Tech--Jubak's Journal: "3 stages of a year-end rally & stocks to watch"
Jubak's Journal
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Jubak's Picks
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>>>Posted 10/20/2000
Jubak's Journal
3 stages of a year-end rally -- and stocks to watch
Rallies follow patterns that can help predict what stocks will gain in a year-end surge. Big-cap techs like Nortel and EMC should follow on the heels of momentum champs like Ariba and Juniper Networks
By Jim Jubak
Was that the bottom we hit this week? The grand rush down that washes out the last of the optimists and sets the stage for a sustained rally?
My best guess is that we haven’t yet seen the last of this bear market. Typically at the bottom, no one wants to buy stocks. Can’t give them away. There’s just too much fear.
And right now, while the fear quotient is certainly rising, I know too many investors who are hoping for -- indeed counting on -- an end-of-year rally. Too many investors with busted stocks aren’t selling, but are instead waiting for the turn. Too many investors with money on the sidelines are expecting an opportunity sometime in the next couple of weeks to profitably deploy those assets. Nope, as painful as it is, I think we’ve got more work to do on the downside before we’ve seen the last of this bear market.
But that doesn’t mean we aren’t going to get a tradable year-end rally. There is money on the sidelines, tax-loss selling by institutions is drawing to a close, the uncertainties of a presidential election will soon be behind us and, well, there is that optimistic belief that we’ve got to rally from here. I wouldn’t want to bet the farm on it, but I do think the odds are better than even that we will have a significant rally to end the year.
Nasdaq 3,700? Roll with it
Don’t plan on it making your portfolio whole -- I don’t think the rally will be strong enough to take stocks back to their March, or even August, highs. But 3,700 on the Nasdaq Composite ($COMPX) is a real possibility. That would be a gain of 22% from the Oct. 18 intraday low of 3,026. But even that size of a rally would still leave the index down almost 10% from the Dec. 31, 1999 close of 4,069, and a whopping 27% below the March 10 high of 5,049.
I also think we’re getting close to the short-term bottom that will provide the floor for that rally, too. Wednesday’s reversal from the steep 185-point drop just shortly after the opening bell to a close down just 42 points at 3,172 didn’t have all the ingredients of a short-term bottom. Worries about Microsoft’s (MSFT, news, msgs) earnings announcement, due after the close, made it hard for investors to get too positive. But with that report now behind us -- Microsoft actually beat estimates by 5 cents a share -- I think the market is ready to stop its slide. Sometime during the next two to three weeks I think we’ll be able to see that the market in general, and for technology stocks in particular, has turned. (Editor's note: Microsoft is the parent of MSN MoneyCentral.).
That, of course, brings us to the practical question: What should investors do about a potential year-end rally?
That’s a tricky question. No investor wants to miss a decent rally -- especially one that comes after so much pain. But on the other hand, if this is an end-of-year rally in the middle of a bear market for technology stocks, no investor wants to get caught in a bear trap, the kind of fake-out rally that tripped up so many of us -- yours truly included -- in August.
My suggestion: Roll with the rally -- but don’t forget to roll out. End-of-year rallies have their own typical pattern -- a result of depressed prices from tax-loss selling meeting up with investors who have cash in their pockets and visions of December-quarter sugar plums dancing in their heads. Bear market rallies have their own pattern -- a result of greed and fear meeting head on. Put the two together this year, and I think we’ll see a rolling rally that takes up groups of stocks in a fairly predictable fashion -- but that is likely to be too tentative to do much for the truly battered equities of this market.
That predictability gives investors a chance to roll their way into this rally, buying groups as they get hot and -- this is critical -- to roll out by selling those buys into the rally as the next group of stocks starts to participate. This strategy should give you an opportunity to participate in the rally, yet give you some protection if the rally fizzles early and the bear market shows its claws again.
How does this roll-in, roll-out strategy work? It’s the opposite of deciding to back up the truck and load up on stocks just because they’re cheap. Remember that we’ve just suffered months of punishment, and we’re all extremely gun-shy. This tide won’t be strong enough to lift all boats.
Instead, investors will have their stock-picking hats on, and they’ll be looking for specific kinds of stories. They’ll be looking for stocks that have had the strength to go up while the market as a whole was selling off. They’ll be looking for “bargains” in rock-solid market leaders that have sold off just enough to make the price seem reasonable, but not so much to suggest that there might be trouble with the merchandise. And they’ll be looking for stories that combine high reward and low risk. Solid 20% earnings growth with price-to-earnings ratios at or below the market average will seem an attractive combination to investors who haven’t given up on growth stocks, but who are tired of taking it on the chin when a high-multiple equity disappoints.
The intensity with which investors pursue each type of opportunity is likely to change as any rally develops. At the beginning, investors will chase stocks that have kept their momentum even in a down market. If the rally gains any steam, they’ll expand their buying to include slightly nicked, long-term, big-cap favorites. And as confidence builds further, I’d expect GARP (growth at a reasonable price) stocks to gain a good share of the action.
Early winners
Based on that general model, I think we can identify the stocks that will participate in the earliest stages of any year-end rally with a high degree of certainty. You can probably name some of these off the top of your head: Juniper Networks (JNPR, news, msgs), Brocade Communications Systems (BRCD, news, msgs), Extreme Networks (EXTR, news, msgs), Mercury Interactive (MERQ, news, msgs) and Ciena (CIEN, news, msgs). If you build a MoneyCentral stock screen, you can increase your universe by adding names such as Network Appliance (NTAP, news, msgs), Ariba (ARBA, news, msgs) and Research in Motion (RIMM, news, msgs). While these high-risk, high-momentum names are likely to be solid winners in the early stages of a rally, be sure you sell when the momentum starts to flag. If I’m right and the bear has more bite left, these are also the names most at risk as the market hits its real bottom.
But the gains of the momentum leaders will build confidence as the rally progresses. It will seem safe to a larger group of investors to venture a foot back into the water. In most end-of-year rallies, the first stocks that institutions seek after they’ve finished their tax-loss selling are any big, high-quality names that have taken a ding or two. This is a chance to add these stocks at “reasonable” prices. (But don’t look for the institutions to take a chance on a stock that’s ready to be earmarked as a “past” leader, or where there are questions about the core earnings story.) Look for stocks that can promise higher-than-market-average earnings growth with some protection from whatever is most worrying investors.
Here’s an example of what I mean from Wednesday, Oct. 18. Prudential Securities gave Xilinx (XLNX, news, msgs), a chip maker trading near $61 at the time, a "strong buy" and a price target of $115. The analyst cited Xilinx’s strong earnings report of Oct. 16 -- the company grew earnings per share by nearly 90% from the same period in 1999 -- and its lack of exposure to the risks troubling the rest of the semiconductor sector. Xilinx, the analyst said, doesn’t sell into either the PC or wireless-handset markets, so questions about growth in those sectors won’t trouble the stock.
What are some other stocks like this? In the current market, I think that means big-cap names such as Broadcom (BRCM, news, msgs), Nortel Networks (NT, news, msgs), Oracle (ORCL, news, msgs), Sun Microsystems (SUNW, news, msgs) and EMC Corp . (EMC, news, msgs), and mid-cap names such as PMC-Sierra (PMCS, news, msgs) and Vitesse Semiconductor (VTSS, news, msgs).
On to small caps, GARP
In a normal end-of-year move, the rally next expands to include stocks with smaller market caps, less-familiar names, great growth stories and shockingly attractive valuations. I think that's likely this year, even in the midst of a bear market. Stocks that score high with a GARP strategy should do especially well in this stage. (See my Aug. 29 column, "5 bargain stocks according to GARP.") The combination of a low multiple and strong growth is attractive at any time, but especially so when risk is on the top of many investors’ minds. Three stocks that I mentioned in that article look especially attractive for this stage: Cypress Semiconductor (CY, news, msgs), California Amplifier (CAMP, news, msgs) and Atmel (ATML, news, msgs).
The year-end rally would typically continue to expand beyond the GARP group to include the tumbled and humbled: stocks trading at multi-year lows such as WorldCom (WCOM, news, msgs), which has retraced its gains in price all the way back to February 1998. But it’s not at all certain that this year’s rally, taking place in the middle of a bear market, will be strong enough to lift these boats.
In trying to assess these battered stocks, I think it's worth dividing them into at least three groups.
First, there are those like WorldCom or Dell Computer (DELL, news, msgs) where earnings growth is clearly positive, but it’s also clear that growth won’t be as positive as it was in the past, and it’s still unclear how much of a slowdown the company is facing. These stocks are cheap enough to rally with the general market. But it’s unlikely they’ll move up strongly and permanently until it’s clear what the growth trend is. For them, the issue is the predictability of growth. Other stocks with a similar problem include Motorola (MOT, news, msgs) and Lucent Technologies (LU, news, msgs).
Second, there are truly busted stocks. These are companies that have lost their way, where growth is at least far below projections and maybe even negative. At the worst, the market entertains serious doubts about the long-term viability of the underlying companies. Xerox (XRX, news, msgs) fits this bill. So, too, does Amazon.com (AMZN, news, msgs), shockingly. If the rally is strong enough, it could tack a few bucks onto the prices of these shares. But there is so much uncertainty around them that there simply isn’t enough of a reason for most investors -- who already have all the risk they can handle -- to buy these shares.
And, third, there are the "baby with the bathwater" stocks. These are stocks that have the bad luck to belong to sectors that the market currently hates, often with a reason. To take one example, I think investors are rightly concerned about cash flow at many startup telecommunications-service providers. These companies could run out of cash before they’ve completed their networks and be forced out of business if they can’t raise the dough they need. Even if they can raise the capital, the cost may be so high that current investors face plunging stock prices from unexpected dilution. But that’s not a reason to sell off well-capitalized telecommunications companies such as Metromedia Fiber Network (MFNX, news, msgs), which has $2 billion in cash and enough revenue coming in from dark fiber leases to cover the capital costs of its current build-out. A stock in another sector that shares a similar problem is semiconductor equipment maker Novellus Systems (NVLS, news, msgs). The company has a leadership position in the new copper-chip technologies that should shield it from the worst of any possible capital spending slowdown. In the PC sector, Nvidia (NVDA, news, msgs) is driving hard into the non-PC market for 3D graphics chips, and that could be enough to offset any slowdown in sales of PCs.
In my experience, though, it’s difficult for investors to look beyond the troubles in a sector to single out promising stocks. The "baby with the bathwater" stocks are definitely the most interesting among the humbled and tumbled of this market. But it’s too early to tell if the rally will be strong enough to let investors give these stocks their due. They’re worth watching, though, and we’ll know more about the opportunities in the group once we’ve had a chance to gauge the strength of any year-end rally.
This column has been all about the short term and whether or not to invest in the current “bargains” over the next month or two. Next column, I’m going to switch to a much different time period and take a look at chip stocks to buy for the long run.
Update: New Developments on Past Columns
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Fast and wireless -- Nirvana on the net
Seems like there’s Nokia and then all the rest in wireless. On Oct. 19, a week earlier than scheduled, Nokia (NOK, news, msgs) spilled the good news. In the third quarter, earnings per share grew to 16 cents -- a penny more than analysts had estimated, and 33% higher than in the third quarter of 1999. Revenue grew by 50% to $6.4 billion. In the handset division, the quarter unfolded just as Nokia had promised -- sales were up as the company took market share from competitors, and margins were down as Nokia cut prices to gain global share. Sales of wireless phones were up by almost 60%, and operating margin fell to 19.6% (from 21.9%) -- both at the top range of analyst estimates. After the gloomy picture painted by competitor Motorola (MOT, news, msgs) for the fourth quarter of 2000 and for 2001, Nokia’s projections were actually shocking. The company said it is headed toward record-breaking profits in the current quarter, and repeated that it expects to meet its sales growth target of 25% to 35% for 2001. I continue to recommend Nokia in Jubak’s Picks -- I think it is the one wireless handset stock that is a must-own over the next two to three years. That said, I do recognize that we’re still in a bear market for technology stocks, so I’m going to cut my current target price. With a strong end of the year rally, Nokia could hit $55 by the end of the year. My one-year target price for the stock is $71 by October 2001.
What’s AOL worth now?
I have to give America Online points for trying. In the conference call after the release of quarterly earnings on Oct. 18, the company kept repeating: “We don’t see an ad slowdown; we don’t see an ad slowdown.” The company even had the numbers to back up the rhetoric -- revenues from ad sales and electronic commerce came in at $649 million for the period, up 80% from a year ago and ahead of analyst projections of $640 million. (For the whole company, revenue came in at $1.98 billion, as expected, and earnings per share at 14 cents, a penny above the analyst consensus). But after warnings from Yahoo! (YHOO, news, msgs) and other online companies about a slowdown for the fourth quarter, Wall Street analysts weren’t buying. Influential Merrill Lynch analyst Henry Blodget, for example, cited the flat advertising backlog -- at $3 billion, it was level with last quarter -- as his reason for not raising his earnings estimates for the company. I think this is actually a non-issue for America Online, since the merger with Time Warner (TWX, news, msgs) will give the company added clout with advertisers that will result in more business and higher rates. I continue to recommend the stock, even though its price is probably stuck below $55 until the merger closes. Continuing fears of an ad slowdown, justified or not, will weigh on the stock’s price even after the merger is completed. So I’m lowering and stretching out my target price for America Online to $80 a share by October of 2001, down from my previous estimate of $88 by February 2001.
Fast and wireless -- Nirvana on the net
On Oct. 17, RF Micro Devices reported September quarter earnings of 10 cents a share -- matching analyst expectations -- but then dropped a bombshell. Earnings for the December quarter would be just 4 cents to 5 cents a share instead of the 11 cents analysts had projected. The stock, already under pressure from worries about wireless phone sales in 2001, dropped like a stone. The problem seems to be a slowdown in orders from customers such as Motorola and Ericsson (ERICY, news, msgs) as these companies work down inventories in preparation for launching their next-generation phones. That weakness, RF Micro Devices told analysts, could last into the March 2001 quarter. No way this is good news, but I do regard the problem as temporary. The company continues to build its customer list and has just been granted certification by Qualcomm (QCOM, news, msgs). That means company products will be attached to the majority of Qualcomm chipsets in 2001. Worries over the health of the handset market should limit the recovery of the stock in the rest of 2000, but I think $25 by December is certainly achievable. After that, the stock’s performance will depend on a pickup in orders and better execution by Motorola and Ericsson. I’m setting a target price of $40 a share for June 2001 -- that’s well below my previous target price of $65 by October.
Shopping for a strong stock? Everything’s relative
Ariba (ARBA, news, msgs) delivered everything analysts had hoped for -- but not enough for some investors, apparently. On Oct. 18, the company reported revenue of $134 million, about 30% above analyst expectations. The company reported breakeven operating earnings -- analysts had expected the company to lose 5 cents a share. So why did the stock fall $10 a share almost immediately in the after hours market, then quickly sink toward a decline of similar magnitude once the regular session began? If you’re inclined to look at fundamentals when valuing Ariba, I suppose you could find reason to worry about a slowdown in deferred revenue. Last quarter, deferred revenue -- that’s revenue from sales that are already booked, but where payment will take place in the future -- grew by 82%. This quarter. it was up by just 30%. Analysts liked the revenue visibility that came with a big jump in deferred revenue -- since it will predictably turn into real future revenue -- so a decline in the growth rate does raise an eyebrow or two. But I think the drop in share price is more likely a simple case of momentum investors selling on the good news. I expect the stock to bounce back relatively quickly after this sell-off. I’m keeping my current target of $180 by December.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: America Online, Ariba, Atmel, Broadcom, EMC, Extreme Networks, Microsoft, Mercury Interactive, Nokia, Nortel Networks, PMC-Sierra and RF Micro Devices.<<< |
