Barron's The Trader: Market's Patience With The Fed Lasts Seconds
(From BARRON'S)
By Michael Santoli
As long suspected,
patience is an under-appreciated virtue on Wall Street. The
Federal Reserve's statement that it could afford to be "patient"
in leaving
interest rates at accommodating levels provided a ready selling excuse
for
traders, giving a shove to a market that had already been looking wobbly.
The
Fed's move to extol "patience" rather than assure steady rates
for a
"considerable period" pulled market expectation of an eventual
rise in
short-term rates into the first half of the year.
The intemperate reaction to the verbiage change -- a 141-point drop
in the Dow
Jones industrials in heavy trading on Wednesday afternoon -- showed
investors to
be more reflexive than reflective. One could argue that the market has
more to
fear from an environment where the Fed sees no call to hike rates, even
if such
a move would lower the penalty on risk aversion that has helped draw
money into
stocks. The post-statement reaction might have said less about investors'
fear
of a Fed tightening, per se, than about the market's extreme comfort
that it had
all elements of the environment figured out.
These elements include a briskly expanding economy, surging corporate
earnings, generously low interest rates stretching to the horizon and
ample cash
available to keep stocks aloft. All remain in place for the moment,
though the
choppy, emotional character of the market so far in 2004 may suggest
that
traders are beginning to anticipate the moment when one or more of those
tailwinds expire.
The release of the
first estimate of fourth-quarter gross domestic product
Friday also gave pause, coming in at a more-than-respectable 4%. That
was well
below the median 4.8% forecast and even farther below the numerous calls
for
5%-plus. The result was a choose-your-poison sort of week, with equal
and
opposite opportunity for investors to worry about a deceleration in
the economy
or a more aggressive Fed preparing to get less stimulative.
The final damage was hardly severe when viewed through the major indexes.
The
Dow slid 80 points, or 0.7%, to 10,488. The Standard & Poor's 500
settled back
10 points, or 0.9%, to 1131. The Nasdaq, though, dropped by 57, or 2.7%,
to
2066, buckling under some concerns about the semiconductor-production
cycle.
The tally is in for the month of January, which many market participants
cling
to as a good harbinger of what the entire year might bring. The softness
in
stocks over the past two weeks wasn't enough to offset earlier January
gains,
leaving each index a bit higher for the New Year. The Dow is up just
a scant 34
points and the S&P 500 ahead by less than 2%, hardly decisive margins,
though
the Nasdaq is up 3%. If the so-called "January barometer"
fails with the year
delivering negative returns, it'll be the second straight year of false
signals.
The fairly gentle meanderings of the indexes so far in 2004 belie some
drama
below the surface. A rolling series of sector retreats have occurred,
some
hitting leading groups such as semiconductors (down more than 8% in
the past
three weeks) and the Morgan Stanley Cyclical Index (down 4% since Jan.
21 and
flat on the year).
On Wall Street, where
the word "pullback" is rarely voiced unaccompanied by
the modifier "healthy," expectations of a period featuring
sideways-to-down
consolidation have been widespread for weeks.
Jim Paulsen, chief strategist at Wells Capital Management, remarks that
"a
cautiousness still remains in the equity market" among many who
believe the past
year's run-up has come "too far, too fast."
It's true that, to hear professional investors speak and to look closely
at
their knitted brows, there is a reserve of anxiety present in the market's
emotional makeup right now. It's also the case that short-selling activity
edged higher, ever so slightly, in the month ended Jan. 15.
But while anxiety is evident in words and body language, the expectations
embedded in stock prices don't exactly suggest an excess of caution.
And,
partially offsetting any sense of generalized worry is the other sort
of fear --
of missing another rally phase.
Valuations are a lousy timing tool, one of the worst. But they work
well to
identify the particular alloy of hopes and beliefs of which stock prices
are
constructed. They are high by nearly any measure.
Value Line's long-lived market model last week arrived at a yearend
forecast
for the Dow of 9,400, a decline of more than 10% from the present level
--
despite Value Line's expectations of 11% earnings growth and only a
slight
uptick in rates. The catch is valuation, which Value Line says seems
already to
reflect likely profit advances.
Cliff Asness of the
quantitatively driven investment firm AQR Capital, cuts
through some of the Street's sophistry about stock multiples on forecasted
earnings, which are often compared to historical multiples of trailing
earnings
to make them appear less elevated. Right now the S&P trades at more
than 18
times projected 2004 earnings. The median P/E on forward earnings since
the
advent of consensus earnings forecasts in 1976 has been 12.1, he reports.
Again, valuation is a crummy device to handicap short-term market moves,
which
can be swayed by simple demand for stocks and the perceived improvement
in
fundamentals. Stock funds have pulled in nearly $22 billion in the last
four
weeks, a rapid pace even for January.
Earnings season has lived up to the publicists' hype, with S&P profits
rising
24% on a market-cap-weighted basis in the fourth quarter, based on 60%
of
companies having reported. And profit margins are stretching toward
the all-time
record levels reached in 2000. For the moment, that latter point is
being taken
as a positive sign of wonderful productivity advances rather than a
suggestion
that things can hardly get much better in terms of profitability --
especially
if companies ever resume hiring.
With only shallow declines having occurred since the March low, there's
considerable conjecture in the market regarding what might ultimately
spark a
real setback for the indexes, the kind accompanied by fear rather than
relief at
getting lower entry points.
Like Hollywood story editors conjuring movie plot points, some have
suggested
that a truly strong employment report could, counter-intuitively, do
the trick,
by compromising the productivity theme. Others are looking to the pending
initial public offering of Internet search firm Google to provide the
poetic
peak of enthusiasm.
Of course, there's a reason they only charge $5 in New York storefronts
to
predict the future -- it can't be done. But knowing where expectations
are
clustered today is possible. And using today's oversubscribed notions
to gauge
where the market is susceptible to surprises is a first step toward
getting
ahead of the curve.
A rise in interest rates, as noted, won't likely startle the market,
even if
the timing and possible impact of a rate hike are subjects for an ongoing
taffy
pull among the opinion makers. A slowdown in earnings growth is a forgone
conclusion, even if the consensus is downplaying how that might affect
stock
prices.
But politics is one area where the collective market opinion seems very
lopsided and vulnerable to a scare at some point, if challenged. All
available
evidence suggests that Wall Street professionals overwhelmingly believe
President Bush will gain a second term in November. In informal surveys
of their
fund-manager clients, ISI Group and Banc of America Securities both
recently
found that 90% or more believe Bush will win fairly easily.
But it makes sense to expect that, over the course of a long and eventful
presidential race, momentum will appear to shift at least temporarily
against
the president. Whether this would be enough to send a bolt of fear through
the
market isn't clear, but the steep tilt of current investor opinion leaves
open
the possibility. (Never mind, for now, the argument as to whether one
candidate
or another would be better for stocks and the economy; perception is
all in the
short term.)
History offers a loose precedent here. In 1992, with a Democrat running
against an incumbent President Bush, investors initially gave Bill Clinton
slim
chance of winning. And when Clinton's prospects were seen to be improving,
Wall
Street went into a minor tailspin.
As Clinton gained ground in the polls after Labor Day, the market sank
in part
on investor fear that he might dislodge the senior Bush. The S&P
500 fell 7% in
less than a month beginning in mid-September 1992, with politics taking
part of
the blame -- especially in a one-day selloff Sept. 22 when Clinton grabbed
a
21-point lead in the polls.
This nervousness is ironic in retrospect, given the 'Nineties bull market
that
soon took flight. And the surface parallels between that campaign and
this
year's contest don't mean they're predictive of market reaction, let
alone of
the election.But it pays to know what Wall Street has installed firmly
in its
worldview, just in case the news flow starts to disagree with it.
-- A bit of trading-desk wisdom holds that the easy, obvious move almost
never
works. For a small example of this maxim at work, look to the shares
of
Tupperware, which had been seized upon by investors seeking out big
beneficiaries of the weakening dollar.
For such a deeply ingrained American brand, Tupperware has one of the
largest
exposures to foreign sales of any major company. The maker of plastic
food
containers alarmed the market in September with a warning that North
American
sales would drop 30% in 2003, as an abortive experiment in selling its
goods at
Target stores crimped recruitment at its signature sales parties. The
stock
crumpled from 16.50 to around 13.
That was just about the time investors began focusing on companies whose
results would get a boost from the translation of foreign sales into
less
valuable dollar. Tupperware, with more than 60% of last quarter's sales
from
outside North America, jumped to the top of the list every time companies
were
screened for overseas exposure. Not coincidentally, the stock soared
46% from
Sept. 30 through early last week.
Then, last week,
came another disappointment. North American sales again
sagged in the just-reported fourth quarter. The currency aspect of the
stock
trade worked, of course. Total sales were up 21%, but up just 1% excluding
currency impact. Yet that wasn't enough to prevent an earnings shortfall,
and
the stock again was hammered, losing more than 8% on the week.
This suggests the behavior of the dollar -- which bounced hard last
week,
incidentally -- shouldn't be the driving reason for owning a stock.
As for
Tupperware's fundamentals, they aren't exactly exciting, but arguably
could be
in the process of bottoming. Recruitment of new sales associates ramped
up in
recent months and more efficient manufacturing processes are in the
works,
though neither is expected to immediately boost results.
The company placed earnings guidance for 2004 at $1.20-$1.30 per share,
versus
82 cents in 2003. That means the stock is trading at a modest 14 times
earnings,
though some discount for the company's recent tendency to disappoint
might be
warranted.
Contrarians should be encouraged that it's a smallish stock in a prosaic
industry at a time when small-cap investors are showing a taste for
more flash
and sparkle. And Wall Street pretty well ignores the company, with six
analysts
and no Buy ratings, according to Briefing.com.
Some sharp value investment firms dotted the Tupperware shareholder
list, at
last report. Cash flow remains healthy. And, most tangibly, Tupperware
now
carries a stout 5% dividend yield at recent prices, which at least should
provide valuation support. Not to mention cash.
-- The market has produced a bounty of "Can you believe that?"
performances
over the past year, with stocks once left for dead taking flight in
seeming
defiance of logic and gravity.
If there were a Bemusement Index to measure this sentiment among those
professionals who cling to healthy skepticism and valuation discipline,
then it
might be hitting new highs right now. They spend time calling other
trading
desks -- and even financial writers -- to share their disbelief about
the action
in such bottle-rocket stocks as Taser International (see page 34) and
Nanogen.
One current assault on these pros' sense of propriety is the puzzling
activity
in the shares and warrants of Redback Networks, an alumnus of the
telecom-equipment bubble that emerged from bankruptcy protection last
month to a
fevered reception by traders.
A quick look at a quote screen shows the shares trading around 8.70.
Yet
changing hands over the counter are two classes of warrants, priced
at an
eye-crossing premium to the stock itself.
One warrant that confers the right to buy a share of Redback stock at
$5 goes
for 10.50; another the lets the owner buy a share at $9.50 fetches 9.75.
Just to
be clear -- the pricing of the warrants implies a willingness by some
"investors" to, in effect, pay $15 to $20 for the same share
of Redback that's
available on Nasdaq at less than $9.
This hasn't gone unnoticed by market watchers on the lookout for signs
of
heedless, speculative mushy-headedness, which are sprinkled throughout
the
seamier neighborhoods of the market. The Redback situation qualifies
by that
standard, though a small part of the distorted move seems shallowly
rooted in
reality.
When Redback was preparing to emerge from bankruptcy, it issued more
than 95%
of its new shares to creditors, leaving former shareholders with a mere
sliver
of their former equity stake. The company effected a 1-for-73 reverse
stock
split. Then it gave approximately one of each of the above-mentioned
warrants to
investors in the original common stock for each new common share they
owned. In
other words, for every 73 old shares, roughly one of each warrant was
given out,
as a gesture toward shareholders who were otherwise largely wiped out.
Understandably, there was sizable short interest in the stock. Bankrupt
companies' shares frequently go to zero or very close to it. Speculators
and
some owners of Redback debt securities shorted the stock, thinking it
was a sure
bet, as it almost was. When the warrants were thrown into the mix, market
sources say that in order to cover their trades, short sellers were
asked to
deliver not only the shares they'd borrowed, but the attendant warrants
as well.
Thus there was some forced buying of relatively scarce warrants.
Still, fund managers involved in the stock insist that a short squeeze
alone
fails to account for the monstrous misvaluation of the warrants, which
--
predictably -- have become catnip for the day-trading types playing
the upward
move. The warrants ought to carry some added "time value"
since they can be
exercised to buy a share of Redback for $5 or $9.50 any time over the
next seven
years, but nowhere near the premium they now carry.
The obvious question is why owners of the warrants aren't collecting
their
windfall by dumping every one of them while the nuttiness persists.
Some traders
claim warrants are being withheld to create a further squeeze. Others
wonder
whether many shareholders aren't even aware they received the warrants
for what
may have been a long-forgotten stock holding.
But maybe the best answer is that the warrants were received by the
sort of
people who would hold on to a stock through a bankruptcy, until it was
diluted
by 95%.
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