Hitchhikers Guide to The Downturn

Baruch came back to the pit face on Monday from his two weeks off, and what a sea of destroyed hopes and dreams he beheld! It hasn’t looked this bad to him in years, and you know Baruch is a cheerful, optimistic sort of person. Everything that follows in this post comes from the assumption that things do indeed get worse and we are in a bear market. I reserve the right to change my mind on this at a moment’s notice, however.

Meantime I have actual reasons to think we are a bear market as well as feeling it, Colbert-like, in my gut (although that might also be gastric flu): key to these things is earnings estimates, and despite the fact that we are entering a recession they have only just started to come down, and only grudgingly, in my space at least. I noted Goldman’s Cisco analyst was recently persuaded to lower his 2008 estimates the other day, and did so by cutting full year revenues by like, $20m, keeping his EPS unchanged. His FY revenue estimate is over $40 billion! So while I applaud the direction, I wish he had cut it a bit more. Generally in my sector I don’t yet see the swingeing cuts in estimates that would be a) possibly realistic, and I make no comment on whether CSCO will make its number or not, but more importantly b) positively beatable. I don’t see the incentive for managers to guide kindly in the upcoming earnings season. I am worried.

You should feel pity for Baruch; his global tech fund has to stay invested all the time. You all with your PA portfolios can simply stay out of the market for a while — I recommend you do this by the way — and maybe some of you can even short stocks. Those of you wedded to your index funds will suffer appropriately. However, it could be still worse: I had a good year last year and can coast off that for a while, I don’t work in M&A, structured debt products, and my bonuses are not about to be “clawed back”, cheered on by “the commentariat“. As an aside I back old TED on this issue, and would make the further point that I am not sure it is possible to reliably isolate alpha vs beta, skill or luck, in investment performance. Perhaps more on that later. But as a broker friend of mine jokingly put it, if 2007 was the year when technology began to shine, “2008 is going to be the year of keeping our jobs”. Ha ha.

So what is a technology fund manager to do? 

What follows is a list of behavioural patterns and strategies, dusted off from the last major downturn, that served me well in the past. I like to think of them as “resolutions”, and by writing them down here I hope to either a) through some hoojoo irony thing forestall the bear market from actually happening, or more prosaically, b) reinforce these behaviours in my own mind by promising to follow through on them in this, a supposedly public forum. Here goes:

  1. Buy yield: yes, yield, either in the form of dividends and/or in mega share buybacks. Yields of 5-7% can be found in European telcos, and that is where I hope to hunt. I even found one with an 11% potential dividend yield for 2008! Nokia, believe it or not, yields 6-7% in dividend and buyback right now. Yield stocks tend to have great characteristics in markets like this, not just because they stack up really well against bonds in an environment of rate cuts, and tend to have sustainable, defensive business models, but also because the investor base is different; income funds, private clients, that sort of thing, and they do not see the same level of redemptions high beta tech funds will (sob). Note you have to buy sustainable yield; blown up banks yielding 7% are NOT DEFENSIVE. They will cut their dividends and stop their buybacks.
  2. Hedge a lot, and trade your hedge: index puts and short futures are liquid and cheap to trade. Keep a moderate to large hedge 80% of the time and trade it aggressively, based on implied volatility, oversold readings, and your sense of how depressed everyone is, because one of the eternal features of a healthy bear market are fantastic short covering rallies, based on chimerical “not as bad as expected” reports, or more likely (and right now probably imminent) rate cuts and fiscal packages. These rallies kill the shorts, but more importantly make the properly hedged long-only guys look stupid, too. Trade trade trade. Last I looked the trading fees of a $10million short future position in the NASDAQ 100 was the price of a taxi ride from Heathrow to Central London. And when trading your hedge. . .
  3. Let the Costanza Doctrine be your guide: do The Opposite of what feels good. You are not alone, and at the moments of maximum stress when you think they’ll never, ever go up again, everyone else will be thinking the same thing. Take your hedges off because that’s when we are about to go up. Similarly, watch out for when you feel really positive about the market. When you think everything is going to be all right for a while, add those puts back. This of course will drive you mad, and if you are successful you will eventually stop being able to recognise what it is you actually think about things, at which point you will no longer know what The Opposite is. I am there already. Never mind, at least try and remember that. . .
  4. Small caps are toxic: or rather, avoid illiquidity. There’s nothing worse than involuntary sales in illiquid stocks. But small also caps tend to have earnings that bounce around a lot more; the law of large numbers applies in reverse. This makes them more economically sensitive. Everything takes its turn in this type of market. When small caps take theirs it is much, much worse. However, bear in mind. . .
  5. There’s always a Krispy Kreme: Krispy Kreme Donuts (KKD) rallied from $10 to $45 in the 2 years of the 2000-2002 bear market, in the teeth of the nastiest sessions, eating shorts as it did so, as the chain went national. It was one of the most controversial stocks of its time. Now it trades at $2.80, but never mind. Only very few stocks will go up in bear markets, but you simply have to be in them as a long only, benchmarked manager, because all of your peers will be too. At this point I don’t know what the Krispy Kreme of 2008 is going to be, but I am watching out for it. For the rest of the market . . .
  6. Stock replacement: why on earth do I own stocks in an environment like this if I don’t have to? If you think RIMM is going up, buy call options instead! I guarantee you’ll be wrong half the time, even if you’re right, you’ll be hit by some peer group profit warning, Circuit City will blow up again, or CountryWide will go bankrupt. Then you lose your premium, and you’ll thank god you weren’t in the underlying as it drops 10% on the day and 5% the next. The minimal capital outlay also means you can take a larger underlying position than you would be able to afford if you had to pony up the full cost of the shares. Use 0.20% of your capital, an amount you would lose down the sofa cushions without batting an eye, and if it goes well you can find yourself with an in-the-money position giving you the economic return of a 3-4% position. Finally
  7. Don’t get used to any of this. The second major killer in bear markets is not actually the bear market but staying short or hedged in the subsequent rally. Ex-super hedge fund Andor Capital fell back into obscurity after 2003 by remaining bearish after the market bottomed. Stock markets generally go up. This too shall pass, hopefully in about 3-6 months or so, and when it does you had better be long again.

That’s about it. Does anyone have any other suggestions?


2 thoughts on “Hitchhikers Guide to The Downturn”

  1. dunno really, what do you think? i thought handsets would be OK, i mean they get subsidised by telcos. but they probably have to blow up too before they prove to be less bad than everything else. my thesis is that tech is “less bad”, like kedrosky’s, but sadly prices are still discounting “pretty good”. They were “really quite good” start november, however, so this is progress.

    oh look RFMD just blew up. good-bye handsets!

    nowhere to run to, baby
    nowhere to hide!

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