NASDAQ Bungee Jumping

Adam Hamilton    May 19, 2000    2334 Words

In a tragic incident, a 22 year old American man was killed Monday while bungee jumping from a cable car in the Swiss Alps.  His leap of faith began 300 feet above the ground, and ended unfortunately as he burned in when his rubber bungee rope failed to bounce back as planned.  The event was so gruesome that a half dozen onlookers had to be treated for shock.

After hundreds of thousands of safe bungee jumps worldwide, the odds were the only lasting fruits of the leap for the man would be a memory of a great rush of adrenaline and maybe a few gray hairs.  In a cruel twist of fate, however, the unthinkable occurred and what seemed like a small risk rapidly proved fatal.

The whole disastrous scenario reminded me of the NASDAQ this week.  After a spectacular five year bull market followed by a six month mega blow-off, general investor sentiment is still very bullish for the NASDAQ.  Each time a talking head on CNBC raved about buying the dips this week, I found myself thinking back to the poor man who was told bungee jumping was risk-free.  Buying the dips is an acceptable strategy in a secular bull market.  In a land of uncertainty with deteriorating fundamentals and record volatility, however, buying the dips may be like bungee jumping with a bad cord.  Sooner or later the big dip is coming which will snap the rope and forever shatter the dreams of those who have placed unquestioning faith in the NASDAQ.

As expected, the big news of the week was the Federal Open Market Committee’s decision on Tuesday to raise the Federal Funds interest rate.  Following the usual modus operandi, after extensive telegraphing of the 50 basis point hike possibility, Greenspan played into market expectations and pulled the trigger on both barrels, doubling the potency of his last five quarter point moves.  In a move not seen since 1995, a half percentage point fed funds and discount rate hike signal the Federal Reserve is becoming more and more concerned about inflation.  Bad news?  The manic bulls sure didn’t think so, citing the unchanged CPI numbers from last month.  The DJIA closed up over 1% and the NASDAQ surged 3% on the day.

What are the bulls excited about?  After this sixth rate hike in less than a year, has the Fed finished turning the screws on this tightening cycle?  According to the hawkish statement by the Fed following the rate hike, more interest rate hikes are in store for the US economy in the near future.  The next FOMC meetings are in June and August, and the Fed made it quite certain that still higher rates are coming.  The juggernaut of inflation is barely beginning to disturb the economy.

The ambivalence of the bulls to the whole spectacle makes one wonder if interest rates even matter.  In order to explore that possibility, let’s take a graphic look at over 30 years of federal funds rates and the S&P 500 to see how the broad stock market performed in changing interest rate environments.  The results are quite interesting.  If you are bullish on equities at the moment, you better sit down or quit reading now, for your own safety.

The red and green arrows represent tightening and loosening cycles in the federal funds rate by the Federal Reserve.  The percentage near each arrow indicates the average annualized return of the S&P500 during that particular cycle.

As you can see, during the loosening cycles between 1970 and today, the S&P 500 returned a healthy average annualized return of 18.8%, which is quite impressive.  During the tightening cycles, however, that average annualized rate of return dropped an incredible 71%, to a mere 5.4%.  With M3 increasing over 10% per year and inflation surging into the economy at a probable rate far above 5%, will sophisticated investors be willing to sit in the US equity market, at a possible negative real rate of return, for another few kicks in the teeth as the Fed continues to tighten? 

While your attention is focused on this 30 year chart of the S&P 500, check out the 1987 stock market crash relative to the size of the current equity bubble which began in 1995.  Surely no one can argue in good faith that this anomaly in the markets since 1995 is a normal, sustainable, backed by real fundamentals type of rally in the S&P 500.  If it looks like a bubble, smells like a bubble, acts like a bubble, then it is probably … (insert drum roll) … a bubble.  And bubbles can’t stomach higher interest rates.

What about the NASDAQ bungee jumpers?  Is their passionate assertion that NASDAQ stocks are interest rate proof plausible?  The standard CNBC party line spewed forth states tech stocks are immune to interest rates because they are equity financed and are not subject to higher borrowing costs.  This view is a tad myopic, as we shall explore.

A higher interest rate environment is bad for virtually all stocks, including the NASDAQ darlings.  Here are just a few reasons why persistently higher interest rates have a very high probability of decimating tech stocks.

1)      Valuation.  The time-tested standard model for providing the valuation of any investment is the discounted cash flow model.  Using DCF, future cash flows are stated in the terms of current dollars by discounting using a “risk-free” rate of return.  The yield on US Treasury paper with a maturity comparable to the investment in question is used as a proxy for the risk-free rate of return.  As interest rates rise, the risk-free rate of return also rises.  This number manifests in the denominator of the net present value calculation, so increases in interest rates yield lower DCFs and hence lower valuation estimates for a particular investment.  If there are any analysts left actually trying to value technology companies rather than simply believing the hype, the resulting price targets will be much lower in a tightening environment.  Lower price targets for tech favorites will severely dampen investor enthusiasm.

2)      Competition for capital.  In these increasingly volatile times, when tech companies can lose 95% of their value in a few weeks, the relative stability of debt instruments like bonds can appear mighty alluring.  As interest rates rise, nominal rates of return on bonds also rise, increasing their appeal to beleaguered investors seeking safety in turbulent times.  Less capital chasing tech stocks equals fewer bids, lower volume, and lower prices.

3)      Reduced Demand/Sales.  The technology companies ultimately need to sell their products to earn a living, just like “traditional” companies.  As “traditional” companies and consumers feel the bite of higher interest rates, more of the funds they have been spending on technology products will be diverted to financing increasing debt loads in a higher interest rate environment.  This also can become a vicious circle, as the customers of the customers of the tech companies are also tightening their belts and eliminating non-essential projects, like annual information technology upgrades.  The compound effect throughout the economy and tech customer base of rate hikes could eventually be quite astounding.

Rising interest rates fundamentally alter capital flows and expenditures for the entire economy, and the NASDAQ will not be exempt from the effects of the Federal Reserve’s current tightening cycle.  Indeed, due to NASDAQ’s stellar valuations built on assumptions of the best of all worlds for many years into the future, these stocks may be hurt far more from the rate hikes than more “traditional” companies selling at more reasonable valuations.  Investors willing to climb up to the top of the NASDAQ cable car, don the harness, clip on the rubber rope, survey the carnage on the landscape below, and still jump are either at the pinnacle of contrarian courage or the depths of greedy folly.  The future will make the judgement and tell the tale.

Last week we discussed the IPO market, including how AT&T Wireless, the biggest IPO ever, was trading well below the offering price.  That trend continues this week, with AWE now trading at an ugly $26.50.  In addition, more bad news accretes on the new company front.  After an IPO, inside investors are usually prohibited from selling their stock in the new company for six months.  In May, over $100b of IPO stock finishes its lockup period, potentially swamping a market that is barely treading water with a fresh supply of paper.  Monday, for example, eight new companies’ insiders were released from lockup.  The largest of these companies, Agilent Technologies (A), represented over 95% of the market capitalization of this group.  Agilent was hammered for an incredible 26% this week, three of the companies (IMAN, RMKR, WEBS) lost more than 13% of their value this week, one (RETK) lost 5%, one (ALSK) was unchanged, and only two (SMMX, MSLV) had significant gains on the week.  As more and more lockups expire, the added supply of stock will continue to drive down prices of most of these formerly high-flying IPO companies.

The general market fundamentals continued to deteriorate this week.  Contrary to the leaps of joy by the market on Tuesday when the CPI numbers for last month were released, the inflation picture remains grim and promises the worst is yet to come.  The CRB commodity index soared to another 2 year high this week as oil punched back through $30/barrel, twice.  The international picture continues to look ugly as well.  The United States trade deficit rose to a record $30b in March, indicating foreigners are financing US consumption to the tune of $1b per day.  If the foreigner creditors and investors get tired of the recent lackluster performance in the US markets and begin to sell, the equity bubble will shatter dramatically and the dollar will fall like a millstone cast into the sea.  International bear pressure continues to mount as well, as the major European bourses got hammered this week.  Japan continues to drift hopelessly, after eleven years of a brutal bear market.  The Nikkei 225 fell dramatically this week, and closed near its 52 week low at 16,800. 

The NASDAQ “buy the dip” bungee jumping crowd would do well to study Japan.  In 1989, the Nikkei touched 39,000, and was the most exciting stock market in the world.  The vast majority of Japanese and global investors thought the party would continue forever, and an unlimited supply of rationalizations why the market simply had to climb higher were everywhere in abundance.  The small voices in the wilderness proclaiming this was an irrational bubble valued at ridiculous levels were either ignored or laughed at.  Today, after 137 painful months, the index struggles to reach 45% of its former glory.  Many fear the Nikkei 225 will continue to drop to support levels at 13,000. 

Gold continued its slow drift lower this week in anticipation of the next round of the very unpopular Bank of England gold bullion sales scheduled for next Tuesday.  The 25-ton traunch, a trivial amount of gold compared to the estimated 700+ tons of paper gold traded daily in London, will be easily absorbed by the markets.  On gold’s political flank, GATA continued its assault on Congress this week, winning valuable allies with carefully researched and meticulously presented evidence of collusion in manipulation of the gold price among bullion banks, investment banks, and elements of the government.  A 70+ page research report was hand-delivered to each member of Congress and a large advertisement was placed in the Congressional Rollcall.  GATA is helping the US Representatives and Senators understand the potential for a catastrophic and systemic failure of many large US money-center banks when an inevitable accident in gold derivatives occurs.  GATA has unambiguous evidence that the physical gold price is being artificially suppressed through naked short sales and exploding paper contracts on gold.  As history has taught so many times, the iron laws of free-market supply and demand can be bent for a time, but never broken.  They always bounce back with great violence, creating life-threatening risk for entities caught owing but not OWNing physical gold.

Gold will always be the ultimate hedge against paper volatility and the only asset of refuge in troubling times.  Gold has intrinsic value that has been recognized universally for 6000 years, and it does not represent another’s debt like virtually every other kind of financial instrument.  At the moment, with popular sentiment arrayed so mightily against it, it is the ultimate contrarian play.  The metal is held in such unbelievable contempt by the paper investment establishment, governments with fiat currencies, the bubblevision media, and the speculating public, that it is hard to imagine gold prices deteriorating any further.  On the contrary, if even one half of one percent of the money invested in US equities decides to buy some physical gold as a portfolio hedge, the price of gold will skyrocket and there will be massive shortages overnight.  The entire world gold mining industry has a market capitalization of less than $40b.  This number is unimaginably small, as the Agilent Technologies IPO mentioned above has a market cap above $30b alone.  When global investor complacency is replaced with an increasing sense of fear and entrapment in the cratering US stock markets, there are simply not enough gold mines to go around.  The mining companies’ stocks will be bid to fantastic prices as investors seek to preserve capital. 

Are the markets warning the NASDAQ “buy the dip” bungee jumpers to buy gold and protect their assets?  I think the numbers speak for themselves.  This week, on pitiful volume, the index broke decisively through its 200 day moving average, declining another 4%.  The charts indicate the next strong support levels are at 2400 and then 1600.  That leaves a long way yet to hopelessly spiral down into the gaping abyss!  The NASDAQ “buy the dip” bungee jumping gang would do well to stow their bungee cords in the closet and build themselves a fort of gold bricks in which to weather the coming financial maelstrom.

Adam Hamilton, CPA     May 19, 2000