Market Insider Trader Talk with Bob Pisani

It's a rather slow year for IPOs, but Thursday we'll see an IPO floated at the NYSE that is getting more than the usual amount of attention.

The company is Social Capital Hedosophia, and they are planning a fairly healthy IPO of $600 million: 60 million shares at $10. (That's up from 50 million shares first indicated.). The company's shares rose 2.8 percent mid morning Thursday after it opened for trading.

Normally, of course, IPOs announce price ranges, say, from $9 to $11, not just one price of $10. Why is this just $10 with no range?

Because the company has no assets, at least not yet. It is a special purpose acquisition company (SPAC), a company that is being set up to invest in technology companies that are not yet public.

These SPACs are enjoying a banner year: more than 20 have gone public so far in 2017, the highest number since 2007, according to Renaissance Capital, a research firm that tracks IPOs and runs the Renaissance Capital IPO ETF (IPO), a basket of the most recent IPOs.

SPACs are based on a simple premise: a seasoned manager in an investment space (energy, tech, etc.) buys assets and assembles them in a portfolio for investors. They are sometimes referred to as "blank check" companies.

I got a call Thursday morning from Kathleen Smith, who runs Renaissance Capital, an investment firm that specializes in investing in IPOs and also runs the Renaissance Capital IPO ETF (ticker: IPO), a basket of the largest 60 or so most recent offerings.

She had just finished reading the S-1 filing of a proposed IPO called Social Capital Hedosophia Holdings, a holding company that is aiming to raise $500 million in an IPO that will then go out and buy other tech companies who have been reluctant to go public.

The S-1 notes that tech startups have plenty of access to private venture money but don't want to go public for a number of reasons: "We believe management distraction, a sub-optimal price discovery mechanism and the resultant longer-term aftermarket impact have discouraged private technology companies from pursuing IPOs." (You can read more here).

Here's excerpts from our conversation:

What's bothering you?

Smith: The prospectus implies the IPO market is broken. It's not. It may be broken for overvalued private companies, but it's not broken for investors, because they are not jumping up and down to invest in overvalued unicorns.

The prospectus also says that the number of IPOs has been dropping. That's certainly true, no?

Smith: Yes, but it's because the companies staying private are overvalued and they don't want to float them at lower prices. Those that have gone public, for the most part, have done well. We count 28 tech IPOs in the last 12 months. The average return from the IPO prices is 31 percent. That includes Snap and Blue Apron. It tells us that the IPO market is functional and working as it should, enabling investors to earn a return. And our IPO ETF is up 25 percent for the year.

What about Blue Apron and Snap?

Smith: They are failed IPOs. Investors made a mistake buying Snap and Blue Apron, and they have corrected.

The prospectus says that the IPO process "lacks an effective price discovery mechanism and encourages participation from many investors that are focused on short-term performance." True?

Smith: No. There is plenty of smart money in the IPO market, so the price discovery is there. The problem is the companies are not providing enough information.

What about the statement that investors are too focused on short-term performance?

Smith: It's the job of management to get them to focus long-term. They need to do a better job at working with shareholders to manage expectations. There are plenty of companies that are doing that, and they have high multiples. Just ask Jeff Bezos, ask Mark Zuckerberg.

What about the way this Social Capital Hedosophia IPO is structured?

Smith: It is a SPAC [Special Purpose Acquisition Company]. The people behind this are well-known and have very good reputations, but with a SPAC you're putting all your trust in a manager. You have to trust that that investor is going to invest at the right price, and we already know that the venture community is caught up in irrational exuberance because there is so many dollars competing for the same companies. Valuations are high and the IPO market are not accepting them.

You note that the people behind this have invested in many tech startups in the past. Is there a potential for conflicts of interest?

Smith: The prospectus says they will obtain an opinion from an independent investment banking firm about the fairness of investing in any business that's affiliated with the sponsor or directors, but then go on to say "potential conflicts of interest still may exist and, as a result, the terms of the business combination may not be as advantageous to our public shareholders as they would be absent any conflicts of interest."

But don't these people have a point about the IPO process? Spotify is talking about a direct listing that would go around the whole process of filing an IPO and list directly on an exchange. Now we have this proposal to set up a SPAC to buy up companies that, for whatever reason, can't or won't go public.

Smith: These are examples of the increasing desperation of the venture capital investors to get out of their overvalued investments in any way they can. The public market has been resisting paying high prices, and this is a workaround. What a lot of hubris.

What should be done to improve the IPO process?

Smith: We need more time to evaluate these companies. THE JOBS Act rushes the process and takes too much information off the table. You used to be required to provide three years of financial history, now it's only two. With this confidential filing, people don't get to see the prospectus until about two weeks before they launch the deal. That is not enough time to study the deal. And I'd like more information on who holds the IPO. When a company goes public, we don't know who the big holders are. It could take several months to find out. We'd like to know a lot sooner, particularly if insiders purchased on the IPO. We should know that immediately. We are in a market economy, and when the investors don't know something, it makes it more expensive for companies to raise capital because there's more risk.

The retail business is shrinking dramatically. While Amazon and Google and Wal-Mart duke it out for retail supremacy on the internet, vast swaths of the retail space have been reduced to micro-cap status, with tiny market valuations that make it impossible to borrow money and fund economic expansion.

Amazon and Wal-Mart are the two giants of the retail space, with market capitalizations of $464 billion and $241 billion, respectively. But 60 percent of the roughly 97 stocks in the Retail ETF (XRT) now have market capitalizations below $3 billion, which qualifies them for small-cap status.

Small-Cap Retailers
(Market Cap)

American Eagle Outfitters: $1.9 billion
Dillard's: $1.6 billion
J.C. Penney: $1.1 billion
Chico's: $991 million
Barnes & Noble: $541 million
Express: $430 million

J.C. Penney has a roughly $1 billion market cap. Some have even descended to micro-cap status, now valued at $300 million or less:

Micro-Cap Retailers
(Market Cap)

Cato: $347 million
Francesca's: $283 million
Fred's: $233 million
Hibberts: $231 million

Here's a delicious irony: Amazon's old rival, Barnes & Noble, now has a market cap of $540 million. Amazon has a market cap approaching $500 billion.

That means Amazon has a market value roughly 1,000 times its old rival.

And those are the ones that have survived.

Ken Perkins at Retail Metrics noted that at least two dozen retailers have gone bankrupt in the past two years, including The Limited, Wet Seal, RadioShack, Payless and Gymboree. Many that are left are ghosts, trading under $10 per share.

"Amazon has essentially leapfrogged the entire industry and came up with a lot of other innovative ideas ahead of everyone else, particularly Alexa," Perkins told me.

Will any of this ever change?

Wednesday morning, The New Yorker published a long article, "Who Owns the Internet?" — where writer Elizabeth Kolbert argued, "It is troubling that Facebook, Google parent Alphabet and Amazon have managed to grab for themselves such a large share of online revenue while relying on content created by others. Quite possibly, it is also anti-competitive."

Indeed, there has been a growing chorus arguing that Amazon and Google are simply too large, from USC professor Jonathan Taplin, who authored the book, "Move Fast and Break Things: How Facebook, Google, and Amazon Cornered Culture and Undermined Democracy," to NYU Stern School of Business professor Scott Galloway — a founder of advisory firm L2 — who has received considerable attention for a lecture he gave in July, in which he argued that Amazon, in particular, should be broken up.

Cooper Smith, who advises retail clients with Galloway's firm, L2, thinks we may be years away from a serious discussion on breaking up Amazon, but he advises retailers to not sit around and wait for that to happen.

He thinks Wednesday's announcement that Wal-Mart is partnering to sell some of its products on Google Home is significant for struggling retail survivors: "A lot of luxury brands like LVMH, which has refused to touch Amazon with a 10-foot pole, are talking about banding together to create a new luxury e-commerce space. Amazon hasn't been able to disrupt that market yet. Google and Facebook are the platforms with the reach, those are the alternative platforms that would help brands and retailers reach consumers without having to partner with Amazon."

Chris Horvers, retail analyst at JPMorgan Chase, was on CNBC Wednesday morning with a similar sentiment: "Wal-Mart's move to enable voice ordering and linking the history is really important. The idea is if we can get the Home Depot's and the Costco's to enable that and the Target's to enable that same feature, you start to develop an alternative platform to Amazon. ... We need to create an alternative site where the rest of retail can go and create critical mass from a customer's perspective."

That's likely one reason many retailers are trading up Wednesday.

James Maguire Sr., a titan of the Wall Street trading community, has died at age 86.

He served Wall Street for over 60 years beginning in 1949 (the Dow Industrials was 181 when he started), working on the New York and American stock exchanges.

Maguire ran the specialist firm Henderson Brothers for many years, which he sold to LaBranche around the run of the century, and was later a specialist for Barclays. He traded the stock of The Washington Post, but perhaps most famously he was the specialist for Berkshire Hathaway and was a good friend of Warren Buffett.

His kindness was legendary, which I experienced personally. When I came on the floor 20 years ago, he allowed me to stand next to him for hours to watch him trade Berkshire. He introduced me to Buffett at a time when Buffett rarely spoke to the press.

Here is what Buffett wrote to me Monday on Maguire's passing:

"As a very young kid, I was fascinated by the NYSE, an infatuation intensified by my visit there in 1940 as a 9-year-old. I read everything available about the operation of the Exchange, and even wrote a paper about the specialist system when an undergrad at Wharton.

"So when Dick Grasso came calling in the mid-1980s to talk about listing Berkshire, I was more than receptive. There were technical problems, involving a change in the 'round lot' rules, but, as you would expect, Dick found a solution. He then asked me who I would like as a specialist and after checking around it was obvious that the choice should be Jimmy.

"We immediately became the best of friends and I labeled him the 'World's Greatest Specialist.' He also was the world's greatest guy.

"Jimmy and [and wife] Diane would come out to the Berkshire annual meeting and we would have a blast. He would give me elaborate lectures — in front of Diane — warning me that she should be banned from our jewelry store. (In truth, he loved to buy her something special.) Diane likes to make customized belts and Jimmy proudly gave me a beautiful creation of hers featuring Berkshire products.

"Jimmy was an original and his passing leaves a big hole in the heart of everyone who knew him. I'll be singing 'Wait till the Sun Shines, Nellie' on New Year's Eve in his memory."

Maguire was widely respected for his wit, wisdom and leadership. He was renowned for his professorial demeanor, often wielding a baton to point to important stock information on the screen above him.

"We used to call him 'The Chief,' because he always knew the answer to everything," UBS' Art Cashin, a friend of his for many decades, told me Monday morning.

Trading was mixed early on, but at roughly 11:18 a.m. ET word came from Washington news site Axios that the White House was prepared to fire Bannon, the chief strategist. The S&P, which was down 5 points, promptly rallied 7 points in a matter of minutes and another 5 points over the next hour. When The New York Times confirmed that Bannon was leaving at about 12:40 p.m. ET, the market moved up another 5 points.

In an interview with the American Prospect earlier in the week, Bannon had made a big point about stressing his battles with President Donald Trump's chief economic advisor, Gary Cohn, and Treasury Secretary Steven Mnuchin, seemingly painting himself as a populist arrayed against the "globalists."

But the markets clearly preferred ex-Goldman executive Cohn for the stability he provides. How much? Stocks dropped on Thursday on erroneous reports that Cohn might leave the White House, and have rallied on confirmation that his arch nemesis Bannon is gone.

Floor traders, who are overwhelmingly Republican, cheered here at the New York Stock Exchange when it was reported that Bannon was out. (Though, some later said part of that cheering was due to the departure of a colleague.)

They want a concerted effort to raise the debt ceiling, pass a budget resolution and then move rapidly to tax cuts. Friday's gains is the market's way of saying investors believe tax cuts are still alive.

The S&P started moving down after 1 p.m. ET, shortly after Breitbart's Senior Editor Joel Pollack tweeted #WAR, implying Bannon and/or Breitbart may launch attacks against Cohn and Mnuchin.

The markets ending anywhere in the green would be a big victory for bulls and would reinforce the strategy that it is still safe to buy the dips.

Are the markets in trouble?

Not yet, but there's some cracks. We've seen something in the last two weeks we haven't seen in some time: a succession of selloffs.

Last week, we saw a familiar phenomenon: a brief 1 percent dip in the market that turned around within a couple days. But on Thursday we had another bout of selling that is starting to do some technical damage. The small-cap Russell 2000 and the Dow Jones transportation index have both broken through their 200-day moving averages, a major technical indicator.

Almost half of all NYSE stocks are below their 200-day moving average.

Several events have come together to cause this:

1. Trump leadership doubts. Who knew there was a Gary Cohn premium in the market? The markets drifted lower Thursday morning on a rumor that Cohn, the director of the National Economic Council and President Trump's top economic advisor, might resign. The White House later said he was staying. More importantly, it's getting harder to pull together a tax reform bill with the president's own party in revolt. Later in the day on Thursday, the market took another dip lower when Sen. Bob Corker (R-TN) told reporters that the president had yet to show the "stability" or "competence" necessary to be a successful leader. There is still a Trump premium in the markets. Traders are still very focused on tax cuts and believe that Congress and the White House have to first negotiate an increase in the debt ceiling and a new budget before turning to tax reform. Increasing doubts on the ability to execute the plan are bound to ruffle stocks.
2. The stock market is not cheap, and leadership looks tired. There's no doubt that stocks are expensive: about 18 times forward (12-month) earnings expectations, above the historic norm of roughly 16. The big market leadership stocks like the FANG names (Facebook, Amazon, Netflix, and Google parent Alphabet) have had huge gains this year but are showing signs of exhaustion: Amazon, for example, is 11 percent off its recent high but is still up 28 percent for the year.
3. Earnings may be topping. Earnings have been strong this year, but they may starting to top for this cycle. After reporting gains of 15.3 percent and 12.0 percent in the first and second quarter, respectively, the S&P 500 is now expected to post a gain of only 6.7 percent for the third quarter, with fourth quarter expectations rebounding to a gain of 12.2 percent. Part of the problem: big expected gains in earnings from the energy group are not materializing because of low oil prices. Retail stocks are disappointing as the companies struggle with shrinking margins.
4. The Federal Reserve, which has been such a help for years, is now mostly perceived to be neutral for stocks. As we saw from the minutes of its most recent meeting released on Wednesday, the Fed is in a real quandary. It can't get too hawkish because inflation is below its target and will likely continue to be. But a benign Fed is largely priced into stocks. The risks to stocks is on the downside, in the event the Fed misplays its hand and raises rates too aggressively.

The next few days will be an important test. All this year, people have been set to buy the dips —and there haven't been many of them. That hasn't happened today. People are getting burned after buying last week's dip, so they are not getting the same reward they used to get. It's interesting that the S&P took a dip to a new low at the end of the day when it dropped below the low from last week (2,437).

Makes sense: once you get burned a few times, it's tougher psychologically to buy the dip.

Look, we've had a huge run in the market. Now is the right time to get a pullback. With buyers on strike due to seasonal low volume, issues with Presidential leadership, and sheer exhaustion of market leaders after a strong year, it makes sense for stocks to pull back some. For the moment, the risks outweigh the benefits.

What's a pullback? In today's context, 5 percent would be notable. We haven't had that in a long time — you have to go back to Brexit in June, 2016.

A 5 percent drop from the recent closing high of 2,480 would bring us to 2,356, which would bring us back to the levels last seen in May.

Seems like a long time ago, doesn't it?