Barron's The Trader: An Unhappy New Year As Stocks Retreat

(From BARRON'S)

It took just one week of January to undo most of the cheer from December. With
both bulls and bears clustered on the same side of the boat expecting more
short-term upside due to positive seasonal trends, the market took on water.
Some selling of appreciated stocks had clearly been deferred from 2004 into the
New Year for tax reasons, and not enough new money arrived in time to soak up
the supply.
The benchmark Standard & Poor's 500, having closed last year just ahair below
its 2004 high, was relieved of 25 points, or 2.1%, to settle at 1186, a level last seen in early December. The Dow Jones Industrial Average fell 179, or 1.6%, to 10,603. The Nasdaq Composite, dragged lower by a fresh round of pessimism toward semiconductor shares, lost 86, or 4%, to 2088.
There's some evidence that much of the heavy selling pressure represented
forestalled profit taking. The hardest-hit sectors last week were the biggest
winners from 2004, including small stocks, real-estate plays and commodity-based
names. The small-cap Russell 2000, up 17% in '04, dropped 5.9% last week.
Real-estate investment trusts as a group slid 5.5%, large-cap energy shares lost
3.7% and the S&P basic materials sector declined 3.1%.
In other reversals from late '04 patterns, the dollar bounced nicely off recent lows against the major currencies, and crude oil gained more than $2 a barrel to surmount $46.
Though the old saw that the first week of January indicates the year's fortunes doesn't hold up well to scrutiny, the market's sour start was unusual.
It was the worst initial week for the Dow and S&P 500 since 1991 (a down year)
and the worst for the Nasdaq since 2000 (enough said).
For those who impulsively (and mistakenly) seek a discrete reason for the market's behavior in the headlines, the released minutes of the Federal Reserve rate-setters' December meeting proved a conveniently timed news item. Fed officials' veiled alarm over inflationary pressure and possible speculative activity due to low rates got plenty of ink. Yet Treasury-bond yields, corporate-debt spreads and interest-rate futures contracts didn't register much concern or build in additional expectations of rate increases beyond the next few Fed meetings.
The swiftness of the downside equity move in the first half of the week more likely reflected a lazy consensus that the path of least resistance for the indexes was higher through January. That may indeed be true, but the market has a way of breaking up crowds like an old-fashioned beat cop.
There are some signs that the selling assault, for the moment, did the job of
scuttling the masses that were playing for the "easy" upside. Indeed, the small-time opportunists emerged to pile on the short side.
Tony Dwyer, strategist at FTN Midwest Research, noted that the tally of
odd-lot short sales -- a gauge of small-time speculators' bearish trades --
reached an all-time high Wednesday. This often signifies a short-term tradable market low.
Stocks did stabilize as the week drew to a close. Retail-chain sales for December were soft, but better than recently feared. And Friday's employment report of a middling 157,000 new jobs in December was close enough to the formal forecasts to elicit a collective shrug. The macro data, then, continue to please neither the furrow-browed pessimists nor the growth cheerleaders.

-- More than once in the closing weeks of 2004, this column cited Robin Carpenter's work showing tactical hedge funds were eagerly chasing stocks higher. Carpenter, who runs Carpenter Analytics (www.carpenteranalytix.com), tracks the net equity exposure of the S&P tactical/directional hedge fund index using careful statistical inference.
In the past, these funds have rushed to catch up with market moves, up and down. When they reach high relative stock exposure, the market tends to be near a short-term peak. Well, they got pretty close to "filled up" coming into the year, with equity exposure higher than 70% of all days since 2002 -- and it cost them in the opening frames of '05. The equity-commitment level is now higher than it's been since late 2003.
Carpenter says this hedge-fund index dropped 1.3% in value Tuesday, when the
market itself lost almost 2%. For the hedge index, that's as rare a decline as would be a 3.5% tumble in the S&P 500, statistically speaking. And it appears these funds continued buying into the drop, clearly believing that the expected January rally is merely delayed and not cancelled.
Perhaps more notable is the fact that tactical funds' allocation to bonds is higher than 98% of all past readings. If anything, Carpenter says, extreme bullishness in bonds by these managers is even more predictive of short-term declines in the bond market than the degree of equity ownership would suggest about equities.

What's Normal?

One of the strangest things about 2004 is how "normal" it was. Normal, in this
case, refers to the level of S&P 500 returns (9% appreciation and just over 10%
total return), which fell right at the long-term norm of 8% to 10% annualized
gains since the 1920s.
What's strange is that individual calendar-year results almost never fall anywhere near that long-term average. Last year was only the third in the past 50 years when the S&P gained between 8% and 10%.
In fact, single digit returns -- positive and negative -- occur only a small minority of the time. The total return landed in a range of minus-10% to plus-10% only 23 times in the past 78 years, according to figures kept by ISI Group. The long-term average, clearly, is arrived at through big jumps and sudden swoops.
Which is worth keeping in mind now, as most market forecasters pencil in another year of single-digit positive returns for 2005. Nothing says it can't happen two years in a row (it happened in '47 and '48, after all). But the weight of history suggests that those looking for another placid year will probably be surprised.

Show Us the Money

American International Group's dividend increase last week was a nice gesture,
but it hardly qualifies the company for any shareholder generosity awards.
The enormous insurer and investment-services company raised its quarterly
dividend by 67%, to 12.5 cents a share, its largest increase in a quarter-century. But the percentage jump still doesn't obscure the remarkably low payout level, relative to AIG's earnings and the dividend practices of its peer financial giants.
At the new 50-cent annual dividend rate, AIG will be distributing barely more than 10% of its earnings. (AIG's earnings are expected to total $4.40 a share for 2004 and $5.22 this year). Other mega-cap financials now pass out closer to 40% of their profits in the form of dividends.
Stacking up the largest financial stocks by market value and dividend yield shows AIG's relative stinginess. Its yield, now 0.7%, compares unfavorably to the other four largest financials in the S&P 500: Citigroup, Bank of America, J.P. Morgan Chase and Wells Fargo all yield better than 3%. The only other member of the top-ten financial club with a yield below 1% is American Express, at 0.8%. Even AmEx pays out a larger share of its earnings than does AIG. Most other insurers have yields between 1% and 2%.
AIG, no doubt, maintains a self-image as a growth company, one that needs to
husband its prodigious cash flows to reinvest in its business and further strengthen its capital base. But AIG is already one of the select few companies rated triple-A by the credit agencies. And the company could easily double its dividend and still have plenty of discretionary cash to deploy.
Of course, the impetus for raising the payout pace would come if the stock market began to reward heavy dividend payers over skinflint cash hoarders. That hasn't happened consistently, though late last year it appeared investment flows began seeking consistent yield sources. Perhaps AIG Chairman Hank Greenberg won't feel much need to distribute more cash this way unless and until he sees his stock's premium valuation versus other mega-cap financials disappear entirely.
As it stands, AIG shares -- after a couple of years of underperformance -- trade for 13 times forecast 2005 profits (down from more than 20 times in the late-'Nineties) compared to 11-to-12 times for comparably sized banks.

Naked Shorts Exposed

The market runs a constant audition for new key indicators, data that can serve as the ideal trading cue for a particular phase. Over the past year, the weekly oil and gasoline inventory reports every Wednesday morning have taken a star turn for stock players. And, more recently, the equity markets have fixated on the Treasury's monthly numbers on foreign ownership of U.S. government debt.
Now, get ready to start hearing about the release of "threshold lists."
Beginning Monday, the major stock exchanges will begin posting lists of stocks that have a certain number of shares which have "failed to deliver." This serves as a proxy for shares sold short without the seller's broker having firmly arranged to borrow them. These so-called "naked short sales" have been targeted by regulators. Exchanges must now publish stocks with many unconsummated trades, a rule meant to force brokers to clean up the practice.
The Securities and Exchange Commission rule, called Regulation SHO, requires that any stock with at least 10,000 shares and 0.5% of the stock's float categorized as failed to deliver will be on the threshold lists. Brokers will
then be required to cancel or close out short sales in these names, presumably
through forced buying of the stocks.
Heavily shorted small stocks likely will show up on this list, and many traders have decided to speculate on potential upside "short squeezes" by buying them in anticipation. Early indications are that popular day-trader favorites and short targets such as TravelZoo, American Pharmaceutical Partners, Biosite, Pre-Paid Legal, Martha Stewart Living and Novastar Financial will be featured on the initial lists.

Let the games begin. But note that because of technical reasons, no genuine short squeezes are likely to occur for a couple of weeks.

Porn's Appeal to Wall Street

Of all the New Year's trade ideas intended to exploit some shift in investor appetites, putting money on the revival of media stocks may be one of the more
promising.
Media was one of only a few industry groups to show a loss last year, as a promised advertising resurgence never materialized. Moreover, investors started worrying about video games, satellite radio and online ads eating out of traditional media's cupboard.
But big media stocks such as Time Warner, Viacom, Comcast and News Corp. began
to recover some ground in the home stretch of 2004. The stocks combine defensive
and cyclical attributes in a way that frees the investor from having to pinpoint the amplitude of the economic recovery or worry about steel-input costs. Yet the group offers participation in long-term growth stories of digital cable, satellite TV and the world's unceasing desire to be entertained.
Sanford C. Bernstein strategist Vadim Zlotnikov cited select media stocks as one of a handful of growth areas that looked ripe for good performance in 2005.
And Rick Bensignor, studying the stock charts as technical analyst for Morgan Stanley, thinks the media sector of the S&P 500 is showing signs that it will run ahead of the index over the next few months.
Far from the marquee names of the media industry -- indeed, in the dim upper reaches of your cable-channel directory -- resides a small, intriguing play on
Americans' willingness to pay to be amused. New Frontier Media is a little, fast-growing and quite profitable seller of "adult" video programs over cable and satellite television.
The company buys skin movies cheap, and then sells access to them over and over again via its pay-per-view channels and through video-on-demand services.
New Frontier has distribution deals on most of the major cable networks and via
DirecTV. Indeed, DirecTV's announcement last week of a new video-on-demand
platform with digital recording capabilities helped put a bid into New Frontier's shares.
The stock climbed more than 12% to 8.92 on brisk volume, also helped by a surge in the earnings and shares of Rick's Cabaret International, the only publicly traded operator of strip clubs. Along with the appearance on best-seller lists of porn star Jenna Jameson's book, these news items woke Wall Street up to the fact that adult entertainment is gaining wider acceptance.
Still, even near 9 a share, New Frontier shares seem attractive based on their
modest valuation and the impressive economics of the business. The market
capitalization is $195 million, there is no debt and cash holdings amount to $26
million, or $1.20 a share.
Earnings for the current fiscal year, ending March 31, are projected at 50 cents a share on $59 million of revenue, up from 35 cents and $43 million a year ago. Dialing forward to fiscal 2006, profits are seen growing another 25% to 63 cents by the three analysts who follow the company.
There's a fair amount of predictability in the business. As cable companies steadily convert their customers to digital cable, pay-per-view and, especially, video-on-demand, capabilities expand dramatically. Fewer than 40% of cable households now have digital service. In addition to the overall market growth, New Frontier steadily has gained market share from its main competitor, Playboy.
Jay Arnold, manager of a small hedge fund, Abacus Asset Management, says,
"Adult-entertainment content companies print money every time a new digital-video subscriber comes on." He points out that New Frontier owns its content and has most of it digitized for easy conveyance over new programming systems.
Revenue per household tends to remain quite steady, says Roth Capital Partners
analyst Richard Ingrassia. And, according to Merriman Curhan Ford analyst Eric Wold, more than 75% of incremental revenues flow to the bottom line.
The main negatives in the story have been some insider selling of the stock in recent months and a slightly slower digital build-out rate last quarter.
Given the cash cushion, strong cash generation and attractive growth profile, though, Wold thinks the stock is worth in the low teens.

-- Buyside traders looking to do some good with their order flow Monday might
consider giving Jefferies & Co. their business. The broker has pledged all of
the day's net trading revenues to tsunami-relief efforts.
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