Barron's(9/29) MARKET WEEK -- Stocks: The Trader: There's More To Market's Slide

 

   (From BARRON'S)

   By Michael Santoli

 

  There's a cute and tidy story going around that the downturn in the dollar

last week combined with the OPEC-engineered bounce in oil prices to knock the

stock market for substantial losses.

  Could be. But if so it's a little curious that the sector hit hardest was

technology -- the very group that benefits most from a weaker dollar and is

perhaps the least energy-intensive industry in the market.

  The dollar's tumble and oil's uptick were, more likely, "MacGuffins," as

Alfred Hitchkock called his convenient, simplistic plot devices. They propelled

a drama playing out mostly in the psyches of professional investors. This is

hardly trivial, given that investor psychology has been the propellant of the

intense rally that had evaded serious pullbacks for months.

  The tempting conclusion suggested by last week's losses is that portfolio

managers' performance anxiety is now manifesting itself in different types of

behavior. While the zeal to grab a fair share of the market's upside has for

months spurred the pros to chase the highly valued market leaders, last week

there were hints that money managers were eager to preserve their gains, sell

some winners and pare risk levels.

  The selling hit the tech-driven Nasdaq hard, driving it down 113 points, or

6%, to 1792, extinguishing a month's worth of gains. The S&P 500 gave up 39

points, or 3.8%, to settle below 1000, at 996. The Dow Jones Industrials lost

331 points, or 3.4%, to reach 9313.

  There are other possible fundamental items on which to pin the sudden selling

impulse. Earnings warnings from Viacom and a few others rattled investors a bit,

though the overall preannouncement season isn't shaping up to be a particularly

poor one.

  There were also a couple of economic releases that undershot forecasts and

spread concern that the economy's momentum might be flagging. One of the

market's weaker days, Thursday, was explained in part by a decline in

durable-goods orders during August. But that number had been out for a good

seven hours by the time stocks began registering the bulk of their losses in a

late-day flop.

  Merrill Lynch economist David Rosenberg notes that 80% of this month's

economic data releases have failed to beat expectations, a reversal from the

ratio in August. That couldn't have helped the bulls' cause, but the fact is

that investors had for weeks been able to absorb or ignore most negative news as

they punched in the buy orders, and last week that changed.

  Scott Jacobson, a trader and strategist at Jefferies, says, "Getting close to

the end of the year, if you're an average portfolio manager and you're at or

near your benchmark, you'll start to `closet index' and hug the benchmark."

  That would imply selling many of the kinds of stocks that have worked

especially well for the past six months. High-expectation, low-profitability,

fringe-dwelling tech stocks, for example. If this activity continues, it would

also suggest that the massive outperformance of small-cap shares could be about

to curdle. The valuation gap that once favored smaller, more aggressive, more

deeply cyclical stocks is no longer quite so compelling.

  Vadim Zlotnikov, strategist at Sanford C. Bernstein, told clients last week:

"To make a significant bet on small-cap names now, you need to believe in a very

strong recovery" in the economy.

  Jacobson adds that Treasury bonds, which have rallied to knock 10-year yields

to 4.02% from 4.60% right after Labor Day, "are telling stocks something again."

Namely, bonds might be whispering that the hopes for a galloping economic pickup

might've been premature.

  If indeed investor psychology is beginning to take on a more defensive cast,

then larger, more stable stocks might be expected to grab the lead, at least

temporarily, from the long-shot, highly leveraged bets that have been rewarded

for some time now.

  Zlotnikov notes that his firm's model for selecting stocks with high-quality

earnings and attractive valuations has underperformed the market since its March

low. In examining past periods back to 1966 when this quality screen has trailed

the market this badly, he found that its laggard behavior tends to last five or

six months before rebounding strongly. It's been just over six months this time.

He's now favoring health-care-services stocks, as well as energy names.

  Even stock-market bulls, of course, have been talking about the likelihood of

a retreat, albeit a shallow one, in the indexes. Some have professed to be

hoping for just that, so they might do a little buying at lower asking prices.

And certainly, there's enough liquidity out there to allow for that to play out

on a broad scale. Yet a couple of index levels deemed significant by technicians

were breached in the latest downdraft. Heretofore invincible momentum champions

such as Yahoo were taken down a peg. Short sellers have stopped kicking the dirt

and are looking for fat pitches to hit again. And, naturally, the same dynamic

that pulled fresh buyers in as stocks surged could begin operating in reverse.

It's happened before.

 

  -- The action in Viacom shares had been evidencing deep investor concern for

several days before the company finally validated the market's fears on

Wednesday, by tempering its revenue and profit outlook for the rest of the year.

  The media outfit blamed continued softness in local advertising demand for a

reduction in its revenue and operating-income projection to "mid-to-high single

digit" percentage growth from a prior forecast of double-digit income growth

atop single-digit revenue gains.

  In each of the three trading days before Viacom's announcement, its shares had

sold off steadily on roughly twice their normal volume. Hints of a

slower-than-hoped rebound in local advertising had emerged from the New York

Times and Gannett, and some observers had begun to worry that Viacom's CBS

television stations might have a tough time matching last fall's ad performance

that was helped disproportionately by political ads. Paramount's weak summer box

office showing was another drag.

  In fact, from Sept. 5 -- the day after Congress voted to preserve many

restrictions on media-outlet concentration -- Viacom's heavily traded B shares

are down some 17%. This radical underperformance is something new for Viacom,

which was a nearly bulletproof stock throughout much of the bear market,

consistently afforded a valuation premium by an investor base in the thrall of

Chairman Sumner Redstone's grand vision and President Mel Karmazin's vaunted

operational acumen.

  Last week several loyal analysts came to the company's defense, calling the

stumble an aberration and, predictably, a buying opportunity. The bullish case

always begins with a tribute to the quality of its assets: CBS, Showtime, MTV,

Nickelodeon, Paramount, Simon & Schuster, the list goes on. True enough. But AOL

Time Warner and Walt Disney and Fox Entertainment each has its own set of

enviable media assets, too.

  What Viacom has that the others don't is significant exposure to radio,

through its ownership of the Infinity Broadcasting stations. Radio accounts for

only 9% of Viacom's revenues. But because it's such a high-margin business it

produces some 19% of earnings before interest, taxes, depreciation and

amortization -- the coin of the realm in media. This accounts for much of

Viacom's exposure to local ads, which has badly trailed the recovery in national

advertising.

  Spencer Wang of J.P. Morgan published a cautious note a week ago Friday on

Infinity's ratings, which have fallen even more than the overall declining

listenership rates of the industry among the important 25-to-54 age group. The

growth drought in radio has led some investors to question whether there are

more worrisome trends to be inferred.

  Drew Marcus of Deutsche Bank believes it simply means that radio has stopped

gaining market share from other media. Meanwhile, he thinks, "The weak pacing of

local advertising calls into question the strength of the economic recovery."

  Others, though, wonder whether there's something more significant happening in

radio, whether consumers are being increasingly turned off by the homogenization

of radio formats and the aggressive increases in commercials aired per hour. The

long-term expected growth rates of radio companies -- no surprise --  hint at

none of these concerns, as analysts pencil in three-to-five-year earnings

increases of 15%-25% per annum.

  There has been management shuffling at Infinity in an effort to revive the

group, and it seems Viacom is committed to spending money to get ratings higher.

One skeptical observer notes that the real story in Viacom's announcement last

week was that management effectively said margin expansion wouldn't happen this

year. It brought profit-growth guidance in line with revenue growth. So much for

those hopes of gaining leverage to an advertising recovery.

  He also points out that Viacom has effectively had to cut back its guidance

three years in a row. Until now, the market has overlooked these hiccups and

tuned right back in to the Mel and Sumner show. Yet even with its recent

decline, Viacom's stock doesn't appear to be a particular bargain compared with

other companies with exposure to the same businesses, such as Time Warner, Fox

and Tribune.

 

  -- There was a line of thinking among certain investors, cited here recently,

that a drastic dividend cut by Eastman Kodak could lead to a higher stock

valuation. The idea was that the company would thereby signal a plan to marshal

resources to maximize cash returns from a declining film market while

selectively making acquisitions in higher-growth businesses.

  Well, Kodak's announcement last week that its lavish, $1.80-a-share annual

dividend would be hacked down to 50 cents wasn't received quite so well, as the

company's shares were knocked down by 6.40 to 21.40.

 Barron's(9/29) MARKET WEEK -- Stocks: The Trader: -2- [CZBGKVR]

  The hostile reaction can be traced to a couple of things. Clearly,

yield-fixated investors see no reason to stick around. But the nature of Kodak's

announced plan -- to pursue some $3 billion in acquisitions and enter the

savagely competitive ink-jet- printer business -- spooked even those who thought

a dividend cut could be spun positively.

  The company posited that its plan would lead to $3 a share in earnings in

2006. No one has enough faith in a strategically challenged company's

fortune-telling abilities to buy into that, especially given Kodak's mixed

record on acquisitions and only tentative success turning a profit from digital

photography.

  Bond analyst Carol Levenson of Gimme Credit calculates that Kodak could

achieve even better earnings growth by 2006 by using the same $3 billion to

simply buy back stock, with little operational risk.

  One intriguing element of Kodak's plan is its vow to start making

private-label film. This suggests Kodak is indeed looking to pull as much cash

out of every available segment of the film business, rather than retain premium

pricing and sniff at the mucky business of competing for market share.

  Once the yield investors and the understandably skeptical former bulls finish

selling, Kodak shares should find more stable ground. The best-case scenario

might be if Kodak were to pull a McDonald's and answers a disillusioned Wall

Street by forgoing delusions of fast growth in favor of retrenchment,

cash-maximization and humility. But with such a dramatic makeover in the works,

today's Kodak stock buyers won't be able to gauge its prospects for success for

quite some time.

 

  -- After three calendar years of eroding stock prices, virtually every

powerful constituency in the Washington-New York politico-financial world has an

acute interest in stocks riding higher.

  Brokerage houses and mutual-fund firms have their bottom lines at stake, of

course. The Fed wants to forestall asset deflation and to see the market ratify

its attempts at goosing economic growth. The Bush administration needs Wall

Street to augment re-election prospects. The Treasury and Congress desperately

covet capital-gains taxes to help offset some of a soaring deficit.

  Just about the only people that have a stake in seeing the market decline are

a couple thousand hedge-fund managers habitually attached to the short side.

  The liquidity thrust from tax cuts, higher government outlays and teensy

interest rates are widely discussed as contributors to the market's rebound this

year. But there's also been a market-friendly effort by Congress to legislate

away the bad or inconvenient items that can plague companies' books.

  One goodie offered to corporate interests by the tax-cut law was the chance to

accelerate the depreciation of newly acquired capital goods. This effectively

lowered the after-tax cost of these investments and provided a great, temporary

incentive for companies to load up on new technology products. Those incremental

sales, mostly booked over the summer, have been dutifully incorporated into

analysts' run rate of tech demand.

  Another idea clattering around the halls of Congress would have

farther-reaching effects. This is a proposal to allow companies to use a higher

discount rate when calculating the present value of their future pension

liabilities.

  If Congress does make such a change, no doubt Wall Street will be happy to

bless the cosmetically enhanced earnings numbers. Investors have already been

blithely dismissive of the potential earnings-corroding implications of pension

shortfalls, and such a legal shift would make the problem that much easier to

ignore.

  The tomorrow-be-damned attitude among investors is perhaps most pronounced in

their treatment of airline stocks. As a group, airline shares have more than

doubled since the market low in early March. The traditional major airline

shares -- AMR, Continental, Delta and Northwest -- have soared from levels

implying they were bankruptcy risks.

  Yet the market might not be taking a full account of the sorry state of the

industry's pension situation, according to an extensive new study by Bear

Stearns analyst David Strine. Those four carriers have a combined $13.9 billion

pension shortfall, against total pension plan assets of $17.8 billion. Strine

forecasts that their likely required cash contributions to pension funds will

jump from $594 million this year to nearly $1.8 billion in 2004.

  As a proportion of forecast operating cash flow, the companies' expected 2004

pension contributions amount to 31% for Continental, 37% for AMR, 42% for Delta

and 62% for Northwest. For each, operating cash flow is expected to fall short

of the airlines' combined net capital expenditures, debt payments and cash

pension contributions. Congress may ease the airlines' crushing pension burdens

with a little "new math," but as Strine shows, stockholders have little hope of

staking a claim to these cash flows any time soon.

 

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