Barron's Market Week -- Stocks: The Trader: Are Laggards Poised To Become 

(From BARRON'S)

By Michael Santoli

The investors who've been driving the market's seven-month surge haven't cared

about the place to go for the best weather, but only where the mercury was

rising the most. This has meant, so to speak, that investors have flocked to the

beaches in areas where the temperature was climbing from freezing to merely

chilly, leaving the steadily mild territories behind.

The rate of change has mattered more than the resulting number. Those

companies poised to show the swiftest improvement have gotten all the attention,

never mind whether even that boost in profits would justify a higher stock

price.

In Wall Street terms, the result is the supremacy of beta and earnings

leverage  -- the jumpiest stocks of the companies rebounding from the deepest

depths. The much-remarked leadership of low-priced, low-quality, long-shot

stocks over steady ones has been the result. To shift analogies, every feckless

brother-in-law is getting rich while the solid citizens struggle to stay afloat.

The persistence of this pattern has been sending some of the more thoughtful

market observers to ask when the beta-and-leverage trade might give way to the

quality-and-predictability rotation.

The market's answer to this question last week was, "Not yet."

Stocks resumed an upward tilt early in the week, propelled by mechanical

buying at the start of the fourth quarter after a late-September dip, which left

aggressive sellers back on their heels by the time Friday's positive employment

numbers arrived.

After Friday's reaction rally was through, the Dow Jones Industrial Average

had climbed 259 points on the week, or 2.8%, to 9572. The Standard & Poor's 500

made a run at its recent closing high of 1039, jumping 33, or 3.3%, to 1029. The

Nasdaq Composite, reasserting the leadership of beta and aggression, advanced

88, or 4.9%, to 1880, 1% below its latest peak of 1909 on Sept. 18.

The initial buying thrust occurred Wednesday, when the S&P 500 jumped 2.2%,

suggesting that Oct. 1 is becoming a reliable date to be a one-day player,

perhaps because of quarterly institutional cash flows into equities. On that

date last year, the S&P was up 4% after having dropped hard in the prior two

days. The index then collapsed to the Oct. 9 low that for now still stands as

the market's bottom.

The report that spurred Friday's up leg said employers added to payrolls for

the first time in seven months. Certainly the 57,000 net new jobs in September

were a pleasant surprise, given the forecasts for a drop of 20,000. But the

broader picture of a slack labor market was left undisturbed by an unchanged

unemployment rate and slippage in hourly earnings. The Dow's 84-point one-day

gain was less half its peak intra-day rise, as the bidding flagged ahead of the

holiday weekend.

From the file labeled Counterintuitive Market Calls, there's talk in some

circles that the news item that might coincide with a top in the indexes could

be an eventual blockbuster monthly jobs increase.

This arises from a mixture of gut-driven iconoclasm -- the market's up big in

a year of huge job losses, after all -- and the rationale that a hiring surge

would compromise corporate profit margins that have generally been nursed to

healthy levels. Consider that a UBS investment strategist just raised S&P 500

earnings forecasts for 2004 based on margin increases helped by "rising sales

per employee," a sign that a hiring lag is integral to the consensus

profitability assumptions.

Of course, a spike in interest rates from a gaudy payroll increase might also

prove unfriendly to stocks. Be that as it may, this hypothesis isn't likely to

be tested very soon.

If, as some have suggested, a leadership shift is under way from momentum moon

shots to laggards, from speculative to stolid, it's happening in a tentative and

halting fashion.

True, the charts of Chinese Internet stocks, the very EKG of aggressive

traders, have reached a momentary plateau after their mountainous runs higher.

In recent weeks the Morgan Stanley Consumer index -- full of traditional staples

names -- has gained some ground on its doppelganger Cyclical index, itself a

measure of earnings-leverage hopes.

Still, that's mere spotty evidence. The front-running Nasdaq, which is

dominated by the blue chips of the technology economy, hardly tells the whole

story of the high-beta rally that was revived last week. Just see the Internet

HOLDRS, an exchange-traded fund containing a dozen once-glorious Web stocks,

which ramped 7% higher last week and are 75% above their March low.

Whether the market is readying itself for the "quality trade" just yet, there

are plenty of reasons for investors now to consider pursuing it, all the same.

Morgan Stanley strategist Steve Galbraith is among those pointing out that

corporate earnings growth rates are strong but appear poised to ebb after this

quarter, meaning profit improvement will continue at a slower pace. In contrast

to the March panic low, when earnings-growth rates bottomed and share prices

were deeply discounted, the current situation features higher stock prices and

decelerating earnings growth.

The result could be a jump in market volatility, possibly already under way,

and more-frequent "blowups." Galbraith suggests the way to play this phase is

"to shift toward laggards and stable growth stocks."

Another minor point: Household-products stocks have been an excellent bet to

outperform the overall market by a healthy margin in the fourth quarter, going

back to the mid-'Eighties, says UBS.

If such a turnabout is going to happen, in which tech stocks cede the

forefront, another logical defensive play is the drug sector. Russ Koesterich,

equity strategist at State Street Global Markets, calculates that pharmaceutical

stocks are three-times more likely to beat the market when tech is lagging. Drug

stocks, as frequently noted, are as cheap based on earnings as they've been

since 1995, partly a result of declining long-term earnings-growth assumptions.

And tech shares, say what you will, can be called impressive but not

inexpensive. As the nearby charts show, the Nasdaq has followed a post-bubble

revival path dictated by history, nearly tick for tick. That upside inertia has

frustrated many a tech denier.

But a look even at the more fundamentally admirable tech heavyweights shows

the risk of capitalized optimism. One tech-focused investor remarks that at the

end of '99, Intel shares were at 41, or 25 times what Intel was expected to earn

in 2000.

Today, at 29.61, Intel trades for 38 times forecast 2003 earnings and 28 times

the hoped-for 2004 number. Intel might have better luck meeting next year's

estimates than it did with the forecasts for 2000, but that in itself doesn't

make the stock a Buy.

-- John Hancock Financial's agreement last week to be acquired by Canada's

Manulife for a slim premium is part of a pattern of life insurers apparently

throwing in the towel. MONY Group recently sold out to AXA Financial at what

many investors complain is an insulting price. And Safeco last week said it

would seek a buyer for its life business.

This activity smells to some stock pickers as capitulation by the sellers, a

sign of exasperation at their low stock multiples awarded for generally

low-return life operations. The question is whether this marks a kind of bottom

and buying opportunity for other vulnerable life insurers.

It might not be quite so simple. Even though these deals do suggest a long-

awaited round of industry consolidation is brewing, there aren't enough

ambitious and aggressive buyers to create attractive premiums for likely

targets.

Morgan Stanley analyst Nigel Dally suggests that the big European insurers are

no longer looking for entree into the U.S. market, and the notion of creating

"financial supermarkets" no longer involves owning a life-insurance provider.

Distribution, not underwriting, seems to have gotten the upper hand.

Nonetheless, further consolidation stands to help overall industry returns by

reducing capacity and rationalizing capital use. This view has him favoring the

larger, better-capitalized players who could stand to benefit by making sensible

acquisitions and riding overall industry profitability improvements.

In particular, Hartford Financial and Met Life stand out in this category.

Both companies have shares trading at nine-to-10 times expected 2004 earnings

and 1.3-to-1.4-times book value. Both stocks ticked higher following the Hancock

news. Yet even though Dally remains neutral on the life-insurance sector, he

still can see around 20% upside for Hartford and Met Life.

This is the kind of idea that would have the average screen-blind Nasdaq

junkie reaching for the Delete key, but in apathy may lie opportunity.

-- In their herd-like rush to bet against several hot specialty retailers,

short sellers have been early. Which is also known as wrong in this daily

mark-to-market game. A handful of trendy mall-based clothing chains have

attracted skeptics with their breakneck growth rates, generous valuations and

stock charts that slope precipitously toward the upper right.

The result is that some teen retailers such as Hot Topic and Urban Outfitters,

and women's chains including Bebe Stores and Chico's FAS, are sitting with

anywhere from 10% to 23% of their available shares having been sold short. By

comparison, short interest in the market over all is around 2%-3% of all shares.

As often noted, a big short position can prolong a stock's upward run by

providing latent buying interest.

Short sellers frequently operate with a wide moralistic streak as

self-anointed administrators (and profiteers) of a kind of market justice,

targeting companies they believe to be financial sinners in need of punishment.

Such moralism is lacking with regard to these flourishing retail names, which

most skeptics will allow have managed to grow impressively by plying successful

niches in a tough industry. The doubters are simply positioning for that time

when an expensive growth stock that's slave to high investor expectations

succumbs to the reality that the stores' sharp fashions turn to stale fad.

For Chico's, which has won over many women over 30 with its flattering apparel

designs and bold accessories, there's no clear evidence in the numbers that its

impressive momentum is about to slow. Sales at stores open at least a year have

been rising at a 12% rate so far this fiscal year and earnings are on track to

jump 25%. Its gross margins are enormous, thanks in part to its in-house design

and manufacturing.

Keith Long of Otter Creek Management in Palm Beach, Fla., concedes all of

that, and further extols Chico's merchandising smarts, such as a

customer-rewards program that engenders loyalty. Still, with the stock having

tripled to 33 over two years and now trading above 25 times projected earnings

for the year ending February 2005, he sees enough hints of potential trouble to

put himself in the crowded short camp.

He spies a red flag in the company's recent $90 million purchase of White

House, a smaller and sleeker women's retailer whose gimmick -- insiders would

call it the "concept" -- is that its White House stores carry only white clothes

and its Black Market locations are all black.

On one level this could be a shrewd hedge by Chico's, whose clothes are more

colorful and loosely draped, in the Sun Belt style. One distinguishing point of

Chico's is its ego-buffering sizing scheme, which runs 0-3 and spares women from

the unforgiving standard size scale that stretches well into the double digits.

Chico's recently decided to shutter a test unit called Pazo, intended to appeal

to somewhat younger women.

Long, by his own admission no expert on women's fashion, nonetheless has

encountered anecdotal hints of a minor backlash, such as a couple of women in

Chico's target demographic he overheard poking fun at the "Chico's look" at a

South Florida dinner party. He also notes that Chico's style is fairly easy to

knock off, and department stores have begun trying. It's also worth mentioning

that founder and Chairman Marvin Gralnick has been selling healthy amounts of

stock, though he retains a large stake.

These concerns may not impede Chico's momentum for some time to come, assuming

they ever do, in which case the stock might continue to stampede over the

frustrated short sellers. But at minimum, it has rarely paid to be a buyer of a

fashion-dependent stock that's already inflated with such giddy expectations.

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