The cyclical bull market seems to be taking a pause

Quarterly Letter

The cyclical bull market -- that we have been talking about for a year or so now – seems to be taking a pause in the midst of all the doom and gloom about the US deficit, the US debt level, the Iraq situation turning into another Viet Nam etc. If you have been reading our quarterly comments throughout the years, you will remember the Wall Street saying we have quoted several times: “Bull markets always climb a wall of worry”, albeit a lot smaller today.

The following table summarizes the price performance of the main indices for the first quarter of 2004.

  First Quarter
  In local Currency In Canadian Dollars
S&P/TSX (Cdn) +4.44% + 4.44%
S&P 500 (US) +1.29% + 2.33%
Nasdaq (US) -0.46% + 0.49%
Europe (Euro) +3.08% + 0.49%
Nikkei (Japan) +9.73% + 13.96%

The US economy is improving nicely in 2004, creating more jobs than economists expected. A broad range of indicators points to a rise in employment despite the misguided perception that overseas outsourcing is the main culprit of the weak labor market. Unfortunately, the media hype about outsourcing is triggering political responses we consider protectionist. In reality, the weak employment trend is also due to the reluctance of the corporate sector to expand production. Until they feel better about the economic outlook, corporate managers tend to be more risk-averse, thus more inclined to cut costs than to expand. Nevertheless, this should gradually change as corporate profitability improves.

The US Dollar has regained a little bit of its value during the first quarter against the Canadian Loonie and the Euro. The bear market in the US Dollar remains intact, but a period of temporary calm is likely. On the long term, we are still bullish on the Canadian Dollar, the main reason being that Canada is a resource country and the fast growing Asian countries will need our resources over the next decade. As for the Euro, we do not share the overall optimism regarding the old continent. It is hard for us to imagine that when it comes down to economic and political issues, harmony can exist between such different nations and cultures. Living in Quebec, we can say that we are speaking from experience.

Oil prices have been going up steadily as the market continues to reflect concerns about the Iraqi situation and a possibility of a coup in Nigeria. Over the past three decades, we have witnessed huge swings in the price of oil. We believe there is no reliable method in projecting oil price with any accuracy. However, demand from Asia – China and India with a combined population of more than 3 billion – is growing fast. Given the tightness of supply/demand balance, the time and investment required to bring oil to market, and the geopolitical risks these days, we can expect above average volatility in a rising trend for oil price in the next 5 to 10 years. As we have mentioned in previous comments, oil prices are actually lower than they appear given the devaluation of the US Dollar.


It has been 30 odd months now since the implosion of the largest bubble in recent market history. The main indices have recovered some 25% from their low, with the exception of Nasdaq having zoomed up more than 50%. What is going on? Is another bubble in the making?

Although we believe this is not the case, we do observe mania in smaller scales in some specific sectors. In the financial markets, there are periods of temporary insanity when investors get swept away on tides of emotion, thereby ignoring risks in search of unrealistic returns.

For entertaining purposes, we have picked out for you several of those insane stocks that exemplify what we call investor delusions. There is such a thing as falling in love with a stock.

As a preambule, let us remind you how AOL (America Online) defied gravity in 1999. Then, based on the potential earnings that the company could make on a per subscriber basis, the company would need to have 18 billion subscribers to justify the stock price, about 3 times the population of the earth…

Fast forward to April 2004:

  1. After rocketing 1000% from April to December 2003, the stock of Taser International blasted another 60% higher in 2 days last February on absolutely wild trading after the company announced a 2 to 1 stock split!! Crowd madness is such that the 10 million shares or so outstanding turned over 3 times on average during those 2 days (i.e. the company has been bought and sold 3 times in 2 days; is it insane enough for you?). You must be wondering what the company’s business is behind this wonderful, high performing stock price.

    Taser International develops, assembles and markets non-lethal weapons for use in the law enforcement, private security and personal defense markets.

    The stock keeps going up and trades at close to $100.00 now, with a market capitalization of over 1 billion dollars. In the meantime, sales are forecast to reach $50 million dollars in 2004, with profits of $10 millions or so. Let’s see: 20 times sales, 100 times earnings, hum… Does it sound like Amazon.com back in 2000? The only thing we can say is that those guns had better work, meaning that they ‘d better not kill anybody…

  2. You would not believe it but there is a company in Montreal called MAMA.com (symbol – MAMA). It calls itself “the mother of all search engines” and competes with the likes of Google, Yahoo and Microsoft. History shows that this company has never been profitable but somehow, in the last quarter, it managed to squeeze out one penny of earnings per share (according to their accounting standards, not ours). That was enough for the crowd to pile in and, in a matter of two days, MAMA’s stock price rocketed from $4.00 to $16.00 with an unbelievable volume of 68.4 million shares traded. In short, with only 6.4 million shares outstanding, this company has been bought and sold 11 times a day, 2 days in a row.

    Insanity did not stop there. Eager for another high-flying opportunity, the mad crowd soon discovered another stock with the symbol BABY. Thinking that MAMA and BABY must be somehow related, investors drove up the latter’s stock price by 45% intra-day, with an even more amazing volume of 10.9 million shares traded. A week earlier, BABY traded a mere total of 402 shares on 700,000 shares outstanding. In case you are wondering, BABY has nothing to do with the Internet; its name is Natus Medical, a manufacturer of screening products used to identify medical disorders in babies.

    Too bad there is not a stock with PAPA for symbol. The nut cases would have been able to claim they traded the whole family several times in a matter of days.

  3. Have you heard about satellite radios? Do you think people would be willing to pay $155 per year ($12.95 a month) for the privilege of listening to additional radio stations while driving down some highways? Apparently so, judging by the stock prices of these companies in the US. XM Satellite Radio (symbol XMSR), the leading satellite radio provider, is trading at $28.00 up from$1.70 some 16 months ago.

    As they say, a picture is worth a thousand words. So let us show you the simplified financials of this high-flying company:

    All these figures are in millions of US dollars.

      1999 2000 2001 2002 2003
    Revenues 0 0 0.53 20.18 91.78
    Profit (Loss) (36.90) (51.87) (284.38) (495.01) (584.53)

    Currently, investors value XMSR at about 55 times sales, or $5 billion dollars. As if this is not insane enough, they actually think this is a bargain… compared to its competitor Sirius (symbol SIRI), which trades at 358 times sales (with a $4.6 billion dollars of market capitalization).

    Just for the fun of it, let ‘s examine the business model and see how many clients they need to justify these lofty valuations (please bear with us while we crank some numbers through our super powerful computer – a pencil and a piece of paper). Here they are:

    • With a total market capitalization of over $10 billion, they will need revenues of $ 3 – 3.5 billion a year to justify their stock prices.
    • By charging $ 150 a year ($12.95 a month), that means they ‘d better convince 23 million people in the US that it is really worthwhile to pay fees for the privilege of listening to more radio stations, when most of them are free across the country.
    • Last quarter, it costs SIRI $522.00 for every subscriber it added since they have to subsidize the radios, the installation costs, the component costs and pay sales incentives (commissions and bonuses).

    If you ask us how they are going to make this work and get a return, we don’t know. Call us skeptics, maybe even ignorant if you want but we have a hard time grasping the concept. This reminds us of the on-line grocery companies’ model (with free shipping), the TireRack.com’s concept of selling tires online and delivering them (for free) to your door or the FreeLotto.com’s plan to charge nothing for lottery tickets yet still award cash prices.

In conclusion, we just want to remind you that market actions are not always rational because of the participants. Human beings are governed by emotions and more often than not, are likely to be sucked into periods of collective hallucination that could be very costly to their pocketbooks. That is the main reason for our attempt to stick with discipline to our quantitative models when building a portfolio. In Star Trek terms, we are supposed to be Spock and not Captain Kirk in fulfilling our duty as portfolio managers. Our strategy might not lead us to participate in the discovery of major technologies or drugs but it sure helps us sleep a little better at night.

The Claret Team