Private Equity Prays the Hardest that the Market Has Not Topped Out
- including CSCO, XHB
By Dr. Duru written for One-Twenty
February 28, 2007
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Every bull market has its share of scares. Most markets eventually recover, some crumble never to return to their former glory. The Dow and the S&P have essentially recovered from the bust of the tech bubble. The NASDAQ still dreams of its glory days. The large drops in global stock markets on Tuesday (and Wednesday?!), particularly in China and the U.S., have spooked the formerly complacent, emboldened the bears, and perplexed the believers. The long-term is too far away to imagine for now, so in the short-term we naturally wonder whether the market has topped out. We hear headlines that the drop in the Dow is the largest since the markets re-opened following 9/11. We read that the market's ability to delay Tuesday's kind of sharp correction week-after-week, month-after-month was relatively historic. No wonder then that the VIX, the measure of fear in the market, spiked 64%! A lot of folks are offering prognostications on what comes next and what you should do now. I will boldly state that the market has seen its highs for at least the year. If we rally from the open on Wednesday, then we will not even reconquer former support lines at the 50DMA in the "short-term." If we get some follow-through selling at the open before the inevitable snapback rally, then there is a much better chance that we will retest the highs in the coming months. In the first scenario, complacency tries to continue where it left off. In the second scenario, the weaker hands are flushed out for now, and the stronger hands wait for better days to do the selling they feel they should have done when they had the chance. And while the media is busy digging up all the negative events of the past two days and using them to explain Tuesday's big drop, you should focus on the prospect of the market turning these same bad news items into fresh reasons to believe in a Fed interest rate cut that will save the day and send the market on up.
The private equity folks represent one group of investors having no choice but to hold for now. They have been snapping up public companies like the public market themselves are going out of style. Typically, these buyers snap up damaged assets that have been unfairly (temporarily) hammered to ridiculously low prices with the intention of repackaging and selling these assets back into the public markets at much higher prices after the markets have recovered. What we have now is the purchasing of many assets at big premiums at close to or around fair values with the expectation of buying high and selling higher one day. Until that day, those private holdings are about as illiquid as can be - no selling into today's latest market panic. But you can bet they are just a tad nervous about the timing of their voracious appetites. Calculators are working overtime to see how much a sobering market might delay the eventual liquidation payday.
In the years since the collapse of 2000-2002, we have witnessed a set of rolling booms, some of which have already been ground back into the dust of bust. The celebrated largesse of private equity is certainly the latest of these booms. It seems as if we cannot go one week without the financial pages heralding the triumphant acquisition of another public company by private money. As we have noted many times, the world is awash in cheap and easy money, and these buy-outs are yet another manifestation of the boom in paper. But what is more interesting than the chase after public companies is who is chasing the private equity. The Wall Street Journal reports in "How Labor's Pension Funds Are Playing Private Equity Two Ways" (by Alan Murray) that public pension funds were the largest source of funds for private equity in 2005...22% of all newly raised money. Essentially, "public" funds are being used to convert public companies into private companies. Nice! To the extent that this boom is headed to some kind of bust, we can see the ripple effects could be wider than we might originally expect.
But we cannot hate on the private equity fund flows. A reduction in the shares available for public trade tips the supply/demand balance in favor of higher equity prices. The dashing heroics of private equity players have created a sense of value underpinning the markets. Even the prospect of leveraged buyout offers have helped buoy the shares of many stocks. Private equity's comfort with the markets generate goodwill and comfort toward the inherent risks in equities. The easy and cheap money then has freely flowed into stocks. What was disturbing about Tuesday's sell-off was not the magnitude of the drop itself, but instead the implications about the market's risk attitudes. I have written several times about the outsized appetite for risk that is out there. When (and it WILL be when, not if!) risk attitudes correct back to norms (whatever they are), credit will become less available and liquidity will suffer. These are the fuel of our debt-dependent economy. Purchasing beyond our means requires some bigtime support! How do we know risk attitudes are finally adjusting? The Wall Street Journal recently reported that Kathryn Dick, deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency warned bank executives that "we do believe there is risk building in the [banking] system." Investors are beginning to return the hot potato of sub-prime loans back to the originating banks.
Yet, Tuesday's sell-off included gold (ok - NOTHING was spared!) - commodities took particularly harsh hits. Ironically enough, Credit Suisse upgraded Freeport-McMoRan Copper & Gold (FCX) to Outperform with a $70 target and said "...copper prices will continue to move higher in the near term, FCX shares are undervalued even at lower copper price assumptions, and FCX has the potential to significantly de-leverage once the Phelps Dodge transaction closes." FCX followed up with a 10% decline - one of the biggest losers in the sell-off amongst commodity stocks! I have long been a fan of commodities on these pages, and I interpret the selling to mean that market players are acting out fears of recession if China succeeds in cooling off its economy. The 10-year Treasury obliged this flight by dropping yields a whopping 118 basis points - yet again confirming the multi-decade decline in rates. An interesting counter-force will be the upward pressure on rates that will come if Chinese demand for dollars follows a cooling in their economy. I am nearly jumping out of my seat at the prospects of getting some long sought after commodities shares at much better prices. I am particularly eyeing steel, but even Tuesday calamity is yet but a "nick" when compared to the strong run steel has had this year alone. (See disclaimer here.
Let's take a look at some other indicators of the dangerzone we have entered...
I wish I had written about Cisco (CSCO) earlier. Something about the way it behaved after earnings was unsettling. I will admit I was short and I clearly covered a bit too early, but what tipped me off was that the stock gapped up, faded, and in two days it was already trading at pre-earnings levels. In another two days it was back at the close before earnings. During this time, no one seemed to be alarmed, and everyone kept talking about how great CSCO's earnings were. And these warm, fuzzy feelings were used to help explain why the Nasdaq was soaring to challenge the January highs at the same time CSCO struggled. These kinds of disconnects in major stocks should always ring alarm bells. Now, CSCO finds itself on the bloody end of a 5.6% shellacking that took it convincingly below the 50DMA. CSCO's earnings charm has officially been wiped clean I would say. The chart below shows the recent action. November's gap up from the last earnings cheer is now being threatened again.
Just a few days ago, I noted that XHB's uptrend was being threatened yet again. Well, the long-standing up-trend from the summer bottom seems to finally be over. I am still bought in on a bottom for these stocks, but it now also seems a top has formed (is forming?). We can now add Pulte Homes (PHM) to the list of housing stocks that have dropped below the all-important 200DMA. KBH and BHS have now tumbled below the 50DMA. Our list of homebuilder stocks in favorable technical positions is slowly whittling away...and so goes the prospects for the XHB.
Be careful out there!