Capital Observer

Does Sentiment Still Matter

I have spent far less time discussing market sentiment this year than in previous years. The reason being that I believe that the marginal buyers of stocks have been corporations repurchasing stock and buying other companies for cash. The level of float shrinkage is setting records. Corporations repurchasing shares have no sentiment. They just keep buying steadily on a daily basis.

I still believe that market sentiment matters but in the current environment it matters less than usual. It takes larger extremes in bullish sentiment to knock down the market when there is an underlying bid from corporations. I believe that we are nearing a point where sentiment is extreme enough to matter. The vast majority of the sentiment indicators I track are now urging caution and the market is stretched:

• Investors Intelligence bears are below 20% while the bulls are at 54%
• Newsletter writers tracked by Hulbert are recommending the largest long position in stocks since January 2002.
• Rydex traders are positioned at a bullish extreme
• Investment advisers tracked by NAAIM stock exposure remains at the upper end of historical allocations.
• The most speculative of stocks are flying.
• Margin debt is nearing record levels.

While sentiment has not mattered all year there are now a confluence of indicators in extreme territory. At the same time breadth has been lagging in recent days. If sentiment still matters at all this should be the time when it asserts itself. Normally, I would expect an intermediate term top under these conditions. But with the underlying bid from corporations still present I would not be shocked to only see a shorter term correction.  I am expecting a 3% to 5% pullback at a minimum leading me to take a net short position in the market.

Technology To Take The Lead

Technology has been one of the poorest performing sectors in 2013 and over the past 12 months. The S&P 500 has returned 13.98% over the past 12 months while the S&P 500 Information Technology sector has returned -2.93%, lagging by nearly 17%. The two main drivers of the market rally have been a chase for yield and the float shrinkage that has been occurring through cash M&A and share repurchases. Technology has not been one of the main beneficiaries of these trends but I believe the record cash return by Apple will mark a turning point.

The stock market has been shrinking. In February there was over $100 billion in share repurchases & cash M&A announced. This float shrinkage has helped propel the overall market higher but has been less prevalent in the technology sector. For the most part technology companies have continued to stockpile cash, with the Dell LBO having been an exception. That all changed this week when Apple announced the largest cash return in history.  Apple has pledged to return $100 billion to shareholders before the end of 2015. That works out to over $33 billion a year, a little over 8.6% of its current market cap. With this announcement technology has joined the float shrinkage party and the sector is likely to play catch up. Its also possible that Apple’s technology peers will follow its example.

The poor performance in the technology sector does have some fundamental justification. There is a large amount of disruption occurring in technology. The PC related companies have been disrupted by tablets. The tablet and mobile device markets are becoming more competitive. The enterprise software companies are feeling the slowdown in global GDP as well as the move to open source and cheaper alternatives. However, there has always been disruption in technology and the lower valuations already account for this. Its not like everything is perfect in consumer staples, one of the best performing sectors. Companies like Coca Cola and Procter & Gamble have barely seen any revenue growth yet the stocks are flying.  The same can be said for pharmaceutical companies like Pfizer.

I believe that technology will be the best performing sector between now and year end and have positioned myself that way. Technology is by far my highest allocation with Check Point Software, Amdocs and Apple being my largest tech positions. All trade at greater than 10% free cash flow yields (to enterprise value) and all are returning cash to shareholders.

Rally On Fumes

I believe that the current rally is running on fumes. Before I get to the bearish side of the ledger I want to acknowledge the positives. The large float shrink (ie. share repurchases & cash M&A) is an undeniable positive. As long as the share repurchases and cash M&A continue at the current pace it is difficult to imagine much more than a correction. The second positive is seasonality. April is one of the stronger months of the year for stocks. Extended markets often become more extended during seasonally positive periods. The negative side of this is that in another month we enter the weaker part of the year where we have seen market corrections in each of the past 3 years.

Investor sentiment is troubling as the vast majority of the sentiment indicators I follow are showing excessive optimism. Whether it be hedge fund managers, investment advisers or newsletter writers the consensus in unanimously bullish. Former “Chicken Littles” suddenly have  a greater appetite for beta. The following excerpt from an article in the WSJ captures the current mood:

The market’s record-breaking spree has raised a new fear in many American households—dread that they are missing out on big gains.

When stock prices collapsed in 2008, the bear market wiped out half of the savings of Lucie White and her husband, both doctors in Houston. Feeling “sucker punched,” she says, they swore off stocks and put their remaining money in a bank.

This week, as the Dow Jones Industrial Average and Standard & Poor’s 500-stock index pushed to record highs, Ms. White and her husband hired a financial adviser and took the plunge back into the market.

The economy is stumbling along and profit growth has slowed to crawl. The full effects of the tax hikes and the sequester have yet to be felt as spending habits do not change on a dime. A slowing economy with more headwinds ahead is not the ideal environment for profit growth. Valuations are full even with profit margins at record levels. It is difficult to see where further profit growth will come from.

Up until now the large float shrink has kept me from getting too bearish. But as we approach the seasonally weaker part of the year with the market even more stretched I am more likely to act on my bearish inclinations. The bears, if there are any left, may be coming out of hibernation soon.

A Tidbit From The Oracle Conference Call

Amdocs (DOX) and Comverse (CNSI) both provide billing software and services for telcos. As a shareholder of both I found a portion of the Oracle Q&A very interesting. The following is a portion of the Oracle conference call on Wednesday from Seeking Alpha (my emphasis added):

Larry Ellison

We have a very, very significant presence in billing systems, in provisioning systems, in the telco space. And what we’d like to become is one of the most strategic suppliers to telcos overall, which involves broadening our footprint of what we supply them.

So you’re going to see us, through our own engineering, through innovation and acquisitions, greatly broaden our footprint as our ambition is to be the primary technology provider to the telecommunications industry. So that’s an area where we’ve been very successful, in certain parts of it, and we think we can expand that business by adding to the footprint.

Crimson Wine Group: Bull Case on a Unique Spin-off Opportunity

My write-up on Crimson Wine Group (CWGL) is up at Market Folly. I explain why the stock may have 70% upside.

Doing Less

As the market has risen it has become increasingly difficult for me to find stocks that meet my value criteria. I look for companies with predictable free cash flows at a low price. These companies suddenly seem few and far between. I tend to stay away from companies that are highly levered, capital intensive or cyclical.

During 2010, 2011 & 2012 there were periods when the market got ahead of itself but I was still able to find bargains. During that period healthcare, select consumer staples and enterprise software companies were trading cheap even when the market became expensive. Even though there were periods when the market as a whole became unattractive I did not have  a hard time finding individual securities. Currently, I can hardly find any new stocks to buy that meet my criteria.

The reason I believe this has occurred is that the market has rightfully put a premium on companies with more predictable free cash flows. But I cannot help but wonder if I am becoming more complacent and not looking hard enough. This weekend I came across  a chart that argues for the former. Defensive stocks are more expensive than they have been to cyclicals in forty years.

I have made some adjustments to my strategy by buying select cheap, cyclical stocks but carefully hedging out the cyclical risk by shorting similar companies. However, for the most part I have been selling off positions as they reach my targets without being able to replace them.  The past few years have been ideal for my strategy but the current environment argues for doing less and that is precisely what I am doing.

A History Lesson From 2006 and 2007

It was obvious by late 2006 that the real estate bubble was beginning to deflate. Leveraged speculators were starting to get into trouble and the housing market was slowing down. With all the leverage in the system it was a certainty that the collapse would be massive. Let me refresh your memory if you forgot: 108% no money down mortgages, liar loans, janitors getting $500,000 mortgages, no doc, no problem.

Despite the writing on the wall the market steadily climbed through late 2006 and all the way until the summer of 2007. There were some hiccups during the year when a number of subprime lenders collapsed but the market recovered quickly each time. There were some bigger hiccups that Summer when problems began to surface at larger banks but the market still did not not put in a high until October of 2007.

By October of 2007 the problems were painfully obvious. The economy was slowing and the real estate bubble was quickly deflating. Shouldn’t the market have realized this instead of making new all time highs? Isn’t the market a discounting mechanism? What was the reason the market kept climbing?

The answer to this mystery was quite simple. There was a boom happening in M&A, LBO and share repurchases. The supply of stock was quickly shrinking. It seemed like every other day there was a massive share repurchase, LBO or M&A announcement. If you don’t remember than the two charts below should refresh your memory

I remember this period very clearly because I was short. My saving grace was that I bought SPY leap puts when the VIX was at 10 so it allowed me to weather the market going against me. While this trade turned out to be the trade of my lifetime it was a grueling experience. Knowing for certain that the economy was collapsing, yet watching the market go against me every day was painful. If I were managing OPM at the time I likely would not have been left with much money.

This period ingrained into my head the power of share repurchases and cash M&A. The market was able to shrug off subprime companies collapsing, banks running into trouble and a slowing economy. It wasn’t until the economy choked off the M&A and share repurchases that the market collapsed.

I was reminded of this experience in the past week as TrimTabs reported that there was nearly $100 billion in cash M&A and share repurchases in the last 2 weeks. Than on Friday it leaked that Wal-Mart, the nations largest retailer, was having one of their worst starts to a month ever. The main culprit being the payroll tax hike. The market dived at first but by the end of the day the Dow was up.

I don’t believe a collapse is imminent like I did in 2007, even though there are no shortage of imbalances and risks. The reason I tell this story is that if the share repurchases and cash M&A continue at the recent pace it is likely to trump any fundamental factors.

Light My Fire

In my outlook for 2013 I wrote:

The level of cash M&A, LBOs and share repurchases have been on the low side considering where rates are. A buyout boom fueled by low rates is a real possibility. The fuel is there. Somebody just needs to light a match.

In the past two weeks there has been $97.5 billion in cash M&A and share repurchase announcements. TrimTabs has done extensive studies on what they call float shrink. This extreme level of float shrink is very bullish in the short term. It is intuitive that less supply of stocks should lead to higher prices.

Unfortunately, other factors are not as rosy for the market. Sentiment is excessively bullish and valuations are full. At the same time we are about to see the effects of the payroll tax hike. Many Americans live paycheck to paycheck and a broad tax hike is likely to effect the economy. There are also likely to be spending cuts even if we don’t see a sequester.

It seems that the market is setting up for a third bubble. In the same way that artificially low rates have driven up real estate prices it seems the same is now happening to stock prices. This will likely not end well but being early to try and fight this is the same as being wrong.  The facts have changed with the massive amount of M&A and share buybacks announced in the past 2 weeks. I have bitten the bullet and removed some of my hedges, accepting a very low level of market risk.

Changes

There has been an undeniable change in recent weeks but it is not an economic change. The economy continues to muddle through while corporate profit growth is slowing. The major change has been one of psychology. Investors are suddenly feeling comfortable with more risk and have been shifting their exposure towards equities. After years of obsessing over risk management investors have shifted their attention towards rewards.

Hedge fund managers have been increasing their gross and net exposure as every survey and prime broker report has shown. Large asset allocators  such as family offices and pension funds are suddenly more comfortable with long only exposure as assets have been exiting bonds and hedge funds.

I prefer to buy at times when uncertainty is high and stocks are cheap. While in the long run this strategy has worked for me there can be long periods of time where I miss the party. There is no reason the  market cant stay overvalued and participants remain over bullish. In the past the market has stayed overvalued for years at a time and it can happen again. In a relative performance world these sort of rallies tend to persist until they suck everybody in.

I continue to remain patient and am finding very little to buy. I have been selling stocks when they reach my price target but have not been able to replace many of them. The winds have indeed shifted but I am remaining patient. If one thing is for certain is that sentiment will one day cycle back to excess pessimism and when that happens I will be ready to buy.

The Great Rotation Myth

The rallying cry of the bulls has been a “Great Rotation” out of “safer” assets like bonds and into “riskier” like stocks. The argument goes that stocks trade at fair valuations but are relatively cheap compared to bonds of all stripes. There are many flaws in this argument but the main reason I don’t believe we are at the beginning of a “Great Rotation” is demographics. The baby boomers are in or near retirement and a secular move into riskier assets is unlikely to occur under these conditions.

It is undeniable that there has been a rotation into riskier assets in recent months. Hedge fund surveys and actual positioning reports from broker dealers show higher gross and net exposures from hedge funds. Sentiment surveys like the NAAIM & AAII combined with inflows into stock funds show that advisers and the public have had a  stronger risk appetite as well. While data on institutions is sparse, I have been hearing anecdotal evidence that they are feeling more comfortable with riskier assets. I believe this is  a cyclical rotation seen in the latter parts of a bull market rather than the beginning of a secular move.

The following excerpt on baby boomers comes from Wikipedia:

A baby boomer is a person who was born during the demographic post-World War II baby boom between the years 1946 and 1964, according to the U.S. Census Bureau

… Baby boomers control over 80% of personal financial assets and more than half of all consumer spending

The oldest baby boomer is now 67 years old. By 2020 more than half of baby boomers will be over the age of 65. The vast majority of pension assets are for the retirement of the baby boomer generation. A great secular move towards risk seems highly unlikely to me when the group that controls the majority of assets are heading towards retirement or already in it.

I believe it is far more likely that we are in the latter part of a cyclical bull market than at the beginning of a “Great Rotation” and secular move into risk assets. We have had a four year bull market where the S&P 500 has had a total return of roughly 135%. This “Great Rotation” argument is a rationalization for those who have missed the move to follow their primal instinct to herd. “The Internet Is The Future” was the rationale for throwing caution to the wind during 1999. While the slogan was true the investment implications were disastrous. With that said, the market did not top out for another year after we started hearing that catch phrase.