A Love/Hate Relationship

05/24/05 Hedge fund managers hate tech stocks…Is there any better reason to love them?

Last Thursday, we dispatched our colleague, Hilaire Atlee, to a hedge fund manager’s investment conference in Midtown Manhattan. His mission: To gather intelligence – not the quasi-intelligence that issues forth from the podium, but the anecdotal intelligence that one gleans from informal comments and off-the-cuff remarks.

“Everyone hates tech stocks,” Hilaire reported during his debriefing.

“Really?” we replied, “Who’s everyone?”

“Everyone,” he repeated. “Everyone I talked to said that they were ‘underweight’ tech and that they had no interest in upping their exposure to the sector. Even though techs are bouncing a little, I think a lot of guys are afraid to step in and buy them. They don’t want to get burned again, like they did when they bought energy stocks earlier this year.”

“So what’s your takeaway?”

“Well,” Hilaire answered, “I think you have to take a good, hard look at tech stocks, at least for a trade. These stocks had been flying below the radar for the last several months while everyone was busy piling into oil stocks. So the tech rally began kind of quietly. But now that it’s well underway, maybe the techs will keep rallying for a while.”

“Sounds reasonable,” we replied.

“I’m not sure if you can use this in your column,” Hilaire continued, “but while I was riding up the elevator a few minutes ago, I saw a UPS guy with bunch of Dell Computer boxes. So I asked him if he’d been doing a lot of Dell deliveries lately. ‘Oh man!’ the delivery guy said, ‘You can’t believe how many Dells we’ve been delivering, especially servers. Over at 65 Broad Street, we’ve been going in almost every day with armloads and armloads of Dell computers!’”

After debriefing our colleague, we reviewed his findings…

Item #1: Hedge fund managers hate tech stocks.

Item #2: UPS deliveryman testifies to numerous Dell Computer deliveries.

These provocative — albeit random and non-scientific — observations might not be sufficient to validate a substantial investment in tech stocks, but neither should they be dismissed out of hand.

The three-week old tech-stock rally on Wall Street seems to have something more going for it than two random anecdotes.

For starters, hedge fund managers are not the only group of investors who profess to dislike tech stocks. Bearish sentiment toward the tech-stock-heavy Nasdaq Index remains very high, which, as a contrary indicator, bodes well for the index. (Faithful Daily Reckoning readers may recall the column of April 12 in which we noted that put-buying on the Nasdaq 100 had reached a significant extreme. Since that time, the index has gained about 5%).

Meanwhile, the Nasdaq’s “technical” structure continues to improve, according to the many folks who track the ambiguous squiggles etched by stock price trends. “The Nasdaq Composite Index broke through its 200-day average on Tuesday and has broken its 2005 down trend-line,” observes veteran market technician, John Murphy. “Its relative strength line has turned up relative to the S&P 500. [As the chart below illustrates].

“That’s usually a positive sign for both. Nasdaq leadership is essential in any market upturn. That’s what we’re getting right now. One of the missing ingredients in recent market bounces has been higher volume. Yesterday’s market upturn, however, saw all the major averages exceed their normal daily volume. That’s a sign that institutions are starting to buy back into the market with more enthusiasm. The Nasdaq now appears headed toward its February/March peaks near 2100.”

The shares of Dell Computer and Intel Corp. appear to be leading the charge…just like in the days of old. For the last few weeks, both stocks have been handily outpacing most market bellwethers, including ExxonMobil, a stock that lead the market for most of 2004.

Two weeks ago, Dell delighted its investors by announcing “stronger-than-expected” first-quarter results. Revenues, net income and net margins all topped analysts estimates, which prompted CEO Kevin Rollins to declare that he is “confident and optimistic.”

So are Dell’s shareholders. The stock, which sells for 25 times estimated earnings, may seem a bit pricey to some investors. But to the Dell faithful, 25 times earnings seems like a bargain compared to the stock’s 10-year average PE ratio of nearly 50.

Semiconductor stocks are also making a charge. The booming PC sales reflected in Dell’s most recent results are driving a related boomlet in semiconductors. “Global semiconductor sales will this year rise by more than earlier forecasts because of better-than-expected computer demand and inventory management,” Bloomberg News reported yesterday. “Worldwide semiconductor sales will rise 5.9% to $233 billion this year and increase 6.5 percent to $248 billion next year, Gartner Group analyst Andrew Norwood said during a press conference in Seoul today. Gartner had earlier forecast 2005 sales of $228 billion and $232 billion for 2006.” Intel shareholders seem to be even more optimistic than the Gartner Group. Intel’s stock has jumped 20% since early April.

Short-term, many tech stocks might be a little “overbought” and vulnerable to a “correction.” For example, before yesterday’s mild retreat, the SOX Index of semiconductor stocks had advanced eight days in a row. The last time that happened was exactly 10 years ago, on May 23, 1995, according to Morgan Stanley Deane Witter. Over the next 4 days, the index tumbled 8%. Perhaps some version of history will repeat itself. But the Nasdaq seems likely to recover quickly from any setbacks.

Then again, it’s possible that the Nasdaq will NOT recover from any setbacks. It’s possible that the recent Nasdaq rally is much closer to an end than a beginning. So you probably shouldn’t buy Dell at 25 times earnings…unless you REALLY want to own Dell at 25 times earnings.

It’s never easy for us value-based investors to embrace a rally that seems to rely primarily upon touchy-feely factors like “sentiment,” “momentum” and “technical strength.” We would prefer to base our buying decisions on the terra firma of tangible value. But the stock market does not always accommodate our desires. Sometimes cheap stocks go down while expensive stocks go up. Specifically, sometimes lowly valued resource stocks go down, while pricey tech stocks go up.

And sometimes, pricey tech stocks go up a lot. So we would not be surprised to see the Nasdaq continue rallying for a while…until, eventually, hedge fund managers fall in love with them once again…or at least hate them less.

Did You Notice…?

By Carl Swenlin

One of Decision Point’s proprietary indicators is the Participation Index (PI). It measures extreme (climactic) activity within a short-term price envelope. When a large number of stocks are participating in a particular price move (up or down), we recognize that such high levels of participation are unsustainable and refer to it as a "climax".

There are two kinds of climaxes — an initiation climax, which marks the beginning of a longer-term price move and an exhaustion climax, which marks the end of a price move. Both kinds of climax can be followed by some consolidation activity before the trend changes or continues.

On the chart I have marked three upside climaxes. With 20-20 hindsight we can easily conclude that the first two are exhaustion climaxes, but I have designated the last one, the highest PI reading in a year, as an initiation climax, although the jury is not in on that one yet. My reasons are that price has broken out above the declining tops line that has been in effect since January, and during May UP Participation has expanded significantly while DOWN Participation has contracted sharply.

While my annotations point out upside climaxes, there is a classic downside initiation climax on the second trading day of January. It is followed by two weeks of consolidation, then the down leg is completed with an exhaustion climax on January 24. The final selling climax for the four-month down trend doesn’t occur until April 17.

Climactic indicator readings identify points at which the market is overbought or oversold, but they don’t always mean that the trend is about to change directions. Currently, the market needs to correct its overbought condition, but it does not appear to be vulnerable to a reversal of trend.

And the Markets…

	Monday	Friday	This week	Year-to-Date
DOW	10,524	10,493	384	-2.4%
S&P	1,194	1,191	40	-1.5%
NASDAQ	2,057	2,043	80	-5.5%
10-year Treasury	4.07%	4.11%	-0.05	-0.15
30-year Treasury	4.38%	4.44%	-0.10	-0.44
Russell 2000	613	610	31	-5.9%
Gold	$417.45	$420.60	-$2.95	-4.6%
Silver	$6.96	$7.14	$0.04	2.1%
CRB	296.47	293.54	2.62	4.4%
WTI NYMEX CRUDE	$49.16	$46.92	$0.49	13.1%
Yen (YEN/USD)	JPY 107.60	JPY 107.62	-0.28	-4.9%
Dollar (USD/EUR)	$1.2586	$1.2627	48	7.1%
Dollar (USD/GBP)	$1.8301	$1.8372	205	4.6%

Eric Fry

Eric J. Fry, Agora Financial’s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling. Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant’s Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant’s International and Apogee Research — institutional research products dedicated to international investment opportunities and short selling. Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry directs and supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts. His views and investment insights have appeared in numerous publications including Time, Barron’s, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.