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According to Commonfund, an organization that invests money for colleges, about 13% of the money invested by educational endowments is now in hedge funds, up from 7% two years ago. "Hedge funds, which are typically owned by wealthy investors, require large initial investments and have steep fees", says Forbes Magazine. "The loosely regulated investment vehicles use aggressive strategies including selling short, leverage, program trading, swaps, arbitrage and derivatives to attempt to make money even when the market is down". The hedge fund sector really took off when the Internal Revenue Service's short-short rule, which penalized funds for having too much of their profits from short-term gains, was repealed. Over the last twelve months (ending August 30th) the performance of the CSFB/Tremont Hedge Fund Index was 2.16%, noticeably better than the S&P 500 that was down 19.2%, but not as stellar as long Treasury bonds (up 14%). The favorite time to short the market is the month after a calendar quarter, or MAQ. As companies pre-announce disappointing quarterly results and analysts revise their earnings to lower levels, stock prices plunge downward due to imbalances of sell orders and inefficient specialists who are unwilling to make an orderly market. The reverse can also occur when the numbers are better than expected. Then hedge funds need to "cover their shorts" and a short-term buying panic occurs. In this instance, the specialist is equally inefficient. September and October are the most favored months for taking advantage of potential downward price momentum. It is at this time of year that the following year's revision can truly change valuations based on far forward earnings. Since the IRS ruling of 1997, the MAQ effect was seen in October of 1998, 1999, 2000, February of 2000 and 2002, April of 2002, and July of 2002. Selling stocks in MAQ periods without "cause" is not a good idea. The current environment is a great example. The "bad news bears" are on the prowl and sentiment is very negative. And yet there are "positive divergences" from the late July low such as fewer 52-week new lows. As Dick McCabe, Chief Market Analyst for Merrill Lynch put it, "such divergences can be viewed as evidence of an exhaustion of broadly-based downside momentum in the wide array of stocks, and they have often happened at important market bottoms such as those which occurred in 1974 and 1998." The jury is out on this one. The flip side of
this coin is that there may be reasons to sell certain stocks or sectors
for cause. From a short sellers viewpoint it is the loss of earnings
momentum through downward revisions to earnings. In the chart below
we have identified the downward revisions for three months ending in
the MAQ for 2002 and 2003. (Next year's earnings become relevant in
the second MAQ ending July.)
Clearly there are few signs of anticipated earnings growth except in a few sectors. Regardless of valuation, it is the hedge fund manager's job to take advantage of unanticipated changes in earnings outlooks. This temporarily disrupts normal valuation levels and may offer a great opportunity for buyers once the news has been absorbed. On the other hand, it may be a poor place for sellers. Better to wait for a normal valuation to occur. Let's review where the sectors stand and how they are currently valued.
From the chart above, one can see that there are some economic sectors that offer a valuation upside. For example, consumer staples, financials, health care, and even utilities. For investors to become enthused, however, earning momentum must turn positive. With the S&P 500 selling at 16.3 times our estimated earnings of $51.27 for 2003 (vs. the consensus of $53.44), then it is undervalued at current levels. At 18 times earnings, the index would trade at 922, or 10.5% higher than at current levels. THE POST-BUBBLE ECONOMY Few of us have ever lived through a post-bubble economy. There are still many missing economic metrics by which we benchmark the Great Depression. Nonetheless, it is my belief that in the post-WWII economy, it was expectations about the economy that "drove" the stock market. The post-bubble economy is more likely to be driven by asset values, i.e. the stock market is driving the economy. This could create a vicious cycle of asset values falling, demand fading, and then asset values falling again. As in Japan, this can lead to an environment where cash is hoarded and no one buys anything. This "economic winter" scenario has been around for some time, however, it has not been championed by credible economists. For this very reason, we must consider it as a plausible outcome but of low probability at this time. As for the near term economy, inventory/sales ratios are low relative to trend, orders for non-defense capital goods are still rising, and new capacity additions are falling. These three elements augur well for a rebound in non-financial corporate profits, albeit not across the board. With many stocks selling at reasonable multiples and the seasonal MAQ lows probably in place, it is better to hold equities rather than sell equities. Furthermore, an improvement in market psychology may come when the Fed lowers the funds rate again and if the potential for a unilateral Iraq conflict is ruled out. John K. Dolan October 14, 2002 |
| The information and opinions
in this report were prepared by Dolan Capital Management. The investments
discussed or recommended in this report may not be suitable for all
investors. Investors must make their own investment decisions based
on their specific investment objectives and financial position and using
such independent advisors as they deem necessary. This report is based
on information available to the public. No representation is made that
it is accurate or complete. |
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