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Lots Of Movement Below A Calm Surface

(From BARRON'S)

Like a satellite photo of the ocean, a flat stock market gives an illusion of calm that's often belied by an up-close look.
The market, in aggregate, was static last week, with the headline indexes making a virtual round trip. But underneath that apparent inaction were some dramatic moves in several important sectors.
The Dow Jones Industrial Average slipped a mere 10 points on the week, 0.1%,
to settle at 10,785. The Standard & Poor's 500 index sagged nearly 4 points, or
0.3%, to hit 1201. And the Nasdaq Composite, again underperforming, lost 18, or
0.9%, to finish at 2058.
Pretty sleepy action. Unless, of course, you had a big bet on the banks or
brokerage stocks, which lost more than 3% each on the week amid a nasty selling
storm in the bond market.
Federal Reserve Chairman Alan Greenspan's suggestion that short-term interest rates will continue their upward march -- and his avowed confusion over still-low long rates -- helped send the 10-year Treasury note yield from 4.09% to 4.26%. The carnage was exacerbated Friday with a greater-than-expected rise in core wholesale inflation. That qualifies as rather violent one-week move for the government-bond market.
So, the week was pretty deflating, then -- unless, of course, you had loaded up on oil or drug stocks, both of which sprinted ahead. The major oil stocks as a group surged 3.9%, led by a big 6% climb in ExxonMobil shares to a new high.
In the process, Exxon vaulted ahead of General Electric to become the largest stock in the market at $383 billion in equity capitalization.
The ebullience in the major oils suggests burgeoning institutional rotation into a group that's generally under-owned by professional investors, and in which there are a mere handful of very large stocks. Chart experts will tell you the energy sector is overbought for the short term, but in the way that genuine bull markets sometimes get a bit ahead of themselves.
As for the drug stocks, they popped Friday in a news-driven move that hinted at some relief from their regulatory and legal challenges. An FDA panel cleared Merck to return its painkiller Vioxx to the market in limited fashion, and allowed Pfizer's comparable Celebrex to stay on pharmacy shelves.
There's a seeming desire among investors to hear that the drug stocks are safe
again, and there have been a couple of "false spring" rallies in the sector on its way to underperforming the S&P 500 by 15 percentage points over the last year. If, indeed, the news continues to get "less bad" for Big Pharma, investors' thirst for stability and the stocks' hefty dividend yields could well support them.
If that happens, look for other health-care shares to suffer the brunt of the shift. As the near-vertical charts of Aetna and Wellpoint suggest, fund managers have been using the HMOs to provide much of their health-care allocations, in effect hiding from the tricky drug names.
Of course, there's always more going on at the individual stock and sector level than on the surface of the indexes. Still, the degree of rotational activity last week stood out.
The question is what, if anything, it means.
Without drawing too many grand inferences from a few days' ticks, the pullback
in financial stocks -- if it persists -- and the continued sluggishness of technology could weigh on indexers. Those two sectors account for more than 35% of the S&P 500 market value.
Energy, meanwhile, represents 8%. Other recently strong groups -- such as materials and utilities (at least until Friday's bond selloff) -- combine for just 6%. Those are some pretty small horses to expect to pull along the whole market.
That would be consistent with the idea that this is a maturing, narrowing bull
market that won't necessarily spread its rewards as broadly as it did the past two years.
That said, expect the bulls next week to derive encouragement from the fact that the broad market has, so far, weathered the backup in bond yields without much damage. A benign consumer price index report Wednesday could also allay the direst Fed-related fears of stock traders.
After all, the market is only 2% from a new high, and it wouldn't be like bullish-leaning traders not to give another run at it before long.

-- Evaluating the investment merits of Fannie Mae and Freddie Mac was tough
enough when the variables were generally financial. It was necessary to take a
view on interest rates, the yield curve, hedging strategies, not to mention the
relative eagerness of the mortgage-finance duo to shoulder risk.
Now, though, the fate of Fannie and Freddie shareholders is largely in the hands of politicians and regulators, thickening an already soupy fog that shrouds the companies' future. By the evidence of the stock action late last week, a number of its stalwart shareholders may have sold into the dimness.
Fannie shares dropped 7% from Wednesday through Friday, to 58.90, after they had already slid from 71 at the start of the year. Freddie also fell 7% in from Wednesday on, to 61.73.
The latest trigger was Greenspan's comments to a Congressional committee, in
which he recommended sharply curtailing the size of the companies' mortgage
portfolios, perhaps to a small fraction of their current size. This would mean
shrinking their balance sheets and likely eliminating the prospect of profit growth for some time to come.
Congress is considering various restrictions on Fannie and Freddie, meant to reduce the concentrated financial risk of their huge portfolios.
There is a small but passionate short-selling community that continues to gun for much lower prices in these stocks, based in part on the prospect of a potential derivatives blowup.
Numerous smart and patient value investors have stood in opposition -- so far
wrongly -- sticking by Fannie and Freddie amid loud attacks on the companies,
bond-market tumult and the departure of Fannie CEO Franklin Raines.
The stocks' valuations long ago lost their growth premium, indicating that the
market didn't believe the stated earnings were either fully real or sustainable.
Otherwise the shares wouldn't trade at multiples of official 2005 profit forecasts as low as the current eight and nine.
Fannie is already shrinking itself, buying back billions of its debt, allowing mortgage holdings to run off its books and bidding less aggressively for new paper. This has helped agency-bond investors. And a voluntary reduction in the companies' targeted profit-growth rates could in fact work to shareholders' advantage, too.
But for shareholders now, the burning question is what the real and future earnings base of the company will be. Is the stock dirt cheap, or are the companies about to have their capacity to grow permanently taken away?
That's something that won't be answerable until the interplay of Congressional
horse trading, lobbyist maneuvering and regulatory rhetoric plays out.

-- Apparently, having a former chief executive defending himself in court isn't always a bad thing for a company.
MCI, of course, is being courted by both Verizon Communications and Qwest Communications, even as its former CEO Bernard Ebbers is on trial for federal
fraud charges.
And Tyco International has regained its one-time status as a Wall Street darling, while former CEO Dennis Kozlowski faces state larceny and securities fraud charges in New York. The stock is up 25% in the past year and has tripled since its panic low in early 2003.
At this point, apparently, to know Tyco is to love it. The affection is evident in the 16 of 18 sell-side analysts who recommend buying the shares, with the other two urging investors to hold it.
Tyco has also won over the professional value-investing fraternity, with the shareholders' list top-heavy with some of the most accomplished value seekers
(Capital Research & Management, Legg Mason Funds, Davis Selected Advisers and
Wellington Management among them).
Does this imply, then, that all the good news is out and all the big money already in?
Perhaps, although it may just mean that any further upside in the stock will come more grudgingly and will require the company to deftly transition from a restructuring posture to growth mode. The company's annual investor meeting
Tuesday will indicate whether the company can make the case that it's doing just
that.
The impressive ascent of Tyco shares -- to 33.61, down from a high above 36
late last month -- have come as CEO Ed Breen has sold some weaker businesses,
dramatically cut the debt load and won the confidence of the Street.
Last week's announcement that chief financial officer David FitzPatrick would retire and be replaced by Christopher Coughlin was taken in stride by Wall Street, a sign of how far investors have come in trusting Tyco, the former perpetrator of aggressive accounting.
With a market capitalization of $67 billion, Tyco is now valued just over 17 times forecast earnings of $1.97 for the fiscal year ending Sept. 30. (Tyco last week affirmed its own projected earnings range of $1.88 to $1.98 for the year).
In fiscal 2006, profits are forecast by analysts to grow by 16%. That places Tyco's valuation a bit below the elite industrial conglomerates such as General Electric, 3M and Honeywell International, but it is in line with the broader group.
John Snider, co-portfolio manager of Tyco holder TCW Galileo Large Cap Value Fund, says Tyco's free cash flow generation is a big reason to stick with the stock. Free cash flow -- or cash generated beyond required interest and capital-spending needs -- should hit $4.5 billion in the current year, the company said. Snider thinks that can grow to $5.4 billion next year and $6 billion in fiscal 2006. He notes that well-run industrial conglomerates with leading brands (such as Tyco's) tend to be capable of 12% to 14% earnings growth during economic expansions.
Though free cash flow was a bit below expectations in the latest period, Snider says that frequently occurs at Tyco in its first quarter, related to working-capital needs.

The business mix at today's Tyco is concentrated in electronics, health-care and fire/security products, in roughly equal proportions, with smaller units in engineered products (tubes and valves and such) and plastics.
The betting among shareholders is that Breen is satisfied with the current portfolio of businesses, even if the divisions bear no intuitive connection to one another. Though it continues to pare debt, the company has $3.4 billion in cash and is entering a phase in which it will start to scout for add-on acquisitions. Big, ambitious deals, though not very likely, would probably spook the market.
As for Tuesday's meeting, the Street is looking for Breen to emphatically state that he's staying at the helm, given recent talk that he might be a fit for the vacant top job at Hewlett-Packard. The new CFO, Coughlin, will be introduced and his background at Interpublic, Pharmacia and Nabisco extolled.
Beyond that, there's little suspense on financial guidance now that the company reiterated its projections last week. But Breen's statements and body language on acquisitions, further divestitures and other strategic matters will be in focus.
Given the upbeat sentiment surrounding Tyco, it stands to be a friendly audience -- but one that arrives with already-high expectations.

-- Once more back to the theme of the corporate breakup, an underrated way to
create value often lost amid the excitement over lavish mergers.
When empire builders start to liberate distant provinces, all parties often benefit. The researchers at Spinoff Advisors in Chicago attempt to value the parts of pending corporate breakups, while trying to handicap future spinoff candidates.
The idea is to identify big companies that have an underperforming division that could be profitably set free via a stock offering or spinoff to shareholders. The firm recently came up with a half-dozen prospects, none of which has stated an intention to unload any businesses.
The companies and the lagging divisions are: Abbott Laboratories and its diagnostics group; Cendant and the vehicle-services business; Fortune Brands' office-products unit; General Dynamics and the marine-systems division;
Honeywell and its specialty-materials business; and Textron and the fastener unit.

-- The homebuilding stocks might be responsible for more broken keyboards and
shouted curses in short sellers' offices than any other group of stocks.
For more than two years the term "housing bubble" has been the two-word bearish thesis on these stocks, which tend to feature fat short-interest levels and just as many momentum investors happy to take the other side. Over those two years, the Philadelphia Housing Index has risen about 125%.
The stocks have recently suffered a minor setback. And an influential bullish analyst, Stephen Kim of Smith Barney, downgraded the group to a neutral stance
this month. The verdict is hardly in, and the skeptics can't declare victory until new-home demand enters a deteriorating trend, or Treasury yields continue last week's steep ascent.
But a popular arbitrage idea -- one that so far hasn't been profitable -- could act as a sort of stealth, safer short position in the housing group. The trade involves playing the spread in the two share classes of homebuilder Lennar.
Lennar's share classes are identical except that the A shares have no voting rights, which are only available in the B shares. Yet the A trades at about a $5 per share premium despite their non-voting status, or close to a 10% premium at recent prices. In theory, voting shares should be worth a bit more, but the A shares are much more liquid and are a component in the S&P 400 Mid Cap index.
Since it was described here in late 2003 (The Trader, Nov. 3, 2003), the spread has stayed static, meaning it's been dead money for arbs.
Yet Jonathan Blumberg of Ronin Capital thinks the trade is now worthwhile. He
notes that the spread tends to widen when the stock rises, and contracts in
downturns. This way, shorting the A and owning the B to capture the spread would
likely be profitable if the stock were to collapse with the homebuilder group.
The other way the spread could narrow, or be eliminated, would be if the company
elected to eliminate the separate classes. Insiders generally own the
lower-priced B shares.
Any braver housing bears, of course, could always short just a bit more B
shares than the A they own. At the risk of broken keyboards, of course.
---

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