Investors Start Second Quarter On The Defensive

(From BARRON'S)

The second quarter started the way the first did, with a hopeful early spurt in stock prices followed by a deflating drop -- a formula for maximum frustration for those fleetingly confident morning buyers.
The named culprit for the latest first-day deflation was inflation. At least, the turn downward early Friday coincided with clear hints of building inflation in both a soft employment report (rising wage gains) and a release of service-sector growth (higher prices paid).
The inference, apparently, was that inflationary evidence would keep the Federal Reserve unfriendly, compromising the easy-money conditions that have helped to float stocks for more than two years.
Bond yields stayed momentarily tame, though the rest of the news put stock investors on the defensive, as a relatively recent retreat from risk continued.
Crude oil rushed back above $57 a barrel, the word "indictment" appeared on the
front page of the Wall Street Journal in connection with American International
Group; and retail bellwether Best Buy warned of an earnings shortfall.
For all the drama, the indexes were nearly flat for the week as a whole. The Dow Jones Industrial Average slid 37 points to 10,404, while the Standard & Poor's 500 nudged higher by a point and a half to 1172. The Nasdaq eased by 6 to 1991.
The Friday washout swept away most of a nifty one-day bounce that started -- with the suspicious precision of a market run by chart-gazing short-term traders -- right as the S&P 500 equaled its January low of 1163 Tuesday.

That bounce was widely anticipated and offered some reassurance that the bottom of the narrow trading range in place since early November had held up under a stress test. Friday's pullback, perhaps, shows that widely anticipated market moves can be a bit fragile and susceptible to counter-surprises.

Though the range, for now, remains in place and is approaching five months in duration, there have been some differences in the action since 2005 started.
Taking the measure of the first quarter's market characteristics, Jason Roney of the Minyanville financial-commentary Website reports that it was the first time since the second quarter of 2000 when stock and bond markets both fell appreciably (excluding a fractional dip in equities in early 2002). The S&P managed only two daily gains of more than 1% over the three months, including last Wednesday.
The quarter's 65-point range from high to low on the S&P 500 was the slimmest,
in terms of points, since mid-1996.
The Nasdaq, meantime, has yet to close above its year-end 2004 level of 2175.
Just eight times since 1980 has the index failed to close above its prior quarter's ending value. Seven out of eight of those times, the next month was positive, says Roney. But the prominent exception is 2000, when the market began its downward cascade.
More recently, the Nasdaq has touched or crossed the 1999 level in every one of the last 10 trading sessions. It may be understandable that the Nasdaq would love to return to 1999, the year of its greatest glory. Still, the key unknown is whether this is a bottoming attempt or a sign of exhaustion.
Discussions with attentive traders reveal a general belief that many ingredients for a rebound rally are again in place, even if another couple of percent to the downside might produce a better-quality bounce.
These conditions include statistically oversold conditions, by some measures, and a public preoccupation with negative headlines (GM, AIG, Morgan Stanley, oil) that can often culminate in a relief rally. Some signals of speculators' behavior show a bit too much pessimism to persist for long, as well.
One major impediment, though, for anything other than a modest bounce in prices, is the anemic look of the financial sector, the market's largest and easily most important.
Large-cap financial stocks are down 8.3% year to date. The selling, too, has been concentrated in the big wholesale financials, those most likely to be hurt by adverse moves in the capital markets. J.P. Morgan Chase, for instance, is off 12% on the year.
Is the sloppy look of the financials a foreboding sign of more market trouble, or does it represent a nice buying chance? It shouldn't be too long before the market renders a verdict.

-- The market has concluded that Pfizer is no longer a growth company.
Pfizer's management this week will have the chance to tell the Street whether it
agrees, when it presents its view of the future at a meeting with analysts
Tuesday.
It won't exactly be a hostile audience. The preponderance of sell-side analysts continues to back Pfizer's poorly performing shares, with Buy ratings and average forecasts of 25% price appreciation. That's an uncomfortably sunny consensus for a stock that's lost 26% in a year and a company whose long-term business model is up for debate.
Yet the market is pricing in more suspicion than the analysts betray, with shares valued at just over 12-times forecasts of $2.12 for 2005 earnings. For a company in pristine financial condition such as Pfizer, that's the valuation of a no-growth company. And, with some $9 billion in expected lost sales to generic competition over the next four years, and estimates of flat profits through 2007, that's pretty much what Pfizer has become, in Morgan Stanley's view.
Jami Rubin of Morgan Stanley handicaps a few potential scenarios for what message Pfizer's brass might convey Tuesday, and the likely market reaction to each. The central question is whether Pfizer will vow to slash its cost base dramatically by shrinking its huge sales force and reducing research spending, in favor of returning more cash to shareholders.
Rubin believes investors want Pfizer and other pharma companies to acknowledge
that they face a low-growth future, and to cut back on spending accordingly.
That said, she doubts investors will hear that on Tuesday. Rubin thinks the likeliest outcome is a vow by Pfizer to maintain current sales and research spending levels, or perhaps slow its growth modestly from current mid-single-digit annual rates.
In which case, Pfizer shares would probably remain stuck in the mid-20s, where
they've spent the past four months.
Aside from the details of Pfizer's strategy, pharma stocks likely will be steered in the near term by investors' appetite for risk. The stocks have squandered their former status as havens of stability, but they are still less tied to the economy and broad market movements.
Value investors must be tempted by the sub-market multiples in the group. At minimum, the stocks look tentatively to have bottomed. Strong cash flow and nice
dividend yields could offer downside support.
But absent greater clarity on the course of the industry and companies' plans to approach generic challenges, it's hard to get very excited about Big Pharma.

-- Traders have at least two ways to bet on some kind of radical shake-up of Morgan Stanley (MWD), where CEO Philip Purcell is trying to fend off attacks
from former senior executives. One way is to log on to Tradesports.com, a betting Website that Thursday began listing contracts tied to the prospect that Purcell would be out by June 30. As of Friday, the contracts' price implied that there's better than a 30% chance he'll be gone by midyear.
The other, more mainstream way traders positioned for some sort of dramatic change at the securities firm was to buy Morgan Stanley shares, which blipped
higher by 1.28, to 56.87, on the week, as the power tussle spilled into the public realm and speculation began about a possible breakup or sale.
In all the play-by-play and color commentary on the turmoil -- Purcell's passing over longtime Morgan Stanley big shots in naming co-presidents, former executives' blunt protest letter to the board and all the rest -- there's been a general acceptance of the premise that the company is sick or ill-managed, or both.
But, compared with other companies where shareholders or dissident insiders have fomented mutinies, Morgan Stanley hardly seems rudderless in financial terms. Objective measures of business quality and management effectiveness wouldn't seem to lead to an indictment of the Purcell regime.
Rochdale Research keeps a database of companies' returns on capital, using this measure as the lodestar for the firm's effective stock-picking analysis.
Over time, return on capital distills the essence of public-company performance. Morgan Stanley currently has an ROC of 18.5%, says Rochdale research chief Nick Colas, up from a low of 15% in late 2002. That rate edges out the recent 14.6% achieved by Merrill Lynch (MER), probably the company most similar to Morgan in its business mix.
And, versus other companies whose managements have faced open revolt, Morgan
is steaming along at a good clip. Walt Disney (DIS), for instance, returned 4% to 6% on capital from 2001-2003, preceding the Roy Disney-led assault on Michael
Eisner. And Circuit City (CC), which was singled out by the hedge fund Highfields Capital for criticism and a possible leveraged buyout, had an ROC of 3.5% at last report.
Coincidentally, Merrill and Morgan are both projected to earn almost the same amount per share this year (though Morgan is on a November fiscal year). The
estimates (notoriously fluid for brokers) are both about $4.85. The stock prices
are virtually the same, with a slight (and recently achieved) edge to Morgan;
Merrill closed Friday at 55.95. Looks like the market hasn't punished Morgan too terribly, in terms of relative valuation.
Of course, one of the complaints of the dissenting Morgan alumni is that very
business mix, which they view as diluting the elite institutional securities business with a very ordinary retail broker and a downmarket charge-card business.

Sure, maybe the original Morgan Stanley-Dean Witter merger was awkward to begin with, based on obsolete doctrines about financial conglomerates, and wasn't deftly integrated. The impressive fundamental and share-price performance in recent years of Goldman Sachs (GS) and Lehman Brothers (LEH) -- both institutional shops helmed by former traders -- has no doubt grated on Morgan, being run by the former consultant and Dean Witter man, Purcell.
Admittedly, there's no solid rationale for the Discover credit-card business being attached to a retail broker and institutional firm -- something Purcell has essentially conceded. Yes, Purcell has been slow to name possible successors. And it's true that Morgan's shares have lagged its big competitors in recent years.
So, by all means, the frequently made case that Morgan should sell Discover or the asset-management division, or cleave the retail network from the institutional business, should probably at least be evaluated by management and the board. Analysts are floating potential breakup values at or above $70 a share.
But if anything is done, long-term logic suggests it be in the interest of realizing hard value for shareholders and positioning the company on an optimal growth path, rather than caving in to some bankers with a runaway case of Goldman envy.

-- The market is like high school. everyone wants to be in the popular crowd, but often it's the humble outcasts who go on to make the most money.
Following on last week's discussion of the sometimes badly timed changes in the makeup of the S&P 500, here's additional evidence that being expelled from the index can mean a higher stock price.
Bill Hester, an analyst with Hussman Funds, looked at the performance of S&P's
castoffs, which he dubbed "misfit stocks." It turns out that since 1998, the stocks removed from the S&P 500 have regularly outpaced those added to the index.
Deleted stocks appreciated an average of 11.4% annualized from the day they were removed through last week, versus 0.4% for those added. Part of this disparity results from the typical movements of the stocks in the period between S&P's announcements of index changes and the date they become effective.
Over a shorter time frame, the disparity is even greater. Hester says the 12-month returns following index changes are 31.4% average gains for deleted stocks, and a 2% increase for the new entrants.
Further plumbing these patterns, Hester looked at whether the stocks were dropped into another S&P index (such as the Mid Cap 400 or the Small Cap 600), or simply discarded all together. Those that went into another S&P index rose an average of 5.2% thereafter, and the ones that were summarily orphaned gained 14.4%.
"I think it's another example of how neglected and underappreciated stocks often have more life in them than most investors expect," says Hester.
In the interest of fairness, there's nothing about S&P in particular that makes it tend toward ill-timed index changes. Almost exactly a year ago, Dow Jones (DJ), publisher of Barron's, made the most recent changes to the Dow Jones Industrials, to rather deleterious effect on the index.
Added to the Dow were -- ouch! -- AIG (AIG), Pfizer (PFE) and Verizon Communications (VZ), replacing AT&T (T), Eastman Kodak (EK) and International Paper (IP). The three Dow rookies have fallen by an average of 21% since the day
they were called up, principally because of the nasty spills in AIG and Pfizer.
The three stocks let go have clocked an average return of about 2%, thanks
entirely to Kodak's 23% jump. Since the changes on April 8 of last year, the Dow
overall is off by 0.8%.