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BARRON'S:
The Trader
New Year's Rally
Fizzles On Limp Data And Earnings
By Michael Santoli
For two weeks on Wall
Street, ignorance was bliss. But last week the evidence
ran amiss.
Investors met the New Year with hopes that the economy was righting
itself,
corporate profits were poised to ramp higher and the geopolitical threats
could
be resolved rapidly. These articles of faith drove stocks upward for
one of
their best January debuts in history, led by the technology stocks that
best
measure investors' willingness to believe.
Last week, however, some hard numbers and harsh talk put the market's
faith to
the test, triggering a broad retreat in stock prices.
The advent of earnings-report season brought decent results for a tough
fourth
quarter, but companies were downbeat in assessing the coming year, depleting
investor confidence in the amplitude of the expected profit rebound.
Economic
data fell limp, with unanticipated declines in consumer sentiment and
industrial
production and an unforeseen expansion in the U.S. trade deficit. And,
outside
the Wall Street cocoon, weapons inspectors found suspicious warheads
in Iraq,
heightening the perceived risk of early military action.
The Nasdaq, whose moves are always hyperbolic among widely watched gauges,
suffered the sharpest decline, losing 71 points or 4.9% to 1376, bringing
the
index's year-to-date gain to 3%. Intel and Microsoft gave book-ended
reports of
as-expected earnings and unenthusiastic outlooks.
Intel's plan to trim its capital-spending budget for 2003 redounded
on the
rest of the computer-hardware universe. The Philadelphia semiconductor
index,
which soared 80% from the October bottom through November and was up
17% the
first seven trading days of 2003, lost more than 12% last week, no doubt
fracturing the confidence of the tech-revival camp.
The Dow Jones Industrial Average slid 198 points, or 2.2%, to settle
at 8586,
while the Standard & Poor's 500 lost 25 points, or 2.8%, to reach
901. The
week's declines put the broader market represented by the S&P 500
up 2.5% so far
this year.
The week's selloff,
at least some of which was fueled by profit harvesting
after the quick run higher, nonetheless exposed some of the beliefs
held by a
preponderance of professional investors. John Roque, a technical strategist
at
Natexis Bleichroeder, says, "My take is that everyone wants to
believe that if
not for Iraq, things would be fine. And that fiscal and monetary policy
will
save the day and that oil prices will come down" after a speedy
resolution of
the Iraq crisis.
In each of these elements of consensus thinking, Wall Street found itself
leaning in the wrong direction last week. Oil prices surged above $33
a barrel
on supply constraints related to Venezuela's national strike and the
requisite
unease tied to a potential war in Iraq. The dollar was blasted, reaching
$1.07
against the European currency thanks to the war prospects and the
trade-imbalance figures. There remains a week until the U.N. weapons
inspectors
will give a report on their findings, meaning the unfortunate war vigil
will
continue.
For sure, there's
plenty of earnings season left to sway the fundamental data
in a more positive direction, though it will take some pretty strong
pronouncements to act as counter-weight to the evident caution of General
Electric, Intel, Microsoft and IBM. The limited sample of fourth-quarter
earnings that are in have been fine relative to published estimates,
with 64%
beating forecasts through Thursday, 22% meeting them and 14% falling
short. But
the way stocks had rallied coming into last week indicated the market
was
pricing in high hopes for 2003, never mind last year. Reassurance on
the future
has been meager.
Still, fund managers might be expected some time soon to seek a chance
to pick
up stocks on pullbacks in a bid to catch up to the market benchmarks,
which left
the pros in the dust out of the gate this year. Through Thursday, the
average
actively managed stock mutual fund was already trailing the S&P
500 return --
then up 4.03% year to date including dividends -- by more than 0.6%.
That's a
big deficit so early in the year.
One of the challenges these professionals face daily is how aggressive
or
defensive to be in their security selection. It's a tough choice after
three
years when the meek inherited all the earthly profits to be had. In
fact, bright
and principled professionals can't agree even on how much risk is presently
priced into the markets.
In one of the more
intriguing divergences of opinion, the strategists at
Merrill Lynch and Morgan Stanley are simultaneously arguing that investors
are
either perversely paying up to take on more risk (Merrill's Richard
Bernstein)
or are short-sightedly shunning acceptable equity risk (Morgan's Steve
Galbraith).
Bernstein bases his cautious market view on what he sees as the speculative
tone to trading, the higher valuations of low-quality stocks versus
high ones,
complacency about geopolitical threats and earnings quality. Galbraith
focuses
on the risk aversion embedded in historically low Treasury yields and
the
historically rare fact that stocks' free cash flow yields now exceed
those of
10-year government bonds. Galbraith also believes the gaping inaccuracy
of
earnings forecasts last year won't be repeated, removing some uncertainty.
Such are the varied views that make markets. Yet it's noteworthy that
Bernstein and Galbraith generally agree that the environment continues
to favor
higher-quality, more predictable companies with good balance sheets.
Proof that
whether one calls it half empty or half full, men of different minds
will often
drink from the same glass.
-- For those who sidestepped the tide of newsprint and gale of airwaves
devoted to the decision, Microsoft declared its first ever dividend
late
Thursday. On Friday morning the market studied this purportedly historic
event
and listened to all the commentary on what it meant for the maturation
of the
tech sector and a new age of corporate governance. And then investors
shrugged,
and sold.
Microsoft shares gave up 7% of their value Friday, and lost $4.46 for
the week
to $51.46, as traders focused on the company's lack of enthusiasm about
computer
demand and its damping of revenue expectations in the current fiscal
year.
The general dismissal of the company's slender 16-cent annual dividend
reinforces a point made here several times recently, as excitement bubbled
about
how dividends -- which the president wants to make tax free -- could
boost the
stock market.
Specifically, the
increased emphasis on dividends, taxable or not, is a
modest, long-term net positive and may inspire companies to feed and
care for
their shareholders better.
But dividends, which now account for less than 2% of stock values, don't
have
nearly the power to drown out the daily static and whine that drives
stock
values -- including such little things as economic growth, profit trends,
valuations and general investor sentiment toward equities. The outsized
emphasis
on dividends as panacea seems to indicate there's less hope to be drawn
by the
Wall Street establishment from those other factors.
The size of the dividend, amounting to 0.3% of Microsoft's share
price at the
time of the announcement, might indicate that the company is playing
shareholder
politics, giving the ducks what they have been quacking for lately.
The company
has more than 40 years worth of dividends sitting in cash at the current
payout
rate, hardly enough to warrant calls for a seismic shift in the cash-deployment
orientation of large tech companies.
According to Soundview Technology Group, the 77 tech companies in the
S&P 500
have $169 billion of cash and short-term instruments, and $70 billion
of cash
net of debt. Microsoft accounts for 24% of the cash and investments
and 60% of
the net cash. If they all followed Microsoft's example with proportional
magnanimity, dispersing some 2% of cash on hand annually, that would
come to
another $600 million a year in the pockets of investors.
Hardly a market moving sum. Maybe even too small a dose to be a proper
placebo
to make investors feel much better about tech shares.
-- Microsoft had good company last week as a great company that nonetheless
managed to disappoint investors. These are the winners of the long downturn,
large, over-achieving, well-managed firms that delivered earnings as
promised
but struck a dissonant chord with Wall Street.
International Business Machines, Intel and General Electric also fit
into this
group, producing quarterly profits that met or exceeded forecasts while
their
executives spoke of tough going ahead.
In these cases, many an investor could mouth the cliche that ends so
many
affairs: "It's not you, it's me."
The companies continued to dominate their markets and strengthen their
balance
sheets. But investors have been expecting too much out of these blue
chips and
others, pricing their stocks as if a powerful thrust of earnings growth
was
imminent. In each case, the companies could give no such assurances,
and their
stocks were hurt as a result.
For Intel and IBM, as with Microsoft, the absence of a discernibly growing
appetite for PCs and other computing products and services was the familiar
culprit.
Yet GE, the sprawling industrial amalgam coming to grips with its new
slower-growing self, is perhaps a better proxy for the corporate sector
as a
whole. Like American companies in general, GE is fighting against an
environment
of low nominal economic growth and overcapacity that saps demand and
clips
pricing power.
GE also has exposure
to troubled financial areas via its reinsurance business,
for which it took a $1.4 billion charge last quarter. Some commodity
costs, like
the oil needed for the plastics unit, are on the rise. And GE's gas
turbine
division, hurt by the ailing utility sector, is entering its long-anticipated
cyclical decline.
For the whole of 2002, GE coaxed 7% earnings growth, to $1.51 a share,
from a
5% revenue increase. Its outlook for this year's profits encompasses
a range of
$1.55 to $1.70 a share, straddling the consensus $1.62 forecast, which
amounts
to 3% to 13% growth. The high end of that range would not get GE to
the 14%
growth that's expected -- for the moment, anyway -- from S&P 500
companies in
aggregate. There's the added risk in these forecasts that, for GE and
stocks in
general, the promised profit growth is supposed to be heavily dependent
on a
nice second-half economic acceleration that's scripted to arrive on
cue.
Based on the current
consensus 2003 profits, GE shares' P/E multiple is above
15, versus 16 to 17 for the broader market. With a likelihood of single-digit
profit growth, "that doesn't leave a lot of room for multiple expansion"
for GE,
says one money manager who no longer owns the stock.
Which perhaps leaves GE shares, at $24.08, where the market finds itself
generally. Arguably fairly valued, range-bound and subject to bouts
of hope and
disillusionment. One thing GE has in its favor is its dividend yield,
which is
above 3% a year. More than most, GE pays investors a little something
to wait.
-- In what many agree
is likely to be a trendless yet treacherous market for
some time to come, tactical acuity and individual stock selection are
the most
effective moves for the current game. In case that sounds easy, consider
the
spirited analytical contests now raging among professionals who are
all trying
to trade smart and guess right on controversial stocks.
Apple Computer, which reported results last week, is the subject of
stark
disagreement among analysts and investors, and not because of the overall
weakness in PC sales. The strength of its strategy, products and financial
standing are all in the eye of the beholder.
Here are the facts. Apple lost $8 million, or two cents a share, last
quarter
after five cents worth of restructuring and accounting charges, thus
meeting the
standard Wall Street forecast of three cents.
Apple is losing money selling computers at the moment. Only the interest
on
its ample $4 billion cash stash keeps it in the black. Declining short-term
interest rates might further crimp stated earnings for fiscal '03 (ending
in
September), which are now expected to hit 17 cents a share.
Notebook-computer sales are going gangbusters, and two new laptops just
introduced have received nice reviews from important technology critics
(such as
the Wall Street Journal's Walt Mossberg). Desktop sales are soft. The
stock last
week fell 62 cents to $14.10.
Some skeptics simply call Apple a doomed competitor that will never
grab
enough market share to quench its ambitions. Its retail-store strategy
is risky
and unproven. On a straight P/E or price-to-sales basis, the stock is
quite
expensive. Merrill Lynch's Michael Hillmeyer thinks Apple could trade
below its
cash level of $11 per share and advises investors to sell the stock.
The bulls begin with that $11 a share in net cash, which is a major
buffer for
a stock trading at its present level. They also mention the promising
slate of
products, including the laptops and the iPod digital music player.
Oddly, one bull cites Apple's swollen expense structure as a reason
to like
the stock. Don Young of UBS Warburg points to the increases in sales
and
marketing spending since 2000, when competitors began cutting back,
saying,
"Apple is sized for $8 billion in revenues but is a $6 billion
company."
Apple, iconoclastic as ever, says it's investing for the long term.
Young
calculates that if 2000 expense levels were simply maintained, an extra
$1 a
share in earnings would surface this year. Woulda, coulda, one might
say. But
with $1 a share or more in earnings power, all that cash and a unique
franchise,
the case for the stock at $14 seems plausible.
Today's market is a game of few slam-dunks and many jump balls.
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