Year-End Rally? Better to Buy for a 3-Year Rally

Unlike some Hollywood actors, Wall Street seems to know how to follow a prepared script.

The script, in this case, called for the troubled stock market to bottom in October, just as it reached decisive turning points in Octobers of 1999, 1998, 1990 and 1987.

The rally that began last Wednesday morning kept going on Thursday and Friday, halting the market’s losing streak at six weeks. The Nasdaq composite index surged 5% for the week, which trimmed the net loss from its March peak to 31%.

Perhaps only investors whose portfolio losses for the year had been close to 40% could be delighted with a 31% loss. But it’s the trend that matters most here, of course. What investors--and particularly technology stock investors--want to believe is that the market’s direction has changed for good.

If share prices have in fact bottomed, plenty of highly compensated money managers who have been predicting an October turn ought to be feeling pretty silly. Why were they selling at the lows early last week--driving Nasdaq down 9% from Monday through the Wednesday morning low--if they were confident that the tide would be turning?

Some mutual fund managers would argue that they didn’t have much choice: Because they are supposed to close their books, for tax purposes, by Oct. 31, this month each year can become a time of almost forced trades--mainly to take losses to offset realized capital gains, so that fund shareholders aren’t hammered with a massive capital gains payment in November or December.

That’s the fund industry’s line, anyway, and they’re sticking to it. The point is, if your fund manager was going to sell Microsoft last week, would you have preferred that he or she sell at last Monday’s close of $50.38, or at Friday’s close of $65.19? Call me old-fashioned, but I’d take the higher price.

Obviously, the problem early last week was that many investors had given up hope for an October market bottom, and figured it was time to pull the plug before their losses deepened. They may yet be vindicated: There are seven trading days left in the month, and the situation in the Middle East, and thus with oil prices, remains potentially perilous.

What’s more, the fact that the Nasdaq composite index scored its third-biggest one-day percentage gain ever last Wednesday, soaring 7.8%, can’t be all that consoling to Wall Street. Eight of the index’s largest one-day percentage gains have occurred since March, but Nasdaq is still in a bear market. History has shown that bear markets often are peppered with violent, but temporary, rallies.

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If last week was indeed the start of a sustainable rally, Bill Gates’ software behemoth will get much of the credit. Microsoft’s quarterly earnings report last Wednesday was roundly cheered, mainly because of a better-than-expected sales gain. (In fact, earnings from the software business itself were actually lower than a year earlier. Only a gain on the company’s massive investment portfolio lifted net earnings.)

Microsoft, as befits a leader (or a manipulator, depending on your point of view), also tried to rally the tech troops with an upbeat forecast for sales in the current quarter and into 2001, which assumes Windows 2000 software sales will continue to pick up from what had been a sluggish debut in February.

Another tech industry leader, wireless phone giant Nokia, went so far as to move up its surprisingly good earnings report to last week, from the coming week, as tech stocks worldwide continued to sink through Wednesday morning. Nokia’s report, issued Thursday, drove its shares up 27% that day, which would be a decent one-year gain for most stocks.

On Friday, though the tech rally overall cooled significantly from Thursday, Nokia added another $1.06 to $39.19.

Lest potential buyers of Microsoft or Nokia think they’ve missed the boat, it’s worth reminding that these stocks have a long way to go before they even retake their recent peaks. Microsoft was a $119 stock last December; Nokia was a $62 stock in June.

It’s also important to keep in mind that some major trends remain at work in the technology sector specifically and in the economy in general: the dimmed appetite for personal computers, the brutal though inevitable shakeout of “dot-com” companies (which last week drove Pasadena-based technology incubator Idealab to pull the plug on its planned stock offering, which once was a sure bet to boost the base of Pasadena millionaires), and the intensifying competition across virtually all tech sectors.

The astounding availability of stock and bond financing for tech companies from 1998 through spring of this year, as investors were all too happy to fund every new idea that came their way, has created scores of new players all battling fiercely for a bigger piece of the pie in their respective markets.

If the economy is slowing, those tech-market pies could shrink as well, or at the very least not grow as quickly. No wonder the market today isn’t willing to pay the same stratospheric price-to-earnings multiples that many tech stocks sported last winter.

Barton Biggs, the veteran investment strategist at brokerage Morgan Stanley Dean Witter in New York who has been far too bearish for the last few years, naturally is feeling better about his calls these days. He still won’t win any friends among true believers in the long-term promise of tech stocks, but he made an interesting point in a recent note to clients.

Many people have compared the creation of the new technology infrastructure, such as the Internet and the wireless communications market, with the build-out of the railroad, telephone and energy infrastructures in the last century.

But as Biggs notes, “The transforming technologies of yesteryear, such as oil, electricity and the telephone, grew as government-regulated monopolies. By contrast, the build-out of wireless and the Internet are pure free-market exercises.

“For the consumer, the result may be much more dynamic growth and far faster penetration [of new services] than under the old model. That’s wonderful, but if it’s also a case of entrepreneurial capitalism run amok, it may not be so wonderful for the equity and debt owners” of tech companies.

Now, all of this is “in the market,” as Wall Streeters like to say. In other words, investors’ eyes are opened, which is why tech shares as a group still are way down from their 2000 peaks, and why there is deep skepticism about any rally--even though, historically, November and December are very good months to be betting on an up market.

The brave and the confident, however, were buying late last week, along with those who merely opt to go with the flow.

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I would argue that the challenge for every investor today is to try and look ahead not just through the end of 2000, but two to three years out. (Indeed, it may be the only way to avoid being driven nuts by this volatile market.)

Pick a stock, or a mutual fund, and ask yourself: If I buy today, regardless of what might happen to the price in the next few weeks or months, could I feel reasonably confident of earning, say, 50% on my money over the next three years?

If a 50% return over three years sounds paltry, it is only in relation to the far-above-average market returns of the last five years. Looking back 70 years, making 50% in three years--an annualized return of nearly 15%--would itself be above average.

If you can accept the idea that stock returns overall may be reverting to historical means, and 50% in three years would be appealing enough, then much of the stock market is on sale for you today. Most money managers will tell you there is no shortage of reasonably priced stocks--just a shortage of money willing to commit to them.

As for the tech sector specifically, historical returns on tech stocks now supply ammunition to both bulls and bears.

As the accompanying chart shows, tech stocks within the blue-chip Standard & Poor’s 500 index scored the biggest gains of the 11 major S&P; industry sectors in five of eight calendar years between 1992 and 1999. It was a phenomenal run, to stay the least.

The bulls argue that that performance was justified by the spectacular sales and earnings growth of the tech sector in the 1990s--and that, if you assume tech will remain the premier growth industry worldwide in this decade, returns on the stocks should lead in this decade as well.

The bears’ case is that the surge in tech stocks since 1995 has already discounted whatever earnings growth is in the pipeline for years to come.

For much of last year, the bullish argument for tech also was based on the premise that many investors had stopped wanting to own non-tech stocks, anyway. What we’ve seen this year, with sectors such as utilities, energy and health-care performing well even as tech sinks, is that investors are in fact willing to look to non-tech industries for a payoff.

I don’t think the ascendance of other sectors this year is a reason to completely abandon tech. But it should hearten investors who are willing to shop around for cheap stocks today, and who also are willing to give those stocks some time to prove themselves.

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What Wall Street Liked, and Didn’t, Year by Year

Here’s a look at how stocks of major industry sectors within the blue-chip Standard & Poor’s 500 index performed, on average, each year since 1992 and this year through Thursday. The data show that, from 1992 through 1999, the best-performing stock sector each year was either the technology sector or the financial services sector, with the exception of 1995, when health-care stocks ruled.

Source: Deutsche Banc Alex. Brown

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to https://www.latimes.com/petruno.