Edgy Money-Runners Chase Big Quarter-End Score

Why is everyone buying stocks now?

By "everyone" I mean every professional money manager who has missed part of this rally.

During the first half-hour of trading Friday on the Nasdaq, buying overwhelmed selling by about 30 to 1. Technical analysts commonly call any market "extreme" where advancing volume outnumbers declining volume by 10 to 1, so on Friday morning this market was genuinely off the charts.

Some of that was euphoria reflecting the good news on the unemployment numbers. The Street had been expecting unemployment to rise by 30,000 or so in the week, so the actual increase of just 17,000 was cause for celebration -- and justification for buying stocks.

But there's clearly more behind the market's behavior than a dose of good news. After all, stocks have moved up recently, even on days like June 5, when the news was stunningly bad. That day's report said manufacturing orders for April fell by 2.9%. That was far above the consensus projection of a 1.9% decline, and a big reversal from the 2.2% increase in orders during March.

Still, the Dow Jones Industrial Average climbed a little more than 2 points to record another close above the symbolic 9000 level on that day, and the Nasdaq Composite tacked on 11 points, or about 0.7%, as that index continued to lead the equity market. So what's going on?

The Lottery-Ticket Stage

The stock market has entered one of those "lottery ticket" periods that come at the closing stages of all big rallies. Calculations of risk and reward that might have restrained stock prices become irrelevant in such a market. And stock prices are driven higher by investors who buy because they fear they'll miss out on the big prize.

This kind of investor psychology makes the stock market extremely vulnerable to huge blowoff moves on the upside during lottery periods. And the sudden end to this psychology can leave investors just as vulnerable to big losses on the downside, when the market decides to correct or consolidate.

The need to play a lottery ticket has grabbed those investment professionals who have been slow to jump on board this rally and now fear being left behind so badly that clients will notice at the end of the quarter. Here are some examples from the mutual fund universe to show you how this works.

It's been a solid three months for many mutual fund managers. For example, of the 1,222 large-company growth funds in our database, 590 have matched or bettered the 19.17% gain on the S&P 500 over the last three months.

Of course, that leaves better than 600 funds trailing the index -- and some of them trailing quite badly. The ( BEONX) Berger Growth Fund, for example, with $417 million in assets, has gained just under 7% for the last three months.

Three Weeks and Counting

Imagine that you're the lead manager of the growth stock position of a university endowment, or of a company pension fund, or of a state pension. You're looking at the distinctly unpleasant task of having to explain to your clients why, after losing money for quarter after quarter during the bear market, the portfolio that you run has also trailed the indexes during this sustained rally. Your job could be at stake if the client is unhappy enough to fire your firm as one of its money managers.

You've got about three weeks -- until the books close for the quarter on June 30 -- to fix the problem, or at least to make it as manageable as possible. What do you do?

You sure don't buy Alcoa ( AA), even though the aluminum company's shares should benefit from any second-half economic recovery. You sure don't buy Microsoft ( MSFT) because the stock is among the cheapest of the technology stocks after sitting out just about the entire rally.

A Place to Pin Your Hopes

Instead, you buy a lottery ticket. You look at which stocks have been going up the most in recent days, and you pile into them in the hope they'll just keep going up for a few more weeks.

So a Genentech ( DNA), which climbed 50% from May 15 to May 30, goes up another 15% last week. An ImClone Systems ( IMCLE), up 16% in the same two weeks, explodes for another 64% in the last week.

Or a Talk America Holdings ( TALK) moves up 12% in two weeks and then soars another 36% last week. Or a SCO Group ( SCOX) runs up 32% and then gallops for another 51% in the last week.

Notice what these stocks have in common? It's not that they're in the same industry. They are all members of extraordinarily volatile sectors and have histories of making big moves once the momentum buyers catch hold of the stock. SCO Group, for example, has a beta above 5, meaning that its price is about 5 times as volatile as the market as a whole.

And you could certainly see the momentum buyers at work in these names last week. Volumes popped in all of these stocks. Talk America, which normally trades an average of 290,000 shares a day, traded 1.2 million on June 6. ImClone hit volume of 19 million shares, way above its average of 2.8 million.

Money managers who buy a lottery ticket aren't looking for stocks with modest valuations that are likely to creep up in the months ahead. Genentech already trades with a market capitalization of $37 billion and a multiple of 65 times projected 2003 earnings per share. Talk America is projected to show earnings declines from last year's levels of 24% and 44% in the next two quarters, 34% for all of 2003.

The Search for the Big Score

But fundamentals aren't what professional money managers who are trailing the pack need right now. Lottery tickets are a chance for a big score that evens them up with other money managers.

And lottery-ticket stocks have another advantage for professional money managers. Even if they don't go up enough in the next three weeks to get the portfolio caught up with the index, their presence in the quarter-end portfolio at least gives the money manager a line of defense. Such quarter-end window dressing probably strikes many of you as so cynical it can't possibly work. But it does often enough to save more than a few jobs.

And when a money manager is in a deep performance hole, what other option is there, anyway?

It's hard to resist playing a lottery when somebody has just scored a big payout. That's why lotteries are so seductive and such a successful way for states to raise money. It's easy to forget that the odds of winning are 3 million to 1 when somebody has just grabbed a check for $80 million.

So at this point in a market rally, it becomes increasingly difficult not to get sucked into the stock lottery. You know that investors have gained 95% in Genentech over the last month, 61% in Icos ( ICOS), 69% in Conexant Systems ( CNXT) and 64% in Avaya ( AV).

Why not buy a ticket for the future ride? The last thing anyone really wants to do at this stage in a stock rally is struggle with hard-to-calculate valuation estimates in search of some approximation of a selling target. Sell? Who wants to sell right now?

And you're even less likely to sell if you've tried to apply your selling discipline once during this rally and been badly burned as the stock you sold just kept going up. Sure, Genentech looked like a sell at $60, but the shares traded for $72 on June 6.

When Valuations Become Plain Silly

But it's important to remember that the lottery stage of a rally is when valuations get out of hand and go from merely extended to silly. It's exactly at this point in a rally that investors need to exercise whatever selling discipline they can muster.

By that I don't mean indiscriminately selling everything. I'm not talking about a crash from here or a retracing to March 11 lows or worse. But it is time to think about the inevitable pullback and consolidation that all markets go through in rallies. The longer this market goes without one, the larger that pullback is likely to be, but at this stage the most likely scenario is a 10% drop in the major averages so stocks can build a new base.

For many stocks that haven't run away from reasonable valuations and that have good growth stories for the second half, the damage might well be even less. If you have positions that you believe in for the long term, it's probably better for most investors with modest trading skills to just sit tight.

But if you own shares of stocks that have become lottery tickets in recent weeks, taking profits now seems advisable. Many of these stocks have put a lot of air between their current price and even the most optimistic valuation for the next six to 12 months.

These stocks could well correct by more than 10% in a pullback. Especially in danger are shares that are largely held by momentum investors whose own selling discipline tells them to cut and run as soon as the upward momentum in any stock starts to stall.

You certainly don't want to be left holding a lottery ticket on one of these equities when the momentum reverses. And I'd pay special attention to any stock that starts to falter when quarter-end buying for portfolio window dressing dries up as June draws to a close.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Alcoa, Icos and Microsoft. He does not own short positions in any stock mentioned in this column.

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