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Barron's The Trader: Late-Summer Bounce Continues


Being late is the same thing as being wrong when it comes to stocks. That
unforgiving truth is a source of great anxiety right now for investors and
traders as they try to figure out what the market knows and when it knew it.
In a week when Wall Street returned to work in earnest, observers across the
sentiment spectrum could find reason to wonder whether the market had already
factored in their expectations while they were on the beach.
An investor convincedthat oil prices have seen their highs and the election
result will be market-friendly might similarly wonder if the latest four-week
bounce means the market already figured all that out.
Another who's certain that the coming corporate earnings season will
disappoint might ask whether stocks' weakness in July and early August amid
strong profits had already digested this prospect.
Last week's activity wasn't quite dispositive on these questions, with a
jumble of encouraging and cautionary signals vying for attention.
The Dow Jones Industrial Average gained 52 points, or 0.5%, to 10,313. The Dow
underperformed the broader market largely due to the drag of Coca-Cola, down
5.5%, and Alcoa, off 6.5%, both on reduced profit expectations.
The Standard & Poor's 500 gained 10, or 0.9%, to reach 1023, a 10-week high.
The Nasdaq surged 49, or 2.7%, to 1844, as a powerful upward reversal in the severely underwater semiconductor group carried most technology shares higher.
The rebound off the Aug. 13 low, which preceded a peak in alarmism about oil
prices, has now carried the S&P 500 to a 6% gain in four weeks. For an index
that has occupied the range of roughly 1060 to 1160 since mid-December, that qualifies as a significant move.

A comparison with the two prior rallies off interim low points (set in March and May) offers some perspective on where the current bounce ranks.
The rally from the March low lasted two weeks and amounted to a 5.8% move. The
next bounce took six weeks and covered 6.5%. That places the current move right
around the average magnitude of the prior two and right at the average duration.
And, notably, each of these rallies has topped out at a lower point than the
prior one.
But of course, the moment the market starts to appear predictable, it
rediscovers its tendency to confound.

Aside from the record of prior moves, the available evidence allows for
plausible arguments that both bulls and bears might pursue as part of internal
dialogues as they try to divine what's already discounted in stock prices.
The case for more upside would point largely to the recent market action
itself. Last week's gain could pass for resilience in the face of nasty terrorism talk and some worrisome corporate news.
Semi stocks -- which play on the id of investors -- jumped 7% following a
wretched 30% decline, in the face of a belated brokerage-house downgrade of the
sector Tuesday and a bad-but-not-terrible outlook from Texas Instruments. Nokia
added upside oomph to the sector by raising its sales targets after having
lowered them serially this year.
The Dow Transportation Average ended Friday on a new 52-week high, usually a
positive economic smoke signal. Bank stocks never joined the broad market at a
new low and have remained firm. There was some trader excitement last week, too,
that the S&P surmounted its 200-day moving average.
Less concretely, optimistic investors were looking to play a political
perception game, front running an anticipated electoral rally based on the idea that the market at least believes it prefers a George W. Bush win.
The negative stance rests largely on what may well become a sloppy
third-quarter earnings season. The tenor of earnings-forecast revisions has
worsened. Yet it's still not clear that the downside surprises in broad economic
measures and the upside shock of strong oil prices through most of the quarter
are yet reflected in the numbers.
The hurricanes and balky consumer-spending patterns have also raised the
stakes for companies to recoup business in the final three weeks of September.
That very same surge in semi stocks, in fact, could be spun as a cautionary
sign, indicating a stubborn instinct to treat hope as an investment strategy and
to buy only in fear of missing a rally.
The above-mentioned anxiety of professional investors trying to out-anticipate
the market is, no doubt, intensified by their generally disappointing
performance this year.
Large-cap "core" stock funds -- the category with by far the most assets and
the closest in style to the S&P 500 -- is trailing the 1.33% year-to-date return
of S&P index funds by more than two percentage points. Hedge funds as a group
are up in the low-single digits this year.
Their managers face the prospect of not getting paid this year, forcing them
to buy puppies rather than ponies for their kids' birthdays. The prospect of a
few thousand hedge funds watching the year tick away and operating in their
two-minute offense makes the job of handicapping the market that much harder.
For nonprofessional investors not held to artificial calendar-year performance
benchmarks, the story remains largely as it has all year. Stocks have gone
nowhere and thereby gotten less expensive without being demonstrably or broadly
cheap. Dividends from mature companies are more plentiful but only marginally
more appreciated than in years past, offering a head start for long-term gains.
And the math governing equity returns still suggests that they'll be modest
for several years to come -- meaning any forceful rally yearend may well borrow
from what 2005 might offer.

Scrutinizing Models

It might as well be taped inside the lid of every market strategist's briefcase: The theory of the Fed model, always handy when better reasons to buy stocks are elusive.
This intuitive stock-versus-bond valuation model is a staple of market commentary, having the twin virtues for stock salesmen of utter simplicity and a tendency to make stocks look like bargains.
The model compares the 10-year Treasury note yield to the inverse of the S&P 500's price-earnings ratio. "Fair value" is supposed to reside at the point
where the yields are equal. Last week's dip in the yield below 4.2% was
accompanied by an increase in such chatter, showing stocks to be a yawning 40% undervalued.

The Federal Reserve noted this relationship in the 1990s and inadvertently
conferred legitimacy on a simple algebraic relationship that launched a thousand
investment pitches. Barron's over the years has helped to propagate it.
Yet an overdue measure of critical scrutiny of the model's logic and utility
is now being applied by some investment professionals. The work of AQR Capital's
Cliff Asness in debunking any theoretical substantiation for the relationship
has been detailed here occasionally in the past.
It shows that, while low interest rates (and inflation) coincide with periods
of high P/E multiples
, they don't justify them or predict good future returns
for stocks. Absolute trailing P/Es are far better gauges of value.
Some Wall Street eminences have taken up the issue. Morgan Stanley's Byron
Wien recently wrote an admirable and thoughtful essay examining his own
long-employed stock-bond model in light of Asness' work.
And just last week Smith Barney's Tobias Levkovich questioned the Fed Model's
usefulness as a valuation and timing tool. He notes that in the 1981-1996 period
covered by the Fed's original study, the statistical measure of the model's
predictive ability (called R-squared) was reasonably strong, at 0.77 on a scale
of zero to one.
But since 1960 to now, this measure came in at 0.5. Since 1997, the model has
been half as good as a coin toss, at 0.24. Rates, obviously, are but one
ingredient that make stocks taste better or worse.
This shouldn't be shocking given that bond yields have fallen from 6.5% in
early 2000 to the current 4.2%, even as P/E multiples have contracted
It could be, in fact, that the only days of the Fed model's practical value
were during the erstwhile two-decade bull market in stocks and bonds. This
period saw virtually uninterrupted disinflation, falling interest rates and
stock-multiple expansion.
The Fed model, perhaps, worked as a means of telling which outer leg in this
three-legged race had gotten too far behind the other and was due to catch up.
All this doesn't mean the market can't rally. But if it does, it won't be
because the bond market told stocks they were cheap.

Tale of Two Middlemen

To thrive as one of the stock market's wholesale middlemen, it's necessary to
be huge, smart or both. Executing stock trades is a fragmented and exceedingly
competitive business, with prices charged to trade a share often reaching
fractions of a penny.
Two of the smaller firms trying to thrive via smarts and servers are Archipelago Holdings and Knight Trading.
Archipelago, a fast-growing electronic stock exchange, recently debuted as a
public company and has quickly attracted the fancy of investors. Knight, a
calloused veteran of the 'Nineties boom, has been largely neglected by the buy
Born in 1997 and backed by several Wall Street firms, Archipelago is technically a stock exchange and executes some 25% of all order volume in Nasdaq-listed stocks. The firm was the first "alternative trading system" to link all major trading venues on one platform. It completes about 85% of all trades by "matching" orders internally between investors in its system, sending the rest elsewhere for completion.
The company went public Aug. 12, pricing its shares below its expected range
at $11.50. Since then, firmer markets and delayed investor enthusiasm have
driven the stock up 32% to 15.
Profitable since 2003, Archipelago is on pace to earn just under $1 a share
for 2004. Rich Repetto, analyst at Sandler O'Neill, last week launched coverage
of the stock with a 2005 earnings forecast of $1.11.

With $3.37 a share in cash, the Archipelago business, ex-cash, is valued at
less than 11-times forecast 2005 earnings. That's comparable to the valuations
of similar operations such as Instinet's electronic trading network (ECN), says
Repetto. He deems the stock a Hold.
Now that the stock has run up so far, so fast, the looming unanswered
questions involve Archipelago's ability to navigate the brutal economics of the
execution business and potential new regulatory rules.
Transaction fees represented $251 million of Archipelago's $275 million in
first-half revenue, with $24 million coming from sales of quote data and a
negligible amount from fees paid by companies to list their shares on the
Archipelago received an average transaction fee of 0.35 cents per share from
investors using its system to trade by accepting posted bids and offers.
The SEC's current project reviewing market structure, called Regulation NMS,
includes proposals to cap such transaction fees at 0.1 cents per share.
Another concern: Archipelago's minority owners -- including brokers Goldman
Sachs, CSFB and Merrill Lynch -- accounted for 40% of its volume. Those firms
sold shares in the IPO and could reduce their commitment further.
And Archipelago is also intent on winning more outright stock listings from
companies who would otherwise pay to be listed on the NYSE or Nasdaq. To do so,
it plans to ramp up spending on advertising and other branding initiatives. This
remains a long-shot proposition.
All these risks were detailed in Archipelago's IPO documents, so the stock's
enthusiasts are betting that the firm's well-regarded management can continue
its knack for staying a step ahead of the industry's fast-evolving trends.
One opportunity is for Archipelago to use its new currency to consolidate the
industry, most notably by merging with Instinet or just buying that company's
ECN business, says Repetto.
In contrast to the market's willingness to bank on Archipelago, suspicion
pervades Knight Trading.
A Nasdaq market-maker and asset manager, Knight rode the online-trading
bonanza of the late-'Nineties by handling the torrents of orders from
discount-brokerage clients. Management made arrogant public statements about its
purported no-lose trading techniques. The firm eventually agreed to fines to
settle allegations it mishandled customer orders.
Though top management is entirely new and Knight's practices have changed for
the better, the firm still carries a taint among investors. Its shares have
fallen below 9 from 16 early this year. Part of the story is the steady slide in
retail trading volumes and low stock-market volatility, which may or may not
revive any time soon.
Yet Knight's shares are now being viewed by some investors as a low-risk value
play and a potential beneficiary of a buyout some time down the road.
Knight handles 15% of all Nasdaq-listed share volume. Much of that is still
from discount brokers. But the firm is also expanding its share of
institutional-order flow, currently about 2.5%.
The other part of the business is the asset manager Deephaven, a hedge-fund
group that manages $3.2 billion in relatively steady, arbitrage-type strategies,
and has a 15-year record of strong risk-adjusted returns.
Knight -- with a $1 billion market value and $230 million in reported cash on
hand as of June 30 -- has a $200 million investment in Deephaven and earns 50%
of its income. The firm sold its options-trading business to Citigroup last
month for $225 million in cash. Knight retains its 7% stake in the International
Securities Exchange options market, which is about to go public.
The bull case goes on like this: Knight is now extremely conservative, taking
minimal trading risks. The market-making business earned a small profit in one
of the slowest quarters in years, this year's second, and has leverage to busier
or more jumpy markets. Net of its cash, the stock trades at less than 10-times
forecast 2005 earnings. And the company announced recently it will buy back $160
million in stock, or some 15% of its shares.
One important risk is that Knight may decide to use its armored balance sheet
to make a major acquisition. Another is that the pace of trading trails off even
more amid broad investor apathy.
Yet recent converts to the stock think it preferable, and more likely, that at
some point Knight's new, shareholder-focused management may elect to sell for a
double-digit share price to a player who thinks it smart to get much bigger in a



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