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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 O’Brian series of books we’ll 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. We’ve 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 market’s 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 fund’s
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 that’s 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 Nasdaq’s after-Christmas sale" and "Sinking real
estate means rising stocks.")
No, we never did, and
we’re 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. We’ve
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 | |
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
Lizard’s Land’
IBM’s 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 Melville’s "Moby Dick" and Homer’s
"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 O’Brian. Based on the life of the daring 19th
century British seaman Thomas Cochrane (as was C.S. Forester’s
Horatio Hornblower series), the O’Brian 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," Aubrey’s 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, O’Brian 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
We’ve been getting what we’d like to consider a
lifetime’s 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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