Stock
Market Still
Adjusting To Realities
by Alexander Paris, editor
The Alexander Paris Report
The general environment of uncertainty has clearly been impacting the stock market, especially the technology sector. It took a long time for technology stocks to finally reflect that valuation reality that rising interest rates mean lower P/E's. Additionally, the further into the future investors have to look to justify the current valuation on a stock or sector, the more devastating the impact of higher interest rates. So, it was no wonder that the technology sector in general, and Internet stocks in particular, were hit the hardest. The current uncertainty regarding the economy and the Fed had added to the pressure with another reality. Uncertainty equals risk and risk means lower valuations.
The Earnings Reality
The
most important newer reality to which the technology sector,
especially, is now adjusting is lower earnings growth. If the
central bank of the nation is determined to reduce economic growth
to a non-inflationary rate, is it so difficult to conclude that
the growth in corporate profits will slow as well? Sounds simple
enough, but for a long time, technology investors ignored that
reality, believing that the technology sector could breeze through
unscathed. But, technology stocks, for the most part, are also
cyclical stocks. If the Fed will ultimately be successful in
slowing consumer spending, and it won't quit until it does, it
means slower purchases of cellular phones, computers and the
array of new digital consumer electronic products. That, in turn,
means less demand for semiconductors, other electronic components,
and all the other ingredients of the final product. If it gets
bad enough, capital spending by the electronics and telecommunications
industries will slow, as well.
To drive the lesson
home, technology investors have recently been subjected to a
number of warnings from such technology leaders as Nokia (NYSE
NOK) and Ericsson (Nasdaq ERICY) that cell phone demand
and revenue growth will be slowing in the second half. Semiconductor
industry stocks have been hit by pronouncements from Wall Street
of slower growth ahead. Computer shipments slowed in the second
quarter.
Actually, the shift
in market emphasis to earnings concern began in June. Our concern
had been that investors were so focused on the short-term what
the next Fed move might be or celebrating its success in slowing
the economy and obviating another rate increase, that they were
not reflecting the impact of that success on earnings. The market
started to correct that oversight in June. Technology stocks
were very strong in June, continuing to ignore the earnings reality.
But relative strength patterns in the rest of the market were
clearly indicting some discounting of lower future earnings growth.
Defensive stocks, those whose earnings are least sensitive to lower economic growth, gained considerable relative strength in June. Consumer discretionary spending stocks, on the front line of the Fed assault, were especially weak and were discounting perceived lower consumer demand ahead. Industrial stocks were also very weak, with over half of the 20 related S&P indexes in the worst-performing quartile, with absolute price declines of 8% or more. Importantly, the concern is not simply about what the future effect of the Fed policy will be on economic growth. Earnings are already being negatively impacted by higher interest costs due to the higher rates and rising material and labor costs that cannot be passed along due to the tighter Fed policy. Actually, that is exactly the Fed's goal to make it difficult for companies to pass inflation down to the consumer. As discussed in last month's issue, before the summer is over, investors may even start questioning whether Greenspan can indeed engineer a soft landing.
Two-Tiered Bear Market
We
hesitate to use the B-word at this late date, but it appears
that we are in a two-tiered bear market. Over the past few years
we've had a two-tiered economy old economy versus new economy;
a two-tiered stock market technology versus non-technology; two-tiered
valuations with record high multiples on the new economy stocks
and record low multiples on much of the rest of the market; and
a two-tiered market between large and smaller stocks. Why not
a two-tiered bear market? The old economy stocks have already
been in a bear market for well over a year and are in the process
of trying to build a bottom. The bear market in new economy stocks
only began this year and that sector is still searching for a
bedrock bottom. As discussed above, they have only recently begun
to reflect upon the possibility of lower earnings growth, while
still grappling with proper valuations. Actually, this conclusion
is not very new on our part. We've already dwelled on the various
dualities in the market and economy for some time in a number
of publications. We've also talked about the market gradually
returning to normal this year.
Old Economy Bear
Market: We also wrote frequently that the old economy stocks
have already been in a long relative, and in many cases, absolute
bear market since the Fed began tightening over a year ago. Their
valuations have been compressed both due to the direct impact
of higher interest rates and to discounting their eventual impact
on the economy and their earnings. This has been especially true
for non-technology manufacturing stocks. They already had what
amounts to their own recession as they bore the brunt of the
Asian economic crisis. They were hurt by lower exports to depressed
overseas economies, by the sharp rise in imports because of the
strong dollar and by inventory liquidation among distributors
and OEM customers during the post-Asian crisis period. More recently,
their earnings have been hurt by negative currency translations,
higher interest costs and rising material costs. Much of this
was going on while the new economy stock market was booming.
Investors in the industrial stocks could clearly say, We don't
worry about a bust, we lost money during the boom. So, we
don't worry much about Old Economy stocks. Sure, they will come
under some pressure from a weak technology sector, which has
become a key swing factor in investor sentiment and confidence.
But the downside risk in most Old Economy stocks is relatively
limited. Most are grinding along the bottom and looking for the
right conditions to begin looking over the economy valley. At
worst, they may just be boring.
Technology Bear Market
The
technology bear market is much more problematic and it is not
over. The excesses have been substantial, and as mentioned, investors
have only recently been exposed to the possibility that earnings
of even the healthy large technology leaders can be pressured
in the period ahead. The Internet sector, the area of the most
excesses, has already been severely pounded. This has been especially
true of the secondary issues. Since there are still no signs
of any profits on the horizon for most of them, they are still
not cheap by any sense, only cheaper than what they were. We
suspect this will be a primary target of tax-loss selling as
we enter that season. We also wonder how investors will react
to increasing numbers of Internet companies going out of business.
One very prominent Internet analyst at a major firm recently
estimated that at least 30% of all publicly traded Internet stocks
will be bankrupt, or be acquired at $1 to $2 per share and that
75% will disappear. We have frequently compared the Internet
bubble to a major commodity top. Both traded up primarily on
pure speculative supply and demand with current fundamentals
taking a distant back seat. When a huge market rise takes place
and a commodity finally peaks, it means that supply/demand has
changed. The tendency of traders is to buy in the first dip with
very painful results. Rather, they should have simply sat back
and waited for supply and demand to again come into balance,
a process that usually takes a long time. That has been our advice
with Itnernet stocks. The very large Internet stocks, such as
Cisco (Nasdaq CSCO), Oracle (Nasdaq ORCL) and others
have held up much better because they have had earnings, but
they are still richly priced and earnings have now been called
into question going forward. Long-term fundamentals are still
great for many technology sectors, but the market may be challenging
for a while yet.
Editor's Note: Alexander
Paris is editor of The Alexander Paris Report, 161 North Clark
Street, Suite 2950, Chicago, IL 60601. Monthly, 1 year, $195.
Telephone (312) 634-6370, Fax (312) 634-6350. With over three
decades of experience, Alexander Paris is one of the best known
and well respected economists and investment strategists in the
business. The Alexander Paris Report provides a no nonsense analysis
of economic and political events and trends and their implications
on domestic and world economies. In addition, Mr. Paris spotlights
several stocks which he expects to outperform the market.
Mr. Paris founded Barrington
Research Associates, Inc. and Alexander Paris Asset Management,
Inc. Barrington Research Associates, Inc. is a brokerage firm
which provides economic and investment research to institutional
investors, including most of the leading mutual funds, banks,
pension funds, insurance companies and other professional investors.
Alexander Paris Asset Management is a registered investment advisory
firm specializing in small and mid-cap growth stock investment
management.
