Barron's (11/17) The Trader: Stalling On Wall Street

(From BARRON'S)

By Michael Santoli

The difference between stalling and idling can be as simple as the level of

fuel in the tank.

In the early part of last week, the major stock indexes appeared stalled just

beneath recent highs. But a mere feathering of the gas pedal by stock buyers

Wednesday showed the market simply to be in a restorative idle, when a lopsided

one-day rally stretched the indexes toward new yearly highs, before another

pause Thursday. Then a sluggardly, sputtering decline Friday again stalled the

market below week-earlier levels.

The Dow Jones Industrial Average finished with a loss of 41 points at 9768,

while the Standard & Poor's 500 dipped 2 to end right at 1050, a round number

that has acted like the center line in a tug-of-war among short-term traders for

weeks. Wal-Mart's earnings shortfall and a light reading on October retail sales

led to some moderate worries about the state of consumers' minds and wallets as

the heavy shopping season begins.

The Nasdaq Composite was set back on its heels by uncharitable reactions to

earnings from Applied Materials and heaviness in the longtime-leading Internet

sector. The index forked over some of the steep outperformance it's built for a

year, dropping 40 points, or 2%, to 1930.

The main fuel for the eight-month rally has been the free-money,

aggression-stoking policies of the Federal Reserve and the Bush administration,

which have penalized risk aversion, provided windfall spending money to

consumers and floated everything in sight -- stocks, bonds, gold, oil and the

egos of stock investors riding the wave.

Fed officials, on banquet-room podiums and in press interviews, were straining

last week to convince investors that it has no intention of bleeding away any of

this liquidity any time soon.

The unspoken objective seems to be this: Deliver a weakened form of the old

bubble-causing virus as an inoculation against deflation, a boost to employment

and an invitation to asset and price inflation. Inflation, an enemy the Fed

knows well and is confident opposing, would ease the huge debt-service burden

and grease the gears of an economy with lots of capacity to spare. Or so the

story goes.

In the end, stocks didn't fully cooperate, as leadership groups such as

Internet names, semiconductors, biotechnology and brokerage stocks sagged to

sink the broader market. Certain defensive groups, most notably pharmaceutical

shares, bounced hard, with the drug-sector indexes up nearly 6%. Merck,

recipient of a couple of analyst upgrades, added 2.65 to 46.50 and Pfizer

climbed 2.31 to 34.08.

Among the presumed catalysts for the moves were some industry-friendly

developments in the Medicare bill talks, positive scientific data on

blood-thinning drugs and rising monthly prescription volumes.

The question is whether this marks the long-anticipated rotation from

technology and cyclical fixation toward drug and consumer blue chips. The groups

tend to trade at odds. Valuations for drug companies are depressed while techs'

are strained and virtually every Wall Street handicapper has expected a rotation

toward quality to occur at some point.

There was certainly an effort by pressing traders to push this process along

late in the week, but it's far from clear that the two-day tango of these groups

means a leadership handoff is under way. For one thing, history suggests that

meaningful rotations don't often occur "on the run" with the overall market

hanging firm. More often, the switch is formed in the crucible of a market melt,

and then a new sector comes out of the correction ahead.

Russ Koesterich, strategist at State Street Global Markets, has been eyeing

the prospective tech-to-drug move for months, and believes it's not necessarily

identifiable yet. Head fakes that looked similar have happened before this year,

albeit not any that was quite this dramatic or featured such heavy trading

volume.

For it to happen, he says, "we need techs to roll over and for people to

question whether the reflation trade has gone too far." Alternatively, growth

estimates from drug pipelines need to stop falling and start turning higher. In

other words, the drugs will start outperforming only if "people want to get

defensive, or because they look like growth stocks again." It's not clear -- not

quite yet -- that either of those things is the case.

-- Go ahead and talk about favorable seasonal trends. Note how the Fed is

making sure that money's easier than the farmer's daughter. Mention that

fund-manager urgency and the arrival of some less-than-savvy money could easily

carry stocks another leg higher. Even make the case that today's sugary

valuations can be sustained as earnings continue to climb, raising share values

apace.

But just let's not hear any talk that stocks are cheap. Or, more

interestingly, that there's even an appreciable selection of cheap stocks to be

found. Among the reasons to buy stocks, highly attractive prices are not among

them.

This isn't a novel assertion. Eminent philosopher-investors such as Warren

Buffett, Marty Whitman and Jeremy Grantham have accentuated the point in

Barron's in recent weeks, of course. But it bears a deeper look.

Even beyond the current S&P 500 price/earnings multiple of 20 times the

current year's expected operating earnings-much higher on the more stringent

standard of trailing reported profits-and the sub-2% dividend yield, indications

of cheapness are hard to locate.

Looking at the distribution of individual stock multiples, there are far fewer

stocks valued below 10 times earnings today than there were at the bubble's most

bloated in early 2000. Of course, there are fewer stocks with infinite multiples

(meaning negative earnings) and not as many trading above, say, 40-times

profits, too.

So the lunatic fringe isn't as populous now. But the scarcity of earnings

available at exceedingly depressed prices means there just aren't many

no-brainers out there for the taking.

Approached a different way, it's stunning how many big stocks have already met

or exceeded the stated upside expectations of Wall Street's sell-side analyst

community, a group not usually renowned for swallowing its enthusiasm.

Richard Steinberg, president of Steinberg Global Asset Management and manager

of the Reserve Large Cap Growth fund, keeps an eye on how stocks are trading

versus the consensus share-price targets of the analysts who cover them. It's a

way to neatly gauge what might be called the "opportunity quotient" of the

market.

Exactly half the stocks in the S&P 500 last week had already exceeded their

consensus price targets or were within 1% of them. That's a situation he

considers a Sell signal for the affected stocks.

Another 26% of stocks had less than 10% of upside to the collective price

objective and 16% had between 10% and 25% of headroom. Only 8% were more than

25% underneath their targets, which Steinberg views as potential Buys.

He calls the exercise "a litmus test of the overall market," and believes that

currently the breakdown suggests "we need to have a pullback to re-justify

certain expectations" embedded in share prices now.

Now, there are ways for backyard contrarians to argue their way around these

numbers and recast them as a positive sign for stocks. This involves insisting

that sell-side analysts are poor mouthing, underestimating corporate earnings

power and offering conservative upside targets after a psychologically damaging

bear market.

This possibility can't be dismissed out of hand. If an investor could go back

and be granted one single insight at the start of this year, a smart one might

indeed choose to bet that analysts would finally be shown to have cut earnings

forecasts too much. It had happened by the time third-quarter earnings arrived,

and by then stocks had well foreseen it.

But that's not to say that analysts-who have been busily elevating earnings

forecasts for 2004-are still struggling to catch up with the upward arc of

profits and stocks. At some point-maybe now, maybe soon-these stockpickers will

shift back toward an enthusiastic posture that pushes upside expectations ahead

of probability.

There's no saying it's happening this minute. But if and when it does it may

be marked by analyst moves like these from last week. Credit Suisse First

Boston's Kevin McCarthy jacked his price target on Dell to 43.50 from 36, with

the stock at 35.64 after Dell's earnings report. The analyst didn't boost his

$1.01-a-share earnings forecast for the current fiscal year or the $1.20 for

fiscal '04. But he initiated one for fiscal 2006 at $1.45, slapped a 30 multiple

on that and arrived at the $43.50 target.

That puts more daylight between the stock price and the target, but at some

point this activity represents over-reaching.

As a company, of course, Dell is a peerless operator, and it's hard to quibble

with the idea that its shares deserve an ample premium to the market. The only

argument is how much, and the argument should probably settle on a generous one.

Then there's Kohl's, which retains the affections of analysts (18 Buys, six

Holds and one Sell, says Thomson First Call) who are intent on holding high its

valuation, despite recent slippage in corporate results. The retailer's earnings

last week hit its recently reduced projection, though they were down from a year

earlier, and the company guided current-quarter numbers toward the low end of

Street estimates.

Still, the stock-though down 25% from its high of almost a year ago-goes for

21 times next year's ambitious forecasts, generous for a company that managed an

11% drop in same-store sales last month.

Linda Kristiansen of UBS Investment Research, though, is carrying a 70 target,

based on the idea the multiple "will improve to a 70% premium to the S&P, which

is below its most recent high of 96% in May 2002."

Conservative forecasting-redefined.

To press on with the interplay of sell-siders, retail stocks and the

expectations game, last week Smith Barney upgraded Federated Department Stores

with the stock trading in the high 40s. In doing so, the firm lifted earnings

forecasts for the coming quarter and next year, buttressing its call with an

improving fundamental trend.

Now consider what's gone on with Federated this year. At the end of 2002, with

the stock at 28.76, Federated was expected to earn $3.75 a share. Clearly, with

a forward P/E below 8, the market was mocking the notion that those earnings

were likely to materialize.

And it was right. Sliding sales pressured earnings prospects to a low near

$3.10 in late winter, when the stock bottomed around 21. Things have improved,

but even now the company is expected to earn only $3.37 in 2003. And next year?

That's when analysts see that old $3.75 that was promised a year ago to show up.

Meanwhile, the stock more than doubled, placing its forward multiple at 13.5.

That's not by any means egregious, but for a company in a tough industry whose

stock has already been generous, one might think investors would be quick to

ease out.

But upon the upgrade last week, investors stretching for just a little more

boosted the stock to a new intraday high above 50. That doesn't seem like the

action of a Wall Street combine that's reluctant to become optimistic.

Steinberg notes that stocks with good share-price momentum without much

fundamental momentum leave no room for the slightest error or disappointment.

For recent buyers of Federated to win, the market had better be forecasting that

the estimates are poised to surge, the way the market was foretelling the

shortfall a year ago.

Valuations won't likely be the reason for any eventual market setback, as they

rarely are. And, to be fair, there's plenty of talk all the time about valuation

concerns, from some strategists and TV commentators, suggesting that there's

still a reservoir of disbelief in stocks' run that will have to be drained away

before they weigh on the indexes.

 Still, once a setback is triggered, multiples that build in no cushion will

make the fall that much more painful.

if skepticism is a waning asset on Wall Street, it's got to be growing in

worth every day.

This makes it sensible to scan stocks that the Street has labeled toxic but

that have been finding buyers anyway.

Analysts have no use for Eastman Kodak. Not a single big brokerage house

recommends the stock, five are telling clients to sell and two are neutral. Good

thing for Kodak that Bill Miller doesn't get his ideas from analysts' reports.

The Legg Mason funds run by Miller -- the current holder of the record for the

longest streak surpassing the S&P 500 -- last week disclosed an increase in

their stake in Kodak to 10% from 8.7% in the third quarter. That was a quarter

in which the company announced its radical plan to focus on digital photography

and slashed its dividend. The move unnerved the market and knocked Kodak shares

from 27 to 20.50 in a matter of days. But the shares have clawed their way back

above 24, with no help from the sell side.

Miller is by no means infallible, but he is brave and pretty successful-his

flagship fund is up 35% this year. He's admired and occasionally maligned for

his capacity to reload on stocks that are way down from his initial cost,

something he did with Amazon to great success.

Meanwhile, a different breed of maverick, Carl Icahn, met with Kodak

management last week and is reportedly thinking about investing a sizable sum.

Another Wall Street orphan is State Street, which enjoys only three Buy

ratings among 19 analysts. For the most part, it's covered by bank analysts.

Some of them note that, at 18 times expected 2004 earnings, it's quite expensive

for a bank. Which makes sense, since State Street isn't really a bank, but a

huge institutional investment manager, asset custodian and securities processor.

It has massive scale in its main businesses and just got bigger, having bought

Deutsche Bank's custody business. The deal has some observers fretting about

possible poaching of Deutsche customers in this very competitive business. State

Street says it's retained nearly 90% of clients, but the risk is believed still

to exist. Cost pressures, meanwhile, have caused some to fear for profit

margins.

There's something more timely to get investors interested here, perhaps, given

that State Street is among the few potential beneficiaries of the messy

mutual-fund market-timing scandal. For one thing, it's big in the business of

"transition management," helping pension funds transfer assets between fired and

hired money managers.

Also, it's a major index and global-markets asset manager, one that hasn't yet

been implicated in the industry scandal, the kind of player that might be a net

winner of mandates. Finally, it has a presence as an overseer of exchange-traded

index funds, which could well win market share from disgusted retail investors.

Perhaps it's no surprise that since Sept. 3, the day New York's Eliot Spitzer

went public with the improper fund-trading allegations, State Street shares are

up 14%, versus 6% for the S&P. Again, without much cheerleading to egg it along.

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VITAL SIGNS

Friday's     Week's  Week's

Close        Change  % Chg.

DJ Industrials               9768.68     -41.11    -0.42

DJ Transportation            2927.64     -51.65    -1.73

DJ Utilities                  248.66      -1.46    -0.58

DJ 65 Stocks                 2833.85     -23.34    -0.82

DJ US Total Mkt               248.75      -0.79    -0.32

NYSE Comp.                   6010.73     +21.56    +0.36

Amex Comp.                   1073.17      +6.47    +0.61

S&P 500                      1050.35      -2.86    -0.27

S&P MidCap                    557.17      -2.65    -0.47

S&P SmallCap                  259.67      -3.39    -1.29

Nasdaq                       1930.26     -40.48    -2.05

Value Line (arith.)          1445.74     -13.77    -0.94

Russell 2000                  532.96     -10.00    -1.84

Wilshire 5000               10244.66     -45.10    -0.44

Last Week  Week Ago

NYSE

Advances                           1,850      2,298

Declines                           1,580      1,133

Unchanged                             88        104

New Highs                            631        905

New Lows                              25         16

Av Daily Vol (mil)                 1,593.4    1,746.3

Dollar

(Finex spot index)                    91.44      93.02

T-Bond

(CBT nearby futures)                 110-08     107-04

Crude Oil

(NYM light sweet crude)               32.37      30.85

Inflation KR-CRB

(Futures Price Index)                257.29     251.03

Gold

(CMX nearby futures)                 397.80     383.30

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