BARRON'S:
The Trader 22 feb 2003
Is "War Paralysis"
Perception Or Reality?
By Michael Santoli
It's tough to prove a negative, but that isn't stopping lots of people
from
trying.
That the U.S. economy would be gaining pace if not for the threat of
war in
Iraq is a common, though hardly provable, assertion. Start with Alan
Greenspan
and go all the way down to the grocer interviewed on the local news,
and the
same case is made.
Last week a survey at a gathering of corporate chief executives showed
they
believe "geopolitical events" are the biggest restraint on
economic growth. And
40% of manufacturers polled in the Philadelphia Federal Reserve report
cited
"geopolitical uncertainties" as a major growth retardant.
Of course, there's no good way to do the counter-factual analysis to
figure
out just how much growth this perceived "war paralysis" is
costing the economy.
Still, the fixation on global hostilities allowed investors to largely
shrug off
disappointing economic signals last week on manufacturing activity,
unemployment
claims and wholesale inflation, while taking slightly higher consumer
prices in
stride.
The gut-level belief
that the market will be a happier place once the Iraq
standoff is "resolved" helped stock indexes to modest gains
for the second
straight week. Tellingly, nearly all the upside movement in stocks during
those
weeks came on days when the chances of imminent war seemed to have diminished.
That included Friday, when vaguely conciliatory words from Iraq's vice
president emboldened traders to lift the Dow Jones Industrial Average
by 103
points to 8018, nearly the entire 109-point rise it posted for the week.
The
Standard & Poor's 500 index showed a similar pattern, rising 1.6%
for the week
to 848, while the Nasdaq Composite exhibited more bounce in adding 3%
to 1349.
The Nasdaq is now up about 1% for the year to date, compared with a
4% decline
in the Dow.
In contrast with the
gains made on whispers of peace, the biggest drop of the
week came Thursday, when the Washington Post reported the White House
is
targeting a mid-March start to a military campaign.
This type of market action could compromise the broadly held view that
starting an invasion would in turn start a rally. Or it could at least
mean that
such a rally would come off meaningfully lower levels, as the market
weakens
should war begin to look inevitable.
As Prudential Securities strategist Ed Yardeni puts it, "We continue
to see
this `waiting for Iraq' sort of stance that could end up being disappointing."
That kind of commentary has given rise to the opposing view, which says
the
new consensus now doubts a post-war rally; or, at least, investors haven't
positioned their portfolios for one. If so, says this camp, it means
the clever
contrarian move is to act as if we'll get the rally after all.
This game of "I'm not in the consensus, you are," will very
likely continue
until reality intrudes on the fun.
There is some evidence
to be found that professional investors perhaps aren't
geared for a cathartic rally. Sketchy polling data suggests hedge funds
are more
aggressively playing the short side of the market than they have recently.
Merrill Lynch's monthly global survey of institutional investors showed
that 34%
of fund managers say they're pursuing a more conservative investment
strategy
than they do normally, a higher reading than that registered right after
Sept.
11, 2001, and up from 25% in January.
That raises the question of who, exactly, is doing all the technology-stock
buying that's propping up the Nasdaq, and it also speaks to some level
of risk
avoidance by the big money.
Morgan Stanley's Steve
Galbraith calculated what a "normalized" level of risk
tolerance ought to be given current macro-economic factors, based on
the
market's historical pattern. His working of the numbers indicate the
market is
perhaps 10% lower than it otherwise would be, due to extraordinary risk
aversion
based on noneconomic concerns, implying "roughly a 10% relief rally"
if the Iraq
situation is clarified.
That would get the market all the way back to where it stood at this
year's
high point in mid-January. As Galbraith concludes: "Those expecting
a major new
bull run in a post-Saddam world . . . may still be disappointed."
There's also the question of whether simply changing the Iraqi regime
would
clear away all those fears that are lumped together as "geopolitical
concerns."
Consider that Friday morning, a fire visible from lower Manhattan knocked
more
than 1% off the S&P 500 in the space of 15 minutes before it was
termed an oil
refinery accident and not a terrorist act.
-- The beltway kept a tight squeeze on the Baby Bells last week, confounding
wishes for some regulatory easing that would help the companies stanch
their
loss of local-phone business. Wall Street registered deep disappointment
by
further discounting the regional Bell stocks and some telecom-equipment
names.
In its triennial review of the 1996 Telecommunications Act, the Federal
Communications Commission elected to maintain rules that require the
Bells to
lease their local phone lines to competitors on the cheap, countering
the wishes
of FCC Chairman Michael Powell and thwarting the desires of Wall Street.
The pure Baby Bell shares -- BellSouth, SBC Communications and Verizon
Communications -- fell between 5% and 8% Thursday when the news hit.
Though all
three stocks regained firmer footing Friday, they each lost significant
ground
on the week.
The unexpected turn
caused the tech-and-telecom research boutique Precursor
Group to reverse its bullish stance on telecom services and equipment
shares,
which analysts Scott Cleland and Bill Whyman detailed in a Barron's
interview
last week ("A Clarion Call," Feb. 17; for more on the FCC
ruling, see page T5).
Precursor now urges clients to underweight the sector, because "this
fractious
FCC decision creates much new uncertainty that is likely to increase
further,
and because the FCC decision actually discourages capital from entering
the
sector."
An obvious question now is when and at what prices the market might
fully
build in the likely negative impact of the FCC decision. Wall Street
analysts
only marginally reduced their earnings forecasts for the regional Bell
operating
companies, or RBOCs. But that's almost beside the point, since investors
worry
that the erosion of the Bells' local-phone market share could accelerate
into an
ungovernable spiral, pulling future earnings down with it.
According to Deutsche Bank Securities analyst Viktor Shvets, "At
current
prices RBOCs are now increasingly priced on the basis of permanent value
destruction."
Could that possibly
be the fate of such a massive, politically connected
industry? Even if not, the courage to bet the other way was scarce last
week
among investors. Shvets indicated an urge to upgrade his Hold rating
on
BellSouth, but refrained given "heightened uncertainty."
Credit Suisse First Boston's Lara Warner found the nerve Friday to recommend
buying Verizon shares, saying the recent selloff left perhaps 20% upside
based
on relative valuation measures.
With so much doubt about the financial repercussions, the stocks may
not
settle out until they gain support from the high yields provided by
what appear
to be relatively safe dividends, say some industry watchers. At what
yield
threshold that might happen is largely guesswork, but levels are high
by recent
standards.
SBC now yields a bit more than 5%, a level not seen since at least 1992.
But
the stock stands to remain in the penalty box as investors jeer the
company's
reported interest in buying Hughes Electronics' DirecTV.
Verizon's 4.4% yield is around a six-year high, as is BellSouth's with
a 3.8%
payout. When companies' fortunes are thought to be falling as quickly
as these,
even those yield cushions might not give comfort. But at share prices
perhaps
not much lower than today's, they're likely to look inviting enough
to attract
determined buyers.
-- Seeking out top-quality companies in the stock market is being discussed
as
one of those new, old-fashioned virtues, like collecting dividends and
wearing a
tie to the office. But the truth is that verifiable earnings quality
only
briefly went out of style, and betting on the most proven financial
models has
been a winning investment tack over long periods of time.
These are the findings of a new study by Standard & Poor's of its
own Earnings
& Dividend Quality Rankings. The report concludes that, over time,
the stocks of
companies with the highest-quality financial attributes meaningfully
outperform
the market, with less risk borne by investors.
The rankings date to 1956 and assign companies a letter grade, from
A-plus to
D, based on the prior ten years' earnings growth and stability, dividend
growth
and stability, and total sales. It's a simple model and one whose top-rated
companies tend to have superior profit margins and are less leveraged.
The new study covers the years 1986 through 2002. That isn't a terribly
long
period, but the analysis extends earlier academic research that arrived
at
similar results dating back to 1956. For the 17 years through 2002,
A-plus rated
stocks compounded at 12.3% annually, compared with 10.8% for the S&P
500.
All A-rated stocks (A-plus, A and Aminus) beat all B-rated issues by
2.4
percentage points a year. When the lower volatility of the A-rated stocks
is
taken into account, the S&P researchers concluded that the A category
outperformed the B group by four percentage points a year on a risk-adjusted
basis.
It's tough to prove a negative, but that isn't stopping lots of people
from
trying.
That the U.S. economy would be gaining pace if not for the threat of
war in
Iraq is a common, though hardly provable, assertion. Start with Alan
Greenspan
and go all the way down to the grocer interviewed on the local news,
and the
same case is made.
Last week a survey at a gathering of corporate chief executives showed
they
believe "geopolitical events" are the biggest restraint on
economic growth. And
40% of manufacturers polled in the Philadelphia Federal Reserve report
cited
"geopolitical uncertainties" as a major growth retardant.
Of course, there's no good way to do the counter-factual analysis to
figure
out just how much growth this perceived "war paralysis" is
costing the economy.
Still, the fixation on global hostilities allowed investors to largely
shrug off
disappointing economic signals last week on manufacturing activity,
unemployment
claims and wholesale inflation, while taking slightly higher consumer
prices in
stride.
The gut-level belief
that the market will be a happier place once the Iraq
standoff is "resolved" helped stock indexes to modest gains
for the second
straight week. Tellingly, nearly all the upside movement in stocks during
those
weeks came on days when the chances of imminent war seemed to have diminished.
That included Friday, when vaguely conciliatory words from Iraq's vice
president emboldened traders to lift the Dow Jones Industrial Average
by 103
points to 8018, nearly the entire 109-point rise it posted for the week.
The
Standard & Poor's 500 index showed a similar pattern, rising 1.6%
for the week
to 848, while the Nasdaq Composite exhibited more bounce in adding 3%
to 1349.
The Nasdaq is now up about 1% for the year to date, compared with a
4% decline
in the Dow.
In contrast with the
gains made on whispers of peace, the biggest drop of the
week came Thursday, when the Washington Post reported the White House
is
targeting a mid-March start to a military campaign.
This type of market action could compromise the broadly held view that
starting an invasion would in turn start a rally. Or it could at least
mean that
such a rally would come off meaningfully lower levels, as the market
weakens
should war begin to look inevitable.
As Prudential Securities strategist Ed Yardeni puts it, "We continue
to see
this `waiting for Iraq' sort of stance that could end up being disappointing."
That kind of commentary has given rise to the opposing view, which says
the
new consensus now doubts a post-war rally; or, at least, investors haven't
positioned their portfolios for one. If so, says this camp, it means
the clever
contrarian move is to act as if we'll get the rally after all.
This game of "I'm not in the consensus, you are," will very
likely continue
until reality intrudes on the fun.
There is some evidence
to be found that professional investors perhaps aren't
geared for a cathartic rally. Sketchy polling data suggests hedge funds
are more
aggressively playing the short side of the market than they have recently.
Merrill Lynch's monthly global survey of institutional investors showed
that 34%
of fund managers say they're pursuing a more conservative investment
strategy
than they do normally, a higher reading than that registered right after
Sept.
11, 2001, and up from 25% in January.
That raises the question of who, exactly, is doing all the technology-stock
buying that's propping up the Nasdaq, and it also speaks to some level
of risk
avoidance by the big money.
Morgan Stanley's Steve Galbraith calculated what a "normalized"
level of risk
tolerance ought to be given current macro-economic factors, based on
the
market's historical pattern. His working of the numbers indicate the
market is
perhaps 10% lower than it otherwise would be, due to extraordinary risk
aversion
based on noneconomic concerns, implying "roughly a 10% relief rally"
if the Iraq
situation is clarified.
That would get the market all the way back to where it stood at this
year's
high point in mid-January. As Galbraith concludes: "Those expecting
a major new
bull run in a post-Saddam world . . . may still be disappointed."
There's also the question of whether simply changing the Iraqi regime
would
clear away all those fears that are lumped together as "geopolitical
concerns."
Consider that Friday morning, a fire visible from lower Manhattan knocked
more
than 1% off the S&P 500 in the space of 15 minutes before it was
termed an oil
refinery accident and not a terrorist act.
-- The beltway kept a tight squeeze on the Baby Bells last week, confounding
wishes for some regulatory easing that would help the companies stanch
their
loss of local-phone business. Wall Street registered deep disappointment
by
further discounting the regional Bell stocks and some telecom-equipment
names.
In its triennial review of the 1996 Telecommunications Act, the Federal
Communications Commission elected to maintain rules that require the
Bells to
lease their local phone lines to competitors on the cheap, countering
the wishes
of FCC Chairman Michael Powell and thwarting the desires of Wall Street.
The pure Baby Bell shares -- BellSouth, SBC Communications and Verizon
Communications -- fell between 5% and 8% Thursday when the news hit.
Though all
three stocks regained firmer footing Friday, they each lost significant
ground
on the week.
The unexpected turn caused the tech-and-telecom research boutique Precursor
Group to reverse its bullish stance on telecom services and equipment
shares,
which analysts Scott Cleland and Bill Whyman detailed in a Barron's
interview
last week ("A Clarion Call," Feb. 17; for more on the FCC
ruling, see page T5).
Precursor now urges clients to underweight the sector, because "this
fractious
FCC decision creates much new uncertainty that is likely to increase
further,
and because the FCC decision actually discourages capital from entering
the
sector."
An obvious question
now is when and at what prices the market might fully
build in the likely negative impact of the FCC decision. Wall Street
analysts
only marginally reduced their earnings forecasts for the regional Bell
operating
companies, or RBOCs. But that's almost beside the point, since investors
worry
that the erosion of the Bells' local-phone market share could accelerate
into an
ungovernable spiral, pulling future earnings down with it.
According to Deutsche Bank Securities analyst Viktor Shvets, "At
current
prices RBOCs are now increasingly priced on the basis of permanent value
destruction."
Could that possibly
be the fate of such a massive, politically connected
industry? Even if not, the courage to bet the other way was scarce last
week
among investors. Shvets indicated an urge to upgrade his Hold rating
on
BellSouth, but refrained given "heightened uncertainty."
Credit Suisse First Boston's Lara Warner found the nerve Friday to recommend
buying Verizon shares, saying the recent selloff left perhaps 20% upside
based
on relative valuation measures.
With so much doubt about the financial repercussions, the stocks may
not
settle out until they gain support from the high yields provided by
what appear
to be relatively safe dividends, say some industry watchers. At what
yield
threshold that might happen is largely guesswork, but levels are high
by recent
standards.
SBC now yields a bit more than 5%, a level not seen since at least 1992.
But
the stock stands to remain in the penalty box as investors jeer the
company's
reported interest in buying Hughes Electronics' DirecTV.
Verizon's 4.4% yield is around a six-year high, as is BellSouth's with
a 3.8%
payout. When companies' fortunes are thought to be falling as quickly
as these,
even those yield cushions might not give comfort. But at share prices
perhaps
not much lower than today's, they're likely to look inviting enough
to attract
determined buyers.
-- Seeking out top-quality companies in the stock market is being discussed
as
one of those new, old-fashioned virtues, like collecting dividends and
wearing a
tie to the office. But the truth is that verifiable earnings quality
only
briefly went out of style, and betting on the most proven financial
models has
been a winning investment tack over long periods of time.
These are the findings of a new study by Standard & Poor's of its
own Earnings
& Dividend Quality Rankings. The report concludes that, over time,
the stocks of
companies with the highest-quality financial attributes meaningfully
outperform
the market, with less risk borne by investors.
The rankings date to 1956 and assign companies a letter grade, from
A-plus to
D, based on the prior ten years' earnings growth and stability, dividend
growth
and stability, and total sales. It's a simple model and one whose top-rated
companies tend to have superior profit margins and are less leveraged.
The new study covers the years 1986 through 2002. That isn't a terribly
long
period, but the analysis extends earlier academic research that arrived
at
similar results dating back to 1956. For the 17 years through 2002,
A-plus rated
stocks compounded at 12.3% annually, compared with 10.8% for the S&P
500.
All A-rated stocks (A-plus, A and Aminus) beat all B-rated issues by
2.4
percentage points a year. When the lower volatility of the A-rated stocks
is
taken into account, the S&P researchers concluded that the A category
outperformed the B group by four percentage points a year on a risk-adjusted
basis.
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