| Barron's
(10/31) The Trader: Pre-Election Rally Lifts Stocks
(From BARRON'S)
Traders decided last week to green-light the script for a fourth-quarter rally,
which had spent weeks in what Hollywood calls "development hell."
There are too many collaborators on that script to fit in the closing credits.
Still, several key plot points played out on the week. Oil prices pulled back
sharply, the anti-insurance regulatory rhetoric cooled and brokerage stocks took
wing, all contributing to a lift in investors' moods.
The market also followed
itspattern of making a sudden move in advance a widely anticipated event, as if
to front-run the potential relief rally. In this case, the event was the presidential
election. The tactic worked in the run-up to the Iraq war, though a similar gambit
before the first interest-rate increase this year never caught much of a tailwind.
The Dow Jones Industrial Average rode consecutive 100-point gains to a weekly
increase of 269 points, or 2.8%. The blue-chip index ended the five days at 10,027.
The Standard & Poor's 500 stock index climbed 34 points, or 3.1%, to
reach a
three-week high of 1130. The Nasdaq Composite added 59, or 3.1%, to
finish at
1974.
In several respects the rally resembled the one that
carried the indexes off their summertime lows in mid-August. Prior to that rebound,
a near-vertical rise in crude-oil prices and a stew of mixed economic cues had
pressured the market.
Then oil suddenly fell from the $50-a-barrel range,
which cleared the way for an
exaggerated bounce from moderately oversold levels.
The shakeout in oil proved short-lived, however, and the market resumed its
rally within weeks. As was the case last week, stocks were bruised, but not washed
out.
In several recent rallies, in fact, measures of investor sentiment turned
negative, though they never reached the extreme lows from which enduring bull
moves usually arise.
Ned Davis Research's Crowd Sentiment Poll showed an
"extremely optimistic" reading of 64.3% on Oct. 7, the last time the
S&P traded at its current 1130 level. The reading signaled a short-term peak.
By last Monday the bullish reading had slipped to 54.8% bulls, what the firm calls
a "low neutral" level.
"I wish it had fallen even further,"
Davis wrote to clients Friday, as that would have generated a stronger contrarian
buy signal. Other factors, though, such as healthy technical signals, leave Davis
granting the bulls "the benefit of the doubt."
Even while market
psychology seems mixed, and turns negative on sharp down
days for the Dow,
it's hardly despondent. Witness the smashing success of a
half- dozen initial
stock offerings last week (timed, conveniently, for the close of the mutual-fund
industry's fiscal year, when funds needed to put cash to work in stocks that hadn't
made nasty headlines).
Because investors have become so suggestible 10 months
into a frustrating year, the message of sentiment gauges varies day to day. Yet
there's an underlying sense -- evident in strategist reports and money-manager
interviews -- that investors are somehow entitled to higher share prices based
on what, all agree, are good current corporate earnings.
Oil and the election
have acted as the twin MacGuffins of the market in recent
months, the useful
plot devices that are believed to drive the action whether
they're causative
or not.
Investors' views on the election have morphed from confidence in
a Bush win, to fears of a Kerry upset, to worries the result won't be known immediately
to the notion that any definitive result on Nov. 2 will be positive for stocks.
As a result, there's no way to handicap what the market has discounted, or
what outcome might help or hurt stocks. The consensus is certain of only one thing:
that "uncertainty" -- over oil prices and politics -- is holding the
market back.
This view doesn't convey concern about vulnerability in the
market's fundamentals. It simply shows the drag that allegedly extraneous factors
are having on a would otherwise have been, by rights, a strong year.
The
idea that 2004 will follow the pattern of 1984 and 1994, which both gave way to
strong "5" years for stocks, is spreading rapidly among folks who were
certain this "4" year would offer double-digit index gains. There's
no saying this scenario won't play out, or that the year-end "melt-up"
scenario can't happen as it did last year, when the S&P surged 12% in the
fourth quarter as investors rushed to buy into the upward move.
That move,
we now know, was in part the market's way of previewing this year's
impressive
gains in corporate profits. The earnings picture from today differs in a few ways
from that of a year ago. First, the rate of profit growth is slowing from 25%
in the first half to about 14% this quarter so far. That in itself is hardly a
bad thing.
The rate of downside earnings surprises is rising, however, with
20% of large
companies falling short in the quarter and 20% beating estimates.
A year ago,
32% came in high and 12% missed their targets.
What has helped
dent the large-cap indexes is the size and prominence of some
of the offenders,
and their prior reputation as safe havens. These include
Honeywell, Colgate-Palmolive
and -- just Friday -- Avon Products, which fell 8.5%, to 39.55, amid signs of
weakness in its U.S. business.
For most of the past year, the quality of
earnings was pretty good, with few
writeoffs muddling the picture (never mind,
for now, the general avoidance of
expensing employee-stock options).
But Standard & Poor's notes reported earnings (including charges and other
items) are now running 16% below the cleaned-up "operating earnings"
that companies emphasize. That's the highest variance in at least six quarters.
None of this is dispositive, for sure. But the pattern hints at sources of
market sluggishness that have little to do with ballots or barrels of oil.
-- The chart nearby might merely depict a coincidence in search of an idea.
More likely it's indicative of the market's evolving view of financial megaplexes
as mature, unexciting plodders.
In stark four-color visuals, it's apparent
that five years ago the stock market demanded relatively little in the way of
dividend income from J.P. Morgan and, especially Citigroup, relative to five-year
risk-free paper.
Citigroup's yield has steadily climbed as it's paid out
a higher percentage of
earnings and the stock price has stalled. J.P. Morgan's
yield ballooned near the
depths of the bear market, when its financial wherewithal
was being questioned.
Meanwhile, Treasury yields have shrunk to the point
where the five-year- note
yield and the two stocks' dividend yields have settled
around 3.5%.
A bullish interpreter of this situation might say these stocks
are now great bargains, with yields competitive with Treasuries, and the prospect
of continued growth. As for J.P. Morgan, the steep compression in its yield shows
growing investor comfort with the stability of the business following the Bank
One merger.
Of more concern, though, is an alternative interpretation: that
the market has
decided these stocks will deliver mere bond-like returns "with
an equity kicker," says Morgan Stanley strategist Henry McVey.
The question
is whether that kicker is attractive enough to compensate the shareholder for
the increased risk of owning a complex financial institution with somewhat opaque
earnings streams, which in part reflect subjective judgments by management.
The mantra about these stocks, both around 10 times to 11 times forecast earnings,
is that they're "cheap." It's an argument the market isn't buying;
it's suggesting instead that a great portion of the return from these names
will come via dividends.
McVey has been arguing the game has changed for
mega-cap stocks. Their performance "used to be about [P/E] multiple expansion,"
he says. "Now it's
about dividends and earnings growth." He thinks
big, complicated companies will
need to "reposition their portfolios."
This could mean that, rather than use ample cash holdings to shop for
acquisitions, the biggies might find themselves divesting businesses and
streamlining
in 2005, at the market's behest.
-- On Wall Street a preference for
McDonald's over Wendy's involves more than
just a taste for round burgers
over square. It's a matter of investors privileging an impressive but aging turnaround
story at McDonald's over a good value and possible imminent rebound at Wendy's.
Improvements in McDonald's menu and customer service have fed strong momentum
in same-store sales and driven the shares up 50% in the past two years to 29.
McDonald's, in part, stole from Wendy's playbook, by keeping restaurants open
later, creating Mom-friendly salads and focusing on service.
Wendy's suffered
in comparison, as the product-innovation pendulum swung away
from it. Wendy's
shares are flat over the past two years and have lost more than
15% of their
value in 2004. They recently traded at 33.
This is almost a complete reversal
of fortune from a couple of years ago, when
Wendy's was eating McDonald's
lunch and nearly monopolized investors' affections
among the burger chains.
Wendy's now appears the better value, with a lower
stock valuation, lower
expectations and easier sales comparisons into 2005.
McDonald's trades at
about 14.5 times expected 2005 earnings per share, compared with 13.5 times for
Wendy's. Wendy's, meanwhile, is projected to show 9% 2005 profit growth against
4% for McDonald's. And Wendy's return on invested capital of nearly 11% is on
track to edge McDonald's 10% figure this year, according to Merrill Lynch.
Wendy's shares have underperformed because its fundamentals lack momentum.
Profit forecasts for 2005 have fallen to $2.43 from $2.61 over the past 90 days.
McDonald's '05 estimate has edged higher, to $1.98 from $1.90 a share.
Sell-side
analysts, who hated McDonald's when its shares bottomed in early 2003 in the low
teens, now have 14 Buy ratings on the stock, seven Holds and no Sells. The rating
breakdown for Wendy's is five Buys, 12 Holds and two Sells.
Therein lies the opportunity for those who like to see around corners and lean
into the wind. Merrill Lynch analyst Rachel Rothman last week began coverage of
the fast-food sector and made Wendy's her lone Buy recommendation. She thinks
investors are too panicked about current trends and expects same-store sales
trends to turn favorable in the second quarter. That should fix the market's eyes
on Wendy's superior financial attributes.
The opposite call was detailed
in this column in late July 2002, when Wendy's
was loved near 40 and McDonald's
underappreciated at 23. It was severely early;
McDonald's subsequently tumbled
before its rebound. But time has borne out the
thesis, such that things may
now have gone too far in the other direction.
-- Level 3 Communications
used to be a $130 stock, back in early 2000 when
whispering "fiber optics"
could get you a date and "information superhighway"
could be uttered
without irony. Barron's and other publications put CEO James
Crowe on the
cover and cast him at the center of the Internet economy.
Now, Level 3's
name approximates its stock price and the company is heaving
under a burdensome
debt load.
The shares tend to act as a gauge of true believers' emotional
state and the
level of speculative enthusiasm for Internet telephony. More
technically, the
stock is a virtual call option on the voice-over- Internet-protocol
(VoIP) phone
trend, the latest rage in telecom.
This was vividly evident
last week, when Level 3 jumped as much as 17% Tuesday
on a Wall Street Journal
report that Comcast would use Level 3 to carry its
customers' Internet phone
traffic.
Then, Wednesday, Level 3's earnings report carried a projection
of increased
capital spending and more deeply negegative cash flow for the
fourth quarter.
The shares, for the week, slid 25 cents to 3.36.
There's
a good chance they're still too expensive. Though Level 3 has more
than $850
million, or $1.25 a share, in cash, it's burning the stuff at a rapid
rate.
Cash flow doesn't quite cover interest expense, let alone capital-spending
needs. Debt amounts to $5.2 billion, which starts coming due in large chunks in
2008, versus a $2.2 billion equity market value. The company has a good business
in carrying AOL's dial-up Internet traffic, but that revenue stream is in
decline.
The company's fate is tied to VoIP. But there remains lots of network
capacity
out there, thanks to AT&T, MCI, Sprint and Global Crossing all
vying for
traffic. Prices for carrying data are in a perpetual state of free
fall.
Level 3's complicated capital structure includes several tiers of debt.
Holding-company junk bonds, tellingly, trade below 80 cents on the dollar. That
implies the bond market doesn't even believe the corporate entity will
ultimately
be worth the principal amount of its debts, let alone leaving much
for stockholders.
Management is creative in managing the company's finances, and its survival
instinct has kept the company afloat until now. Unfortunately for equity owners,
this could lead to more equity-for-debt swaps or other dilutive transactions,
says J.P. Morgan credit analyst Avi Benus. He adds, "Given the recent cash
burn
levels, the option could expire before 2008 if VoIP does not reap dividends."
The stock can remain fun to trade for years to come based on VoIP hope and
such. But amusing trades shouldn't be confused with good long-term investments.
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