Targets? Anything Goes

Targets? Anything Goes [¹]
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By Alan M. Newman, Ed., Stock Market Crosscurrents | 26 October 2007

These excerpts from the October 22nd issue have been posted to coincide with receipt by snail-mail subscribers.

Webster's defines mania as an "excessive or unreasonable enthusiasm." If recent action in Google (GOOG) and Apple (AAPL) does not fit the definition, we suppose it must be a brave new world. In all candor, if the rules have changed to this extent, everything about this market is seriously flawed. We remember the halcyon days of late '99 and very early '00 as price targets were lifted on an almost daily basis for those such as Amazon, Cisco, EMC, Brocade and JDS Uniphase, just to name a few. If you bought Amazon at the top, you're still down 21% even though the shares doubled in the last six months. Cisco is still down 61% from the high, EMC is off 78% and Brocade a mere 93%. JDS Uniphase? Don't ask (99%+). Thus, with much apprehension we noted Google's ascension beyond $600 and the prompt and subsequent increases of analyst price targets to as high as $725. As well, Apple's break above $150 on September 25th was celebrated by increases of price targets, which are now as high as $190. At this juncture, fundamental valuations are meaningless. Since only trading and the short term count, any target is deemed reasonable. The average holding period for AAPL is down to 23 trading sessions. Our view is that the analyst community has far too much vested in the coverage of "hot" stocks. It is apparent that a cycle of higher and higher targets has emboldened traders and inspired analysts to further upgrade, again emboldening traders. It's not quite a replay of early 2000, but the similarities are nevertheless, quite disturbing.

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Be Afraid, Be Very Afraid

We read a very scary piece recently that we thought we should share with you here. The Bloomberg sponsored blog addresses the potential for problems when too many think alike. MIT academics Amir E. Khandani and Andrew W. Lo used financial models to simulate this summer’s bloodbath and "Their findings….suggest that hedge funds may have grown more dangerous since the demise of Long-Term Capital Management in 1998." The world is a much more dangerous place than it used to be. Another derivative disaster will occur. It’s not a matter of if, it’s only a matter of when.

The clues stick out like a very sore thumb.

Consider the case of Victor Neiderhoffer, who blew out a $139 million portfolio in 1997 on a wrong bet and incredibly, was able to rebuild his business and reputation, only to lose big time once again. Neiderhoffer’s flagship Matador Fund lost more than seventy-five percent of its value and was recently shut down as the money manager admitted, "I was caught wrong-footed in the market turbulence." This time he was controlling $350 million in assets. Paul Tharp’s NY Post article speculates hubris as a cause for the disastrous encore and Neiderhoffer admits as much in John Cassidy’s must read New Yorker story).

Given the propensity for investors to place so much faith in hedge managers that they are willing to pay a 2% annual fee plus 20% of any profits, we’re not surprised. Many hedge managers appear to be revered for their acumen, yet the repetition of blowups this year point to a sober reality; if an investor gives away the first 22% that comes his way, he had better do 22% better than he could do otherwise. The odds against investors are simply staggering. Consider the case of the hedge fund that gains a remarkable 25% for four years running and is then cut in half in the fifth year. That equates to under a 5% return annualized and we have not even considered fees yet. With fees, a 30% annualized return for four years then cut by 30% gets an investor to roughly the same level as a bank CD. Success must not only be assured, it must be constant and endure.

Worse yet, take a gander here. Steve Johnson’s FT.com report focuses on the most compelling reason to suspect that a substantial price decline is still inevitable; to wit, the possibility of at least $500 billion in withdrawals from hedge funds, predicated on the belief that "….investors are increasingly dissatisfied with industry performance, and that computer-driven quantitative hedge funds now simply run too much money to make healthy returns."

The former is certainly borne out by the many collapses suffered this year. The latter is also in evidence as several market-neutral hedge funds were hit hard. Clearly, as we have suggested repeatedly, far too much money is chasing black box formulas that measure the merest relative price inefficiencies [[and then leverage the results as much as 20 times with borrowed money: normxxx]], without fairly considering the prospects of individual corporations. In fact, value considerations cannot be made or implemented, because they are too time consuming and too expensive to make [[moreover, value considerations are completely at odds with what Wall Street Quants do— and the quants have largely taken over the hedge funds, which need instantaneous results: normxxx]]. If values are not a major consideration for transactions, the transactions have little or no veracity! As well, since leveraged derivative portfolios can return enormous sums, they have become the best game in town. Trouble is, since we cannot trust price and leverage increases risk, we have an environment tailor made for disaster.

Supposedly, hedge funds now control $2 trillion in assets. If leverage has been employed only two-to-one on a large scale, $500 billion in withdrawals could cripple the markets in very short order. From the peak in 2000 to the secondary low in March 2003, stock mutual funds still experienced $205 billion in net INFLOWS. Now consider the possibility of $500 billion in OUTFLOWS, perhaps the scariest scenario we have ever encountered. Can it happen? Extensive leverage suggests the answer is yes.

And it doesn’t end with hedge funds. Institutional activity is at an all-time high and as a result, the competition for performance has catalyzed risk-taking assumptions on the greatest scale ever seen. Christine Harper’s Bloomberg article shows how Morgan Stanley’s "….quantitative strategy traders lost $390 million during a single day in August as their computer models failed to account for ’widespread' investor selling." This huge loss was suffered in only 13 days as "….Stocks that they anticipated would decline in price rose, and shares that they expected to rise instead fell." In our view, instances such as this represent only the tip of the iceberg. The stuff has really yet to hit the fan. We believe it will.

Bhattiprolu Murti’s article in the WSJ (see here) points to $72 billion in so-called "Level 3" assets controlled by Goldman Sachs that are valued solely on management assumptions. Level 3 assets are those that trade so infrequently that there is virtually no reliable market price for them [[and, lately, there has been NO market for them: normxxx]]. In its third-quarter financial report filed with the Securities and Exchange Commission Wednesday, the firm said level 3 assets for which it bears economic exposure amounted to about $50.9 billion. Eventually, the many "what if?" scenarios MUST come into play. What then? Goldman’s entire market cap is $100 billion [[but its working capital, which is what it would have to use to cover all losses, is only about a third of that at $36 billion! : normxxx]]. Perhaps our continued stance on risk exposure is too conservative. However, the fallout from the many "what if" scenarios says the opposite. Better safe than sorry. The risks to investors today are probably the highest they have ever been in the history of the U.S. stock market.

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Sentiment

Our own sentiment indicators are mostly negative but have not been consistently predictive for awhile, so for now, we elect to focus on other sentiment indicators. Below, the Investors Intelligence survey of newsletter writers is as lopsided as it has been in two years and implies we may yet face a substantial correction. In short, it is usually best to fade the majority. As of a week ago, the Rydex stats were startlingly imbalanced, with assets in bull and sector funds four times that of bear funds. The ratio has since fallen to 3.6, but still suggests much more to come on the downside.


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  M O R E. . .

Normxxx    
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