Am I Early or Wrong?

Editor's Note: In the Strategy section of this column, Whitney offers theRydex Venture 100 Fundas a means of profiting from what he considers a likely sell-off in tech stocks. Since publication, Whitney has reconsidered this option and does not recommend this Rydex fund to his readers, as he discusses in this subsequent column:How to Bet Against Tech.

Sometimes it can be hard to tell whether an investment decision or prediction is correct -- but early -- or just plain wrong. In one classic example, Warren Buffett warned investors about the rich valuations in the market -- especially the Internet stocks -- in late 1999, only to watch the Nasdaq soar 50% over the next four months. He sure looked wrong at the time, but, of course, we now know he was simply early.

Don't look now, but Buffett is again feeling mighty bearish -- so much so that he's standing on his soapbox and using the media to communicate his views, something he only does when he feels very strongly about something (see, for example, his warnings earlier this year about the dangers of derivatives). In an interview (subscription required) in last week's Barron's, he said, "he's 'not finding anything in the stock market and isn't enamored of Treasury bonds or junk debt." This state of affairs, he notes, is "no fun. But occasionally, successful investing requires inactivity." Buffett followed up with a lengthy article in Fortune in which he warns about the dangers of America's huge and rising trade deficit. He's so worried, in fact, that for the first time he's made major investments in foreign currencies.

Here we go again, again
I confess, part of the reason I mention Buffett's propensity to be early but almost always right is that I'm smarting a little from perhaps the worst prediction I've made in my four years as a columnist on this site (how time flies!). On June 6, in Here We Go Again, I lamented the return of "rampant speculation" in the markets, especially in the tech sector, calling valuations "ridiculous." Since then, the Nasdaq has led the market up, rising more than 17%.

Given what's happened, should I concede that I made a mistake? Not a chance. We've all been pleasantly surprised by recent data about the economy, which President Bush summarized earlier this week: "America is starting to add new jobs, retail sales are strong, business profits are increasing, the stock market has been advancing, housing construction is surging and manufacturing production is rising."

My concerns are twofold. First, I think there's a strong possibility that the recent signs of recovery are driven by temporary factors, mainly booming consumer demand fueled by increasing debt, tax rebates, and the like. Second, with stocks priced for perfection, there's an unattractive dynamic: If the economy continues to surge, stocks will likely be flat to up modestly, given that this scenario is already built into prices. But if there are economic setbacks, look out below!

Techie bear
I'm especially bearing on tech stocks, as the underlying fundamentals are poor, yet the valuations are extreme. Consider the following valuation comparison between the 30 companies in the Dow Jones Industrial Average and the 100 companies in the Nasdaq 100:

                  Dow     Nasdaq 100P/E (trailing)     21.0    81.7P/E (operating)    18.2    42.7P/E (future)       18.4    37.8P/CF                8.5    21.8P/S                 1.1     3.6P/B                 3.6     4.5Dividend yield      2.2%    0.2%

Notes: P/E: price to earnings ratio; P/CF: price to cash flow; P/S: price to sales; P/B: price to book
Source: Merrill Lynch report by Chief U.S. Strategist Richard Bernstein, 10/27/03

Maybe such a valuation discrepancy could be justified if earnings in the tech sector (which accounts for 64% of the Nasdaq 100) were poised to soar, far exceeding estimates, and companies in the sector were of exceptionally high quality. But I don't believe either of these statements is true. Regarding the latter, it should be obvious by now that tech stocks should trade at a discount to most other sectors given the tech sector's hugely volatile earnings and short product life cycles. In the recent Barron's article, Buffett wondered why leading tech companies traded at much higher valuations than top pharmaceutical companies when "drugs are a better business in the aggregate than technology." Then Buffett answered his own question, quoting the legendary Ben Graham: "Companies with mystery are worth more than those without mystery."

But what about near-term fundamentals? Might earnings continue to soar in the tech sector, justifying today's prices? Not likely says Fred Hickey, author of The High-Tech Strategist newsletter, which has been uncannily accurate for years (incidentally, it's the only newsletter I subscribe to -- with the exception of Motley Fool Hidden Gems). Earlier this month, Hickey wrote:

In general, tech earnings will look good in Q3 thanks to the massive stimulus from the government (tax rebates, low interest rates, massive money supply growth, and huge government spending)... Component suppliers to the PC and cell phone manufacturers are booming thanks to optimistic sales forecasts and related inventory build activity... The result will be one of the greatest inventory overstockings of all time. The impact (bust) will not be felt until later in Q4 and in 2004.

Hickey is especially bearish on Intel's (Nasdaq: INTC  ) prospects due to the impending rollout in scale of Advanced Micro Devices's (NYSE: AMD  ) new 64-bit chips:

While supporters high-five themselves as Intel has been able to hold the line on ASPs and regain some market share during the lull leading up to the deluge of AMD64 shipments coming next year, they are completely missing the big picture. Intel's position in the marketplace has never been more threatened.

Hickey concludes with a stark warning:

Tech stock investing is extraordinarily risky... Today's crop of tech investors sees all of the potential rewards and none of the risks. They do not understand that today's tech leaders are very vulnerable...

Another comeuppance is in the offing, and this time I think it will culminate in a sharp crash. Investors believe they learned a lesson in the 2000-2002 collapse. They believe that if they sold at the first sign of trouble...they could have avoided the damage. This time, all the retail investors...and all the wise-guy hedge fund and mutual fund traders plan to sell and get out first. The problem will be finding buyers.

Strategy
Believing that Hickey is right and finding a safe way to invest profitably based on this belief are two different matters. I don't recommend that individual investors short stocks, as losses are potentially unlimited, so other than selling fully valued positions and raising cash to invest should there be a correction, what might one do?

One idea is to invest (as I have) in the Rydex Venture 100 Fund (RYVNX), a mutual fund that every day moves double the inverse of the Nasdaq 100. In other words, if the Nasdaq 100 falls 1% today, this fund will rise 2% and vice versa. The fund has been a spectacularly bad investment this year, falling nearly 60% as the Nasdaq 100 has soared 44%. However, if you believe, as I do, that this situation is likely to reverse itself, then investors in this fund stand to make substantial gains.

Of course, this would also be true if one were to simply short the Nasdaq 100 tracking stock (AMEX: QQQ  ) , but I believe that going long the Rydex fund is a much better option because gains are unlimited while losses are capped -- precisely the opposite of a short position. If tech stocks retrace their gains over the past year, for example, investors in the Rydex fund can more than double their money, yet if the Nasdaq 100 continues to soar, losses cannot exceed the amount invested. That's the kind of risk-reward equation I like. In addition, because the Rydex fund delivers double the inverse of the Nasdaq 100, one only has to commit half as much capital. So, rather than a 10% short position in the QQQ, one only has to invest 5% in the Rydex fund.

Conclusion
Just about every investor I know agrees that this is the most difficult time to be a sensible, value-oriented investor in at least five years. The broad-based rally in the market has affected nearly every type of stock, in almost every industry, making bargains rare -- and overvaluation rampant. This is not a time to listen to Wall Street's cheerleaders and jump on the bandwagon. In fact, I strongly recommend precisely the opposite.

Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of the Rydex Venture 100 Fund at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.


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