Sir John Templeton: Sell the market!

Porter Stansberry - Fri 13 Feb, 2004

...Sir John Templeton: Sell the market!...Even for Sir John Templeton this stock market operation was the trade of a lifetime...

Sir John Templeton: Sell the market!

John was 88 years old. He’d been active in the stock market his entire life.

But now he thought it was time to sell.

At first glance, there was nothing unusual about his desire. Most 88-year olds don’t own too many stocks. And, at the time John decided to sell, in January 2000, stocks were obviously expensive and therefore risky for conservative investors.

Selling a few stocks was only prudent. But it wasn’t prudence that motivated John. It was profit.

John believed he could make as much money on the way down as other, more foolish investors had made on the way up. Of course, unlike the bullish speculators, if John was right, he’d walk away with his gains in cash instead of watching them disappear on an electronic quote screen.

It’s one thing to have an idea about where the market ought to be heading. It’s another thing altogether to bet an entire $180 million fortune on your hypothesis. But, that’s exactly what John did, beginning in January 2000. John sold short 84 different Nasdaq stocks, putting an even amount of his fortune against each position - roughly $2.2 million on each stock.

He told his brokers: “This is the only time in my 88 years I’ve seen technology stocks go to 100 times earnings; or, when there were no earnings, 20 times sales. It is insane, and I am going to take advantage of the temporary insanity.”

By “shorting” these stocks, John borrowed shares of stock from brokers who held large inventories of shares on behalf of their clients. These shares were then sold in the market. The money from each sale was put into John’s margin account. John was now on the hook for the shares that he’d borrowed and sold. If the shares rose in price, he’d lose money - perhaps all of his money - because he’d have to buy the stock back at a higher price to repay the brokers from whom he’d originally borrowed the stock. On the other hand, if the shares fell in price...John would never have to repay the full value of his loans, earning him a profit.

He told his brokers to sell short every new technology IPO that came to the market in 2000 - every single one. He told them to establish his position 11 days before the stock’s IPO lock-up expired, which was typically six months after the IPO took place. In this way, John was selling just before all the company’s insiders were allowed to dump their shares.

In about half of these positions, the stocks fell 95% or more before he “covered” his short position, repaying only about 5% of the value he’d borrowed. In other stocks, he covered when share prices retreated to more reasonable multiples of earnings (30 times earnings). On average, he made over $1 million per position, increasing his fortune by 50% in just a few months.

Even for Sir John Templeton - the “John” in our story - this stock market operation was the trade of a lifetime. As you probably know, Sir John is one of the world’s all-time best investors. He is famous - and was knighted in 1987 - because he made fortunes for long-term holders of his emerging market mutual funds, which profited by investing in dirt cheap foreign growth markets, like Japan in the 1970s and Peru in the 1980s.

John Templeton grew up in rural Tennessee. He attended Yale, but was only a mediocre student until the crash of ’29. The crash wiped out his father, who could no longer pay for John’s education. To stay in school he had to earn a scholarship. Only the top students were awarded such grants...so he became the top student in his class and, in addition to his Yale tuition, was awarded a Rhodes scholarship to study economics at Oxford.

Today Sir John Templeton is a British citizen and lives on Lyford Cay, in the Bahamas. He’s still - even at 91 - active in the markets. He granted an interview to Forbes magazine earlier this year. He offered a warning to investors, telling them it’s difficult to find reasonably priced stocks anywhere in the world. “You can always find bargains somewhere but it’s difficult now. My advice is to own government bonds.” He’s not recommending US bonds, but bonds from countries that don’t have huge fiscal and trade deficits - like Hong Kong, Singapore and South Korea.

I found Sir John’s recent remarks significant because, for the first time since January 2000, when he began his now famous short selling operation, you will find Nasdaq 100 stocks trading at the same kind of absurd valuations as they did at the top of the bubble.

Personally, I think the craziness started back in September of last year. That was the month when Prudential, which is the only major Wall Street brokerage that doesn’t also conduct investment banking operations, altered its rating system. Instead of having its analysts decide objectively if a stock offered good value, Prudential instructed its analysts to offer only “relative” valuations. In other words, nobody was willing to tell investors that things were getting out of hand. Instead, as long as all stocks were getting equally overvalued, Prudential could still find something to recommend to you. Great.

And so today The Wall Street Journal is once again reporting on the lives of 20-something financial whiz kids who have been mistaken for geniuses in the midst of a raging bull market.

Featured last week was Mr Bret Grebow, the 28-year old manager of HMC International - a hedge fund. Bret is so confident that he’ll be able to maintain the 40% annual gain his fund scored last year that he recently purchased a $160,000 Lamborghini Gallardo. Bret’s big winnings allow him to keep a residence in Highland Beach, Florida and an office in New York City. He charters a $10,000 per flight jet for the round trip. In reference to the jet, Bret told Wall Street Journal reporter Gregory Zuckerman, “It’s fantastic. They’ve got my favorite cereal, Cookie Crisp, waiting for me, and Jack Daniels on ice.”

Another hedge fund manager rented Versailles for his wedding last summer.

And broker Grant Morgan, who says “We’re comfortable the market won’t take a new downturn,” was confident enough in his future earnings to spend a week at the Breakers in Palm Beach...after buying a $150,000 Ferrari 360 and spending $600,000 to remodel his home.

Once, not too long ago, I was a part of the hotshot crowd, piling into growth stocks without a care. Well, at least in a small way. For a short time, I posted gaudy performance numbers. My picks were up 134% in 1999. And I heard people tell others that I was a “genius”. I remember squiring my girlfriend around New York City, staying in hotels that cost more than a month’s rent just for the night. As your editor, Bill Bonner, wrote of me, I was living as though God whispered in my ear.

But, having been a part of that once, I remember all too clearly how it ends.

In November of 2000, I hosted a lavish conference for high-tech, growth-stock investors at the Ritz-Carleton in Montego Bay, Jamaica. In the days leading up to the conference, my portfolio collapsed. As I hit my stops, I sold, sometimes at a loss.

One of the speakers at the conference was a director of VA Linux, a company that was attempting to compete directly against Microsoft by selling desktop computers with a version of the free Linux operating system installed on the hard drive, instead of Microsoft’s Windows. In other words, its business plan was the Charge of the Light Brigade. On the day of his presentation in Jamaica, VA Linux’s stock dropped 20%, reducing this director’s net worth substantially - probably by more than a million dollars. He flew home the next day. VA Linux had become the largest loss ever recorded in my model portfolio.

The conference attendees - my best customers - were stunned when, in my closing presentation, I warned them about the impact of the Fed’s interest rate tightening, which had produced an inverted yield curve, making it prohibitively expensive for speculative companies to get additional financing. I wrote the same message in my newsletter, to all my subscribers: get out, it’s a bear market and it’s going to last a while.

People were angry. In less than a year I’d gone from a genius to a fool. As the market began to spiral lower, I lost most of my subscribers, who had largely ignored their stop losses and my warnings of an impending bear market.

I lost my bull market girlfriend, too.

But I learned a very valuable lesson: what you put at risk in the market is far more important than what you might gain.

Given this background, the run-up of 2003 looks suspiciously like the party year of 1999 to me - and the risk of stock investing in 2004 akin to investing in the year 2000. As Templeton told Forbes, there are almost no cheap stocks, anywhere in the world. Within the S&P 500 there are only 10 stocks that have P/E ratios below 10. That’s the lowest tally of cheap stocks ever, according to Barron’s.

What should we do when all of the signs, not least the crumbling dollar, point to higher interest rates? What should we do when the world’s best, most experienced investors issue public warnings about worldwide stock market prices? What should we do when there are literally no reasonably priced stocks trading in the entire US market? What should we do when individual investors are wildly bullish, but insiders are selling at a record setting pace?

It’s simple. We sell the market.

Regards,

Porter Stansberry,

for The Daily Reckoning