| Mid-Year
Market: Stuck In The Middle Again
(From BARRON'S)
Like a team confused by a lousy halftime pep talk, the stock market has started
the third quarter with a sloppy, uninspired performance.
Knocked back on
their heels by a run of subpar profit news from technology companies and unnerved
by a bounce in oil prices, traders have spent the past two weeks in a pattern
of anxious, tentative selling. As a result, the key indexes have sagged toward
the lower part of the tight trading range that has prevailed for what seems like
forever, but has really only been seven months.
The Dow Jones Industrials
last week slipped 69 points, or 0.7%, to finish at 10,282. The S&P 500 dropped
12 points, or 1.1%, to 1112, placing the benchmark about 3% above the 2004 low
set in May, and up less than one point on the year.
The Nasdaq Composite
was thrown for a 3% loss last week, falling 60 points, to 1946, as a succession
of big software companies fell short of hoped-for results and Yahoo! merely met
published forecasts.
The software shortfalls -- from Veritas Software, Siebel
Systems, BMC
Software, Computer Associates and others -- changed tech investors'
primary question from when corporate IT spending would resurge to whether it will.
Similar to the man who drinks in a bar all night and never gets one on the
house, investors reacted nastily to Yahoo!'s on-target earnings, clipping its
shares by 11% (after the stock had risen 50% in the first half). Now, with the
prime weeks of earnings reporting poised to begin, the indexes sit in a bit of
a hole, with the S&P down 2.5% this quarter and the Nasdaq off 5%.
The
itch to sell into earnings news was soothed a bit Friday by General Electric's
report of a slight gain in its second-quarter net, which topped forecasts by a
penny at 38 cents a share. More than the results themselves, GE's comment that
it detects the strongest economy "in years" seemed to offset gathering
concern that a broad slowdown is setting in, based on soft retail-sales and job
numbers.
The slim gains Friday lent hope to those faithful investors still
banking on strong profit growth to boost stocks, despite the evidence of the past
two quarters that it's not always the way the story goes. The
refrain is familiar:
Rising earnings will carry stock prices upward, as soon
as "extraneous" concerns about oil, Iraq and presidential politics abate.
Earnings forecasts have climbed, even as stocks have stagnated, true believers
add. Pulling
apart profit expectations can be instructive. It's true that estimates have risen
over recent months, but a good chunk of the increase has come from fatter expected
energy profits -- driven by those same high oil prices the bulls consider a weight
around the market's neck.
S&P 500 company profits are seen growing 19.5%
over year-earlier levels, according to Thomson First Call. (Most observers think
they'll easily top 20%.) Yet 2.6 percentage points of that 19.5% projected growth
is attributable to the energy sector, which is seen showing 49% gains. Just two
months ago, second-quarter energy earnings were expected to rise a mere 8%. So,
sure, forecasts have gathered steam, but largely in a part of the market most
investors don't pay up for.
The fact that the market has weakened ahead of
earnings season may suggest that the upbeat scenario has a shot; in earlier quarters,
stocks were firm going into the reporting period.
There are also some indications
that stocks are nearing the kind of technical "oversold" condition that
has recently foreshadowed a decent -- if fleeting -- bounce.
Making a buck
with smart stock-picking has become tougher than usual this year, as the market
trades almost as a single piece of merchandise. Piper Jaffray strategist Brian
Belski notes that stocks are moving in synch to a degree not seen in five years.
This has led more investors to focus on pan-market clues about short-term inflection
points in the indexes. No doubt, some market commentators this week will begin
comparing the latest pullback to those in May and March, which ended with tradeable
rebounds.
Traders are now conditioned to buy when the indexes stretch
toward the lower end of the long-standing range between S&P 1080 and 1160.
It could work again.
But it should also be remembered that, after they were
good and conditioned, Pavlov's dogs were eventually denied their food. --
The swift, harsh justice given companies that disappoint investors has raised
the stakes in that quarterly Wall Street game called, "Predicting Surprises."
Getting a fix on which companies are candidates to shock or amaze the market has
become a preoccupation of analysts and strategists. Anticipate the anticipators,
seems to be the objective.
Vadim Zlotnikov, Sanford C. Bernstein's two-hatted
equity and technology strategist, sifted for tech firms for which the Street has
set a low or high hurdle.
The former group includes companies for which formal
second-quarter forecasts incorporate decelerating sales and lower margins versus
the prior quarter's. The idea is that these companies should have an easier time
meeting or beating the expected numbers. There were 13 such "safer bets,"
according to Zlotnikov, including Microsoft, Motorola, Taiwan Semiconductor and
Automatic Data Processing, as well as Amazon.com and Intuit.
The list of
tech issues for which the market has set demanding expectations -- accelerating
sales and expanding margins -- is more than twice as long, a sign of how aggressive
investors have become in setting their sights. One of the stocks Zlotnikov named
as vulnerable to disappointment -- Siebel Systems -- has already profoundly disappointed.
Others on the list that have yet to report include Nortel Networks, Maxim Integrated
Products, KLA Tencor, Microchip Technology and Novellus.
Quantitative analyst
Gary Tapp of SunTrust Robinson Humphrey applied his earnings-surprise model to
stocks in his firm's coverage universe. Among the large stocks that he says seem
likely to deliver upside surprises are Gillette, Aflac, Colgate-Palmolive and
L-3 Communications. Of those, Aflac and L-3 also score well on his valuation screen.
Tapp's potential disappointers include BB&T, Eli Lilly, Schering-Plough
and King Pharmaceuticals, with Lilly and Schering more exposed to negative price
reactions, owing to heftier valuations.
Watch for a scorecard on these calls
later in the earnings season.
-- At some point in decades past, the
daily television audience overtook national newspaper circulation. To the surprise
of some, the Republic has survived. But has its character changed in a way that
remains important?
This question is prompted by the seemingly inexorable,
and recently
accelerating, increase in computer-driven program trading as
a proportion of all market activity, a phenomenon that has some observers wondering
whether something fundamental has changed in the way the market operates.
The New York Stock Exchange reports weekly on program trading activity, which
includes any trades comprising the simultaneous purchase or sale of at least 15
different stocks with a total value of $1 million or more. In eight of the past
nine weeks, program trading has accounted for more than 50% of all NYSE trading
volume. In the week ended June 25, it came to 70.5% of volume. That result was
distorted by the annual rebalancing of the Russell indexes, which involves lots
of mechanical maneuvering by index funds.
By comparison, this percentage
often held below 40% last year and three years ago generally came to 20% to 25%.
This surge in activity is partially attributable to the fact that 15 stocks
and a million bucks aren't what they used to be, so more activity falls under
the program definition compared to years past.
But changes in the way institutional
investors transact business is the real story. Mindful of trading costs, more
professional traders are using services offered by big brokerage houses that slice
buy and sell lists into agglomerated, computer-executed orders.
There has
been enormous growth in certain kinds of "black box" trading
strategies,
too, in which machines look for minute pricing anomalies. The disproportionate
influence of short-term-oriented hedge funds and sell-side trading desks also
contributes to the proliferation of highly tactical, penny-skimming activity.
For most investors, the question about this trend is, "To what effect?"
That's far from clear.
Many veteran investors remember both the days
when the NYSE closed on
Wednesdays to catch up on paperwork and when the sinister,
anti-human computer HAL from 2001: A Space Odyssey haunted first-run theaters.
To them, the encroachment of disembodied trading must be an insidious force, even
if they can't articulate why.
There's a superficial assumption among many
that somehow program trading exacerbates market volatility. And yet program activity's
recent expansion has occurred in a period of persistently declining volatility.
Much program-type order flow is, in fact, arbitraging away anomalous price moves.
A more subtle line of argument holds that the instantaneous, mechanistic
trading leaves no room for human discretion, patience or nuanced thinking, possibly
turning away a certain type of opportunistic trader from the market.
This
isn't measurable, even if it is plausible. --
First, the disclaimer.
Barron's wrote favorably about the prospects for Healthsouth
two years ago, having mistakenly taken the company's financials at face value
in order to argue the stock was unduly cheap at a price around 7. Following the
article (which carried the same byline as this column), the stock promptly rallied
to 11, for some handsome but ultimately fleeting profits.
Only months later,
news would break that founder and then-CEO Richard Scrushy and other executives
were being accused of criminal fraud for systematically inflating cash flow and
asset figures. Scrushy is due to stand trial soon. The stock -- de-listed from
Nasdaq and widely scorned -- sank below a dollar.
But, improbably, the physical-therapy and outpatient-surgery company survived
without being forced into bankruptcy protection. The company's bonds once languished
near 40 cents on the dollar, but now trade at par, a sign that creditors are comfortable
with Healthsouth's finances.
Some influential equity investors, too, are
beginning to warm to the company's prospects, though it should be noted that the
stock remains extraordinarily speculative. The shares, which trade actively on
the over-the-counter "pink sheets," have nearly quadrupled in the past
year, to about 6. New management has impressed some investors as forthright and
capable. CEO Jay Grinney, a former senior executive at hospital giant HCA, joined
the company in May and recently gave a well-received business update to a heavily
attended investor meeting.
He asserted that the company is on track to produce
$650 million in earnings before interest, taxes, depreciation and amortization
this year. Less than half of that will go to interest on about $3.3 billion in
debt, giving the company plenty of financial wiggle room. The company also has
about $400 million in available cash.
Grinney reportedly expressed an intention
to prune the business judiciously and to create the kind of financial controls
that never existed under Scrushy. A small sign of financial discipline came last
month when he shuttered a hospital that was losing $500,000 a month. One of Grinney's
next tasks is to hire a chief financial officer.
It's worth noting that Grinney
left HCA -- a once-troubled but now solid company -- for Healthsouth, and was
awarded one million stock options upon arrival. They carry a strike price of $5.21.
His newly hired chief operating officer got 105,000 options struck at $6.
This means the new top executives have more than just their pride riding on the
turnaround of Healthsouth.
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