Economy Up, Stocks Down?

Once again the week’s economic numbers outperformed the stock market as accounting worries, doubts about earnings, and the speed of the economic recovery kept investors on the sidelines.

The biggest positive for the week was just released.  The ISM manufacturing-purchasing index rose considerably higher than expected and is in expansionary territory (above 50).  I’ve colored ISM prices green because cheaper is usually better, but if manufacturing pricing power continues to erode we may have problems.  Other big positives were durable goods orders, GDP, initial jobless claims, and Greenspan’s comments that the economy was in or near recovery.  The University of Michigan confidence and the Commerce department’s confidence numbers declined this week, but they were mild.  The declines are probably no more than a hiccup caused by the poor market performance in January and February.  Their earlier releases, showed a rising trend since September.  New home sales were less than expected, but still very positive.  So with all the good news out there why does the market continue to decline?

There are a number of worries facing investors such as the accounting problems, terror campaign, economy etc, but we will examine another market force in today’s letter.  The bubble burst and subsequent collapse of technology stocks has spawned new interest in what are known as hedge funds.  These special purpose funds, as the name implies, are designed to perform well when the market, or sectors of the market decline.  The major tool of hedge fund managers is their ability to sell stocks short, a process whereby they borrow stock from others, then sell it in the open market.  They sell short with the anticipation that they can buy the stock back at a cheaper price at some point in the future.

During bear markets this strategy works exceptionally well as many or most stocks are declining.  But, our human nature plays a huge role in the success of this strategy as well.  A curious fact about people is that we believe bad news faster and more easily than we do good news, especially when there is plenty bad news around.

Just as there are in any other area of human endeavor, there are good hedge fund managers and there are the less scrupulous.  The good managers act as the ‘truth police’ in the market.  They constantly monitor companies’ comments and scour financial statements for believability and accuracy.  When they see problems, they make them public for all to hear and evaluate for themselves.  They also provide extra liquidity (more stock available) for those with a positive bias on the company.

Unfortunately, there is an ugly side to short-selling too.  The bad guys float false rumors and innuendo to drive share prices down, quickly profiting before the company can counter the rumor.  This technique is used quite often on small and under-followed companies, but it occasionally happens to the likes of General Electric.  Last week we saw that company fall 10% in a couple of days as rumors circulated about its reporting practices, fueled by the whole accounting imbroglio.

Short-sellers have a major influence on the markets now.  Market volume is relatively light, particularly in certain sectors like technology, biotechnology and utilities, empowering short-sellers with more control over individual stock prices.  They are more willing to take large positions if they are confident that huge numbers of buyers are not waiting on the sidelines to buy on the first significant dip in a stock’s price.

Most often the shorts focus their attention on companies with problems the market does not yet recognize.  But, given the light volume in today’s market, they have had considerable success with stocks that have done nothing more than to succeed in these difficult times.  An example is Chico’s, a successful retailer of women’s fashions and in our aggressive portfolio earlier this year.  The shares have risen 113% in the last 12 months.  The company has excellent management, an impressive balance sheet, excellent growth prospects, and a very successful retail model.  But because of the stock’s rise, short interest rose 72% just last month and now represents 18% of the shares outstanding.  The sharks are just waiting for that hint of blood in the water.  If they don’t get it they will move on.  We watch changes in short interest to find opportunities and as a possible signal of danger.

Another example of short interest comes from our portfolios.  Siebel Corp. was driven down as much as 10% yesterday on rumors that the SEC was ‘planning’ an investigation of PeopleSoft and a ‘competitor’.  There were rumors that Seibel was that competitor.  Siebel denied any knowledge of an SEC investigation or reason for one, but sellers believed the rumors, not the company.  Today Siebel is up 5%, so either more investors believe management after some thought, or the stock is rising in sympathy with the market.

As I prepare to send this brief to you, the DOW is up 110 points and the NASDAQ is up 28 points on great economic numbers, but we all know that is subject to change on the next hint of bad news.  When will this pattern change?   The how and when is in the hands of the holders of the trillions of dollars in cash and money markets.  When they tire of 1.5% returns and when they see market volatility decline they will start coming back.  In the meantime, our companies are doing their part to grow market share, improve operating efficiencies, and build on their unique product or service offerings.  As the economic recovery gains health and momentum the leverage our companies have built into their businesses will translate into growing profits – the ultimate and long-term driver of market prices.  Market performance and consistency will improve when investors believe that corporate earnings are rising and will continue to do so indefinitely into the future.  That time is coming.