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Add to MSN Stock List Message Board Jubak's Journal Recent articles: • Beware: It's Wall Street's marketing season, 9/11/2003 • A jobless recovery can't go on for long, 9/9/2003 • 3 stocks to navigate a tricky quarter, 9/5/2003 More... | Jubak's Journal How to outsmart an edgy market Are we in a horrible tech-stock bubble, a fantastic bull market or something more nuanced? Beats me. But here's a wise way to play all sides. By Jim Jubak Anxiety time: Its a bubble in technology stocks thats about to burst. The smart thing to do is get out or stay out. Its the beginning of a new bull market that could last for years. The smart thing to do is get in now for the long haul. Its a momentum rally that will run strong through the beginning of 2004. The smart thing to do is get in now for the quick profits and jump out before the trend turns. You can hear all those opinions and more on Wall Street today. So how do you cut through the anxiety and come up with a strategy that will send some juicy profits your way if the market keeps rallying, yet protect your portfolio from outsized losses if the market stumbles?
Psychology, baby. And if you think its odd to base an investment strategy on psychology, remember that the discipline of behavioral finance demonstrates convincingly that most losing investment decisions are rooted in individual psychology. Origins of anxiety Lets start with the cause of investor anxiety, the extraordinary rally in the technology sector over the last six months -- a sector that now smacks of overvaluation. As of Sept. 8, the technology-dominated Nasdaq Composite ($COMPX) was up 41% for the year, and an even headier 48% from the bottom for the year on March 11. Technology sectors have been even hotter: The Philadelphia Semiconductor Sector Index ($SOX.X) is up 69% since March 11. And some individual technology stocks have been even hotter. Telecommunications gear maker Avaya The problem is that this huge rally has priced in any likely (and some pretty unlikely) future improvements in performance. Take the recent news from RF Micro Devices Things were so good, in fact, that the company now looked likely to break even for the quarter, instead of posting a 4-cent to 5-cent loss. Wall Street earnings estimates for the fiscal year ending March 2005 climbed to 10 cents. All this good news boosted the stock by 15% that day. Great. Except that the stock finished Sept. 8 trading at 104 times projected fiscal 2005 earnings per share. Id certainly have a hard time recommending that anyone buy these shares now, and in fact, I began selling my position on the news on Sept. 8. Valuations out of whack The news out of RF Micro Devices isnt unique, and neither was my reaction. Texas Instruments The 3% decline in the technology sector on those two days is just a down payment compared to the normal pullback of 33% to 50% of the advance thats historically normal after a six-month advance. That would represent a 204 to 309 point decline on the Nasdaq. The worst may be yet to come. Or maybe not. If we take a look at the psychology of professional money managers, we find evidence that any decline could be limited to around 10%. The first three to four months of the rally that began in March was a godsend to money managers. It produced the first positive period that many of these professionals, especially those concentrating on growth stocks, had seen since 2000. And it was strong enough to propel many portfolios to double-digit returns for the year. In fact, it was so good that many managers turned conservative in an effort to keep those double-digit results intact through year end. New fear But recently these money managers have felt a new fear. As the technology sector roared ahead, more conservative, less risky portfolios were increasingly left behind. At the close on Sept. 9, the Nasdaq Composite Index was up 40%, the average U.S. small-company growth mutual fund 33% and the average large-company growth mutual fund 20%. The pressure to close that gap diminishes the chances that any decline right now will turn truly ugly. Too many professionals are waiting for a 10% correction in order to buy in the hope of closing the performance gap. A 10% drop is enough of an excuse to get these investors over the valuation hurdle. In reality it does almost nothing to fix the technology sectors overvaluation problem, but it is enough to enable investors to buy without feeling like theyre purchasing at a top. A lot of individual investors undoubtedly feel the same way. Theyve been waiting for a buying opportunity. But individual investors should avoid the trap of thinking like the professionals. If they can work through the well-documented psychological tendencies to chase winners, they can develop a strategy that balances the risks and rewards in the current market. Looking backward, its easy for investors who didnt buy technology stocks hand over fist last spring to beat themselves up over that stupid mistake. But put that decision into proper perspective. What looks so pre-ordained in hindsight was anything but that in March or May or July. It was reasonable back then not to put everything into volatile technology stocks and to hedge bets with dividend paying shares or blue-chip growth stocks or cash. Id argue, in fact, that such a strategy was wise. Huge moves by a concentrated sector of the stock market will always produce outsized returns for the group of investors who were lucky or skilled enough to get the call right. Theres no way that a portfolio diversified to balance risk and reward can ever match the returns generated by the best-performing, short-term strategy. Thats the cost the balanced investor pays to reduce risk. Last spring's strategy Lets look at how I built a balanced strategy last March. At that point, Id built a portfolio that combined two different visions of the stock markets future. One group of stocks that I owned in Jubaks Picks were what Id call safe growers that could be counted on even if the economic recovery was more anemic than expected. The other group Id call cyclically sensitive growers, stocks that would show rapid earnings increases if growth accelerated. In March (and Ill be the first to admit that adding the first of these positions on March 11, the low of this market cycle, was mostly luck), I began to add stocks representing a third strategy. These were stocks that would move up strongly if it began to look like economic growth would be above expectations. The result was a balanced portfolio designed to appreciate if growth was sluggish, if growth was on consensus, and if growth expectations started to soar. Now fast forward to today, and look at what has changed my thinking on these groups. First, near term-growth expectations have climbed even higher than they were in the spring. The survey of economists conducted by Blue Chip Economics shows that projections for third-quarter growth in gross domestic product have climbed to an annualized rate of 4.5% from 3.7% a month ago. And theres a good chance that projections will be above 5% before the initial data is reported at the end of October. If the initial report is near that level, expectations for fourth-quarter growth will edge toward 6%. Second, valuations have climbed to levels where the reward doesnt match the risk. It is one thing to buy Texas Instruments at $16.37 on March 11 at a price-to-earnings ratio of 25 times projected 2004 earnings per share. It's quite a different matter to buy shares on Sept. 8 at $26.03 -- 40 times projected 2004 earnings per share. Third, valuations for some out-of-favor growth stocks have declined as money has flowed to the technology winners. For example, in July, when the rally looked like it might be ready for a pause, ol steady grower Pfizer So armed with my understanding of my own psychological bias toward investing in past winners and toward turning past returns into future expectations, I again do my best to construct a balanced equity portfolio. Three groups for the here and now First, I consider the attractive valuations among the steady blue-chip growers. Against that I balance the likelihood that these will continue to underperform the rest of the stock market as long as expectations are for 4.5% growth accelerating toward and past 5%. Looking further out, beyond, say, the next six months, Ill want to own some of these stocks because they will do well if growth falters in 2004, a very plausible scenario. So Ill be looking to add to this portion of my portfolio, but not in any hurry. (Id also put PepsiCo Second, with an economic recovery looking increasingly robust over the next two quarters, Ill overweight the shares of companies that will see revenues rebound with the economy. Among current holdings, Id say stocks like R.R. Donnelley & Sons Third, with cash flow and investor psychology likely to continue to lend strong support to the momentum stocks of the technology sector, I have to consider adding to my positions in this group. Because I thought this rally was due for a breather in August, I sold most of the stocks that fit this description way too early in the cycle, I acknowledge. My only remaining position in this group is GameStop But Im not willing to pay any price no matter how high for stocks in this sector. High valuations put a cap on advances from this point and increase the downside risk in many of these stocks. Finding buy candidates here will depend on picking through the sector to find those few stocks still trading at reasonable prices to their growth potential -- or waiting for a correction to reduce valuations. That would lessen downside risk and increase the upside potential. Now is the time for that search, as we wait to see how the weakness of Tuesday and Wednesday play out. A fourth group And finally, I think its time to seriously consider building a position in a fourth kind of equity in order to hedge against a return of inflation in the long run. Many of the stocks that are likely to benefit from an uptick in prices will also do well if a strong economy increases demand in their sectors, so these are two-for-one winners. Over the next few weeks, Ill flesh out these groups with stock picks in the last three of my four categories while we wait to see if the recent weakness turns into anything of significance. And thats my Psychological Strategy for a Bubble Market. New developments on past columns A jobless recovery cant go on for long The trend continues to point in the wrong direction. Initial claims for unemployment, a key indicator of the economys ability or inability to create jobs, for the week ended Sept. 6, climbed to 422,000. Wall Street and other economists had been looking for about 400,000 new claims. The number is 3,000 higher than the last weekly report and brings the three-week rise in the initial claims for unemployment to 31,000. The four-week moving average, a less volatile number than the weekly figure, now stands at 407,000. This late in a recovery, the rise in the number of initial claims for unemployment remains puzzling; it's a sign of potential weakness in the economic recovery as a whole. 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: RF Micro Devices. He does not own short positions in any stock mentioned in this column. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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