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BARRON'S:
The Trader
A Market With
Its Head In The Desert Sand
By Michael Santoli
05 marzo 2003
Allied soldiers began
last week about 60 miles from Baghdad and after five
days reached the city limits. The Dow Jones Industrials gained 132 points
over
the same span, implying a ratio of roughly two Dow points on the upside
for
every mile added to the lead tank's odometer.
Divining the stock market's priorities, and investors' motivations,
is almost
that simple these days. Measurable progress on the battlefield in Iraq
is about
the only condition necessary to bid stocks higher and sell Treasury
bonds.
Despite the jarring new wrinkle of suicide bombings, and the abiding
unpredictability of the endgame in Baghdad, U.S. and British military
success
proved worthy of a 1.6% rise in the Dow, to 8277. The Standard &
Poor's 500
stock index added 15, or 1.7%, to reach 878, while the Nasdaq underperformed
the
broader market, gaining just 13 points, or 1%, to 1383.
This modest advance came as the indexes found their footing, after
surrendering a third of the gains made during a frenzied rally that
greeted the
start of the war. The market's newfound firmness reflects what has widely
been
called the "free pass" and "look through" trade.
This is not a football play diagrammed in the sand. It's the idea that
investors collectively have decided to give the economy and corporate
sector the
benefit of the doubt, and are ascribing recent weakness to war-related
developments, instead. Investors, it seems, are looking through the
war fog to a
favorable resolution.
This free pass leaves a clear path for traders to goose stocks and swat
down
bonds, all based on war news. It derives from the notion, arguable but
plausible, that a decisive defeat of Saddam Hussein will power a quick
and
meaningful market rally, at least until attention returns to financial
realities.
How else to explain the ability of stocks to sidestep a nasty run of
poor
economic and profit signals? Friday brought a keen example of this attitude,
when the March employment numbers arrived weaker than expected, showing
a loss
of 108,000 jobs versus the drop of 25,000 that had been forecast. The
"Yeah,
but" crowd quickly got on the horn, noting that the unemployment
rate actually
slipped to 5.8% from 5.9%, that 40,000 of the lost jobs were government
positions, and that the numbers were distorted by the call-up of military
reserves.
But coming right after a lousy showing by the ISM manufacturing index
and
another uptick in unemployment claims, it was tough to make the jobs
number look
too aberrant. Clearly, investors buying last week figure that once the
soldiers
are riding triumphantly in convertibles down Lower Broadway, no one
will be
talking about the March payrolls.
Yet, even when the guns are stilled, investors will have to deal with
the
outlook for corporate profits, on which the stalled economy is having
a
corrosive effect. The current earnings-warning season has been quite
negative,
with nearly three downside revisions for every company raising its profit
forecast.
First-quarter earnings for S&P 500 companies are expected to rise
8.7% over a
year earlier. But strip out energy companies that feasted on high oil
and gas
prices, and the increase for everyone else is put at only 4%. The consensus
projected growth for all of 2003 has fallen below 12% from 14% at the
turn of
the year, and most of that is expected to come with a quick ramp in
profitability in the second half.
There were signs last week, though, that the capacity of the market
to ignore
the difficult fundamental picture was faltering. One big indicator was
the noted
laggardly behavior of the technology-driven Nasdaq.
An earnings shortfall from Peoplesoft Thursday spread damage to other
software
companies, even though war paralysis among customers was one of the
company's
excuses. Look out, too, for Seibel Systems, which pulled the underhanded
maneuver of issuing a warning after the market close on Friday. Seibel,
a stock
mentioned favorably (and with bad timing) here at higher prices in February,
shed a few percent in after-hours action.
The fact is, the current valuation of tech stocks can't easily accommodate
erosion in this year's profit picture. Pip Coburn, tech strategist at
UBS
Warburg, notes that the tech sector now trades at 29 times expected
2003
operating earnings, compared to an average forward valuation of 26 in
the
pre-bubble period of 1992-96. And the current multiple is based on earnings
that
are expected to soar by 34% this year.
If, let's say, that profit increase becomes reality, at the average
pre-bubble
multiple the Nasdaq would be 9% lower. A lot has to go right to expect
more
upside in tech.
Interestingly, despite today's heavy-footed economy and the headwinds
facing
business, Wall Street economists generally don't think the Federal Reserve
is
poised to slice interest rates soon. Yet the interest-rate futures market,
where
pros put money on the line to bet on such things, is implying a better-than-even
chance of a rate cut in May and a high probability of a cut by mid-year.
That's not great news for stock investors. Stocks were lower three months
after eight of the Fed's 12 rate cuts since early 2001; they were higher
three
months after four of those 12 cuts. The average decline was 7.9%, the
average
increases 7.2%. The worst drop was 17.8% and the best three-month gain
9.8%.
Sure, it's been a bear market, and maybe the market would've done even
worse
without the Fed's "help." But the record at least shows the
Fed's massaging of
the economy hasn't been great comfort for stockholders.
-- It's good to be one of the few eligible mates when every suitor is
desperate.
Yahoo! last week took advantage of the ardent chase by Wall Street investment
banks for any scrap of business, raising cheap capital on exceedingly
aggressive
terms that left some investors -- and maybe the underwriter -- worse
off for the
encounter.
The Internet portal company announced on Friday that it had sold $750
million
in zero-coupon convertible debt in a private transaction. The bonds
will pay no
cash interest, are due in 2008 and are convertible into Yahoo shares
at a price
of $41 -- 68% above the stock's price of $24.34 when the deal was announced.
Any observer can look at those terms and see that they are a pretty
good deal
for Yahoo and a long-shot bet for a passive holder of the securities.
An
investor needs to have Yahoo shares go up by well over 10% a year for
five years
to be able to convert into the stock at 41. If, let's say, Yahoo's earnings
triple from this year's expected 30 cents a share by April 2008 -- an
aggressive
assumption -- investors will own Yahoo at about 45-times 2008 earnings.
Perhaps
that qualifies as a pretzel-logic bargain, given that today Yahoo fetches
80
times estimated 2003 profits.
But that analysis doesn't really come into play with zero-coupon convertibles,
which are tailored for use by arbitrage hedge funds. The funds effectively
trade
Yahoo common shares against the call option that's said to be embedded
in the
convertible bonds.
Even by this measure, though, the deal underwritten by Credit Suisse
First
Boston is skewed in favor of Yahoo and against the buyers, according
to traders.
Their complaint is that CSFB mispriced the deal by effectively overvaluing
the
call option in the convertible, based on actual market values of equivalent
listed Yahoo options.
This caused the bonds immediately to trade down on Friday, to 96 cents
on the
dollar from 100, which means that even after the underwriting fee, CSFB
likely
lost money on any bonds they ended up holding -- which could be a lot
of them.
The firm was said to have "won" the deal after it was actively
shopped around to
several potential underwriters, though it's believed most bids were
in the same
ballpark. In this case, it could offer a good example of what's known
as the
winner's curse. CSFB declined to comment.
Traders said Yahoo shares would have to trade up to 25 for the bonds
to regain
their par value at 100. As it happened, Yahoo slipped Friday to 24.05
on heavy
volume.
The upshot is that Yahoo was very opportunistic in having deal-parched
Wall
Street firms contend heatedly for a sizable piece of business. Yahoo,
by all
appearances, doesn't need the money for its business, with $1.5 billion
in cash
already on the books and $220 million in free cash flow last year. That
generated speculative chatter Friday that Yahoo must be fortifying itself
for an
acquisition.
One immediate beneficiary of the scuttlebutt was the stock of Overture
Systems, an Internet search firm that relies on Yahoo for a big chunk
of its
business. Overture shares, which were recently near a 52-week low, jumped
11% on
heavy volume Friday as the unsubstantiated buyout talk circulated.
Salomon Smith Barney analyst Lanny Baker told clients Friday that jumping
to
the conclusion that Yahoo will be readying an acquisition is "overthinking
the
situation." He notes that the financing is "as close to free
money as we can
recall seeing." Even just taking the money and buying back Yahoo
shares would
make economic sense, Baker notes.
Yahoo didn't specify any plans for the cash. The company offered only
a
statement attributed to chief financial officer Susan Decker (a former
Wall
Street analyst) that said, "We're taking advantage of historic
pricing levels in
the convertible debt market to lower our cost of capital and enhance
our
financial flexibility."
There were no details on whether she was grinning widely while dictating
the
statement.
-- On the prospective deal front, SBC Communications withdrew from the
bidding
for General Motors' Hughes Electronics business, whose most prized asset
is the
DirecTV satellite broadcasting system. That would appear to leave only
Rupert
Murdoch's News Corp. as the remaining suitor, though GM is said to be
trying to
bring in other contenders.
Interestingly, the tracking stock that represents Hughes didn't weaken
on the
news that a competitive auction is less likely. The GMH shares, as they're
known, gained 50 cents to 11.90 on the week.
Trying to estimate how much GM might fetch in a sale is extremely complicated.
It's not clear whether Murdoch would want to buy all of Hughes or only
the 20%
of its shares directly controlled by GM.
Reports indicate that Murdoch was ready to offer $3.5 billion for the
shares
that GM holds, and possibly bid for another portion of the stock held
by the
public. That would represent a nice 15% premium to the current share
price,
though of course not for all investors immediately.
Any prospective deal aside, Hughes is an inexpensive stock compared
to
Echostar, operator of the Dish network. Comparing the companies' enterprise
value to either cash flow or the number of subscribers, Hughes comes
out looking
like the better bargain.
This has been the case for some time, however, even before Echostar
attempted
to buy Hughes, a deal scuttled by regulators. Yet, if nothing else,
the slim
valuation of Hughes could keep a floor under the shares, to go along
with the
potential upside from a deal with Murdoch.
-- Some of the most popular new entrants on the New York Stock Exchange
lately
have been bonds. Despite the hints that some speculative promiscuity
has
re-entered the market for technology and other once-discarded stocks,
the
biggest offerings on the Big Board have been bond or income-oriented
closed-end
funds.
Nuveen raised $1.5 billion on March 27 for its Preferred and Convertible
Income fund, while back in January F&C/Claymore Preferred Securities
Income fund
sold $912 million worth of shares. Both NYSE-traded funds will buy preferred
stock and other bond-like securities in search of yield. The fact that
$2.4
billion was lavished on funds for which a steep load was charged upon
issuance
shows investors' desperation for perceived safety and income. More are
sure to
follow.
Another deal last week underscored the same point about investor priorities.
A
$140 million secondary offering for Annaly Mortgage, one of the more
intriguing
real estate investment trusts around, was well oversubscribed and the
company
was able to sell 36% more shares than it sought.
Annaly owns no properties, only mortgage-backed securities. Like all
REITs, it
pays out virtually all profits as dividends. In its case, the profits
come from
the spread between the income it collects from the mortgage bonds and
the rate
it pays on borrowings to fund its holdings. Its annualized dividend
yield, based
on its latest quarterly payout of 60 cents a share, is about 13.6% at
the recent
stock price of 17.64.
Now, when stock yields get that high, it nearly always signals that
the market
doesn't believe the dividend rate is sustainable. In Annaly's case,
the concern
is that the mortgage-refinancing boom will hurt its profits. When the
loans that
underlie mortgage bonds are paid off, the securities lose value because
their
income stream shortens and the cash must be re-invested in lower-return
paper,
among other technical reasons. This remains a risk, as does the prospect
that
Annaly could misplay the market as rates shift.
Annaly itself, though, is quite up-front about the hazards and about
the way
it navigates the mortgage markets. Its strategy is to own a mix of fixed-
and
adjustable-rate mortgages, matching fixed- and floating-rate borrowings
to fund
them. Adjustable-rate mortgages are less vulnerable to "prepayment
risk."
Investors who bid eagerly for the new shares are clearly comfortable
with the
way the company has ridden out the markets in the past year, when refinancings
reached historically high levels as rates plunged. Annaly kept its book
value
steady in 2002, and, increased earnings 20%. Its return on equity reached
22%.
The company's rock-bottom operating costs leave more profits for in
vestors.
Since the stock offering was priced Tuesday at $17.15 a share, the shares
have
risen despite the new supply. One likely reason is that the mortgage
market may
soon become less treacherous. The latest weekly refinancing totals tumbled
20%
in the week ended March 28, as Treasury yields edged higher.
Investors clearly believe that mortgage securities will benefit from
declining
prepayment assumptions, which could allow spread players like Annaly
to keep
returns high. They may well be right.
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