King Investors, Inc.

 

 

 

Market Commentary: Year-In-Review (July 2000 – July 2001)

 

 

 

 

 

Executive Summary:

 

Investors received a rude awakening in 2000-2001. What had once been a goldmine of seemingly limitless possibilities suddenly became a treacherous market for investors, with many watching retirement funds and 401Ks decline for the first time ever. When the market’s downward spiral began last March, many expected a quick recovery and the recuperation of lost income.  Unfortunately, there was no turnaround and investors continued to watch both corporate earnings and the markets take major losses. It is possible that the market has now hit its bottom… for a while.  However, the highs of last year will not be seen again for several years.

 

The next few years in investing will see more conservative growth in the market.  While the market is expected to rebound, we believe that the turnaround will resemble the market trends achieved between 1961 and 1974, where despite short-lived up-moves of as much as 85%, virtually no net gains were made over more than a decade. Nevertheless, there is money to be made in this new era for those who are able to move beyond the traditional buy-and-hold strategy.  The next ten years will be more of a trader’s market, favoring the investor who can turn the market’s volatility to his advantage, investing with the trend and staying out of the market (or shorting) during periods of probable decline.

 

Technical analysis is one technique helpful to those wishing to use this strategy, and becoming well versed in various trading techniques will allow the modern investor to take full advantage of both the ups and the downs in the market.

 

Since its inception King Investors, Inc. has used a variety of these techniques, focusing on the technology sector as a whole.  Our major emphasis is on biotech, computers, internets and semiconductors, as well as on two non-technology industries, financials and oil services. Over this first year, we have managed to outperform the market in every sector we cover, just barely in one and quite handily in others.  Overall gains in the various sectors range from 17% in financials to over 100% in semiconductors.

 

 

 

 

 

 

 

 

2000-2001 — A Look Back:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


Wake-up call.  These are the words we would use to describe the events in the stock market since we started publishing our market commentary.  By the end of 1999, investing in the stock market was beginning to become en vogue.  At the dawn of this new millennium, as “Bill Gates”, “dot-com”, and “internet startup” moved into the common vernacular of our pop culture, the stock market had ceased to be viewed as America’s biggest casino, where investing in common stocks and gambling were considered almost one and the same.  Instead, “I can’t afford to take the risk” had turned into “I can’t afford not to.”  Financial news networks like CNBC had started catering to the mainstream buying public, and the preference for stock options, online brokerages, and day trading all underwent explosive growth in the years leading up to last spring.

 

If investing were still likened to gambling, it would more likely be compared with putting down money on the craps tables when someone is on a hot streak.  Every IPO has to double…150% gains in just two days…800% gains in three weeks.  These are the types of returns that many had grown to view as commonplace.  “No earnings?  No problem!  I don’t wanna miss out.  Let it all ride….”

 

A year later, the Dow, S&P 500, and NASDAQ are down over 10%, 20%, and 50%, respectively.  The same financial news networks that were promoting mass interest in investing had begun to use words like “carnage” and “destruction” in stock news reports.  Many of the internet stocks are down over 90%, and within the NASDAQ, the ten largest stocks alone have suffered a combined loss in market cap of over a trillion dollars.

 

It is impossible to fully comprehend the events of the last year-and-a-half without first examining the performance of the stock market (and the US economy) for the decade leading up to the bull market top in March of 2000.   The buildup of pressure that exploded to the downside last March had occurred not over a period of 6-9 months or even 18, but over nearly 10 years.  As such, we must acknowledge the likelihood that markets could indeed take as much as a third of that time, or 2-3 years, to turn around.

 

A full down cycle, from bull market top to bear market bottom, tends to involve a turnaround not only of stocks and the economy, but of public sentiment as well.  At a bull market top, P/E’s are typically at near-term highs (with P/E’s on the S&P 500 in the low 20s), but the general public is buying more than they were when prices were lower.  Consumer confidence is normally very high, and public sentiment is bullish to an extreme.  In March of 2000, P/E’s were at all time highs.  Since that time, the S&P has fallen 20%, and the NASDAQ is down over 60%, with at least two temporary bottoms in the meantime that sent many advisors proclaiming “new bull market” and sent investors rushing in to buy more stock, only to have them ride it down for an additional 20-50% loss.  This marching of prices, to lower highs and lower lows, is actually fairly typical for a bear market and was in large part to be expected.  Stock prices have decreased and we have had a slowdown in economic production, as well as corporate sales and earnings growth.

 

The difficulty, however, is in the public sentiment.  True bear market bottoms seldom occur without a complete reversal in investor sentiment.  But we have been conditioned over the past decade to expect appreciation on our holdings of 20-30% a year, more than double the historical average.  There’s an entire generation of investors who grew up on consistent double-digit returns and can barely remember the crash of ’87, people who buy under the assumption that all stocks eventually have to go up.  This is the sentiment we are dealing with, and turning that sentiment from bullish to bearish, from euphoria to fear, may take a while.

 

At a bear market bottom, P/E’s are typically very low, with P/E’s on the DOW and S&P in the low to mid teens, but the general public refuses to buy stocks they paid nearly twice that price for 6-12 months earlier.  Consumer confidence is usually very low at these points and public sentiment is extremely bearish.  The picture at present, however, is very different.  P/E ratios for the DOW and the S&P 500 are still in their 20s.  An article in the New York Times in February of this year placed the P/E for the NASDAQ 100 (the 100 largest stocks in the NASDAQ) at over 800!  This figure was at an all-time high of 165 in March of 2000 and, because earnings have come down so much in the last year, has risen five-fold in that time.  And while consumer confidence has been declining somewhat, overall public sentiment is still relatively bullish.

           

A contrarian view would suggest that since the general public remains largely bullish, it would be wise to maintain a bear market mindset.  While we do not fully ascribe to these tenets, we must agree that despite severe price declines in technology related sectors, the events of this past year do seem to fall somewhat short of a full reversal.  As such, we do not expect to see anything close to last year’s highs for quite some time.

 

 

 

 

The Market Moving Forward:  Trader’s Market

 

2000 – 2010 à Repeat of 1961 – 1974:

 

The NASDAQ has moved up as much as 40% off of its April lows, which may or may not have been the bear market bottom.  But what do we expect as we go forward?  Our expectation is that this index won't hold much of its gains over the next decade in either real or nominal terms.  In order to understand our reasoning we will examine the bear market history since the turn of the 20th century. [We will look at the DJIA and S&P 500 rather than the NASDAQ, in order to get sufficient history, as the NASDAQ in its present form is only 30 years old.]

 

Bear Market History:

 

There were 17 bear markets in the U.S. from 1900 to 1991, turning in an average decline of 39.8%.  From 1900 - 1938 there were 8 with an average decline of 48.8%.  From 1938 - 1991 there were 9 showing an average decline of 31.9%.  The bear markets with the larger declines began when the price-earnings ratios were greater than 20.  The recovery time to reach the previous high took longer in these cases than when the bear markets began with much lower price-earnings ratios.  We feel the most relevant examples to the current market are the series of bear markets that began in 1929 and those that began in 1961.

 

The bear market that began in 1929 was initiated with the DJIA 's price-earnings ratio (P/E) greater than 20, an inverted yield curve and deflation.  The one that began in 1961 started with a DJIA P/E greater than 20 and an inverted yield curve, but inflation-stagflation.  Since the NASDAQ bear market that began March 10, 2000 had a P/E ratio greater than 20, an inverted yield curve and inflation-stagflation, we feel the present market resembles the 1961-1974 market.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


This series of three bear markets — 1961-1962; 1968-1970; 1973-1974 — can be treated as one long bear market.  The high for the DJIA (1961) was 735, but fell to 536 in 1962; it increased to 995 during the 1966-1968 period, only to fall to 631 in 1970.  Again, the DJIA increased to about 1000 in 1973-only to fall to 577 in November of 1974.  That is, in 1974 the DJIA took a hit which left it at a level lower than the high of 1961 and at its bottom was only 41 points (7.6%) higher than its low of the 1961-62 bear market.  Even when dividends are added the result was a very small gain for the DJIA in nominal terms and a great loss in real terms for that 14-year period.  Since the peak P/E's of the current period were much higher than those of the 1961-1974 period it is highly probable that stocks, and particularly the NASDAQ as an index,,,, will not be a very good investment vehicle over the next 10-15 years.

 

What Is To Be Done Now?

 

If the above scenario is correct, what strategy or strategies will perform best in the coming years?  In June 1987, prior to the August-October crash of that year, Robert Solomon (of Solomon Brothers) suggested that he made a ton of money between 1962-1970 as the averages went flat.  In our opinion, the market today offers the same kind of (an) environment.  That is, the markets will rise and fall, but a buy and hold strategy applied to a NASDAQ type index over the next 10-15 years has a low probability of performing well.  Therefore, the stock trader will have a distinct advantage moving forward.  One must either select securities very wisely or trade the indices with facility.  We shall apply both of these approaches over the next several years.

 

 

On Technical Analysis and Trading:

 

“In the course of years of stock market study, two quite distinct schools of thought have arisen, two radically different methods of arriving at the answers to the trader’s problem of what and when.  In the parlance of ‘the street,’ one of these is commonly referred to as the fundamental or statistical, and the other as the technical.” [Technical Analysis of Stock Trends, Edwards & Magee]

 

Technical analysis is the study of the action of a stock or index in terms of its price movement and volume of transactions, often recorded in graphical form, to determine from that the probable future trend.  More than anything else, technical analysis (TA) is based on one principle.  The markets discount everything.  Technical Analysis of Stock Trends (the “bible” of technical analysis) later states,

 

“Because they reflect the combined market activities of thousands of investors, including those possessed of the greatest foresight and the best information on trends and events, the Averages in their day-to-day fluctuations discount everything known, everything foreseeable, and every condition which can affect the supply of or the demand for corporate securities.  Even unpredictable natural calamities, when they happen, are quickly appraised and their possible effects discounted.”

 

It is the job of the technical analyst, armed with this knowledge and with an understanding of how to interpret this data, to deduce from the action of the market the most likely direction of the coming trend and the most appropriate buy and sell points.  Over the years, many have come to regard fundamental analysis as the only viable long-term strategy for investing.  We believe that this point of view limits the investor and places undue faith in the market’s ability to bring the undervalued stock back to fair value in a timely fashion.  The art of investing is the study of three things: the economy, companies, and people.  Fundamentalists place all of their emphasis on the first two, completely disregarding the most powerful factor in determining the price of a stock.

 

Technical analysis is, in effect, the study of people’s impact on stock prices.  The trader is the person who decides to use these techniques to profit in the stock market.  While the long-term investor frets over the market that moves up and down in a trading range that in the end leaves him with little or no gains, a skillful trader can turn over his money several times.  In the above example of the ’62-’74 DJIA, simply buying and selling three times so as to stay out of the market for the worst 5 of the 13 years, would allow the trader to keep profits of as much as a 300%, while the long-term investor is left with no returns over the same period.  As we leave the bull market of the ‘90s behind us and move into a new era of rising and falling markets, the advantage will go to the trader, as many buy-and-hold investors will find themselves in 2010 with roughly the same portfolio in “real” terms that they had a decade before.

 

 

King Investors Market Call Performance:

 

Overview:

 

To say that we are pleased by the performance of our market calls during this first year publishing our commentary in this format would be a mistake.  We are very proud of our performance during the past year, particularly in light of how weak the market has been throughout this period.  Our goal during severe market downturns is preservation of capital, so we can be no less than delighted with what we have been able to achieve.

 

Sector Focus:

 

In our commentary, our market calls focus on technology, specifically the NASDAQ, and these calls can be traded with QQQ, a NASDAQ 100 tracking stock.  We also explicitly cover four tech-related industries (Biotech, Computer, Internet, and Semiconductor), as well as 2 non-tech industries (Financials and Oil Services).  The indices representing these sectors, and their corresponding tradable tracking stocks are as follows.

 

           

 

Sector

Index (ticker)

Tracking Stock (ticker)

            NASDAQ                                ^IXIC                                      QQQ

            Biotech                                     ^BTK                                      BBH

            Computer                                 ^XCI                                       None

            Financials                                 XLF                                         XLF

            Internet                                     HHH                                        HHH

            Oil Services                              XLE                                         XLE

            Semiconductor                         ^SOXX                                   SMH

 

Major Calls:

 

A major call is a signal that is explicit.  However, in the first few months of publishing this commentary, many of the calls were not explicitly stated up front, and must be interpreted.  The statement that there is a buy or sell “coming” would not be interpreted as a call, but a forewarning of a likely call to come.  On the other hand, “we expect to see this sector moving up shortly” always would be.  For a major call, a number of criteria for a buy or sell signal has to be satisfied according to our models, or the technical action of the market must fit a pattern definite enough to give a buy or sell signal without confirmation from our models.  These calls are likely to last from several weeks to several months before getting a reversal.  Major calls make up the majority of our trade volumes and profits.

 

Minor Calls:

 

A minor call is one in which not all of the criteria for a buy or sell has been met, but there has been sufficient bullish or bearish pressure built up to turn markets in the other direction, at least briefly.  These calls are usually not explicitly stated as a long-term signal, but implied, such as “market weakness anticipated” or “while some of our criteria have not been met, we expect to see the market moving higher briefly.”  The ensuing market moves from these calls are seldom prolonged, usually lasting from a few days to a few weeks, and gains from these calls are generally limited to less than 5% or 10%.

 

Price and Timing:

 

All buy and sell calls are assumed to be in force immediately.  For the purposes of performance tracking, trades are assumed to be made on the trading day following the date of the call, at a price equal to the average of the high and low on that day.  Commissions are assumed to be negligible ($10 commission on a $10,000 trade is 0.1%) and are not calculated in the returns.  We should add that while we do practice trading in both directions in the market, we have not recorded profits from trading the short side of the market here.  Including the outcomes from trading the short side would more than triple the gains in most sectors.

 

Results:

           

 

 

Date of Initial Call:

Current Date:

Performance to Date:

Annualized Performance:

NASDAQ                    17-Jul-00         3-Aug-01         29.7%              27.6%

Biotech                         31-Jul-00         3-Aug-01         42.1%              40.8%

Computer                     17-Jul-00         3-Aug-01         34.3%              31.8%

Financials                     12-Sep-00       3-Aug-01         16.8%              18.6%

Internet                         11-Jul-00         3-Aug-01         35.8%              32.7%

Oil Services                  24-Jul-00         3-Aug-01         34.3%              32.6%

Semiconductor             17-Jul-00         3-Aug-01         114.7%            104.7%

 

In order to get a true picture of these returns in light of the difficult market of the last year-and-a-half, we also present the following comparison.  Figures represent the current value of $10,000 traded based on our calls as described above vs. the current value of $10,000 invested on the date of our initial call in a typical “buy-and-hold” strategy.

 

 

Value of $10k traded based on buy and sell calls:

Percent Gain (Loss) by trading with calls vs. buy-and-hold:

Value of $10K invested in index at initial call and held:

 

 

 

NASDAQ                    $4910                          $12970                        +164%

Biotech                         $6830                          $14210                        +108%

Computer                     $5250                          $13430                        +156%

Financials                     $9730                          $11680                          +20%

Internet                         $3930                          $13580                        +246%

Oil Services                  $10480                        $13430                          +28%

Semiconductor             $5230                          $21470                        +311%

 

While space constraints did not permit us to print every trade here in this format, records of each of our trades can be accessed on our website, at

 

http://www.kinginvestors.com/indcalls/archives/trades.htm.

 

As we stated above, the market in the coming years is likely to favor the investor who takes advantage of timing, as well as selection, of his or her investments.  King Investors is here to provide information that can be useful in that regard, both for the aggressive trader, and for the more conservative investor who only wants to know when not to be in the market.  We have enjoyed providing such commentary over the last year and look forward to continuing to do so for many years to come.

 

 

 

Acknowledgements:

 

We would like to thank all of the readers who gave us feedback (both positive and negative) and helped us to evolve into our current form.  In particular we would like to thank Dr. Jules King, Professor of Finance at the University of Arkansas, for all of his guidance—without which this company would not exist, Phil Horigan, for the many relentless critiques that contributed to the ever-increasing structure and clarity of the commentary, and Runako Godfrey, for his technical expertise in helping bring some of our models into being.