Year-End Rally?

Tony Sagami here, with an update on what’s driving the stock market rally and what you should do about it.

As Martin pointed out last week, the S&P was recently able to regain its uptrend line. And now, it has risen further, reaching a 4-year high.

This may clear the way for still higher prices in the near term.

But Wall Street is counting on a lot more than that: They are hoping for a new, robust, bull market.

And to achieve that, the S&P would have to scale a steep cliff indeed.

Just consider the history:

1. The 1990s bull market carried the S&P all the way up to a peak of 1,553.

2. In the 2000-02 bear market, the S&P’s value was sliced in half as it lost 784 points from peak to trough.

3. Now, since 2003, it has regained about 61% of the ground it lost.

Thats pretty normal for a rally after a big bear market. Even if it goes somewhat higher, it will still be within a typical range.

And no matter what their persuasion bull or bear investors must admit its far too soon to be talking about a brand new bull market.

The Anatomy of
A Year-End Rally

Since October 21, the Dow has risen by more than 5%, while the Nasdaq 100 has risen at double that pace.

But despite the rally, the major indexes are barely up for the year. The Nasdaq and S&P 500 have gained little more than 2%, and the Dow is about flat.

Could there be more of a year-end rally? Yes.

And could that rally give investors a chance for a couple of short-term trades? Perhaps.

But before you get carried away with the year-end-rally story, I think you should take a closer look at whats really behind it, and why it cant be sustained. From everything I can tell …

The latest stock market rally is not driven by a booming economy or surging profits. Its mostly the product of typical year-end maneuvers by portfolio managers seeking to clinch their performance bonuses and fill their Christmas stockings.

Meanwhile, the once-booming housing market is beginning to bust, the Federal Reserve continues to raise interest rates, inflation is starting to look ugly, and, as I’ll show you this morning, retailers are sending out signals that business stinks.

But first, lets take a closer look at the year-end dance of portfolio managers:

Mutual Fund Managers:
Playing for the Big Bonus

The median pay for a mutual fund manager last year was $460,000, and nearly half of that compensation (an average of 45%) came in the form of an incentive bonus.

The bonus is typically pegged to how a fund manager stacks up against a benchmark index. That could be the S&P 500, or for specialized funds, an index representing the sector theyre in.

Since these bonuses can add up to hundreds of thousands of dollars, portfolio managers will often do whatever they can to maximize their chances of hitting their goal. And toward the end of the year, with little time remaining, that often leads to strange behavior.

Here are some of the most common maneuvers:

Maneuver #1. If youre beating your benchmark, play the benchmark itself. Lets say your benchmark is the S&P 500, and lets say its up 5% for the year, but the fund you manage is up 7%.

Youre on track to receive a $200,000 bonus as long as you can stay on track with the S&P for the rest of the year. So your strategy is to invest in a way that mimics the S&P, even if you think the market is ready to tank.

Maneuver #2. If youre behind your benchmark, get more aggressive. In this case, lets say the S&P 500 is up 5% for the year, but the fund you manage is up only 3%.

Youre looking at a big goose egg for a bonus, your plans to buy a summer home in the Hamptons are in jeopardy, and your spouse or children may not understand why their unlimited ATM machine will stop spitting out money. If you dont want to see your income slashed in half, youve got just a month or so to catch up.

You cant do that with conservative, slow-moving stocks like McDonalds or Coca-Cola. So you switch your focus to stocks on the move like Qualcomm, Google, Yahoo, Applied Materials, or Amgen.

Bottom line: They have an incentive to invest in the high-flying techs, which helps explain why techs have been relatively strong.

Hedge Fund Managers:
Going for the Googles!

While mutual fund managers are trying to waltz around the market, the hedge fund folks quick-step to a faster beat.

Remember: While mutual funds charge a fixed percentage of the assets under management, hedge funds typically base their fees on the 1-and-20 formula 1% of assets plus 20% of profits.

So a manager of a $1 billion fund can make $10 million, just for turning up to work and potentially hundreds of millions more, depending upon performance.

Thats why the average income of the top 25 hedge fund managers was $207 million in 2003 and $251 million in 2004, numbers that make the income of mutual fund managers look puny by comparison.

This year, though, hedge fund managers are struggling. The CSFB/Tremont Hedge Fund Index is up 4.3% for the year, which means typical managers are going to take home a lot less in 2005 than theyre used to making.

While most people would be delighted with what these guys can make even in a bad year, it may not be enough to pay for the Merlot, Tiffanys, or property tax bill of the hedge fund crowd.

One of their vehicles of choice: High-beta, rocket ship tech stocks like Google, which helps explain why it has punched through $400 a share.

I Use Google Almost Every Day.
But Right Now, I Wouldnt Touch
Its Stock With a 10-Foot Pole.

The fundamentals simply dont justify the current price of Googles shares. Its no better than most of the other tech wonders of the late 1990s that crashed and burned in the early 2000s.

And thats exactly my point about most tech stocks. Theyre not moving higher because business is so great. Theyre moving higher because theyre the fastest horses the portfolio managers can hitch their wagons to.

Are tech stocks warming up right now? Yes. But its mostly because there are so many hot hands groping for them at the same time.

Why Business
Really Stinks

Very few people are going to make money if consumers arent buying. And right now, consumers have tons of reasons to back off from their borrowing-and-spending rampage of recent years:

1. Many are afraid of losing their jobs. Witness, for example, how General Motors just announced that its going to cut 30,000 more jobs and close nine of its North American plants.

2. Many are afraid of losing their pension. And for good reason! Hundreds of thousands of Americans have already lost theirs, and the Pension Benefit Guarantee Corporation (PBGC) provides anything BUT full guarantees. It covers only a fraction of the pensions that were promised.

3. Many are also afraid they wont be able to make ends meet this winter. Even though gasoline prices have come down, heating oil and natural gas prices are still not far from their peaks, and theyre FAR higher than last year.

Meanwhile, retailers are sending out some very negative signals …

Signal #1
From American Express

Trading of American Express stock was temporarily halted last week when CEO Ken Chenault surprised Wall Street with a warning that its Q4 results would fall short of forecasts. I do appreciate the optimism thats been out there, he said. But I can tell you that number is far too aggressive.

American Express blamed its problem on a surge in bankruptcies and expects to get hit for $200 million more in charge-offs than in Q3.

Chenault also said that the jump in bankruptcy filings impacts the entire industry, so you can expect more of these warnings when we enter the Q4 earnings season.

But I think it would be a mistake to blame all of American Express problems on the change in bankruptcy laws. The problem is simply that Americans are spending and charging less.

Signal #2
From Jo-Ann Stores

This retailer reported a Q3 loss and blamed the shortfall on dramatically declining consumer traffic.

In Q3 of 2004, Jo-Ann Stores made 30 cents a share of profits, but managed to lose 18 cents this year. Year-to-date, same-store sales are up a paltry 0.3%.

In their own words:

Unfortunately, we did not anticipate the extent of the slowing demand and customer traffic, which has dramatically declined in the third quarter. We now face the challenge of liquidating excess inventory in a very difficult retail environment.

The result has been and likely will continue to be deteriorating gross margins, as we are forced to take markdowns to sell through inventories.”

Dramatically declined? Very difficult retail environment? Those are the words of a very worried retailer that doesnt expect business to rebound any time soon.

Signal #3
From Ross Stores

When I hear even discount retailers, like Ross Stores, complain about business, it tells me that something is very wrong.

Ross Stores cut its Q4 and fiscal 2006 guidance and warned the Jack-and-the-beanstalk crowd to tone down its expectations.

Ross Stores now expects to make 44-47 cents of Q4 profits, below the 45-48 it had previously forecast. For the year ending in February, Ross expects to earn $1.60 to $1.70, well below the $1.77 Wall Street is expecting.

Signal #4
From Target

Target is one of the hottest, most successful retailers in the U.S., but business isnt so good.

Target warned that its November sales are going to fall short of its 4-6% forecast and admitted that its Q4 results would also fall short of expectations. Instead of $1.07 cents of Q4 profits, Target now says it will make 90 cents instead.

Were not talking about a pint-sized retailer here. Were talking about one of the largest, most important retailers in the U.S., and an extremely important data point about the health of the retail business.

Signal #5
From Wal-Mart!

Perhaps the most important piece of the puzzle is the news from Wal-Mart that it is going to be especially aggressive this holiday season.

Wal-Mart started its holiday advertising campaign earlier this year than any year in its history.

Wal-Mart is promising aggressive price discounts, which means pitiful profits for everybody else.

For example, Wal-Mart will be selling a Hewlett-Packard Pavilion ze2308wm notebook computer for $398 … an HP Photosmart E317 digital camera for $98.88 … a Lexmark all-in-one printer, scanner and copier for $39.88 … and a 12-cup coffeemaker, food chopper or 2-quart slow cooker for just $4.24.

Watch carefully. I believe that youre going to hear retailers report satisfactory top line sales, but very disappointing bottom line profits.

My Recommendations

Recommendation #1. If youre thinking about jumping on the tech-stock bandwagon right now, ask yourself: Am I ready to roll the dice alongside the pros? Will I be able to buy when they buy … and run before they run? No? Then this short-term play in the techs is not for you. Stay out.

Recommendation #2. If youre already holding tech stocks right now … and if theres nothing I can do to persuade you to let go, then at least follow this strategy:

• Make sure you have a well-defined exit plan. That means protective stop-loss orders in place to prevent small losses from turning into wipe-out losses. Plus, it means deciding, ahead of time, where youll be ready to say hallelujah and grab your gains.

• Stick with the few companies that do have something more than overzealous portfolio managers behind them. Examples: Electronic Arts, Advanced Micro Devices, Apple, and Microsoft.

• Make sure you understand the dance of the OPM (other peoples money) crowd. Then avoid becoming one of the stooges that helps pay for their year-end bonuses. Because as soon as the new years begins, the year-end bubble is bound to pop.

Recommendation #3. Don’t shun cash equivalents embrace them for liquidity, relative safety and rising yields. With a Treasury-only money fund, you get all three. Plus your dividend yield is exempt from local and state income taxes. And you get free checking. Among my favorites: The Weiss Treasury Only Money Market Fund (1-800-430-9617).

Recommendation #4. Stick with your core positions in inflation hedges like energy and gold. Gold is already flying again. Energy is bound to follow shortly.

Best wishes,

Tony Sagami