MICHAEL SANTOLI: Investors Ponder Risks -- of Not Being in the Market
Vital Signs
FOR ALL THE DANGERS that war might loose in the Middle East or that an unresponsive economy could thrust upon the stock market, plenty of investors are more preoccupied with "upside risk."
That's the perceived hazard of missing a potential rally in stocks should the U.S. lead a swift military victory in Iraq, trigger a collapse in oil prices and make the world safe for another bull market, or at least a rush toward the top of the recent trading range.
Stocks have struggled in the three weeks since corporate earnings season began, and the negative action has suggested to some that the old October lows are exerting a strong downward pull. Yet even after sustaining a couple lopsidedly weak days last week, and while ruminating over the likelihood of war within weeks, traders bumped the broad market appreciably higher Friday.
The broad unwillingness to sell aggressively or consistently lends weight to a common remark heard from fund managers: That they must "participate" in the upside if the market rallies to the sound of bombs falling.
With a gain of more than 108 points Friday, the Dow Jones Industrial Average narrowed its loss for the week to just 77 points, or 0.9%, leaving the index at 8053 after trading below the 8000 mark at some point during each session. The Standard & Poor's 500 index slipped 0.6% to 855 and the Nasdaq pulled back by 1.6% to 1320.
If lead changes are the mark of excitement in a ballgame, the same standard would suggest that last week's market was a riveting contest. During each of the five days, the Dow at some point traded both above and below the prior day's close, as players assimilated the President's firm State of the Union address and absorbed hundreds of important profit reports.
Though economic clues and earnings releases were shoved from center stage by the increasing suggestions that fighting could soon start in the Persian Gulf, there were enough encouraging numbers Friday to engender some hope domestically. Walt Disney outdid expectations for a change, Honeywell divested a troublesome division and a measure of Midwestern manufacturing activity was unexpectedly encouraging. The Dow drew strength from all three as the week ended.
These upbeat notices helped dispel the bad taste left by AOL Time Warner's monstrous $98 billion annual loss and asset writedown, as well as disappointing results from Altria (formerly Philip Morris) and its Kraft Foods subsidiary.
The overall pattern of corporate profit performance remained intact, with the usual 60% of companies exceeding forecasts by about the historical norm of around 3%. Yet more than half the companies that have offered hints about the remainder of the year have guided earnings expectations lower, dampening the enthusiasm for a sharp, quick fundamental recovery that helped stocks spurt higher to start the year.
According to the earnings trackers at Ehrenkrantz King Nussbaum, the 332 earnings pre-announcements issued so far for the current first quarter of the year have been weighted toward the negative. The 2.3 ratio of negative to positive foreshadowings ranks as the worst at this stage of the quarter since the third quarter of 2001.
In all, Wall Street is still predicting S&P 500 companies will increase earnings for all of 2003 by just under 13%. Yet more and more of that projected growth is being pushed later in the year.
The idea that earnings and stock prices are being suppressed by commercial paralysis due to impending war, and will rocket higher toward mid-year once Iraq is dealt with, is a solid consensus view right now. Charts illustrating the Gulf War experience in 1991, when the market soared the moment hostilities started, are ubiquitous, as is the comment that in '91 the rally was so sudden there was no time to get in. Thus, goes the logical conclusion, investors should position themselves to capture a rally now.
There is a bullish dream scenario that's not entirely implausible, consisting of an invasion of Iraq and rapid collapse of Saddam Hussein's army and regime, followed by a celebratory market rally and a jolt of animal spirits that will quicken business investment and lead to a new peace dividend.
It's a lot to ask for in a messy and dangerous world, but who's to say it can't happen that way?
Yet it seems clear that one reason the '91 model retains such a hold on professional investors' imaginations is that it stands as the moment when the flint was struck to spark the roaring 'Nineties bull market. It only gained that distinction in hindsight, when the huge and continuous market gains of that decade proved the Gulf War as one of the great all-time buying opportunities.
Distinctions between then and now are important, though. The market leading up to the earlier war fell about 20%, then merely regained all that lost ground in a hurry by the time of the cease fire. Today, the market is up more than 10% from its recent low.
In 1991, stocks were far more cheaply priced relative to earnings. Inflation and short-term interest rates then were far higher than today's, leaving tremendous room for rates to tumble and inflation to cool, thus helping to sustain the upward move in share prices. Perhaps most important, the forceful rally back then was unanticipated, which helps explain why it was so powerful.
It makes sense to expect that a decisive military win or an unexpected abdication by the Iraqi dictator would drive a ferocious emotional buying spree in the market. The question is whether it would be the start of something so enduring that missing it would be disastrous, or just a nice bounce in a range-trapped market that's still challenged by mixed fundamental prospects.
Says one Wall Street trader who spends his days speaking with professional investors: "Everyone wants to believe this is the low. The market is behaving just like it did last January."
More than two months ago, with the indexes slightly above current levels, the market's tone was described here as emotional, irresolute and suggestible; it remains so.
The traditionally defined and ritually anticipated January effect, in which smaller stocks tend to do better than large ones during a year's first month, wasn't very evident this year.
Smaller stocks, in fact, lagged larger names for the month. The S&P Small Cap 600 index fell 3.4%, more than the 3% loss in the S&P Mid Cap 400 and the 2.7% decline in the big-cap S&P 500. This is the second consecutive year in which this traditional version of the January effect failed to materialize.
It was also the second straight January in which the major indexes lost ground. Another of those dusty Wall Street guidebooks holds that the direction of the market in January foreshadows the entire year's movement. The bear market, of course, has delighted in tearing down such guidelines and rules, so the value of this sort of platitudinous wisdom has been diminished. There are better reasons to be concerned about a down year than this.
Wait Loss: The stock market entered nervous waiting mode as prospects grew for military action in Iraq. The Dow lost a modest 77 points to close at 8053 in its third straight losing week.
But the outperformance of larger stocks seems related to a few broad forces out there. For one thing, small stocks have held up far better than big ones for nearly three years, indicating the small-cap cycle is rather mature. The rapidly weakening dollar also acts to the advantage of bigger multinational firms. Subpar economic growth and scarce pricing power is exacerbating the winner-take-all nature of many industries, favoring efficient low-cost producers with scale advantages.
Other explanations include the lack of much tax-loss selling last year, given that few investors had lots of profits to offset. Tax-loss selling typically sets up a rebound of small shares around the turn of the year. Also, cash hasn't flowed into stock funds as it usually does at the start of the year, depriving the January effect of some fuel. Finally, plenty of experts say the effect has become too widely anticipated and occurs months early these days.
Brian Belski, strategist at U.S. Bancorp Piper Jaffray, notes the relative valuations. The valuation of large caps, as measured by the Russell 1000, is near a 10-year low versus the small-cap Russell 2000 based on price to expected earnings and price to cash flow, he says. Belski also thinks professional investors are sticking with larger, more liquid names -- especially tech shares -- as a way to play any potential rally while retaining the ability to sell them quickly.
In fact, the continued willingness of investors to own tech stocks allowed the Nasdaq to perform better than the broader market last month. This, some argue, is a separate element of the January effect, when more speculative issues do better than stable ones.
While investors keep at least a little mad money in the technology area to ensure participation in any emotional, post-war rally, many are simultaneously looking for "places to hide," says Belski.
The search for properly guarded redoubts is made more urgent by the fact that one of the favorite and most effective hiding places of the last two years -- banks, especially large regional banks -- appears to be under assault.
Financials have grown to comprise about 20% of the S&P 500 and of very broad indexes like the Wilshire 5000, a record high weighting for the group. Investors have flocked to the stocks because of their relative predictability, decent dividend yields and ability to thrive as interest rates fall.
But the fundamental challenges for big banks will only grow this year. The spread between short- and long-term rates, which banks effectively collect, is unlikely to widen and is generally expected to narrow. Mortgage loans, the only lending area that grew last year as commercial borrowing constricted, should slow. The analysts at UBS Warburg point out that cost-cutting, a decade-long theme, is about to hit a wall, and that rapid deposit growth rates are unsustainable.
Some of the sharper market watchers have sounded alarms that stocks such as Bank of America, Wells Fargo, Wachovia and Regions Financial have begun to look tired. Understandable, after fighting the downward market trend for so long.
AOL Time Warner's reported 2002 loss of almost $100 billion certainly presented the Street with a galling number last week, an enormous measure of just how mispriced the old America Online was at the time of its merger with Time Warner. The loss was produced by drastically writing down the value of the AOL and cable divisions, and through other assorted bookkeeping adjustments.
But in a practical sense, the loss amounts to AOL's confession of financial misdeeds for which the market has already indicted, convicted and sentenced the company, in the form of a stock price less than one-sixth its peak value.
Scanning the list of all-time largest annual losses in corporate history, which AOL Time Warner now tops by a wide margin, offers an interesting lesson in how good things can sometimes follow such a humbling loss. Corporate catharsis can result when such an enormous deficit segues into a real restructuring.
All but four of the top 25 losses came since 2000, nearly all of them stories of massive overinvestment in young companies during the bubble, financial excesses that later had to be expunged from the books.
Arguably, the examples more germane to the AOL situation are the big baths taken a decade ago by three seminal U.S. companies: losses for 1992 by General Motors and Ford, and one for 1993 by International Business Machines. In the 12 months following the year their losses were booked, GM shares vaulted higher by 70%, Ford's climbed 38% and IBM's gained 30%. In each case, the broader market was either flat or up by a single-digit percentage.
Needless to say, there can be no guarantees of a similar revival happening with AOL. But there are important echoes. In each of the former cases, the losses signaled a profound break with the past, a purge of financial excesses and mismanagement, and they represented the resolve of newly focused top executives to reset priorities and ensure future profitability.
AOL's CEO, Richard Parsons, has been upfront that 2003 will be a retooling year. He's making no promises of cash-flow growth -- a somewhat refreshing stance at a company prone in the past to grandiosity and implausible growth claims. The cable division will be taken public this year. Parsons wants to cut debt to $20 billion from $26 billion by the end of 2004, not an easy task, given pre-existing cash commitments. But reducing leverage is now a priority. And nearly all options for asset sales are reportedly on the table.
Getting America Online subscribers to convert to AOL's broadband service is crucial, and this effort could mean the difference between AOL continuing its Internet dominance or becoming a wasting asset. Therein lies the largest risk for investors.
Even with all the tumult, the ugly reported losses and the balance-sheet carnage, free cash flow last year was more than $4 billion, putting the company's ratio of enterprise value to free cash flow well below that of the market as a whole. With the stock below 12 and the company an object of revulsion among many investors, the risk/reward equation might well have shifted back in buyers' favor.
So far this year, an average of more than 5 million shares of UAL have traded daily. Its price has slid from 1.49 to 1.02. But that counts as a fairly gentle rate of decline, given the overwhelming probability that when UAL, the parent of United Airlines, emerges from bankruptcy protection, the shares will be worthless.
In mid-December, with UAL stock fetching $1.75, this column accentuated the same point. Yet there are some emotional and technical reasons that buyers each day put up $5 million or so to own the shares. Individual investors see the vast company operating almost as normal and can't believe it's worth nothing, so they speculate on what looks like a cheap stock. The airline itself is not worthless, of course. But because there's not enough assets to pay off even the creditors, common stock holders will almost certainly be wiped out.
The technical factors involve an inability, so far, of State Street Bank & Trust to unload its stake. State Street is the trustee for the UAL employee stock ownership plan and wants to salvage some value for its clients. But the bankruptcy judge, at the company's request, has prevented the sale of most of those shares because it might trigger a change-of-control clause that could jeopardize tax benefits to UAL.
It's all quite complicated, but the upshot is that a court hearing this Wednesday could determine whether State Street is allowed to dump the employee shares on the market. That means that anyone who is, inexplicably, still holding UAL shares might want to turn them into what little cash their worth by Tuesday's market close.
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E-mail: michael.santoli@barrons.com |
