Money Managers Recall Math From College: 2D=Recovery?
August 1, 2001
Heard on the Street
By KEN BROWN
Staff Reporter of THE WALL STREET JOURNAL
In their search for a bottom for slumping corporate earnings and share prices, many money managers are harking back to their days of college calculus to figure out when things will turn. "Second derivative," which dredges up memories of unsolved math mysteries in some people, is the latest catch-phrase.
For the art majors among us, second derivative basically means the change in the rate of change. Or, are things getting worse at a faster rate or are they getting worse, but only more slowly? (The first derivative is simply the rate of change.)
This logic may sound like it is two steps removed from reality, but it actually has been moving the market all year. "I think it's a real argument," says Eric Ross, a technology analyst at San Francisco investment bank Thomas Weisel Partners. "Whether people laugh at it or not, investors are looking at it."
Many investors hope it will help them get into the market ahead of any big rallies. In essence, the second-derivative approach involves looking at such things as profit warnings, analysts' earnings estimates and equipment orders (including cancellations) for signs that the downward momentum is slowing. Some people dismiss second derivative as a tool of momentum investors, those gunslingers who buy what is going up, no matter what the price. But even for investors interested in company fundamentals such as earnings and profit margins, trying to spot a turning point is important.
"In April, the fundamentals went from falling off a cliff to rolling down a hill, and that sparked a rally in technology stocks," says Allan Kelley, a money manager who focuses on technology stocks at Trusco Capital Management in Atlanta.
Of course, that rally fizzled, which may indicate the limits of applying calculus to the stock market. Indeed, after being burned by April's short-lived rally, as well as by one in January, some investors have given up on the second derivative and instead are looking for signs that things actually are improving -- that growth actually is resuming -- rather than that the pace of decline has moderated. "I think what we really need at this point are clear signs of an uptick in demand," Mr. Kelley says.
Still, the second derivative matters because the stock market always acts in anticipation of news, be it good or bad. Last year, the market began falling well before evidence of the economic slowdown became clear. Investors believe they have to act before the news becomes obvious.
They want to be early because they are afraid of being late. Many surveys of analysts and money managers show they believe a rebound will occur in the next few months and they don't want to miss it. Many already have acted on that belief, but by doing so they leave themselves vulnerable to being seduced by misleading data.
Jumping on the slightest good news "shows a fear among money managers about being left behind," says Richard Bernstein, Merrill Lynch's quantitative analyst.
In employing the second derivative, some fast-trading investors use computer models to track subtle moves in the numbers they monitor; others simply use the numbers to help discern broad trends. These investors tend to look at several indicators and won't act until nearly all the data move in the right direction. Either way, many numbers being watched by second derivatists show that the economic and market decline is slowing or has ended, though none show any sign of a resumption of growth.
Consider profit warnings. According to Thomson Financial, the number of profit warnings last year soared to 794 in the fourth quarter from 324 in the second quarter. In this year's first quarter, things still got worse, but at a slower rate, when 935 companies warned of bad earnings, and the number dropped in the second quarter to 830, still ugly but enough to excite a second derivatist.
As for estimated earnings growth this year, things are getting worse at the same depressing rate. In other words, there is no change in the second derivative. According to Thomson Financial, at the end of last year, Wall Street analysts expected earnings of companies in the Standard & Poor's 500-Stock Index to rise 9.2% this year. This week, analysts were expecting those profits to fall 7.9%.
For tech stocks, the numbers are more dramatic. At the beginning of the year, analysts expected this year's earnings to rise 11%. By this week, those analysts were predicting a 50% earnings drop, though the pace of decline has slowed slightly in the past three months.
Another set of data that investors track: earnings revisions, particularly the ratio of the number of earnings being revised up to the number being revised down. According to Thomson Financial, the ratio of upward revisions to downward revisions was 2.25 -- meaning there were more than two upward revisions for every downward revision -- as recently as May 2000. But that number plummeted to a low of 0.24 this March -- four downward revisions for every upward revision -- and since has rebounded slightly, to 0.43.
Not surprisingly, investors focus on forward-looking data as they try to spot a turning point. More important is the outlook that companies often provide.
Still, there are signs, in some areas, that things are bottoming out. For example, orders for semiconductor equipment, the machines used to make semiconductor chips, have been steady for the past three months after collapsing early this year.
In many manufacturing industries with high fixed costs, such as semiconductors, a moderate decline in revenue can mean a brutal hit to earnings. By contrast, when revenue bounces, profits can soar. "It's this leverage that makes the second-derivative argument worth paying attention to," says Pip Coburn, UBS Warburg's global tech strategist, who dubbed a weekly report "The Second Derivatist's Handbook."
Consider Texas Instruments, which reported its second-quarter earnings last week. While revenue fell 30%, its earnings excluding charges fell 90%. When sales improve, the reverse can be true. Texas Instruments' sales in last year's second quarter rose 19% from the year-earlier period, but profit excluding charges jumped 35%.
It isn't just investors who have become obsessed with the second derivative. Corporate executives are talking the talk. Commenting on his company's financial results, Texas Instruments Chairman, President and Chief Executive Tom Engibous said: "Make no mistake, this is a severe downturn, but we now see some signs of stabilization. The rate of sequential decline for semiconductor orders has slowed, and it appears our semiconductor revenue is nearing a bottom."
Perhaps investors are growing jaded, Texas Instruments' stock barely budged.
Write to Ken Brown at ken.brown@wsj.com |
