| Barron's
The Trader: Drop In Rates, Oil Quotes Spurs Rebound In Stocks
(From BARRON'S)
An
equity trader could've finished in the money last week without keeping a single
stock quote on the screen, just by watching the pulsating ticks in crude-oil futures
and Treasury-note yields.
Buying when those numbers were falling was a profitable
reflex, which
indicates Wall Street's present absorption with the essential
macroeconomic factors of monetary liquidity and liquid gold.
The ebbing of
oil prices following vows of new supply from the
Organization of Petroluem
Exporting Countries and the downtick in bond yields after some tame inflation
and economic data left clear the upside path for stocks, which have now bounced
more than 3% in the last eight trading days.
Or, at least, that was the proximate
excuse for the latest bout of buying. Others who think economic numbers are only
for government bureaucrats and lazy journalists will say that stocks had sold
off too steeply, important index levels held, transport stocks never sank to meet
the broad market and investor sentiment had gotten too negative for stocks not
to rebound. The buying was done before a largely inconsequential, lightly traded
Friday session ahead of the three-day weekend. But four days' work was enough
to boost the Dow Industrials by 221 points, or 2.2%, to 10,188.
The Standard
& Poor's 500 gained 27, or 2.5%, to land at 1120. The S&P has essentially
rebounded to the halfway point from the low end of the compressed range it's occupied
all year, spanning from 1080 and 1160. For all the to-and-fro, high hopes and
grand pronouncements swirling about the market in 2004, neither the S&P nor
the Nasdaq has strayed even 1% from year-end 2003 levels. The Dow is down less
than 3%.
It's an easy call to say that, to most, it has felt more eventful
than that.
For one thing, the low-volatility environment that has prevailed
for months has caused small moves to seem significant, like a 10-degree drop in
temperature in Miami that has locals donning parkas.
Below the calm surface
of the indexes, there has been a strong enough undertow for investors to lose
plenty in individual stocks.
Going into last week, Smith Barney strategists
had calculated that the average decline from their 2004 high of stocks in the
S&P 1500 (encompassing large and small stocks) was 16%. The average drop from
their 52-week high was 18%, so there's a good chance that plenty of investors
are looking at a flat market year to date and feeling neither lucky nor smart.
This also shows how a market with slim index losses can qualify for an oversold
bounce.
For professional investors, the market hasn't been particularly accommodating,
either. Through Thursday, every category of large-cap stock funds was trailing
the return of S&P 500 index funds this year. The
large-cap core funds average -- the one most comparable to the S&P 500 and
the group with the most assets, at almost a half-trillion dollars -- had returned
0.4%, less than a third of the index funds' total return.
This helps explain
why the most commonly uttered remark on Wall Street these days might be: "Tough
market."
Worsening the confusion is the broad perception that the market
sits at multiple inflection points -- poised to shift from monetary easing to
tightening, from economic acceleration to deceleration and perhaps from disinflation
to rising inflation. Reasonable men, and even black-box trading systems, can disagree
on how the scenarios might play out; thus the lack of conviction and constant
looking over one's shoulder.
Until Friday, four of the latest five big economic
data releases arrived slightly weaker than expected, including the revision to
first-quarter gross domestic product that showed less inflation and damper final
demand than before.
This moderation in the numbers and the resulting firmer
bond market apparently sent investors dreaming lustily of Goldilocks, that temptress
of the temperate 'Nineties economy who made things "just right" for
equity owners.
Such dreams are the stuff that bullish market forecasts are
made of. They animate the consensus view that the economy will cool, but to a
comfy pace, and that rates and inflation can rise gently without compromising
this year's bonus.
The mini-streak of softer economic figures was interrupted
Friday by a hefty rise in the Chicago Purchasing Managers Index, a gauge of Midwestern
manufacturing, which defied forecasts of a decline by jumping to a 16-year high.
This indicator is significant mostly as a foreshadowing of the national ISM manufacturing
numbers, due Tuesday.
The ISM is probably the most important timely measure
of economic momentum and breadth (though not the magnitude of improvement). It
correlates almost flawlessly with the quickening of corporate profits, the outperformance
of economically cyclical stocks and the amplitude of stock-market returns. The
ISM is still expected to tick lower. Even if it doesn't, it's at levels that have
always meant that a peak is near.
Those investors with aggressive expectations
for further upside in stocks might wish for another burst of acceleration in economic
growth, rather than a bond-friendly slowdown. And it may take a hotter-running
economy to drive big upside profit surprises in late 2004 and early '05. Many
market observers compare today's investment backdrop with that of 1994-95, during
which interest rates jumped. But, remember, S&P 500 earnings for all of 1995
came in 20% higher than had been forecast as late as September 1994.
That
helped power stocks higher in the teeth of sharply higher rates.
Yet it hardly
seems that Wall Street is deeply underestimating the profit outlook today. The
rate of upward revisions to one-year forward profit forecasts versus downward
changes has spiked to levels that have usually represented a peak. Pretax corporate
profit margins are also at historic highs, just as hiring has picked up and wage
pressures are building.
The broad measure of business profits in last week's
GDP data showed a
sequential decline in earnings from the fourth quarter,
on a seasonally adjusted basis, while the annual rate of increase slowed rapidly.
Even if earnings merely match current forecasts, they'll show solid double-digit
percentage growth in the second half and next year and could provide support for
stock prices.
But at some point, analysts will probably overestimate how
good the good times can get. If that happens soon, in a market addicted to robust
earnings gains, the heady forecasts of 20% upside for equities won't have much
of a chance.
Leaders of the Pack
Some inspectors of
the indexes' latest upward blip have been going down their checklists and nodding
approvingly.
Several elements that market handicappers like to see have been
present, including broad upside participation. The sectors that have taken the
lead also are prompting some analysts to give this advance the benefit of the
doubt and propose that it could carry on for another few percent.
Semiconductor
stocks are the EKG of the market's speculative metabolism, and they have shot
ahead by 7.5% since May 20, as measured by the Philadelphia Semiconductor Index.
Retail shares, barometers of economic conviction, have also been standouts,
helped last week by solid profit reports from Home Depot, Lowe's and Costco.
Less remarked upon are the regional- bank stocks. The Regional Bank HOLDRs, a
traded basket of the stocks, is up 7% since May 10, the day the 10-year Treasury
yield first hit 4.8%. The yield began receding toward the current 4.65% a couple
of days later. The participation of bank shares is widely understood to be crucial
to the health of any rally, and so far they are holding up their end.
Each
of these groups will need to run through a steeplechase of obstacles to hold or
build on their recent winnings, even before the earnings-warning season begins
in earnest later in June.
The semis stretched their two-week gains Friday
after Novellus offered a cheery outlook for chip-equipment demand. For the moment,
that good news has been taken as good, and not as a worrying sign of future capacity
growth and supply pressures on the chip business.
The sector index, though,
remains nearly 13% below its January peak. And, notably, the Semiconductor HOLDRs,
the exchange-traded fund tracking the chips, saw one of the largest decreases
in short interest in the month ending May 10.
That implies the recent gains
have been more than short-covering. But it also suggests that one chunk of latent
buying demand is gone.
Thursday afternoon brings Intel's mid-quarter update,
always hotly anticipated even by Wall Streeters who try to conjure riches from
estimates of Intel's gross margins and its CFO's verbal inflections. If strong
share prices persist ahead of the news, it will raise the threshold of satisfaction
for Intel partisans.
Also note that Smith Barney is hosting its semi industry
conference Wednesday and Thursday, where every stray utterance by a chino-clad
executive will be conveyed via cell phone to trading desks.
As for retail,
the stocks are suggesting that the cooling of consumer spending lately is a mere
stutter-step before another pickup and not the start of trend.
Yet veteran
trader and financial author Michael Panzner points out a close relationship between
consumers' preference for adjustable-rate mortgages and retail-sales growth. The
most recent Mortgage Bankers Association data showed 32% of all mortgage volume
in April were ARMs. The past two times ARMs hit the 30% level -- November 1999,
and before that in late 1994 -- it coincided with the peak in year-over-year percentage
gains in retail sales.
The relationship seems to be that when consumers are
eager to minimize their monthly payment (and shoulder interest-rate risk) by taking
out floating-rate debt, they're a bit strapped and need to slow their spending.
If nothing else, it offers one other reason to watch the mortgage data.
As for regional banks, the calming of the bond market has helped, to say the least.
And the rising volume of takeover chatter has also excited some buying while no
doubt dissuading some would-be sellers and short players.
Last week, BB&T,
the North Carolina bank, was caught up in takeover gossip that went unconfirmed
and uncommented upon by the company. The stock jumped 2.55, to 37.68, on heavy
volume, even as some analysts downgraded the stock saying it's fully valued barring
a buyout.
Perhaps the stocks' recent sneaky move higher means the market
is betting that violence in the bond pits will subside for some time to come.
Friday's employment report will help settle the wager.
A Quality
Product
When a new investment product debuts, it's usually safe
to guess that the launch is meant to seize on a hot market trend -- one that's
bound to cool before long. That's just the nature of marketing in a business where
a product's "time to market" is often longer than the duration of investment
themes.
A refreshing exception to this rule showed up last week, an exchange-listed
fund that will employ a strategy boasting a fine long-term record but that's been
out of favor for most of the rally off the March 2003 low. It hits the scene just
as the winds seem to be shifting back in favor of this quality-based strategy.
The closed-end fund goes by the clanging name, S&P Quality Rankings Global
Equity Managed Trust, and its shares trade on the American Stock Exchange under
symbol BQY. It is an actively managed fund that uses S&P's quality ratings
of stocks, a tool that has produced excellent risk-adjusted returns since it was
created in the 1950s.
These ratings run from A-plus to D grades, and are
based on a simple but durable evaluation of 10 years' earnings growth and stability,
dividend growth and stability and total sales. As noted here in February of last
year, from 1986 through 2002, all A-rated stocks beat all B's by 2.4 percentage
points a year, and A-plus stocks handily beat the S&P.
As if on cue,
once these results were made public, one of the great
low-quality feeding
frenzies in history was touched off. Cheaper credit and a shift from losses to
profits among financially strapped companies meant that companies rated C and
below gained 62.3% in 2003. B-rated stocks returned 31.9% and A's delivered 24.6%,
underperforming the S&P 500's 28.7% total return.
Higher-quality stocks,
though, still retain their strong advantage over the past three, five, 10 and
15 years.
This outperformance by financially shakier companies is most closely
reminiscent of the 1992-1993 period, when accommodative debt markets and a strong
acceleration in the economy also swung investor attention on the most cyclically
and financially leveraged stocks.
Add S&P researchers to the list of
those who believe a distinct rotation toward higher-quality, lower-risk stocks
is at hand. These stocks fare better when corporate earnings growth is decelerating.
And high-quality shares now trade at a discount to lower-rated ones, contrary
to the historical premiums they were afforded due to their stability.
There
are quality ratings for some 3,400 stocks, essentially every one with 10 years'
worth of data. Of those, about 2,400 are rated B-plus or higher, making for a
big and cumbersome list to digest for any stock picker. The closed-end fund, managed
by BlackRock Advisors, will run those 2,400 stocks through a quantitative model
to focus more tightly on the most solid and highest-yielding issues.
The
idea is to own 60 to 90 names, using real-estate-investment trusts to gain dividend
income and allocating around 30% of assets to non-U.S. stocks in S&P's international
quality rankings.
Investors who buy the fund now that it's already trading
will have avoided the 4.5% sales charge from the initial offering but will pay
1.12% a year in fund expenses. That's not insignificant, but if the active managers
don't squander the inherent advantages of buying quality, it would be well worth
it.
---
|
|
