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BARRON'S:
The Trader
Strong Profits,
Sweet Prophecies Lift The Nasdaq 5%
By Michael Santoli
Hope Floats was a forgettable movie, but it's a pretty good two-word
take on
the recent behavior of the stock market. Taking heart from the respectable
profit reports of some bellwethers of the technology sector, investors
last week
grabbed for fast-moving, silicon-scented stocks. Buying in the techs
buoyed the
broad market and lifted the major indexes to the upper extreme of the
range
they've inhabited since the latest rally commenced on the eve of war
with Iraq.
Implicit in the buying -- which pushed the Nasdaq higher by 66 points,
or
4.9%, to 1425 -- was a widening hope that on-target first-quarter earnings
will
tide investors over until the crucial second-half earnings hurdles approach.
Even so, the rat-a-tat-tat barrage of some 400 major earnings releases
failed to
spur immediate increases in forecasts for second- and third-quarter
profits.
In a week clipped short and drained of trading intensity by the Passover
holiday and the market's closure for Good Friday, the Dow Jones Industrial
Average moved ahead by 134 points, or 1.6%, to reach 8337. The Standard
& Poor's
500 climbed 25, or 2.9%, to 893.
The latter benchmark
is now a whisper away from its recent high of 895,
reached in an eight-day sprint that began just as U.S. troops were mobilizing
for their own sprint to Baghdad. Traders say the ability of the S&P
to surmount
the 895-905 area will be important in determining the fate of the current
advance.
The Nasdaq is slightly
ahead of its highest point since that upward move
began, thanks to profit reports by International Business Machines (a
New York
Stock Exchange-listed tech bellwether), Intel, Microsoft and Nokia,
that came in
as promised and were unmarred by shrill warnings of worse times ahead.
The market appears relieved that the hard questions about the strength
and
character of the technology recovery will be deferred, perhaps until
the end of
the second quarter. No truly offensive shortfalls commanded investors'
concern
in the latest week of profit reports, and by all appearances second-quarter
numbers seem achievable.
Yet, for technology
companies, getting through the first half of the year
without any devastating blow-ups is rather like making it from January
to June
without having a hurricane sweep across the Caribbean. The most vulnerable
time
of year, for both sorts of disasters, comes later. That's when the bulk
of the
year's hoped-for 34% rise in tech earnings is supposed to arrive.
Upbeat reports from non-tech heavyweights such as Citigroup and General
Motors
lent additional reassurance that the fundamentals are proceeding according
to
script, at least relative to fairly muted expectations for business
conditions
in a sluggish first quarter.
Still, stock buyers' fixation on the week's good news was countered
by
slightly stronger Treasury bond prices and a stronger bid in the crude-oil
pits.
Since shortly before the war was launched, a "macro trade"
has held sway:
whenever stocks rise, bonds and oil prices fall. The logic here has
been that
higher Treasury prices and rising energy costs are the stuff of economic
weakness and global turmoil. Last week Treasury bonds firmed, with the
yield on
the 10-year note slipping to 3.96% from 3.98%, while the May crude-oil
futures
contract in New York jumped to $30.55 a barrel from $28.14.
One way to explain the seeming undoing of the inverse correlation between
stocks and bonds is to note that stock investors once more are acting
on
corporate developments. But there are enough cautionary signs about
the economy
-- including another rise in unemployment claims -- to suggest that
the bond
market sees little reason to bet on a quick recovery.
Some strategists
say bullish stock investors should hope that Treasury yields
top 4% for good; after all, that would signal the economy is accelerating.
There are other hints that hope is welling up in the stock market.
The week
ended Wednesday saw the greatest net inflow into stock mutual funds
-- $5.8
billion -- in exactly a year. It would seem the snap-back rally that
began March
11 finally drew in some retail investors. That
intake by equity funds, concentrated in international, aggressive-growth
and tech funds, was the greatest since $7.9 billion flowed into in the
week ended April 17, 2002. Note that retail investors, as is typical,
showed no great prescience a year ago, when the S&P was at 1126,
20% above today's level.
Hope, or at least a willingness to believe things can improve, is also
evident
in a key measure of investor anxiety, the Chicago Board Options Exchange
Volatility Index, or VIX. This measure is largely driven by the prices
investors
are willing to pay for downside protection, and last week it broke down
below 25
-- well beneath the 30-40 range that prevailed for most of the year.
This level
often bespeaks a worrisome complacency in the investment community,
even if some
observers are contending the VIX can be a bullish indicator while it
continues
to fall.
Maybe so. But it's worth mentioning that the last time the VIX closed
below 25
was June 5 of last year, right before the market tumbled 24% in six
weeks.
-- Now that the guns have cooled in the Euphrates Valley, one of the
most
spirited skirmishes demanding investor attention is that over financial
stocks.
Right now, the bulls are winning, as they have for three years. But
the
doubters are undeterred, and have gotten a fresh supply of ammunition
from the
fine print of the latest bank earnings reports.
The stakes are pretty high, for a couple of reasons. One, financials
are now
the most heavily weighted group by far in the Standard & Poor's
500, and by
definition are widely owned. Also, market lore insists that financial
stocks
must participate fully in any market rally for it to be sustainable.
So far, so good. The Philadelphia Stock Exchange bank index (known by
its
ticker symbol BKX) rose 3.76% last week, versus the 2.9% increase in
the S&P
500. Since the market's recent low on March 11, the bank benchmark is
up more
than 14% to the S&P's 11.6%. Year to date, the BKX is up 3.6% to
the market's
1.5% gain. And, perhaps most impressive, since the market topped out
three years
ago, the banks have edged lower by just 4% as the S&P dropped 41%.
Skeptics on the financials first cite their very weightiness in the
market,
accounting for more than 20% of the S&P 500. How, they ask, can
the financials
continue to outperform the market after having grown to such an enormous
portion
of the equity universe? And if they fail to continue to lead the way,
is that
not a net negative for the market overall? This is the crux of the disagreement
about the group -- either the cycle is virtuous or vicious, a self-strengthening
pattern or a Catch-22.
For the moment,
at least for this earnings season, the financials have been
granted yet another reprieve, thanks to numbers that generally exceeded
expectations, and one of the better profit-growth rates of any sector.
Almost
69% of financial companies reporting so far have beaten earnings forecasts,
compared with 60% for S&P members in total. Average year-over-year
growth for
the financials is 12.7%, versus 11.5% for all sectors.
The banks have been feasting on mortgage lending, now that making new
home
loans and refinancing old ones has become as popular as reality TV.
That's bound
to slow over the course of the year, as interest rates likely tick higher
and
comparisons against last year's numbers stiffen. Capital-markets-related
revenue
remains pressured.
Commercial credit losses have moderated -- a positive sign that ought
to be an
incremental help for the remainder of the year.
But a major issue is the squeeze on net interest margins as the yield
curve,
by all expectations, flattens with an expected upward bias to short-term
rates.
Bank One last week reported a shortfall in this margin, as it positioned
itself
(too early, as it happens) for higher rates. But should rates trend
higher, it's
the other banks that could shoulder the pain, along with their shareholders.
If higher rates are a prerequisite for a lasting recovery in the stock
market,
as indeed they seem to be, then it's tough to see how the banks won't
begin to
give up the advantage they've enjoyed over other sectors. And, if the
market's
recent advance doesn't show stamina, the fundamental challenges in the
sector
won't go away.
-- One erstwhile standout in the banks' ranks, a fond favorite of investors
for years, has begun to look vulnerable, both on its own merits and
in
comparison with its peers.
Fifth Third Bancorp is a Cincinnati-based regional bank with a stellar
record
of profitability, growth and risk control. In addition to a fine core
franchise
lending to businesses and individuals in its Midwest region, Fifth Third
has
been a sharp acquirer of smaller banks. Investors also like its
transaction-processing and investment-management businesses, which add
a level
of stability and good profit margins.
All of this has led the market to lavish a premium price/earnings multiple
on
Fifth Third's shares. But as the bank contends with a regulatory issue
and the
pace of earnings growth slows slightly, it seems that premium is being
unwound
to some degree.
Fifth Third shares
have retreated while the overall bank sector has marched
on. While the stock rose 1.6% last week, to 49.44, during the latest
rally, the
stock is off 2.5%. The year-to-date loss, meanwhile, is a painful 15.5%.
One of
the reasons Fifth Third has suffered is its status as a favorite stock
of growth
investors, who saw it as a rare, reliable secular growth play in the
finance
area, and bid it up to an almost tech-like valuation. It remains one
of the
largest financial-stock representatives in the Russell 1000 Growth index.
Lately, Fifth Third has been weighed down by the Federal Reserve's
investigation of the bank's internal controls, which began late last
year. The
company has entered an agreement with regulators to strengthen controls
and
submit to third-party reviews of its practices. Those reviews are ongoing.
While
costly, at $10 million or so in the current quarter, it seems they will
help put
the regulatory concerns behind.
Yet even with all the damage done to Fifth Third shares, they trade
at 16
times expected 2003 earnings of $3.06 a share. That's a good 40% premium
to most
other regional banks, which generally trade for 11 to 12 times this
year's
profits.
Meanwhile, even hitting the earnings forecast for this year will represent
a
slowing of profit growth, to 11%. Annual growth rates over the past
five years,
beginning with 2002, were 16.4%, 12.8%, 14.7%, 12% and 19%.
Wall Street analysts remain enamored of the company and continue to
insist the
stock should be granted a much higher multiple than other regionals,
noting that
it has averaged a 50% premium to the group over the past decade. Morgan
Stanley
has gone so far as to say the shares should reach 70, or 22 times the
firm's
estimate of 2003 earnings -- its average price/earnings multiple over
the past
three years. Never mind the fact that the forward earnings multiple
for the
overall market has come down during that time to about 17.
Clearly, big pockets of support for Fifth Third still thrive on the
sell side.
But given the action in the stock, the market is arguing, somewhat persuasively,
that the company isn't as special as it once was.
-- Given its newfound prominence and popularity, 3M could stand for
McNerney's
Market Mover.
The industrial conglomerate formerly known as Minnesota Mining and
Manufacturing has found new vigor under CEO James McNerney, a General
Electric
veteran. Investors have flocked to 3M, briefly lifting the stock to
a new
all-time high above 136 earlier this month. At 129.98, 3M shares have
been
rock-steady in a wild market for several months. As the highest-priced
stock of
the 30 Dow Jones industrials, it represents a towering 11% of the index,
which
is weighted by price.
The reasons for the market's fondness are several, some of them even
good.
Investors like the cut of McNerney's jib. The chart readers like the
looks of
3M's stock action, and cheered its foray into the mid-130s last week.
Fundamental types are fond if its global breadth and the benefits it
gets from a
softer dollar.
The company has failed to disappoint with quarterly results, a rarity
in
recent years on Wall Street. 3M raised its first-quarter earnings guidance
already, and Monday is due to report profits of $1.40 a share, up 14%
from a
year earlier. For the year, net should climb 13% to $5.93.
At almost 22 times forecast '03 profits, a lot of these good tidings
are
reflected in the stock. It was noted here in late October, with the
stock less
than 2% from the latest quote, that it had probably had the bulk of
its run.
That's likely still the case, though it's tough, as always, to handicap
when 3M
might stumble.
Last week, the shares came off their highs due to whispered concerns
that the
SARS illness spreading in Asia would crimp parts of 3M's business
(notwithstanding 3M's thriving, though small, protective facemask division).
With a fully priced stock and a world of hazards out there, there is
a
reservoir of skeptical sentiment on the name. Wall Street is lukewarm,
with nine
analysts rating it Buy, eight Hold and three Sell. Schaeffer's Investment
Research has noted that bearish options bets have mounted and short
interest is
high.
By contrarian logic, these are signs pointing to continued firmness
in the
stock, barring any nasty surprises. Monday's earnings report will be
worth
watching, at least for a signal of where the Dow's biggest driver might
be
headed.
-- Labranche, the biggest publicly traded NYSE specialist firm, was
highlighted here last week as a well-managed company that provides a
potential
way to play higher trading volumes and renewed interest in stock picking.
For a
couple days, that's the way it played out, the shares gaining 1.04 to
19.14 by
Tuesday.
Then came reports that the NYSE was investigating specialist practices
with an
eye toward illicit front-running of customer orders. A trader from Fleet
Boston's specialist unit was suspended, and LaBranche is among five
firms being
looked at. The shares sank back to 16.49 by week's end. Until the regulatory
questions are answered, there's not much reason to expect the shares
to make up
lost ground.
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