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Tuesday, 10 August 2010

Not-So-Happy Talk at Happy Hour

by Michael Santoli

Meet enough traders and page fund managers for lunches, coffees and happy hours, and some themes start to emerge about what's confusing them at a given moment. Here are a couple of market riddles in heavy rotation:

Professional investors seem to be in a persistent state of reverse sticker shock regarding Big Tech stocks. The marquee names of the go-go tech market of the '90s look "too cheap" by most measures, and have for a couple of years, and yet the stocks just sit there.

Take the representative "big five" of Microsoft (Nasdaq: MSFT - News), Intel (Nasdaq: INTC - News), Oracle (Nasdaq: ORCL - News), IBM (NYSE: IBM - News) and Hewlett-Packard (NYSE: HPQ - News). They all trade at between 70% and 90% of the broad market's price/earnings multiple based on the next 12 months' forecasts, after having spent a decade or more at often wild premiums to the average stock, without even accounting for the tens of billions in collective cash on their balance sheets. This is jarring to a generation of investors accustomed to thinking of tech as the market's version of a luxury good—expensive because it was somehow better, and better because it was expensive.

There are a few ways to explain this reality. One is that the market has finally figured out that tech companies are...just companies, and their stocks mere stocks, and their products, many of them impressive and indispensable, are subject to all the familiar economic and competitive forces. Are Intel chips better than Cheerios or unleaded regular? Investors are collectively saying "not to us" based on the similar-to-higher valuations of General Mills (NYSE: GIS - News) and ExxonMobil (NYSE: XOM - News).

There's also a certain limbo state reserved for "cheap" tech stocks. Growth investors aren't turned on by good but mature and moderately growing businesses. Some value investors are happy to step in, but the companies' resistance to paying generous dividends and the way they report profits, excluding crucial stock-based employee compensation, rankle many.

These stocks all have huge weights in the overall indexes. There is virtually no money entering long-only vehicles such as index mutual funds. And hedge funds, the setters of the marginal price in today's market, avoid most such benchmark-dominating names. (Google (Nasdaq: GOOG - News) and Apple (Nasdaq: APPL - News), however, are fair game for hedgies, embodying as they do a secular "story" they can play.)

In this way, Big Tech is illustrative of all the large-cap stocks, which can be made to look cheap based on expected results, lack sponsorship and are generally held back by an abidingly high-risk premium being assigned by a skeptical, shock-wary market. If tech stays cheap for as long as the sector stayed expensive beginning in the mid-'90s, the cheapness should last quite a while, even if it also reduces the risk of owning it at today's prices.

Another big topic of trader talk: How will this nervous market handle the notoriously treacherous September-October period? Many investors aren't waiting to find out. They are sidelining themselves. Or, to a notable degree, they are placing a bet that volatility will surge as summer wanes into fall.

One way to show this is the large premium that has persisted in futures on the CBOE Volatility Index (VIX) that will pay off if the market gets panicky by late September. This means traders are willing to pay what appear to be aggressively high prices for defense against a volatility storm.

It's possible to read this in a contrarian manner and conclude that too many are too fearful and thus the market is insulated against a truly damaging market shock. And it's true that last year under similar conditions we got a couple of volatility pops and sharp pullbacks, though nothing that even threatened the July 2009 lows. But traders who study these patterns also say a steep premium in the futures simply implies the market is "overbought."

What's sure, though, is that the current market volatility and the levels implied by the futures must converge before too long, either by the market getting skittish again or the forward volatility futures coming down.

This volatility argument aside, the market for the moment seems to have allowed a few plausible reasons to crack pass it by—not least the soft GDP and employment numbers the past two Fridays. Volume remains light, participation thin, conviction levels low. The trading-range idea remains dominant for now, but it's the sort of climate that is conducive to air pockets in either direction, just as the recent data and the bond-market's deflation alarm will inject some drama into Tuesday's Federal Reserve meeting.

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