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Position your portfolio for the Year of the Snake
by James Passin
Our risk-adverse strategy has paid off for Taipan subscribers. As I write this, my stock recommendations are up an average 31% in 2000, despite the bloodbath in NASDAQ. Of course, it hasn't paid to be a shareholder in anything over the last few months; most of the gains were achieved during the first quarter.
But the Russian bubble is more than a lesson in humility for true believers and egomaniacs. The 1998-2000 boom/bust cycle in Internet stocks is hauntingly similar to the 1996-1998 boom/bust cycle in Russian stocks. Contrarian speculators should base their Year of the Snake strategy on a realistic technical outlook for NASDAQ.
It's déjà vu all over again
From late 1995 to late 1997, Russian stocks surged by a factor of more than seven. The RTS Index of Russian stocks rose from a base of 65 to a peak of 575. This bull market consisted of three massive waves. Despite the strong performance of Russian stocks during the first two waves, most Western investors regarded the market with extreme skepticism. The fastest gains were achieved during the third wave of Q2-Q3 1997. During this third and final wave, U.S. retail investors became hysterical buyers of Russian ADRs, while Russian brokers pushed insanely overvalued "fourth tier" garbage stocks into the hands of eager Western institutions.
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Eerily familiar:
The late Internet bubble vs.
the late Russian bubble
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From early 1998 to early 2000, Internet stocks surged by a factor of more than seven. The GIN Index of Internet stocks rose from a base of 105 to a peak of 790. The bull market consisted of three massive waves. Despite the strong performance of Internet stocks during the first two waves, most institutional investors and market watchers regarded Internet stocks with extreme skepticism. The fastest gains were achieved during the third wave of Q4 1999-Q1 2000. During this third and final wave, U.S. retail investors became hysterical buyers of dot-com stocks, while Wall Street investment banks floated insanely overvalued garbage IPOs into the hand of eager mutual funds.
During the third wave, the RTS Index formed a "double top" formation as insiders aggressively distributed shares into weak hands. When it became clear that not only were equity prices ridiculously overvalued, but that the equity bubble itself had introduced fundamental distortions into the real economy, Russian stocks crashed. From the late 1997 peak to the late 1998 low, the RTS declined to 43 (93%), erasing the entire preceding bull market.
During the third wave, the GIN Index formed a "double top" formation as insiders aggressively distributed shares into weak hands. When it became clear that not only were equity prices ridiculously overvalued, but that the equity bubble itself had introduced fundamental distortions into the real economy, Internet stocks crashed. Over the last 9 months, the GIN Index declined to 240 (70%).
The parallels are eerie. If this technical scenario continues to play out, the GIN index will decline another 60%, to 100 or lower, over the next three months. Such a decline would erase the entire preceding bull market. It is my view that this decline is inevitable. After the decline, surviving Internet stocks could rise 5x to 10x from their absolute 2001 lows.
During the terminal shakeout, Internet stocks will become a joke. The vast majority of dot-coms will go bankrupt. Investors will swear off dot-coms forever. In fact, this entire process may already be occurring.
Ursa Minor
While there's further pain ahead for Internet stocks, don't worry about G–tterd”mmerung. Thanks to the Internet bubble and everything it infected, NASDAQ is in a bear market. However, it is improbable that the bear market in Internets will trigger a U.S. dollar crisis or a bear market in the Dow.
If the dollar is not going to collapse after a 50% crash in NASDAQ, when crude oil is over US$30 per barrel, during a political crisis in the Middle East, while there is no president-elect, when will it? While the dollar has softened marginally against the Euro, and gold has made a modest rally, the dollar is still in pretty good shape. In my view, moderate dollar depreciation would be unequivocally bullish for the Dow, since it would boost earnings, improve the trade imbalance, and neutralize the deflationary pressures emanating from tech stocks.
While a number of Internet stocks are outright frauds, the Internet itself is very real. I use the Internet every day at work and every day at home. I use the Internet when I am on the road, via my WAP-enabled cell phone. I don't know about you, but the Internet continues to revolutionize every aspect of both my business and my personal life.
Contrary to the rantings of the perma-bears, the capital invested in e-commerce, telecom networks, fiber optics, et al., was not wasted. The original equity owners might get wiped out. But we all benefit. The capital spent on Internet infrastructure, branding, and software was the greatest charitable public works project in the history of the world.
While there may be overcapacity in the telecom sector today, there will be a shortage within a few years, as the convergence of voice, data, and media eventually consumes available bandwidth. The bondholders who take ownership of bankrupt new-age telecoms (possibly PSIX, GTS, etc.) will make fortunes. In the interim, the painful, deflationary commoditization of bandwidth will radically lower the cost of communicating.
Market sentiment is pessimistic enough to market a possible bottom in specific technology sectors. The "market maven" page in Barron's is now 100% bearish. This is a complete reversal of the 100% bullishness in Q1. Every market professional I talk to is bearish on U.S. tech stocks. While earnings are unlikely to grow in a slowing economy, my colleague Christian DeHaemer points out that managers may be stuffing every charge into earnings, setting the scene for favorable earnings comparisons next year.
BEER goggles
Whatever happens to Internets, the S&P 500 is cheap relative to treasury bonds. If you invert the market's P/E ratio, you get the earnings/price ratio, or "earnings yield." This is a good measure of the return you get for tying up capital in stocks (or course, earnings are generally overstated through accounting tricks). By comparing stock yields to government bond yields (Bond yield/equity yield ratio or BEER), you can determine the fair value of the market.
Since stocks are riskier than bonds, stock yields should theoretically be higher than bond yields. In reality, inflation will erode fixed income streams over time, so the relative riskiness of stocks can be somewhat discounted. As a rule of thumb, I believe that stocks are undervalued when stock yields = bond yields.
The trailing BEER ratio on the S&P 500 is 1.4. After the 35% drop in BEER, it is technically oversold. Based on historic technical action, BEER is likely to bounce materially from current levels.
Given my view on interest rates (economy slowing, Washington gridlock, Fed cuts, falling rates) and earnings (zero growth), the forward BEER on the S&P 500 is 1.1ócheap enough for me.
IRS terrorism
A little-known change in IRS regulations may be having a catastrophic effect on U.S. stocks. Starting on January 1, 2001, a 30% withholding tax will be imposed on all payments to offshore funds with foreign partners. To avoid the 30% withholding tax, the ultimate beneficiary will have to reside in a country with which the U.S. has a tax treaty and the fund will have to submit certain forms to the IRS. As this is putting a tremendous regulatory burden on offshore hedge funds, and possibly scaring away a number of offshore limited partners, a significant number of funds may make a strategic decision to eliminate their investments in the U.S. This could exacerbate tax-related selling. By January, any one-time pressure resulting from these new regulations should end; but any permanent damage to U.S. portfolio inflows will reveal itself in the currency market. As a hedge against IRS insanity, it would be prudent to maintain a diversified global portfolio.
Who cares?
A bull market needs leaders. New speculative themes will emerge. My chips are on agricultural biotechnology (the digital revolution has yet to extend to agriculture!), adult education (rising unemployment = growing need for résumé polishing), and leveraged manufacturers (falling rates, falling dollar, B2B benefits). Globally, I like Caspian region oil (pipelines coming!), Israeli tech (blood-on-the-streets!), and Korea (short-term liquidity crisis!). I am sniffing around in some other markets and sectors, with the objective of finding maximum inefficiencies.
My publisher asked me to identify losing recommendations that are clear tax-loss selling candidates. Given my views, it makes sense to sell the following positions for tax-loss purposes: Uproar (convert to NASDAQ shares before selling or you will immediately lose the spread on restricted EASDAQ shares), TIGA (spun off from ORCT), RBD-NZSE, FAP-NZSE (New Zealanders foolishly rejecting agbio!), ASL, and SASOY (failed to participate in oil rally!).
James Passin manages the Firebird Global Small Caps Fund for Firebird Management and is a Contributing Editor to Taipan. Passin's fund is currently a shareholder in ORCT and TIGA. A fund managed by Firebird is currently a shareholder in Uproar. The views expressed are strickly Mr. Passin's and not necessarily those of Firebird Management or Taipan.
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