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Barron's(10/18) The Trader: Oil Prices Have Allies In Pummeling Share Prices

(From BARRON'S)

Alan Greenspan didn't use the term "irrational exuberance" in characterizing
the heady rise in oil prices, the way he slandered a previous bull market -- in
stocks -- in late 1996.
But the Federal Reserve chairman on Friday did cite speculators as important
drivers of the surge in crude, while attempting to reassure the public that
there's plenty of oil to quench demand and the economy can still grow nicely
given current energy costs.
Greenspan, in effect, raised the speed limit for economic growth above 55.
That is, with crude futures bumping against $55 a barrel, he said: "The risk of
more serious negative [economic] consequences would intensify if oil prices were
to move materially higher."
Stocks caught a sudden bid midday Friday as these words were uttered,
providing the proximate motivation for the indexes to rise in mechanical
fashion, recouping a modest piece of the week's losses.
The bulk of the market's slippage during the week, though, couldn't be linked
entirely to oil, which has intermittently served as the stock market's script
writer. A series of not-so-great earnings reports and the eruption of scandal
among huge insurers were the collaborators.
Possible causes aside, it's clear that the main indexes were put back on the
defensive. The Dow Jones Industrials slid 121 points, or 1.2%, to retreat back
under 10,000 and settle at 9933. The Standard & Poor's 500 Index lost 13, or
1.2%, to reach 1108, returning to a slight loss for the year to date.
The Nasdaq Composite was steadier, surrendering just 8 to hit 1911, as Intel
and Yahoo! reported earnings good enough for big-cap tech to hold its own.
The urgent question being aired constantly among investors now is whether
stocks have yet discounted the upward march in energy prices and the
somewhat-related economic slowdown. Traveling another link down the chain, it's
also not clear whether oil and the economic downshift have made their way fully
into investors' earnings expectations.
In the past three weeks, stocks have effectively made a quick round trip. The
S&P jumped 3% to a recent high of 1142 as the fourth quarter began, and then
rolled over by the same amount to reach its current quote.
In that time, with stocks effectively flat, crude prices have climbed about
10% and forecasts for 2005 economic growth have been edging lower. It could be
that stocks are attempting to price in another reversal in oil and stabilization
in economic outlook. But that's not yet knowable.
Stocks did find their footing with a little 39-point rise in the Dow Friday
amid a mixed-to-negative set of economic numbers. September retail sales
surprised to the good. But industrial production, capacity utilization and
consumer sentiment fell short. So perhaps the slowdown story has been absorbed
to a degree.
Also Friday, economist Ed Hyman of ISI Group cut his forecast for 2005 real
gross domestic product to 2.5%, citing the lagged effects of the oil surge.
Given the near-universal following Hyman enjoys among fund managers, this
tempered outlook must've been seen by a fair number of those participating in
the market's minor bounce.
The coming week will be the busiest of this earnings period, and ears will be
particularly tuned to any remarks about business conditions heading toward 2005,
perhaps even more than to clues about the fourth quarter.
Overall earnings forecasts for 2005 have held up even as those for the current
quarter were trimmed in many sectors.
Citigroup economist Steven Wieting is among the number-crunchers who believe
the prevailing '05 projections remain too high and subject to a painful reality
check.
He thinks S&P 500 companies' profits will grow 6% next year, compared with a
Thomson First Call consensus of 9.4%. Wieting's work finds the greatest risk to
'05 forecasts in consumer, financial, health-care and basic-materials companies,
with tech numbers looking achievable and energy estimates poised for significant
upside.
If the market's recent sluggishness -- along with the latest slide in the
10-year Treasury bond's yield to 4.05% -- is telling investors to cut back their
growth expectations, they don't seem to be listening.
There's now a broad sense of entitlement among frustrated professional
investors that a jaunty fourth-quarter rally is their due. That's why most
inquisitions into why stocks have stalled lately settle on a purportedly fluky
oil market, undifferentiated terrorism concerns and hesitancy ahead of the
election.
Certainly, the idea of a fourth-quarter rally could fulfill itself, especially
once earnings season and the election pass to clear the news slate. Bullish
observers point, too, to additional one-time aids to the year-end melt-up
scenario, including the combined $70 billion in cash soon to enter investors'
pockets from Microsoft's special dividend and the pending acquisition of AT&T
Wireless.
Other scenario spinners will draw you a chart of the S&P 500 in 1984-'85 and
1994-'95, purporting to show that around this time every decade stocks absorb
the reality of a slowing economy before taking off to the upside in the year
ending in five.
If only life were so easy and neat. If, as in 1994, analysts have badly
low-balled the coming year's happy results, this script has a shot. Of course,
oil spent '95 in a harmless range of $17 to $21 a barrel, there was lots of room
for profit margins to grow and we hadn't yet weathered a historic bubble. But
now, anything could anything can happen.

-- Fannie Mae has been accused, in some sense, of being penny-wise and pound
foolish. Regulators have alleged that the company massaged its earnings to hit
internal profit goals, smooth its quarterly profit path and lock in executives'
bonuses. (The company is fighting the charges.)
Now there is a growing curiosity among some investors and analysts about the
way other big financial companies manage to steer their often-complex and
volatile business to gently rising profits that nicely fit with published
forecasts.
Without necessarily a suggestion of wrongdoing, it does appear that the
'Nineties-era habit of earnings management has come in for some close study, and
is perhaps dampening the valuations of bank shares and other financial stocks.
Richard Bove, analyst with Punk Ziegel, says it wouldn't be surprising if
regulators begin poking around other financial firms "to [bring to the] surface
undesirable practices in reporting earnings."
Financial earnings, of course, always have a great deal of play in them. These
companies can freely borrow to buy securities, decide whether and when to
realize gains and losses, and take or release credit-loss reserves with wide
discretion.
More often than not, financial companies pull these levers in a way that lands
quarterly results on or just above the consensus forecasts.
Michael Panzner, head of sales trading at Rabo Securities, screened for the
S&P Financial Index members with a history of tiny variations between actual and
forecast earnings. Among those with the slimmest deviation from estimates over
the past five quarters were AmSouth, American International Group, Sovereign
Bancorp, SunTrust, Marshall & Ilsley, SouthTrust, Torchmark and Citigroup.
Of course, some of the regional banks could have rather straightforward
spread-lending businesses that are easy to predict.
What's interesting is that, unlike in other sectors, predictability doesn't
win the stocks high valuations, given that these groups trade at steep discounts
to the market. This might suggest that the market infuses a measure of
skepticism about the quality or durability of these earnings.
Sometimes, this posture becomes explicit, as with Citi's results last week.
Earnings came in at $1.02 a share, above the 99-cent consensus. But several
cents per share resulted from reversals of loss reserves due to improved credit
conditions. The stock sold off on the news. Note, too, that at 10 times expected
2005 earnings, it's among the cheapest-seeming stocks in the market.
Bove suggests that this apparently heightened skepticism toward financials'
earnings could well reduce the multiples on the stocks for a long time to come.
That's not trivial, given that financials represent more than 20% of the
market's value, and a far greater portion of its earnings.

-- The opening salvos of earnings season prompted several ad hoc meetings of
the Falling Knife Catchers Club, made up of investors who try to find plummeting
stocks worth grabbing, without losing too many fingers.
Netflix -- an object of Barron's skepticism at various times on its way from
its $15 initial offering price to its high near 40 -- lost a third of its value
to about 10 following its profit report and an alarming forecast for the coming
year.
Less dramatically, Novellus shares dropped nearly 10% on a saggy business
outlook, showing that there is still room for disappointment in the beaten-up
semiconductor-equipment sector.
Away from the earnings slate, of course, sits the smoldering pile of rubble
that is the insurance-brokerage and property-casualty group. Eliot Spitzer's
stark charges of bid-rigging at Marsh & McLennan and AIG have led these stocks
to be disgorged in disgust.
One earnings offender that's a bit cooler to the touch and may recover the
market's high regard more readily is Accenture. The big technology-consulting
and outsourcing company, formerly known as Andersen Consulting, reported decent
earnings with the help of a lower tax rate but tempered its projected profit
growth for fiscal 2005, which just started Sept. 1.
Accenture's new CEO, William Green, penciled in 9% to 12% growth in earnings
per share, down from 10% to 15%. That suggests $1.34 to $1.39, up from the
just-reported $1.24. New contract bookings are projected at $18 billion to $20
billion, implying flat-to-down performance, thanks in part to slowing
outsourcing growth.

Investors griped that the latest quarter's bottom line was lightened by an
added $125 million in incentive compensation -- which some took to mean that the
former partnership is enriching employees at the expense of shareholders.
The stock was tagged for a 12% loss to around 23.50, which qualifies as a
harsh punishment for one of the steady segments of the tech galaxy. The shares
are now a touch lower than they were in late July, when Barron's Online profiled
the company favorably.
The positive result of the sour market response is that it has lowered
expectations for a name that still enjoys excellent financial trends and now
appears more than reasonably priced. Accenture's outlook now incorporates no
acceleration in new business, and profit-margin expectations have been eased as
well.
Although the outsourcing business has softened, the decline in that business
lately seems the result of AT&T's move to exit the consumer long-distance game,
says Legg Mason analyst William Loomis.
The consulting business -- which pays quicker returns in revenue and profits
-- appears solid, with bookings up more than 20% last quarter and retaining some
momentum.
At root, Accenture is a story of recurring revenue and free cash flow. The
newly tempered guidance suggests the company will generate more than $1.5
billion in free cash flow in the current fiscal year. Accenture has a $23
billion market capitalization and no debt, making for a "free cash flow yield"
of 6.5%.
The company also has $3 billion in cash on hand, so the operating company is
effectively capitalized at about $20 billion, making the valuation look that
much better. Accenture announced a $3-billion share buyback last week, giving
shareholders some direct benefit from its strong financial position.
Accenture's price-earnings ratio of 17 on lowered fiscal 2005 forecasts
represents a meaningful discount to the IT-consulting sector average above 23.
Stripping out the cash, Accenture's business carries a P/E below 15.
The caveat to this reassuring take on Accenture is that Wall Street analysts
continue to like the stock a bit too much, with a whopping 24 Buy ratings, three
Holds and no one recommending it be sold.
On the buy side, too, it seems that plenty of money managers were "hiding" in
Accenture shares as a cautious way of participating in technology.
The question is whether last week's 12% drubbing sufficiently drained the
excess optimism from the market -- whether, in fact, this knife has yet landed.
If not, the numbers make it appear rather close to that point.

-- In addition to falling knives to catch, the market offers at least a few
rockets to chase.
Apple Computer is one of the most hotly pursued lately. Subjected to a
cautious evaluation here last week, it was noted that Apple would need to
handily beat profit expectations to keep the stock aloft.
The company beat the numbers running away, with sales of its iPod music
players coming in more than 25% ahead of forecasts, and earnings of 26 cents a
share versus 18 cents expected. The stock took off anew, rising from 39 to above
45 in a blink.
Never mind what still appears to be an aggressive valuation. The stock will
now trade as a consumer-product momentum story, with all eyes on holiday-season
iPod and iMac computer sales trends. The iPod, say tastemakers, is the hot item
on bid lists to Santa this year. For now, Apple's head start over Dell and
others has protected it from competition in the music devices.
Fans of the stock point out that there is enormous profit-margin leverage in
surging iPod sales. Others note that growth-fund investors are just now
discovering the story.
The open question remains whether Apple's market share is vulnerable here. A
bigger untested assertion -- that the iPod will generate a meaningful pickup in
iMac sales -- looms. The responses will determine how much fuel is left in a
stock that has smoked its doubters until now.
---

 

 

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