The Case for a Second-Half Recovery
yahoo.smartmoney.com
By Rebecca Thomas June 18, 2001
YOU'VE GOT TO hand it to them. Even in the eye of a storm, many of the pundits we track see nothing but rainbows.
Despite continued predictions to the contrary, the U.S. economy still shows little, if any, sign of turning. And the corporate earnings warnings keep rolling in — most recently from telecom carrier Level 3 Communications (LVLT), which cautioned Wall Street on Monday that its revenues and cash flow would suffer for the next two years.
But that hasn't dulled the horns of such unrepentant bulls as Gruntal & Co.'s Joe Battipaglia, Lehman Brothers' Jeffrey Applegate or Credit Suisse First Boston's Thomas Galvin. All three of these market trackers remain sanguine about the near-term prospects for both corporate profits and stock prices. It's the sort of optimism that has stranded them at the bottom of our monthly pundit ratings, despite the recent upturn in the markets.
Indeed, their comments Monday read like a page from the same book: "The [earnings] outlook shows some early signs of stabilizing," wrote Applegate, Lehman's chief investment strategist. "Our conviction is high that the cyclical trough is upon us and that now is the time to purchase stocks," echoed Galvin, who holds the same position at CSFB. "Much of the shock value from preannouncements and reduced expectations already has been felt," said Battipaglia, Gruntal's chairman of investment policy.
It's certainly true that investors have become somewhat inured to disappointing corporate and economic news of late. Last week's rout notwithstanding, the S&P 500 index has advanced nearly 9% since April 9, while the Nasdaq Composite and Dow Jones Industrial Average are up 16% and 8%, respectively, over the same period.
This prevailing bullishness probably reflects the hope that corporate profits are in the process of forming a solid bottom. A majority of Wall Street analysts holds that S&P 500 operating earnings will slump by more than 16% in the second quarter, but recover to a 5% loss by the third quarter, according to Thomson Financial/First Call. And because of easier comparisons from a year ago, analysts are counting on profit growth of 7% during the fourth quarter.
Since analysts generally overshoot to the downside when making earnings projections, second-quarter estimates will probably be revised somewhat higher once actual results start coming in. Similarly, third-quarter estimates are likely to be adjusted lower as analysts gain visibility on the second half of the year. As such, Chuck Hill, director of research at Thomson Financial/First Call, isn't at all optimistic about the way things are shaping up: "We could well have a third quarter as bad as the second, and that's what we think will happen," he says.
Though Battipaglia, Applegate and Galvin all argue to the contrary, their outlook is, ironically, based on statistics from Hill's firm. The pundits say they're heartened by several statistical developments. For one, the forward 12-month operating-earnings estimate for the S&P 500 was revised upward in May and again in June — the first such upward revisions in nine months. For another, more companies are offering positive earnings guidance, while fewer are issuing profit warnings. Thomson Financial reports that the rate of positive preannouncements is running 28.8% above first-quarter levels. And though a hefty 65% of the 768 second-quarter preannouncements to date have been negative, that's down from the first quarter warning rate of 68%.
While such measly gains would be "nothing to write home about" in "ordinary times," says Battipaglia, any uptick is good news at a time like this. Hill, however, thinks the pundits have prematurely — and possibly incorrectly — interpreted his data. "We're bumping along at such low levels," he says, "that to get a little bump in the positive data doesn't mean much."
Galvin cites other evidence for a turnaround, however. A budding recovery, he notes, is already beginning to show itself in textbook-like manner. Rate-sensitive sectors like retailers and basic-materials firms are leading the way, he explains. And much of the positive guidance this quarter has come from consumer cyclicals, which are typically the first to respond to an economic slowdown and the first to signal economic recovery. "Our sense," wrote Galvin on Monday, "is that FIFO (first in, first out) is panning out for profits and stocks." Indeed, consumer cyclicals, along with basic materials, are the two best-performing sectors this year, with gains greater than 6%, compared to the S&P 500's loss of 6%.
Technology, too, is a leading indicator, Galvin says, but the performance of tech stocks tends to lag behind that of cyclicals by about five months. Consider that semiconductor and chip-equipment equities started to crater in June and July of last year, five to six months after retailers tanked in 1999. And those two sectors appear to have bottomed in April, five months after the low point for most retail shares.
Now, since cyclicals are starting to issue upbeat guidance, it stands to reason that earnings visibility in the tech sector will begin to clear up in the fourth quarter — about five months from now. And since stock prices lead fundamentals, Galvin thinks investors should snap up tech shares in anticipation of a pickup in orders later this year. His favorites in the sector include Applied Micro Circuits (AMCC), Celestica (CLS), Dell Computer (DELL), EMC (EMC), Juniper Networks (JNPR), Nokia (NOK), Microsoft (MSFT) and Oracle (ORCL). It's worth noting that Oracle reported better-than-anticipated earnings on Monday after the close (despite the fact that expectations had earlier been jiggered lower).
As for the broader market, it remains 15% undervalued despite its 11% run-up since early April, according to Lehman's Applegate. And historically, when the market has been this undervalued, its forward one-year equity return relative to bonds has averaged 17%. Figuring in a 5% or lower yield on the benchmark 10-year Treasury bond, Applegate arrives at a year-end S&P 500 price target of 1450.
If he's right, stocks have another 20% to run. But given the clouds still hanging over the economy, that remains a big if. |
