Don’t Fall for This Gimmick!

Bulls looked like they were about to achieve some big milestones this week, including new all-time highs for the large-cap indices and a definitive breakout of overhead resistance for the tech-heavy Nasdaq. But insistent selling pressure in the final days of the week blunted the progress.

The cause? We could name a few. One was a warning from hedge fund manager David Einhorn of Greenlight Capital in a client note that we’re in the midst of “our second tech bubble in 15 years,” and all that is uncertain is “how much further the bubble can expand, and what might pop it.”

Einhorn, who has a decent, though not spotless, track record on such orations, went on to list a few of the indications that things have gone too far, including:

• The rejection of conventional valuation methods.
• Forced short covering by skeptics.
• Big first-day IPO pops for companies that “have done little more than use the right buzzwords” to attract the right venture capital.

Given Greenlight’s small loss during the first quarter, much of Einhorn’s negativity could be dismissed as simply sour grapes. But given what we know about fund positioning (big overweights in tech) and recent sentiment, there is certainly room for a deflation of expectations.

That is, there is justification for a substantial correction, no doubt. I could list five more reasons. Yet for now, the fundamentals suggest the bull market will merely enter a more mature, less vital phase where it grinds out gains in a less flashy, less enthusiastic manner into the start of summer.

Profit margins will come under pressure as the job market keeps tightening. Higher interest rates stemming from new Federal Reserve policy will limit the ability of corporations to use cheap credit to lever up their balance sheets and use borrowed funds to fuel share repurchases — one of the main supports of stock prices lately. And higher interest rates will make M&A deals more expensive.

Headwinds are coming. But it’s not the start of a hurricane just yet.

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The major stock indices were unusually erratic in the past week, with the Nasdaq up, the Russell 2000 down and the Dow Jones Industrials flat. This just shows how company-specific the news has been this month. Normally, you see whole groups move in tandem, whether it’s growth stocks or value stocks, or techs as a group, or retailers as a group. Not so this year, when dozens of stocks are in their own private Idahos, riding high or sweeping low, or just wandering around aimlessly with a half-confused look on their faces.

The primary motivator for the Nasdaq love was a positive reaction to Apple (AAPL) earnings. I can’t help but wonder if this affection will be short lived. The consumer-electronics giant announced a so-so quarter from a business standpoint, including a shocking quarter-over-quarter decline in iPad sales, but saw its shares shoot higher due to some financial engineering.

That is, the stock rose not because Apple proved that it had regained its innovation mojo or proved that it could sell well again, but because it announced a big new stock buyback, dividend increase and — least important but showiest of all — a weird 7-1 share split scheduled for June.

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I’m sure you realize by now that stock buybacks are a false positive for shareholders in that they artificially inflate earnings per share. They are a gimmick to distract from a decline in the overall business, as well as an admission that a company has nothing better to invest in. A buyback actually makes sense in the case of Apple, because its shares are undervalued, but that should not take away from the fact that Apple is resorting to the financial equivalent of slathering on makeup and squeezing into Spanx when it should be organically growing its business.

The positive sentiment surrounding AAPL may have spurred a rotation from the social media and Internet group, which finished lower. Facebook (FB) initially rallied strongly after its earnings, but the stock later gave up gains in volatile trading. Seems like a durable company, but the price is outrageous, and overpaying is just so out these days. Likewise for Twitter (TWTR) and LinkedIn (LNKD), which both lost a lot of ground in the past week.

Best wishes,

Jon

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