The Daily Interview: Momentum on the Downside
By Kristen French
Staff Reporter
3/8/01 10:51 AM ET
Remember when momentum was every investor's friend, back in good old
1999? As the market shows of late, momentum can be the enemy, too.
On the anniversary of the Nasdaq
Composite Index's peak, just a year after
the painful popping of that New Economy
technology bubble, stocks are in a very
different place. The Nasdaq has erased the
gains of 1999 and early 2000, and many
stocks have lost more than 75% of their
value. What everybody wants to know is, is
there any more downside left?
One answer to this question might be found
by looking at how momentum -- the kind of
speculative buoyancy that always
accompanies bubbles -- works. Can
momentum sink stocks to unreasonably low
valuations in the same way it can whoosh
them up to unreasonably high ones? If so, is
that what's been happening, and will it
continue?
For today's Daily Interview, TSC asked
Peter Da Puzzo, market strategist and president of Cantor Fitzgerald,
about how momentum operates on the downside. Da Puzzo's firm
operates one of the largest equity businesses in the U.S. stock market, with
core businesses in equities, fixed income, foreign exchange and derivative
markets. The good news is Da Puzzo is pretty sanguine about the market,
saying the downside momentum won't push stocks far below fair value.
The bad news is he doesn't think the market will see upside momentum like
we recently had for the next decade.
TSC: Does momentum work on the downside in the same way it
works to the upside -- in other words, is momentum capable of
driving stocks down below historical norms, the way it took them up
to unreasonable heights early last year?
Da Puzzo: Oh, absolutely. Momentum can certainly do that. A good
example is when an arbitrage deal is called off. When company A is taking
over company B, let's say, at a 20% premium, company B moves up in
price. But if for some reason the Securities and Exchange Commission
calls off the deal, then company B usually sells off well below its fair value,
and well below the price it started at before the takeover news emerged.
So, if company B is worth $20 and company A offers $30, but after
two-three months the SEC says nope, the deal can't go through, very often
the stock goes down to $15 or even $10. Because the sellers just
absolutely regurgitate it, and the arbitragers would have so much
momentum feeding on themselves.
One of the worst things they teach you in these daytrading schools is
averaging down. Usually it should be 5%-10% and out, as opposed to
5%-10% and then buy more. Prior to that, you heard buy on dips, and that
worked for years, but it stopped working in the middle of last year. So, the
rallies were being used to sell.
TSC: Do you think that momentum trading or momentum leaps in the
market are now confined to technology as opposed to other areas of
the market? Are people less speculative about the Old Economy
stocks?
Da Puzzo: I would break momentum into two areas. One is a relatively
new one -- momentum playing on price action alone -- piling on, they call
it. The stock is running up, and many of these new indicating machines that
you can buy tell you, this stock looks good because it just went up 4%, so
they buy more and then it goes up 6% and the next group buys it at that
level and it goes up 8%, and sellers do the same thing when they see a
stock breaking. There are indicators of weakness and strength that are set
up technologically in these machines, and those players are mostly
daytraders and small institutions like hedge funds.
Now there is also a much more professional, long-term type of momentum
player -- the earnings momentum player. One of the guys who is very good
at this is Mark Driehaus of Driehaus Management in Chicago. There
are also quite a few Lyons managers that are like this, and a bunch of
managers at Fidelity are also like this. The theory is, once a company
loses its earnings momentum, Driehaus will sell it. As soon as the company
stops seeing earnings growth, he sells it. He has a tremendously good
long-term record. Other things work for him as well; this is just part of his
strategy. He was averaging a 30% return for six or seven years managing
for me. If he had managed Oracle (ORCL:Nasdaq - news) and Intel
(INTC:Nasdaq - news) and Sun Microsystems (SUNW:Nasdaq -
news), he wouldn't have owned them anymore when they really broke --
when their earnings fell from 50% growth to 30% growth.
TSC: Under this strategy, how many quarters do earnings have to
show upward momentum for these guys to buy again?
Da Puzzo: I would think he would have to have at least two quarters.
TSC: Do you think momentum on the downside has already taken
stocks to valuations that are below historical norms?
Da Puzzo: They may not be lower than historical norms. They're at more
of a fair value. I definitely believe in looking at what has happened to many
of these stocks. They have taken many of these stocks down to levels
where I feel much more comfortable with them. Fair value can be
determined by looking at the past five years, for example, and determining
what has been its average P/E ratio -- often excluding the periods where a
particular stock rose to irrational heights from calculation of the average.
TSC: Could a reverse wealth effect, generated by the slowing
economy, come in here and drive some momentum drop in stocks the
way the wealth effect helped drive momentum upward last year?
Da Puzzo: I don't think so. I really feel, as many people I've talked to feel,
and Abby Joseph Cohen feels -- 'cause she said so [yesterday] -- that
some value has been brought back into the market in general and that most
of the better-named technology stocks are trading at or near their fair value
to their growth rates. The financials and oil stocks have come down too.
TSC: So you don't think the excess upward momentum stocks saw in
the first few months of last year has to be mirrored on the downside?
Reverse momentum won't necessarily carry them below historical
valuations?
Da Puzzo: No, not at all. What I do think is they won't go as high as they
were, not for another five years or so, not until another mania kicks in. I
don't think you're going to get Cisco (CSCO:Nasdaq - news) up to 100
times earnings this decade. And maybe it shouldn't even get up that high.
You probably won't get another up 85% in the Nasdaq, like in 1999, in
this decade.
TSC: Why doesn't momentum work on the downside the way it works
on the upside?
Da Puzzo: Because there should be underlying value to those that don't
show downside momentum. Now, some of them do get carried down by
momentum. eToys (ETYS:Nasdaq - news) has been carried away. It's
gone. It's filed for bankruptcy and it's finished. You could probably look
and find another 100 of them and they're gone since last year. And you
could probably find a bunch of others that were selling at $160 and now
they're at $2 -- like Priceline (PCLN:Nasdaq - news). That $2 will never
get up to $160 again. It will either go out of business or get taken over by
somebody.
When you have something like the Depression, there's no doubt you can
have downward momentum. The market went all the way up and then all
the way down, and you could have bought telephone and some of the
railroad stocks for pennies. But today you have the Federal Reserve that
can regulate interest rates very quickly. They can regulate margin rates and
loosen it up if it goes down too fast and too hard. You have FDIC
insurance so you know there can't be a run on the banks and you have
many other supports. We would need to have a deep depression to take
stocks down as far as they went up. But the euphoria and excitement you
can have on the way up -- that has no top. People say when you short the
market, you have to be careful because there's no top on the upside. And
that's a question they ask, how much money can you lose on a short --
there's no way of knowing -- you don't know. But how much money can
you lose on the downside? Just the value of what you paid for the stock.
TSC: But you think that's recent.
Da Puzzo: Well, recent since the Depression days and even more recent
in the Nasdaq market in the past 10 years because they made them
marginable and then all of the Fed things I was talking about that came into
play. Nasdaq stocks were not marginable for the first 10 years or so.
TSC: Why isn't there a top on euphoria? How do stocks get so ahead
of themselves?
Da Puzzo: It's human nature. People get carried away. Then people who
think they're smarter -- professionals like myself -- they think they know
where it's going to stop and they short stocks. Shorting just creates new
buyers and ultimately you get the squeeze, and you have to give up
because of the pain. I have a perfect example of a fellow who runs a firm
called Greenlight Capital. He usually just buys mid-cap stocks and he
shorts stocks, and first quarter of last year, he thought biotechs were
completely mispriced. They can't have any earnings for five years because
there aren't any drugs coming out of the pipeline, and he shorted several.
And then three months later he had to cover because they had doubled in
price [they then sold off severely in March]. Shorts have to become buyers
at some points. So on the upside, you never know where the euphoria is
going to stop. But on the downside, you can see it. You can see where
things are going to base out and you can feel it because the price/earnings
multiple gets in line, and then there is often a period of quietness in terms of
volume for a month or two, or even just a day or two in this rapidly
rotating market.
What we have to hope is that the Fed cuts help people spend and get
things rolling with telecom, inventories, and the whole cycle gets started
again, but with more reasonable multiples.
TSC: What about lack of certainty? So many companies have been
saying they're not sure when things are going to turn around. Do you
think uncertainty could create momentum to the downside?
Da Puzzo: Oh, sure. That's what has been in the market. Now all of a
sudden a couple of companies came out today and said they see a turn,
they see a light at the end of the tunnel. Once you see a low minority start
saying that -- companies that are leaders in their industry -- you'll really see
this market take off. Because then, of course, the turn has been made. That
would be the real turning point, if not the interest rate cuts. But if
uncertainty persists, stocks could go down again, and fairly significantly.
Still, the Nasdaq can't go down to a point where we have real recession --
to someplace like 750 -- because it just won't happen. It happened in
Japan because their economy is in terrible shape. Ours is not -- so unless
we get ourselves into a mess like that, it shouldn't happen.
But if uncertainty persists, downward momentum could theoretically drive
stocks below fair value because there's no light at the end of the tunnel and
they would no longer know what fair value really is. You wouldn't have any
idea when things were cheap. |
