OCTOBER 19, 2000
NEWS ANALYSIS
Herd on the Street | Earnings aren't bad so why are investors stampeding? Partly it's the dot-com correction. But this wild volatility could be over in a few weeks
| Who needs Coney Island when you've got the stock market? Talk about roller-coaster rides. Before 10 a.m. on Oct. 18, the Nasdaq had dropped to 3026, almost 200 points from where it had closed the night before. That same morning, the Dow Jones industrial average dropped more than 430 points from 10,086 to 9,656 and the Standard & Poor's 500-stock index fell 45 points from 1350 to 1305. By the end of the day, it was as if nothing had happened. The Nasdaq was at 3171, a mere 42 points off the previous day's close, the Dow was at 9,975, off 114 points, and the S&P had rebounded to 1342, just eight points off.
These aren't the biggest single intraday swings any of these indexes has experienced this year, and they're puny by interday standards. But volatility is clearly on the rise. According to a study by the economists at PaineWebber, from 1940 to 1999, the average movement of the Dow from the close of one day to the close of the next was 0.61%. In 2000, that number jumped to 1.2%, or 60 points. From 1971 to 1999, the Nasdaq's average day-to-day movement was around 0.67%. So far in 2000, daily swings have averaged 2.5%, or 120 points. What's going on? "We attribute this increased volatility to an information overload," says Tracy Eichler, investment strategist at PaineWebber. "We're getting lots of information, but how much real insight?"
Add to that the greater volumes that accessibility of information creates, throw in an increased number of investors, a more sensitive investor psychology, and a stock market environment of valuation correction, and stand back. The result is a herd instinct in the market that seems to jump at every little nuance in the news as it is trying to reassess market values. The force of the herd pushes stock prices to extremes, producing short-term buying and selling frenzies. The good news is that if underlying fundamentals are good, the market eventually snaps out of its panic, and the market readjusts to where valuations are fair. The bad news is that we probably have a few more weeks of rough riding before the stampede is really over.
FOUR FACTORS. The information that has sent investors into various tailspins lately can be summed up in the four E's: earnings, energy, the euro, and the economy. All of these are important factors to weigh in assessing stock market values. Oddly enough, none of them are particularly damaging if you take the long view. It's the short view that's jolting.
Earnings disappointments roiled the market for the third week of October. Case in point: IBM's Oct. 18 announcement that its revenue growth was a bit slower than expected. Not that revenue growth was flat, or heaven forbid, in decline. Big Blue's supposed "bad news" was earnings growth of 20% on 3% revenue growth. Analysts expected the first number -- but thought the second one was going to be higher. Next thing you know, the Dow had dropped 433 points.
Never mind that of the 182 companies in the S&P that have reported third-quarter earnings so far, 58% have reported better-than-expected results, according to First Call data. Only 9% reported worse-than-expected results, and 32% came in right on target. And so far, third-quarter earnings are up 12% over second-quarter earnings. That's hardly a recession scenario.
Looked at that way, the market's reaction to IBM starts to look silly. "The market has priced in perfection for the long term, and when it gets anything else, the bottom falls out," says Marci Rossell, chief economist for Oppenheimer Funds. It's true that by Oct. 18 of last year, 75% of companies that had reported earnings had given an upside surprise, but a full 23% had worse-than expected surprises, and only 3% came in on target. So what's the big deal now?
A big part of the problem is that the market still isn't over the egregious overvaluing of dot-coms that began in October of last year. "In any other valuation environment, people would not be worrying about a recession," says Rossell. "But when valuations hit the peaks [they hit in January], anything less than fabulous [earnings reports] causes these fears." Once it began revaluing stocks in March of this year, the Nasdaq and the Dow started doing the loop-de-loops that are still churning investors' stomachs. "The volatility we're seeing now is typical of a late-stage correction," says Charles Reinhard, senior U.S. strategist at Lehman Brothers. "In the 1960s, we saw an 18% correction over a 26-week period. This time we've got a 15% correction in the middle of the 30th week of a correction."
RATE CUT AHEAD? So if earnings aren't all that bad, do worries about a slowing economy or rising energy prices mean nothing? Most economists think it merely means the Fed has achieved its soft landing. It looks like gross domestic product grew at a respectable 3.8% for the third quarter, according to Reinhard. As for inflation, he points out that the core consumer price index numbers have risen only 2.5% year-on-year, even though last month's number of 0.3% came out a tenth of a percent higher than people were expecting. "The CPI numbers are a little worrying," acknowledges Oppenheimer's Rossell. "But I think it's topping out."
The bond market is so convinced of the soft landing that it is already pricing in a Fed easing for early next year. The Fed Funds Futures for March are at 6.3%, vs. the actual Fed Funds rate of 6.5%. "When they hit 6.2%, it increases the chances that the Fed will reciprocate [by cutting rates a few tenths of a percent]," says Jerry Wang, market strategist at Chicago-based Schaeffer's Investment Research.
Instability in the Middle East remains troubling, but economists are pretty sure that oil prices will still drop by the first quarter of next year. The stock market's response to this threat has so far been fairly fickle. "The Middle East was last week's problem," says PaineWebber's Eichler. "They announced a cease fire, and the market rallied for six minutes."
Even the weak euro is unlikely to cause a lasting problem for investors. On the earnings front, only about 7% of reported earnings will be affected by the euro this quarter, and 9% next quarter, says Eichler. It's true that European funds flowing into the U.S. drove the rally from October, 1999, to December, 1999, but with the last couple weeks of sliding values, U.S. stocks are attractively priced once again. So it's likely that foreign funds are going to resume flowing this way.
BOTTOM-FEEDERS' DELIGHT? Unsubstantiated though they may be, the worries about the four E's aren't dissipating, so investors can expect continued volatility. And the bottom may not have been reached yet. "Since the beginning of the boom, the Dow has traded in channel with a 40% volatility top to bottom, and the Nasdaq with 60% volatility," says Harry Dent, president of the Harry S. Dent Foundation. "That means the bottom of the Dow channel is in the upper 7000s, and for the Nasdaq, it's around 2100 to 2300." While it may not go down that far, Dent expects the market to truly hit bottom within the next two to four weeks.
And what does that mean for any smart investor? A good buying opportunity, of course. "The market is not getting the respect it deserves, given its capacity to generate earnings," Lehman's Reinhard says of current valuation levels. For investors who can take the dips and turns, it might be a fine time to strap on the seat belt.
By Margaret Popper
Edited by Douglas Harbrecht
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Copyright 2000, Bloomberg L.P.
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