To print article, click
Print on your browser's File menu.
Go back
Go back
Posted 1/10/2002
Details
 |
Recent Articles
• Hedge your bets when you look for miracles, 1/03/02
• Real bargains at Nasdaq’s After-Christmas Sale, 12/27/01
• 3 ways to save when trading stocks, 12/20/01
more...
|
The Speculator
Watch the money on the sidelines
Our studies tell us that the more money is stashed in money-market accounts, the more money is about to flow into stocks and raise prices. We're about to see just such a surge.
By Victor Niederhoffer and Laurel Kenner
The law of conservation of energy provides
a fundamental example of the logic and predictive power of science.
-- Alan Lightman, Great Ideas in Physics
Some $2.3 trillion lies in money-market accounts at brokerages right now, more than double the level three years ago. The ratio of assets in equity funds relative to money market funds is 1.5, within a gnat's eyelash of a four-year low in a metric that is more bullish for stocks the lower it goes. The high, 2.6, occurred in spring 2000, just as the market was embarking on its terrible 18-month descent.
| New
stock picks from market professionals every day on CNBC. |
The pile of money stashed away in a safe place is similar, if you’re imaginative enough, to a pendulum pausing at the top of its arc. At that moment, energy seems to disappear; in reality, it is there in potential form and is about to be converted into movement.
The equity fund/money-market fund ratio is one of many ideas we’ve been mulling and testing as we investigate how the laws of physics can improve our trading. In a moment, we’ll share more of those ideas, including a new method for picking biotech stocks. First, though, we’re going to take you on a field trip to see the First Law of Thermodynamics at work.
Conservation of energy
Begin with an all-too-typical chain of events in the financial realm. An attractive TV reporter says, “Tech is back!”... Mr. Investor calls his broker and directs cash to be moved from the money-market account to tech stocks...the broker takes a cut...the stocks rise...the sector attracts more money...the stocks become blue chips...value investors, hoping to preserve their place in the firmament, scornfully assert that nobody ever made money on new industries...investors start to turn a gimlet eye toward the companies...hopes collapse...the stocks tumble...Mr. Investor moves the pitiful remainder of his cash back into the money market...and the cycle is complete.
A remarkably similar cycle is seen in the natural world: The sun generates electromagnetic energy...a plant uses the energy to make sugar...a jackrabbit eats the plant...a coyote eats the rabbit...the coyote dies...bacteria eat the carcass.
The important thing to know is that at the end of such cycles, the quantity of mass and energy is exactly what it was at the start. Any amount that seems to have gone missing can be found somewhere. This law -- the First Law of Thermodynamics, or the conservation of energy -- is the central concept that helps us make sense of what's happening in the world of matter and energy. We think it can help investors, too.
It’s helpful, in considering energy in nature or markets, to think of potential energy on one hand, and all the other active transformations of energy on the other. The active forms of energy include kinetic, chemical, electric, electromagnetic, elastic (as in a bouncing ball), nuclear, heat and sound.
Money put to work
The money available to buy stocks may be considered a form of potential energy. The more money that’s available, the greater the chance that it will be put to work -- i.e., make the market rise.
Our study of the equity/money market ratio found that the S&P 500 tends to rise after months when the ratio is low. Specifically, regression analysis shows that the best prediction for the return the next month is provided by this formula: 5% minus 2% of the ratio. Plugging the current low number of 1.5 into the formula – e.g., 0.05 minus 2% of 1.5, or 0.03 -- leads to a predicted return of about 0.02, or 2 percentage points, for January 2002. Need we remind our readers that 2% is roughly equal to the current money-market return for an entire year?
Our bullishness was reinforced by another study we performed, also inspired by the conservation of energy. Our second study looked at the energy taken out of the stock market through initial public offerings.
Money to buy new stocks must come from somewhere. A good working model is that it comes from the money that would otherwise be available to buy stocks that already exist. And that leads to a working hypothesis:
- When IPOs are numerous, there is little money available to buy existing stock.
- When IPOs are few, there is more money available to buy existing stock.
Fortuitously, the potential energy that has not been absorbed by IPOs is at a maximum right now. Only 97 companies went public in 2001. That is a 78% decline in number from the previous year, and a 56% drop in value. In fact, 2001 saw the fewest IPOs since 1985.
Such declines are highly bullish, as can be seen in the table below, which shows the total number of IPOs in each of the last 20 years.
Fewer IPOs leads to better market performance
| Year | # Of IPOs | % Change in # of IPOs | S&P 500% Return Next Year |
| 1981 | 41 | 28.1 | 14.76 |
| 1982 | 21 | -48.8 | 17.27 |
| 1983 | 91 | 333.3 | 1.4 |
| 1984 | 57 | -37.4 | 26.33 |
| 1985 | 79 | 38.6 | 14.62 |
| 1986 | 191 | 141.8 | 2.03 |
| 1987 | 139 | -27.2 | 12.4 |
| 1988 | 92 | -33.8 | 27.25 |
| 1989 | 95 | 3.3 | -6.56 |
| 1990 | 87 | -8.4 | 26.31 |
| 1991 | 370 | 325.3 | 4.46 |
| 1992 | 559 | 51.1 | 7.06 |
| 1993 | 805 | 44 | -1.54 |
| 1994 | 702 | -12.8 | 34.11 |
| 1995 | 668 | -4.8 | 20.26 |
| 1996 | 882 | 32 | 31.01 |
| 1997 | 587 | -33.4 | 26.67 |
| 1998 | 396 | -32.5 | 19.53 |
| 1999 | 514 | 29.8 | -10.14 |
| 2000 | 356 | -30.7 | -13.04 |
| 2001 | 85 | -76.1 |
Statistically speaking, the correlation between the change in the number of IPOs in one year and the percentage change in the market the next year is -36% -- a strong negative association that reminds us of the transfers of energy we see in the bounce of a ball or the movements of a roller coaster, something that market participants are all too familiar with these days
We next looked at the correlation between the total dollar value of IPOs and market results in the next year and found similar results going back to 1991, the earliest year for which data was available. The correlation was -33%.
We found a similar negative correlation between the amount raised in secondary stock offerings and subsequent market performance. Fortuitously, the total dollar value of secondary offerings also declined last year, by 34%, although the number of offerings was slightly higher -- 406 versus 379. The decline in dollar value is quite bullish.
Of course, First Law of Thermodynamics is not a holy grail to markets. It doesn’t explain how a system operates or what causes it to change, either in physics or in finance. It doesn’t account for psychic energy, or productive energy -- key elements in markets. It applies only to closed systems. It cannot address all the unpredictable ways in which potential energy can be converted to kinetic energy (or waste heat). And there’s a basic problem in measuring the amount of potential energy. As our Tennessee reader Jack Tierney says, “In the realms of biology and physics, it might be possible -- but in a realm with Alan Greenspan and printing presses, you can’t.”
Still, the law is helpful in making predictions in a world that seems to be undergoing constant change. Indeed, stock-picking ideas suggested by the law are so diverse and numerous that it is hard to know where to begin in applying them.
Energy in research
Here’s just one idea. A large part of the potential energy in a stock is embodied in the company’s past research efforts. These are ideas that don’t show up on the balance sheet but are hopefully waiting to express themselves in useful forms in the future. As an experiment, we chose nine biotech companies that have high levels of research expense relative to price and also have had recent insider buying.
| Company Name | Market cap | 1/7 close | Avg. daily vol. | % chg. yr. |
| Targeted Genetics (TGEN, news, msgs) | $135 million | $3.07 | 118,900 | -61.9 |
| Genelabs Tech (GNLB, news, msgs) | $124 million | $2.54 | 182,300 | -56.7 |
| Vion Pharm (VION, news, msgs) | $139 million | $4.50 | 75,000 | -47.4 |
| AVANT Immun (AVAN, news, msgs) | $226 million | $3.80 | 800,700 | -44.9 |
| Eclipsys (ECLP, news, msgs) | $702 million | $16.50 | 807,300 | -42.5 |
| Guilford Pharm (GLFD, news, msgs) | $345 million | $11.59 | 278,000 | -33.8 |
| Corvas Intl . (CVAS, news, msgs) | $189 million | $6.65 | 245,300 | -32.6 |
| Medicines Co . (MDCO, news, msgs) | $415 million | $11.68 | 140,200 | -20.5 |
| deCODE genetics (DCGN, news, msgs) | $417 million | $9.80 | 139,500 | -2.7 |
As it happens, we recommended Genelabs (GNLB, news, msgs), Genzyme Transgenics (GZTC, news, msgs) , Avant Immunotherapeutics (AVAN, news, msgs) and The Medicines Co . (MDCO, news, msgs) last week as part of a seven-stock portfolio of beaten-down biotech stocks with insider buying. The crucial question about these companies is whether the potential energy embodied in their research will be transformed into useful purposes. In the past, we’ve had some success in using insider buying as a signal for determining the likelihood that this potential profitable energy might be converted into something useful.
Because we now own six of the seven stocks in the portfolio we recommended last week, we won’t be buying more. It’s important for all investors to maintain a proper balance between the energy they are deploying in the market and potential energy in the form of reserves. Suffice it to say that the stocks listed above would seem to have some potential.
We will be happy to provide a complete workout of our studies on how market performance correlates with IPOs and on the equity/money market fund ratio. We read all communication from readers. Send requests and comments to dciocca@bloomberg.net.
At the time of publication, Victor Niederhoffer and Laurel Kenner owned shares in Targeted Genetics, Genelabs, Guilford Pharmaceuticals, Avant, Genzyme and The Medicines Co.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.