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BARRON'S:
The Trader
The Stock Toddles
Along, If A Bit Unsteadily
By Michael Santoli
Observing the latest phase of the springtime stock market rally has
been like watching a toddler walk across a crowded room. The pace has
gotten erratic, the posture unsteady and you know it's likely to end
with an abrupt fall. But the
longer it lasts, the more excited the fawning spectators become.
Stocks faltered last week but never quite lost their footing, despite
concerns about the rapidly sliding U.S. dollar, more chatter about deflation
risks and
nagging terrorism concerns.
A handful of cheerful profit reports from blue-chip companies and Congress'
passage of a tax-cut bill were enough to contain the losses. Upbeat
investor
sentiment -- an asset to the market until it crosses over into overconfidence
--
fortified the major indexes later in the week as the approach of the
long
Memorial Day weekend slowed trading activity.
The Dow Jones Industrial Average slipped 77 points, or 0.9%, to finish
at
8601. The gains in Altria, up 9.01 to 42.31 on a favorable court ruling,
and
Home Depot, which climbed 1.35 to 30.54 after a strong earnings report,
added
more than 70 points to the Dow on their own, somewhat overstating the
market's
strength. The Standard & Poor's 500 fell 11, or 1.2%, to 933, while
the Nasdaq
gave up 28, or 1.8%, to settle at 1510.
There's a fine line between impressive resiliency and the blithe denial
of
potential risks, and it's either difficult or impossible to know where
Wall
Street sits in relation to that crucial frontier.
There are some signs of cavalier speculative activity and excessive
investor
comfort bordering on complacency. But also in evidence are remaining
pockets of
skepticism, along with tentative indications of fundamental improvement,
which
give some hope that the rally need not succumb immediately to the pull
of
gravity.
The footprints left by the happy dance of speculation among some investors
are
visible near surging tiny stocks. The DFA Micro Cap mutual fund, which
tracks
the littlest 4% of all stocks, was up 20.5% from the March 11 market
low through
Thursday, four percentage points ahead of the broader market.
Momentum chasing has returned, with some traders listening closely to
the
whisper wire as in the bubble days. Goldman Sachs last week held an
investment
conference for Internet companies (its fourth annual, meaning the firm
inauspiciously inaugurated the function right near the market top in
2000).
Stocks took flight on the hopeful words of Web executives, with Yahoo
stretching
to a new 52-week high Friday.
The Internet HOLDRs basket of online stocks, which trades on the American
Stock Exchange, has average daily volume of 157,000 shares. During the
first
four days of last week volume ranged from 500,000 to 1.2 million shares.
Does
that constitute froth?
Elsewhere, it's possible to detect a tendency to buy first and analyze
later.
The sinking dollar, abetted by the tactical rhetoric of the Treasury
secretary,
is generally causing less alarm about foreign capital flight than comfort
in the
idea it will stimulate growth and awaken inflation.
The tax package, which will cut taxes on dividends to 15%, understandably
drove up the shares of some high-yielding sectors such as utilities.
But also
gaining unusual strength were some real-estate investment trusts. Of
course,
REITs do pay big dividends. But because their profits are untaxed at
the
corporate level, they get no break from the so-called double taxation
of
dividends, leaving their disbursements subject to the old higher levies.
As much as resolute bears will seize on these items as proof that investors
are whistling past the graveyard, the picture of market psychology is
more
ambiguous.
Short interest
-- the total number of shares with which investors have bet
against stocks -- has declined slightly but remains very near record
high
levels. The New York Stock Exchange last week reported that short interest
slid
2% in the month ended May 15. But short bets on the popular Nasdaq 100
exchange-traded fund, known as the QQQ, leaped by 32% in the month.
Overall
Nasdaq short interest won't be reported until Tuesday, but this measure
has
recently been climbing even as stocks have gained.
There's some chance, it seems, that bearish hedge-fund managers who
cultivated
an image as the cool-handed rooftop snipers of the bear market now find
themselves building the wall of worry that stocks are managing.
Cautionary notes are being also struck by analysts. Example: As Yahoo
has
thrust upward to its new yearly high, Wall Street has been collectively
lukewarm, with seven Buy ratings, eight Holds and three Sells.
The deeper issue, of course, is not the psychological heat map of the
investing public but whether the market, with its recent 16% advance,
has
correctly handicapped a genuine improvement in economic growth and company
profits. If so, then current valuations have a shot at being maintained.
If not,
a nasty episode of deja vu awaits.
On Memorial Day weekend a year ago, the S&P 500 was just above 1100
and had
eased off its highs just a bit. The day-to-day economic news was unimpressive,
but there were broad expectations that activity would strengthen in
the second
half of the year. Measures of investor anxiety were low and easy talk
was rife
that the bear market had ended the prior fall.
The parallels with the current moment are clear, though of course that
doesn't
mean this year will follow the 2002 trajectory. Hugh Whelan of money
manager ING
Aeltus notes several variables that are more constructive today: inflation
and
interest rates are now lower, the recent four quarters' gross domestic
product
growth quicker, housing starts higher, liquidity pointing upward. Stock
prices,
of course, are lower today, improving valuations.
But here's the key. Last May, the expected operating earnings for the
S&P 500
companies over the ensuing 12 months was $53.25 a share. Today that
number is
$53.62.
How good was last year's forecast? The actual results were closer to
$49. It's
hard to believe today's stock prices could survive a similar failure
of
analytical foresight.
-- Treasury bonds are traded over the counter on the upstairs
trading desks of
banks and other institutions. But one of the bigger beneficiaries of
the
energetic rush into government bonds is a floor-based financial exchange
peopled
by hoarse traders in colorful smocks.
The Chicago Mercantile Exchange, where interest-rate futures trade,
has seen a
percussive surge in volume. A publicly traded company since December,
its shares
have vaulted 34% higher since mid-February, when they were mentioned
here as a
good way to play the hedging and speculative instincts of pro investors.
Turnover in the CME's Eurodollar futures, used by investors to bet on
short-term interest-rate moves, is running between 1 million and 1.5
million
contracts a day, versus an average of 725,000 in the first four months
of 2003.
Traders desperate to play the Treasury rally have become hyperactive,
as have
mortgage-bond funds and dealers, which use these instruments to hedge
their
portfolios in times of heavy mortgage-refinancing activity. The CME's
futures on
currencies and on the S&P 500 and other stock indexes are also trading
briskly.
The war helped, goosing demand for overnight trading on military news.
All this has propelled CME shares to a pretty lofty height. Now near
their
all-time high around 60, the stock trades at 18 times expected 2003
earnings of
$3.30 a share. The exchange is an extremely high-margin business (it's
good to
be the middleman), and forecasts of profits have been rising. They may
rise
further still, but the multiple is getting a little steep even for a
well-run
capital-markets player.
One reason the stock has risen so fast, in addition to the zeal of momentum
players piling in, is its slim public float. Only 15% of the total shares
trade
freely. But that's soon to change. The post-initial offering lockup
period
restricting insider sales ends June 3. Shortly thereafter, CME members
who
received stock before the IPO are expected to sell perhaps 7 million
shares.
Several million more will come thereafter.
If Eurodollar futures volumes stay frenzied, the market would likely
absorb
the new shares without a serious hiccup. Otherwise, CME stock may be
due for a
retreat, or a rest at the very least.
-- No one sought to hobble the United States' chemical industry. That's
why
they call it the law of unintended consequences. That figurative law,
along with
some strict environmental regulations and stubbornly high natural gas
prices,
are threatening to make things exceedingly tough for chemical companies.
That, at least, is the view of Graham Copley, chemicals analyst at Sanford
C.
Bernstein, who has been urging clients to stay away from several big
producers
that have heavy exposure to natural gas as a fuel and raw material.
A few other
analysts have also been cautious about the effect of high gas prices
on chemical
stocks, but Copley is bolder than most, last week titling a report on
the
industry, "U.S. Chemicals: Is Natural Gas the Grim Reaper?"
From a big-picture perspective, Copley says whole industries have been
structured over the last 20 years on the basis of cheap natural gas,
chemicals
among them. Environmental incentives, or mandates, to employ gas as
a
cleaner-burning fuel have augmented this shift. Now, all of that has
put some
gas consumers in a bind.
Natural-gas prices
have jumped by 18% in the last four weeks, to more than $6
per million British thermal units, even as seasonal heating demand has
abated.
The bull case on gas for years has been that North American supply was
being
depleted. It finally seems to be happening, just as both residential
demand and
the need for gas among utilities are rising briskly.
There's a growing sense that the price might stay well above $5, if
not $6,
with new supply unlikely to show up soon. Drilling activity in the Gulf
of
Mexico has picked up, but the wells are not as productive as in the
past.
Imports from Canada help, but can't fully cover the shortfall.
Copley says he spoke to one chemical company chief financial officer
who said
he was so worried about a possible spike in gas back towards $10 that
he was
considering hedging to lock in today's elevated prices through the summer.
This is bad news for several chemical makers, who desperately need gas
to drop
down near $4 to keep profitably making products like ethylene.
Copley's bottom line is that with normal weather patterns, chemical
makers
will be strapped for years, leading to big restructurings and possibly
bankruptcies. And this: "With above-average weather demand at any
point in the
next 12 months, the sector . . . is in for a gas pricing shock that
will likely
bring part of the industry in the U.S. to its knees and bankruptcies
are
inevitable."
Most at risk to feel the pain are Lyondell Chemical and Millennium Chemicals,
along with Eastman Chemical and, to a lesser extent, Dow Chemical. Copley
is
carrying Underperform ratings, the equivalent of Sell, on all four.
The industry is in varying degrees of denial, building in assumptions
that
lower gas prices are a matter of when, and not if, says the analyst.
Wall Street
is sharply polarized, with some analysts and investors very nervous
and others
optimistic that an economic upturn will bail out chemical margins. Several
chemical stocks have held up well, and the Street's earnings forecasts
for 2004
have climbed.
"I've never seen such a divergence in opinion," Copley says.
"The bulls argue
there will be a cyclical recovery in commodity chemical demand and it
doesn't
matter what gas does. This misses the fact that there is simply not
enough gas.
The price will rise until someone stops using it, and that will be the
chemical
companies."
Copley says some investors have expressed alarm at his suggestion that
the
industry could radically shrink to near insignificance. He answers with
a
question: "I ask them how many textile analysts they have seen
this week?"
-- Electric utilities,
though not helped by higher natural gas prices, are
better insulated from the commodity, and the stocks in the sector are
having a
noteworthy run. In some measure, the law cutting dividend taxes to 15%
is
responsible. In this high-dividend group, the impending tax-law change
effectively turns a 6% yielding stock into a 5% after-tax income producer,
up
from less than 4%.
The Dow Jones Utility Average has actually outpaced the S&P 500
since the
recent market low on March 11, rising more than 20%, and the index gained
4.2%
last week in a sluggish market.
At minimum, the dividend tax cut will put a floor underneath higher-yielding
utilities at current valuations, according to Stephen Goldfield, managing
director of Imperium Capital Management, a hedge fund specializing in
utility
stocks.
Yet Goldfield remarks that gains in utility shares have been "indiscriminate,"
with risky, zero-dividend stocks rising alongside stable, high-yield
names.
Among the stocks rising without the support of dividends or good fundamentals
are CMS Energy and Allegheny Energy. Other dicey situations are Teco
Energy and
Duke Energy, which continue to deal with troubled merchant power businesses.
Goldfield thinks the most likely longer-term beneficiaries of the tax
change
will be the higher-yielding traditional utilities with safe dividends
and a
retail shareholding base. In that category, he places Consolidated Edison,
OGE
Energy, Hawaiian Electric Industries, Ameren and AGL Resources. With
the
exception of AGL -- whose yield is 4.4% -- these stocks are producing
yields
between 5% and 6.5%.
Goldfield also recommends playing another subset of the industry, small-cap
companies with attractive yields and the potential of being acquired
at some
point. Here he names RGC Resources, Chesapeake Utilities and EnergySouth.
The lower tax rate on dividends helps raise the long-term worth of stocks
when
valued on a dividend-discount model. Using fairly conservative assumptions
for
2.5% long-term utility earnings growth and a 75% dividend payout ratio
for most
companies, Goldfield has produced fair-value estimates for each publicly
traded
utility. He says 22 stocks now sit 10% or more below their conservatively
calculated hypothetical values, implying decent capital gains potential
in
addition to the nice income.
Who knew utilities, or taxes, could be so interesting?
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VITAL SIGNS
FRIDAY'S WEEK'S WEEK'S
CLOSE CHANGE % CHG.
DJ Industrials 8601.38 -77.59 -0.89
DJ Transportation 2383.36 -35.95 -1.49
DJ Utilities 244.90 +9.82 +4.18
DJ 65 Stocks 2494.53 -2.94 -0.12
DJ US Total Mkt 218.42 -1.93 -0.88
NYSE Comp. 5288.45 -33.26 -0.62
Amex Comp. 926.53 +33.87 +3.79
S&P 500 933.22 -11.08 -1.17
S&P MidCap 454.59 +2.19 +0.48
S&P SmallCap 204.70 +1.28 +0.63
Nasdaq 1510.09 -28.44 -1.85
Value Line (arith.) 1142.74 +1.67 +0.15
Russell 2000 418.40 +3.71 +0.89
Wilshire 5000 8916.23 -73.64 -0.82
Last Week Week Ago
NYSE Advances 2,071 2,216
Declines 1,378 1,231
Unchanged 89 88
New Highs 661 599
New Lows 26 17
Av Daily Vol (mil) 1,733.3 1,779.2
Dollar
(Finex spot index) 93.05 94.08
T-Bond
(CBT nearby futures) 121-09 119-08
Crude Oil
(NYM light sweet crude) 29.16 29.14
Inflation KR-CRB
(Futures Price Index) 239.70 241.33
Gold
(CMX nearby futures) 368.80 354.70
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