News: Analysis & Commentary
What's the Best Way for Investors to Hang On?
Proven tech companies--"New Old Industrials"--look like smart buys
"April is the cruellest month," wrote T.S. Eliot--and he never owned a Nasdaq stock. Consider the week of Apr. 10. That's when one-quarter of the value of the Nasdaq stock market, where shares trade in Information Age giants and wannabes alike, simply evaporated. The worst day was Apr. 14, when the Nasdaq rout accelerated and the Dow Jones industrials and Standard & Poor's 500 collapsed under the weight of the worst one-month rise in the consumer price index in five years. The day's events were uncomfortably similar to October, 1987, when a Friday sell-off preceded a Black Monday.
But on Monday, Apr. 17, the worst didn't happen, perhaps because pundits spent the weekend warning that it would. By Apr. 19, the Dow had bounced back 3.6% from the Friday bottom, and the Nasdaq had moved up a snappy 11.6%. Helping the comeback: stellar profit reports from leaders such as Citigroup, Oracle, and even Ford Motor. Indeed, first-quarter earnings are coming in 22.4% above last year's--and some 6.7% above consensus estimates, says First Call/Thomson Financial.
Still, the severity of the market's descent left even seasoned pros stunned. "I just didn't foresee the magnitude of the decline. It was clearly above and beyond my expectations," says Trent E. May, co-manager of Invesco Blue-Chip Growth Fund, who bought tech stocks as they rolled downhill in late March and is now snapping up more.
What to make of this whipsaw market? The best take is that it was an extremely sharp correction in a bull market characterized by extreme moves. The fallout is a shift in how investors think about stocks. "Investors got used to the market going up, up, up," says Kathleen Gurney, president of Financial Psychology Corporation, a Sonoma (Calif.) investment-research firm. "They've seen that it can go down and that has been devastating to many because it's not a sure thing anymore." In fact, investors did what they always do in the wake of a shakeout--dial back on risks and momentum plays. Now, they're favoring high-quality tech companies with real earnings and products, rather than untested dot-coms.
The first half of April was a costly lesson for traders who had leveraged their portfolios with margin loans or who lacked the discipline to sell sinking stocks before they fell further. "The volatility was too much for us," says Gary Mednick, president and CEO of OnSite Trading in Great Neck, N.Y. Mednick's firm stopped trading for its own account in early April, though it still executes trades for others.
A rebound should keep most mutual-fund investors in place. The four weeks leading up to Apr. 14 were undeniably brutal for many tech and small-cap growth funds, but the average domestic equity fund lost just 7.4% during the period, for a current year-to-date loss of 3.8%, according to Morningstar Inc. Especially in the wake of 1999's outsize returns, that's not a disaster.
In fact, some are wondering what has changed about the market other than prices. Value investor Theodore R. Aronson of Philadelphia institutional investor Aronson+Partners, figured the rout would create opportunities in growth stocks beaten up enough to be tantalizingly cheap. That's not proving to be the case. Nor did the plunge prompt Robert Zuccaro, portfolio manager of Grand Prix Fund, to make any changes among the 24 tech stocks he has in his 25-stock portfolio. Zuccaro invests in companies that are tops in earnings growth, positive earnings surprises, and stock-price gains--a strategy that has rolled up a 470% return since the start of '98. "Nothing has displaced technology as the market's leader," he says. From Apr. 14 through 19, S&P tech stocks beat the S&P 500, 7.8% to 5.2%.
Investors' return to tech isn't mindless. The outlook for the sector remains bright (page 42). Not that earnings are lacking in the broader market: First-quarter profits are strong in such unsexy sectors as chemicals, machinery, and metals. Still, there's not much chance that these stocks will capture investors' hearts. This time last year, investors had a six-week fling with heavy-duty industrials and then turned back to tech. "If you believe earnings drive stock prices, you have to go with technology," says May. "The tech companies that make money have highly visible earnings streams, and earnings growth will even accelerate."
These stocks, while cheaper than they were in early March, aren't exactly bargains by historical standards. Then again, these are not traditional times, and investors are still grappling with new frameworks to assess companies' prospects. Edward M. Kerschner, an investment strategist for PaineWebber Inc., divides the market into three parts. One is "Old Old Industrials"--the 20 largest smokestack companies in the S&P 500, such as Caterpillar, DuPont, and Ford. Battered earlier this year, they have improved in the past six weeks--and remain cheap by conventional measures. Their price-earnings ratio, based on projected year 2000 earnings, is 12.2, about half that of the S&P 500. That doesn't make them a buy, though. "There's value there," says Kerschner. "But where's the growth?"
At the other extreme are "New New Industrials"--the 20 largest Nasdaq stocks that have been public less than five years but aren't yet in the S&P 500. They include Amazon.com, Ariba, and Ebay. Since most don't have profits, Kerschner can't compute their p-e's. So he looks at the price-to-sales ratio. As these stocks cratered, the p-s was halved, from 85.7 to 41.4. But they're no buy, either. "You get growth but no value," he says.
The sweet spot in the market--"New Old Industrials"--is where much of the rebound money is going. These are the 20 largest tech companies in the S&P 500 that have been public at least five years. They're familiar names: Cisco Systems, America Online, Microsoft. In the slide, this group's p-e dropped from 54.3 to 44.6. Still, that's about twice the market's p-e. "In a low-inflation environment," says Kerschner, "very rapid earnings growth is worth a very high p-e."
Low inflation? While few economists predict an inflationary surge, many now believe that the core rate is creeping upward. "If inflation takes off, all bets are off," warns Invesco's May (page 44).
For sure, even as the market appears to recover, it will be edgy and less willing to shrug off bad earnings reports or economic statistics. Volatility in the Nasdaq is already at record highs and could get worse. In all of 1999, the Nasdaq had only 20 days in which it moved over 3%; as of Apr. 18, 2000, it had already had its 21st of this year. By comparison, from 1995 through 1998, there was only one 3% day per year.
Higher volatility doesn't mean the market can't work its way higher. With a favorable economic backdrop, prospects remain good. Remember what Eliot also wrote about April: It breeds "lilacs out of the dead land."By Jeffrey M. Laderman and Marcia Vickers in New YorkReturn to top