half recovery fizzles.
A place to pin your hopes
No, instead you buy a lottery ticket. You look at what stocks have been going up the most in recent days, and you pile into them in the hope that theyll just keep going up for a few more weeks.
So a Genentech (DNA, news, msgs), which climbed 50% from May 15 to May 30, goes up another 15% last week. An ImClone Systems (IMCLE, news, msgs), up 16% in the same two weeks, explodes for another 64% in the last week.
Or a Talk America Holdings (TALK, news, msgs) moves up 12% in two weeks and then soars another 36% last week. Or a SCO Group (SCOX, news, msgs) runs up 32% and then gallops for another 51% in the last week.
Notice what these stocks have in common? Its not their industry: Genentech and ImClone are biotechs, SCO Group makes UNIX software, and Talk America sells long-distance phone service. What they share is their membership in extraordinarily volatile sectors and a history of making big moves once the momentum buyers catch hold of the stock. SCO Group, for example, has a beta above 5, meaning that its price is about five times as volatile as the market as a whole
And you could certainly see the momentum buyers at work in these names last week. Volumes popped on all these stocks. Talk America, which normally trades an average of 290,000 shares a day, traded 1.2 million on June 6. Genentech, which isnt a small capitalization company by any means, traded 9.2 million shares for the day, more than twice the usual average of 4.8 million. And ImClone hit volume of 19 million shares, way, way above its average of 2.8 million.
Money managers who buy a lottery ticket arent looking for stocks with modest valuations that are likely to creep up in the months ahead. Genetech already trades with a market capitalization of $37 billion and a multiple of 65 times projected 2003 earnings per share. Talk America is projected to show earnings declines from last years levels of 24% and 44% in the next two quarters and of 34% for all of 2003.
The search for the big score
But fundamentals arent what a professional money manager whos trailing the pack needs right now. Lottery tickets are a chance for a big score that even the score with other money managers.
And lottery ticket stocks have another advantage for professional money managers. Even if they dont go up enough in the next three weeks to get the portfolio caught up with the index, their presence in the end of the quarter portfolio at least gives the money manager a line of defense. I can almost hear them explaining: See, I own shares of the right stocks now -- the big performers that youve heard of -- even if my results lagged in the quarter just completed because I caught them a little late. The portfolio is headed in the right direction. This end-of-the-quarter window dressing probably strikes many of you as so cynical that it cant possibly work. But it does often enough to save more than a few jobs.
And when a money manager is in a deep performance hole, what other option is there anyway?
Its hard to resist playing a lottery when somebody has just scored a big payout. Thats why lotteries are so seductive and such a successful way for states to raise money. Its easy to forget that the odds of winning are 3 million to 1 when somebody has just grabbed a check for $80 million.
So at this point in a market rally it becomes increasingly difficult not to get sucked into the stock lottery. You know that investors have gained 95% in Genentech over the last month, 61% in Icos, 69% in Conexant Systems (CNXT, news, msgs) and 64% in Avaya (AV, news, msgs). Why not buy a ticket for the future ride? The last thing anyone really wants to do at this stage in a stock rally is struggle with hard-to-calculate valuation estimates in search of some approximation of a selling target. Sell? Who wants to sell right now?
And youre even less likely to sell if youve tried to apply your selling discipline once during this rally and been badly burned as the stock you sold just kept going up and up. Sure, Genentech looked like a sell at $60, but the shares traded for $72 on June 6.
When valuations become plain silly
But its important to remember that the lottery stage of a rally is when valuations get out of hand and go from merely extended to the silly. Its exactly at this point in a rally that investors need to exercise whatever selling discipline they can muster.
By that I dont mean indiscriminately selling everything. Im not talking about a crash from here or a retracing to March 11 lows or worse. But it is time to think about the inevitable pullback and consolidation that all markets go through in rallies. The longer this market goes without one, the larger that pullback is likely to be, but at this stage the most likely scenario is a 10% drop in the major averages so that stocks can build a new base. For many stocks that havent run away from reasonable valuations and that have good growth stories for the second half, the damage might well be even less. If you have positions that you believe in for the long term, its probably better for most investors with modest trading skills to just leave well enough alone.
But if you own shares of stocks that have become lottery tickets in recent weeks, taking profits now seems advisable. Many of these stocks have put a tremendous amount of air between their current price and any valuation that even an optimistic read on their prospects for the next six to 12 months might support. These stocks could well correct by more than 10% in a pullback. Especially in danger are shares that are largely held by momentum investors whose own selling discipline tells them to cut and run as soon as the upward momentum in any stock starts to stall.
You certainly dont want to be left holding a lottery ticket on one of these equities when the momentum reverses. And Id pay special attention to any stock that starts to falter as end-of-the-quarter buying for portfolio window dressing dries up as June draws to a close.
In my story for CNBCs "Business Center" on Wednesday night, Ill be taking a look at how hopes for a fourth-quarter earnings surprise are now driving this rally. Youll be able to find a transcript of that TV story on this site on Thursday.
New developments from past columns
Have you mortgaged your future?
Apparently the Federal Reserve was serious when it promised that it would print as much money as it had to in order to fight inflation. For the week ended on June 4, the Federal Reserve continued to buy in the open market -- paying with dollar bills that it had created -- and increased its assets by about 9% on an annualized basis. For the last six months, the growth rate is near 15%. By the way, the Federal Funds futures contracts were priced last Friday for a 100% chance that the central bank would cut interest rates by 25 basis points (another one-quarter of a percentage point) when it meets on June 24-25.
A 10% gain in stocks from here? Sure, but
Motorola (MOT, news, msgs) kicked off the traditional earnings warnings season June 9 when it told investors to expect second-quarter revenue of $6 billion to $6.2 billion instead of the $6.44 billion that Wall Street now projects. Earnings should come in at breakeven instead of the 4 cents a share profit now projected. The company said that the slowdown was concentrated in Asia and blamed SARS for slowing sales in the region. Overall sales were running about 20% below projections in Asia as a whole and 30% below projections in China. Motorola said the problem was industry-wide and not specific to the company or its products. Not exactly cheery words for technology investors.
Changes to Jubaks Picks
Sell Icos
Im going to take my own advice and sell Icos (ICOS, news, msgs) out of Jubaks Picks. The stock is up 125% in the last three months and, as much as I like the prospects for Cialis, the companys challenger to Viagra, at current valuations I think investors are starting to rely on the success of other drugs in the Icos pipeline before that success can be approximated. Id certainly buy back the shares if they corrected to a level that took some risk out of the shares. Its been quite a ride with Icos since I added the shares to Jubaks Picks on May 10, 2000 at $34.813. The stock traded as high as $65 in the summer of 2001 and was as low as $15.90 as recently as March 12, 2003. My final gain is 16%. (Full disclosure: I will be selling my shares of Icos three days after this column is posted.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Alcoa, Icos, Microsoft and Sysco. He does not own short positions in any stock mentioned in this column.
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