Investors Exploring Uncharted Territory
As the stock market’s rally of the last month suddenly sputters, investors face big questions about which sectors might lead, and lag, in the near term.
The biggest gains in the last four weeks have accrued to investors who bet “offensively”--bidding up depressed shares in technology, heavy industry and other sectors that would stand to benefit from an economic rebound, whenever it arrives.
But some money managers say the better strategy for investors looking to put money into the market is to play “defense”--that is, stick with sectors and companies whose earnings are likely to hold up relatively well even if the economy remains weak. Those might include drug, food, household-products and utility stocks, among others.
In the wake of Sept. 11, the only certainty in the economy and the stock market may be uncertainty. The conflict in Afghanistan and the threat of more terrorism on U.S. soil have left many investors feeling that trying to predict the economy’s next turn is futile.
Indeed, that is the message many companies have given in their third-quarter earnings statements.
“Who out there has analyzed a situation like this before? Nobody,” said John Forelli, portfolio manager at Independence Investment in Boston.
The defensive camp got a lift last week as the market’s rebound since the terrorist attacks fizzled. The market had rallied for three consecutive weeks after diving the week of Sept. 17, when trading resumed following the attacks.
But last week the Standard & Poor’s 500 index fell 1.7% and the Nasdaq composite index lost 1.9%.
Technology stocks still are among the S&P; 500’s biggest winners measured from Wall Street’s lows the week of Sept. 17 through last week. For example, QLogic Corp., Jabil Circuit Inc. and JDS Uniphase Corp. have soared more than 40% each in the last month.
But the market leadership tug of war may have turned last week: Health-care and consumer-staples companies (such as makers of household products) held up better than most other sectors as the broad market declined.
Among mutual fund sectors tracked by Morningstar Inc., the average technology stock fund fell 4% last week while the average health-care fund eased 1%.
Some strategists say the market overall may have rebounded too far, too fast as post-Sept. 11 losses in key indexes were fully recouped by Oct. 12.
Part of the bounce was expected after stocks fell drastically in the first few days after the market reopened. But many investors appear to have been looking past the economy’s valley without considering how deep and wide it may be, some pros say.
“When we erased all of the losses and got back above the [Sept. 10 levels], I kept asking myself whether the market overreacted,” Forelli said. After all, he noted, “Looking at it economically, most companies are worse off than they were a month ago.”
That has been evident in third-quarter earnings reports.
“The profit outlook keeps getting gloomier,” said Sam Stovall, senior investment strategist at New York-based S&P.;
About half the companies in the S&P; 500 index have reported their results, according to earnings tracker Thomson Financial/First Call in Boston. Though many companies are posting earnings above analysts’ expectations, First Call’s research director, Charles Hill, notes that those expectations had been dramatically lowered in the first place.
Analyzing the reports, Hill said First Call finds “nothing positive about the [data], and certainly nothing positive enough to indicate any signs of a coming upturn in earnings.”
First Call now estimates that final operating earnings for the S&P; 500 will show a 22% decline from the third quarter of 2000.
No Slackening in Profit Warnings
What’s more, the pace of corporate warnings about weaker earnings in the current quarter shows no signs of slowing, Hill said.
Last week, companies such as Microsoft Corp. and Corning Inc. either met or exceeded third-quarter profit expectations, but warned that results this quarter will fall short of already depressed estimates.
Bullish investors take the view that this year’s earnings should simply be written off, and that there are good reasons to be optimistic about a profit rebound in 2002 for battered sectors such as tech and heavy industry.
The Federal Reserve’s nine interest rate cuts this year, and the government’s massive economic stimulus package, should foster a recovery next year, optimists say.
“A lot of investors feel that we can spend our way out of this,” Stovall said.
Because the stock market typically looks six to nine months ahead, this is the time to be aggressive in the market if you believe an earnings revival is certain next year, the bulls say.
But the risks are too high to justify an aggressive approach, Stovall and others argue.
“We’re advocating a semi-defensive approach,” he said. S&P; is suggesting that clients emphasize health-care and consumer-staples stocks, two sectors considered relatively insulated from economic swings.
Among the stocks S&P; rates highest currently are drug maker Merck & Co., soft drink giant Pepsico Inc., Hershey Foods and retailer Home Depot.
Adds Forelli: “We’re paying a little more attention now to things like dividend yield, being a little defensive and not necessarily looking for the next growth story. We’d rather invest in a company where we have a high degree of confidence in their earnings rather than try to catch the inflection point with [a tech stock such as] EMC Corp., for example.”
He said he has added to his holdings in insurance giant American International Group Inc., which took an immediate hit after Sept. 11 but has since pared that loss. Despite its exposure to the World Trade Center disaster, AIG is expected to earn about $2.81 a share this year and $3.46 in 2002.
Finding Comfort in ‘Steady Earners’
Forelli said other “steady earners” he likes include consumer products maker Johnson & Johnson and drug maker Pfizer Inc.
But he also considers some heavy-industry names to be attractive. He likes Dow Chemical Co. in part for its annualized dividend yield, currently 4%. In a weak market, a high dividend can help support a stock’s price, he noted.
Some portfolio managers say they’re still comfortable with a more aggressive approach.
Ron Muhlenkamp, who manages the value-oriented, Pittsburgh-based Muhlenkamp Fund, said he lightened up on tobacco and food conglomerate Philip Morris Cos., whose stock has held up well this year.
Muhlenkamp said he recently has bought shares in auto parts makers Delphi Automotive Systems Corp. and Superior Industries International Inc., and in other companies that fall under the heading of “consumer cyclical” or “consumer discretionary”--meaning demand for their products ebbs and flows with the economy overall.
“We had thought the bottom for the economy was going to be in September, but the terrorist attacks basically pushed back the clock a few months,” he said. “Now it looks like the bottom might come at around Christmas. Consumers will start spending first, and then corporations will follow. That’s typical coming out of a recession.”
Thus, Muhlenkamp said, he’s investing in names he expects to rebound first in an improving economy.
But that doesn’t yet include many technology names, he said. “They may get interesting in six months,” he said.
Along with consumer cyclicals, Muhlenkamp said he also has added to his financial sector holdings, such as Citigroup Inc., and to his stake in Cendant Corp., whose varied franchises include real estate and tax-preparation firms.
The financial sector should benefit from the steep decline in interest rates, Muhlenkamp said, while Cendant, whose shares slid 38% in the first week of post-attack trading, got “especially cheap,” he said.
