Has Rapid Rise Pushed Stocks to Value Limits?
When the stock market reopened after the terrorist attacks, some individual investors believed it was their patriotic duty to buy shares.
They were met in the market by institutional investors who believed it was their fiduciary duty to sell shares.
The sellers dominated the week of Sept. 17, producing one of the worst declines in Wall Street history.
But nearly two months later the buyers have more reason than patriotism to brag about their actions: They have doubled their money on many stocks since that week, as the market has bounced back much more strongly than expected.
Last week, the Dow Jones industrial average became the last of the best-known indexes to recoup all of its post-attack losses. The Dow ended Friday at 9,608.00, up 3.1% for the week and 2.5 points above its close on Sept. 10.
Major market indexes have risen between 13% and 29% from the three-year lows reached Sept. 21 after five days of heavy selling.
Those returns are respectable enough for a two-month period, even considering the high risks involved in buying during that week. Remember, it is only in hindsight that it looks easy to have been committing new money to stocks at the time. Great fear gripped the nation and Wall Street. It seemed probable that more attacks on the scale of the Sept. 11 ones were imminent.
Many of the investors who waded into that gloom to pick out individual stocks wound up snaring prices that must have been absurdly cheap, if the stocks’ performance since then is an indication.
A buyer of telecommunications-chip maker Broadcom Corp. on Sept. 21 would have paid $23.98 a share at the end of the day. The stock has since surged 82%, to $43.73 as of Friday.
Affymetrix Inc., whose systems analyze genetic data, closed at $14.50 on Sept. 21. It has rocketed 107%, to $29.99 as of Friday.
Cisco Systems Inc., the preeminent computer networker, has jumped 59% since Sept. 21, from $12.09 to $19.20.
Outside technology, health-maintenance organization PacifiCare Health has nearly doubled since Sept. 21, rising from $11.06 to $20. Discount brokerage Charles Schwab is up 59% in the same period, and retail giant Wal-Mart is up 23%.
But the market, of course, is a never-ending story. For now, the people who bought into the post-attacks plunge look like geniuses, and the sellers look like they were giving shares away at any price, just to get out.
If the market collapses to new lows in the months ahead, the sellers naturally will be viewed as the smart money.
The intensity of the market’s rebound, and the rally’s resilience in the face of much more bad news over the last two months (mounting layoffs, crumbled corporate earnings, anthrax attacks, etc.) is both comforting and troubling to many investors.
There remains a strong sense of disbelief that stocks have climbed as far as they have. Both bulls and bears wonder whether prices have risen too quickly.
Early on in the rally, pessimists argued that stocks were gaining largely for technical reasons--for example, because “short sellers” (traders who had borrowed stock and sold it, correctly betting on a decline in prices) were buying stock to close out their bearish bets.
But short-covering, as it’s called, can’t explain more than a portion of the rally. In fact, the total number of shorted shares outstanding on Nasdaq fell only 2.5% between mid-September and mid-October, Nasdaq data show. That suggests there was no massive rush by short sellers to close out their positions in that period. (Mid-November data won’t be available for about two weeks.)
The popular wisdom is that the market is foretelling that an economic recovery will start by mid-2002. But it’s worth remembering that, since March 2000, every broad market rally preceding the current one proved to be a false alarm--and a better time to sell most stocks than to buy.
Consider: The Nasdaq composite index surged 41% between April 4 and May 22 after plummeting in the first quarter. That beats the current rally, which has seen the index rise 28.5% from its Sept. 21 closing low.
After May 22, the Nasdaq swooned again for most of the summer. The bottom line: A buyer at the tail end of the spring rally, when the index reached 2,313.85, would still be down 21% today with the index at 1,828.48 as of Friday.
Indeed, the market’s gains since Sept. 21 are of only mild consolation to millions of investors who bought stocks earlier in the year, or have just held tight all year. Despite the rebound, most individual stocks and stock mutual funds still are deep in the red year to date.
Broadcom shares are off 48% for the year. Affymetrix is down 60%, and Cisco 50%.
The average diversified U.S. stock mutual fund is down 16% year to date, according to Morningstar Inc. That’s an improvement from the 26.2% average loss as of Sept. 21, but it still leaves 2001 on track to be one of the worst years ever for stock funds--unless the rally continues to gain steam.
Nonetheless, if the choice is between a 16% loss and a 26% loss, most investors wouldn’t have too much trouble deciding.
The important question today, as always, is the one posed by market strategist Jay Pelosky of brokerage Morgan Stanley in a note to clients last week: “What’s in the price?”
In other words, how much of an earnings recovery has already been priced into stocks?
The danger is that some stocks may have reached price-to-earnings valuations that won’t allow for further price gains in the near term, because investors will collectively decide the stocks already reflect all of the potential good news of any 2002 economic recovery.
And if a stock stops going up, gravity can take over. Rather than simply holding at a certain price level until corporate earnings catch up to the price, a stock that is viewed as having peaked can suddenly find itself the target of heavy profit-taking, as short-term traders move on to something more likely to continue rising.
(Yes, “momentum” investing still is a hot game in the market. It clearly didn’t die with the technology stock peak of March 2000.)
But judging what is a fair stock price remains an art rather than a science. Broadcom is a case in point: On average, analysts polled by Thomson Financial/IBES expect the company to lose 33 cents a share this year and lose 13 cents a share in 2002.
So investors who pay attention to fundamentals can’t even figure a price-to-earnings ratio for Broadcom. If they’ve been buyers in recent weeks they might have based their decision on one of these expectations:
* Broadcom’s losses will narrow in 2002 and the company will be profitable later in the year, attracting more investors’ interest.
* Broadcom’s long-term earnings potential is stellar, justifying a higher stock price.
* Broadcom’s price momentum since Sept. 21 showed a pent-up demand for the stock that could take it higher in the near term regardless of the fundamentals.
Buyers who bought based on the last item listed above are merely playing the momentum game, which also is known as the greater-fool game: “I’m a fool for paying $43 a share for this stock, but there’s a bigger fool out there who will pay $50 in a few weeks.”
In any market rally it’s impossible to separate the demand that is solely momentum-based from demand that is driven by the fundamentals. One feeds the other.
Yet with every new advance in this rally, the question of fundamental value will become more important. Even many momentum investors are unlikely to forget the pain inflicted on those who overpaid for technology stocks in 1999 and early-2000 and then held on.
There will be limits to what sober investors will pay for stocks, even assuming the economy recovers significantly in 2002. The longer the current rally continues, the greater the likelihood that the hottest stocks will start bumping up against those limits.
But many market pros argue that it’s more dangerous to underestimate the potential still in the market. “Risks remain,” says Sung Won Sohn, economist at Wells Fargo & Co. “However, less risk exists now than earlier this year when prices were higher and economic stimuli were limited.”
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How Stocks Have Gained: A Sampling
Technology, financial and industrial stocks have led the market advance since Sept. 21. Here’s a look at how some stocks have fared, analysts’ consensus estimate of earnings per share (EPS) for the companies in 2002, and the stocks’ price-to-earnings ratios (P/E) based on estimated 2002 earnings.
*--*
Gain Ticker Fri. since Est. 2002: Stock symbol close 9/21 EPS P/E Broadcom BRCM $43.73 +82% -$0.13 NC Intel INTC 27.88 +44 0.57 49 Oracle ORCL 15.38 +43 0.47* 33 Citigroup C 48.30 +33 3.30 15 GE GE 40.41 +29 1.61 25 3M Co. MMM 111.54 +28 4.76 23 Du Pont DD 42.77 +27 1.63 26 IBM IBM 114.08 +26 4.83 24 Alcoa AA 34.99 +24 2.05 17 Wal-Mart WMT 55.10 +23 1.71 32 S&P; 500 index 1,120.31 +16% 55.44 20
*--*
NC -- not calculable because of expected loss
* for fiscal year ending May 2002
Sources: Bloomberg News, Thomson Financial/IBES, Zacks Investment Research *
Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to www.latimes.com/petruno.
