"Halftime Review"--Multex/MarketGuide:>>> Be Careful What You Wish For
By Marc H. Gerstein
June 27, 2000
The stock market celebrates when the US economy slows, because that lessens the odds of more big rate hikes. But there may be more to life than interest rates.
Rehashing The Obvious
I can't imagine that any investor who's been awake through the first half of 2000 needs me to tell them the market's been extremely volatile. The causes have also been widely discussed. Interest rates have been going up. New economy valuations soared to extremely high levels, only to come crashing down after Barron's discovered fire and other pundits started to trumpet an end to the new economy. And overall morale has been dampened by the stubborn reluctance of certain government employees to accept Microsoft (MSFT) as supreme lord of the universe.
Looking ahead, we'll all feel a lot happier about owning and buying equities if the Fed will stop raising interest rates, or at least give us a hint the end of the uptrend is in sight. If new economy-bellwether Amazon.com (AMZN) can find a way to start losing less money, we'd feel downright giddy.
Putting Things In Perspective: The Not-So-New Economy
There are certainly many who wish the new economy pack up and go away so we could all get back to valuing stocks based on methods we read about in textbooks and learned about in finance classes. Sentiments like that remind me of a scene in the PBS adaptation of the Robert Graves' novel I Claudius. A young actor in Ancient Rome is talking with an elderly Greek actor about how wonderful theater must have in the good old days. I can't recall the exact words but generally, the Greek actor chuckled as he told the young man good old days never really were the good old days.
You can say pretty much the same thing about stock valuation. It's uncanny that so many investors are shocked that money-losing companies can have such high share price valuations. Has anybody heard of cellular or cable TV? Years ago, those stocks were flying even though it seemed as if every ballpoint pen in finance department supply cabinets had red ink.
I still remember a debate I had with a senior executive of Comcast (CMCSK) who was annoyed my reluctance to value the stock based on EBITDA. "Why should I count interest expense as part of the cash flow for stock valuation" I asked. "That money belongs to creditors, not stockholders."
I thought my argument made sense. I never did get a straight answer from the company. But as it turned out, the stock survived and went on to flourish for a long time. Silly me.
Then, there's JDS Uniphase (JDSU), one of those stocks you'd better love if you don't want fellow investors to tape "Kick Me" signs on your backside. Has anyone noticed the stock trades at about 200 times estimated EPS for the fiscal year ending 6/01? High P/Es are justified by high growth. But the projected long-term EPS growth rate here is 47%, making the PEG (Price/Earnings-to-Growth) ratio 4.25.
To those who shake their heads at such silliness and wait for knowledge and professionalism to push the crazy daytraders aside, I have a question. Can you tall me why Coca-Cola (KO) still deserves a PEG ratio of 2.35, why Gillette (G) still deserves a PEG ratio of 1.90, why Procter & Gamble (PG) still has a PEG ratio of 1.54 even after the stock has had a new-economy like collapse as investors were forced to face the fact that the company can't even come close to hitting growth targets?
Speaking for myself, all of those PEG ratios make me nervous. But if someone were to put a gun to my head and say "You'd better invest in one of these overpriced stocks or else..." I'm going to take JDSU, the highest PEG ratio in the group. I'll do that because JDSU is in a new business and I know from experience that in areas like this, analysts aren't nearly as good at forecasting as they think they are so I have the luxury of being able to hope the growth projections will turn out way too low. I don't know that will happen, but remember, there's a gun at my head and look at the alternatives. I definitely won't bet the farm on the ability of Coke, Gillette or Procter to outperform analysts' long-term projections.
So what am I missing? Can someone explain again how rational everything was in the old economy?
More Perspective: The New-Economy Crash
Now, let's talk about that new economy stock market crash we saw in the spring. Huge stock market gains were wiped out, so much so, that we now see overall 52-week stock price percent changes like -22.5%, -35.7%, -48.2%,
-37.0%, -45.4% or -21.2%. Oh ... wait a minute ... my mistake. That's the wrong list. Those price declines are for Gillette (G), Procter & Gamble (PG), Newell-Rubbermaid (NWL), Wendy's (WEN), Staples (SPLS), and Berkshire Hathaway (BRK.A) respectively.
How could I confuse those stocks with new economy. Professional investors have long regarded most of these as "defensive" names, the sort of issues you buy when you want to protect yourself from big losses at times when you expect corporate earnings to weaken.
Here's a list of new economy 52-week price changes: -24.2% for Ebay (EBAY), +66.0% for Yahoo! (YHOO), +0.2% for America Online (AOL), -59.0% for Priceline (PCLN), +93.1% for VerticalNet (VERT), +558.3% for JDS Uniphase (JDSU), +107.3% for Cisco (CSCO), and -40.4% for Amazon (AMZN).
But what about those internet flameouts, such as -79.1% for drkoop.com (KOOP), -83.9% for CDnow (CDNW), or -59.7% for Peapod (PPOD)? You can really get hit hard in new economy if you make the wrong picks.
I'm not going to touch that one. I'll just save time and provide a downloadable spreadsheet listing 1,066 non-technology and non-biotech (i.e. old economy) stocks that fell more than 50% in the past 52 weeks.
Yes, I know the risk of permanent mega-drops is probably bigger in new economy. But the coupling of high risk and opportunities for high reward has long been one of the most fundamental investment concepts. And frankly, I'm not convinced the loss exposure in supposedly solid old economy names is commensurate with the relatively limited prospective gains. Did those who invested a year ago in Wendy's ? and Dave Thomas ? really envision the prospect of losing 37.0%?
So what am I missing? Can someone explain again about that new economy crash?
Why Perspective Is Important
I certainly don't intend to minimize the valuation risk inherent in new economy stocks, or the pain experienced by many who favor this kind of investing. It's downright frightening. It really is. And the risk of big loss is greater in emerging businesses.
But as annoying and damaging as hype can be for investors in general, it's far more irritating when you need when you're holding stocks with triple digit P/E multiples based on profit expectations stretching 10 years or more into the future. You need to focus on facts. You don't need to marvel at the ability of major news organizations to find images of burning stock certificates in their photo archives.
Looking Forward: The Big Scary
When I look ahead to what the stock market's likely to do in the next six months ahead, I'm worried about valuations of popular stocks and long-term viability of new economy companies. These same issues concerned me in the past six months.
Looking ahead, I worry about the prospect of more interest rates hikes, if not this week then down the road. But to tell the truth, I'm a lot less concerned about this than I was at the start of the year. The economy is clearly slowing and if we aren't at the end of the interest rate uptrend, we're probably pretty close.
Recently, I read a brokerage report in connection with MICROS Systems (MCRS), a stock featured on this site some months ago and one which, to be honest, hasn't fared very well. There was something in the first part of the analysts' Key Points list that terrified me, not so much for MCRS (which has already taken substantial hits) but for stocks in general. Here's what the analysts wrote.
Academics classify an event that is so far off the scale of probabilities (such as the quick stock market crash of 1987) as a "negative gamma" event. In our worst case scenario we could not have imagined a quarter as poor as Q$'00 and thus classify this quarter as such an event.
For the record, the three-person analyst team reacted to a negative company earnings pre-announcement by cutting their quarterly per-share estimate from a $0.50 profit to a $0.19 deficit. Among other factors, the pipeline of orders for new restaurant information systems is dry, as prospective customers stretch their order cycles, first in response to Y2K and now in response to fears of economic slowdown.
This is certainly disappointing, but that's not what's keeping me up at night. The analysts expressed shock at the unpredictability of the June quarter (this is the first time I've never seen the phrase "negative gamma event" in a research report). So what sort of a new estimate do they present? They offer a new estimate calling for a per-share deficit of $0.19.
HELLO!!! $0.19! Would the world come to an end if, perhaps, they rounded to $0.20? After talking about a negative gamma event, why are they still functioning under the illusion they can hit the exact penny?
Do you ever look at such estimates and wonder how analysts can be so exact? I've been in the business nearly twenty years and had who-knows-how-many conversations with corporate executives and published who-knows-how-many estimates, and I still can't figure out how they do what they do. I've even had the chutzpah to ask CFOs and about those estimates, and I'll tell you that many corporate executives make fun of estimates like that behind the analysts' backs. Of course we see companies that do constantly hit the numbers. And if you have a friend or relative who just got out of school and took an entry level job at a big-time auditing firm, perhaps you'll now understand why they find their jobs so stressful.
This is a very serious issue and one I addressed before in a previous article describing the forecasting process. The reason I don't laugh at estimates like that is because stocks get hammered when companies don't measure up to analyst dreams of perfection.
And it's getting worse, not better. Stocks are getting hit harder and harder and analysts are becoming increasingly oblivious to the fact that life isn't quite as neat as a spreadsheet file. The reason this $0.19 thing has me so riled is it shows these analysts still don't get it. And they aren't alone. Most analysts continue to overestimate their abilities to know the future with total precision.
Negative Gamma Or Business As Usual?
Let's backtrack to Fed watching. Investors love indications the economy is slowing because it takes pressure off rising interest rates.
But there's more to life than interest rates. A slower economy also means ... a slower economy ... as in less buoyant business conditions ... as in less attractive corporate profits ... as in negative earnings preannouncements and surprises, and you know what that means.
So we could see some very strange things happening in the equity markets over the near future. We could see incredible rallies in response to numbers that suggest better interest trends coupled with lots of bullish sentiment, coupled with many scattered explosions as companies miss earnings targets. If it goes on long enough, sooner or later, the major indices will reflect it. But earnings announcements come in ones, so for a while, it will be possible to see major market indices rise briskly while individual stocks get hammered.
I'm not just talking about the June quarter. There's a lag between interest rate changes and their impact on the economy. We can debate the extent to which analysts factored economic weakness into their second quarter numbers (I'm not sure they really did this effectively).
But I'm more worried about those third quarter numbers. I've covered stocks through two recessions (yes, I'm old enough to have been employed back in 1981) and several periods of sluggishness that don't meet the classic definition of recession. I'll tell you that analysts generally do a very poor job in getting their numbers down to where they really need to be in advance of a period of bona fide economic weakness.
Economists now aren't looking for a recession. But the sluggishness we're expecting and hoping to see does not, as far as I can tell, appear to be reflected in analyst estimates for the third calendar quarter. And even those analysts who think they've moderated their expectations may later find so many negative gamma events as to force them to reclassify them to "business as usual."
I'm not suggesting widespread shortfalls of a nickel a share here or a dime there. I'm thinking about surprises such as the one for MCRS. If the economy does what we want it to do, we could be seeing a lot situations like that.
Be careful what you wish for.<<<
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