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7 reasons the bears might be right
The bears can make a persuasive case for a continued pullback, and I think we're looking at another decline. Here's how to play the weakness.
By Jim Jubak
The stock market is poised at one of those very scary inflection points. From here it could fall another 3% on the Dow Jones Industrial Average ($INDU) or another 8% on the Nasdaq Composite ($COMPX). Or rally back to its March highs for a gain of 8% on the Dow industrials or 13% on the Nasdaq Composite.
Which will it be? Lower prices and more gloom? Higher prices and smiles?
News events that we can't now predict will certainly have a big role in settling the question. But I think I can make a strong case that we've got a 3%-to-8% decline ahead of us before we can start looking for an end to this punishment and the beginning of the next temporary rally.
Let me count the reasons why
Let me lay out the case for believing that the stock market will fall further.
1. Technically, the stock market has broken down. The Dow Jones Industrial Average is now below its January 2005 low of 10,369 and has broken through both the 50-day and 200-day moving averages. With that major support for the index behind it, the next resting place is the October 2004 low at 9,750. The picture over at the technology-laden Nasdaq market is just about the same: The Nasdaq Composite is well below the Jan. 24 low of 2,009 and below both the 50-day and 200-day moving averages. There's decent support for the Nasdaq Composite at the September 2004 low at 1,879 and very solid support at the Aug. 12 low of 1,752.
After a long slump, the markets soar. See Market Dispatches.
2. Stocks haven't rallied on a decline in oil prices, and oil prices are more likely to tick upward than downward in the next couple of weeks. The flow of oil news has been almost uniformly positive of late, which has helped push oil prices lower. The news flow in coming weeks, however, seems full of the kind of uncertainty that makes prices move up again. With so much oil in countries with unstable politics, it's just a matter of time before some news item raises the oil market's anxiety level again. For example, the Venezuelan government has decreed that private oil companies will have to sign new contracts that give the state-run oil company a majority share of all oil projects. The government has also said that oil companies aren't paying enough in income taxes.
3. Forecasts of economic growth just keep edging downward. In some cases, the lower growth is a result of a weaker dollar raising the price and therefore depressing demand for a country's exports. So, for example, on April 14, the Bank of Canada lowered its forecast for growth in Canada's gross domestic product to 2.6% in 2005, down from 2.8% in its January forecast. In other countries, the culprit seems to be higher energy prices that are taking a toll on growth. On April 13, the International Monetary Fund lowered its forecast for European economic growth to 1.6% in 2005, down from 1.8%, and for Japanese economic growth to 0.8% in 2005, down from 2.6%.
4. The already frightening U.S. trade deficit will increase. With growth in the U.S. outstripping that in any of the other economies of the developed world, there is almost no chance that the U.S. trade deficit will fall, even if the dollar weakens further. Because the U.S. economy is growing, U.S. consumers and businesses are buying; because Japan and Europe are barely growing, buying in those economies isn't likely to increase much even if U.S. goods get cheaper thanks to a weak dollar (and a strong yen and euro). A rising trade deficit -- along with a continued lack of progress on reducing the U.S. budget deficit and on reducing the coming Social Security and Medicare shortfalls -- will keep the credit markets on edge. And that's never good for stocks. .
5. The Federal Reserve will deliver more interest-rate increases. Investors got a one-day reversal in the stock market last week when the release of the latest minutes from the Federal Reserve showed that the U.S. central bank wasn't thinking of raising rates in aggressive 50-basis-point jumps. But the minutes showed no wavering in the determination of Alan Greenspan and friends to raise rates in more-gentle 25-basis-point lumps. Higher interest rates are still coming inexorably, just not as quickly as some investors had feared.
6. Technology earnings continue to disappoint. Latest case in point: IBM (IBM, news, msgs), which on April 14 reported earnings of 84 cents a share, well below the 90 cents a share expected by Wall Street analysts. Revenue for the first quarter of 2005 climbed just 1% from the first quarter of 2004 after factoring out the boost from a weak dollar. With technology stocks in an earnings slump and financial stocks depressed by the prospect of rising interest rates, the stock market can't count on much from the sectors that usually lead market rallies.
7. The sectors that had been leading the market in 2005, energy and transportation to name two, are in the midst of a correction. This is absolutely normal in any rally -- and this decline will help build the floor for the next leg up in these sectors. But it certainly doesn't help the tone of the overall market. It's one thing to have IBM or Wal-Mart Stores (WMT, news, msgs) going down when Exxon Mobil (XOM, news, msgs) and Burlington Northern Santa Fe (BNI, news, msgs) are climbing. It's quite something else -- and very unsettling to the market as a whole -- to have recent leaders falling along with the laggards.
The pain isn't over
Maybe last week's punishment was enough to shake out the weak hands and set up the next rally in what I still believe continues to be a range-bound stock market. For the week, the Dow Jones Industrial Average tumbled 3.6%, the Nasdaq Composite fell 4.6% and the Standard & Poor's 500 ($INX) dropped 3.3%. And the week did finish, after all, with three days of 100-point losses or more for the Dow. Volume picked up into the close on Friday, always a good sign on a down day if you're looking for the Big Washout that marks the end of a stock-market decline.
But my best guess is that we're not there yet. I think we'll need at least another week with a failed rally -- to suck in the last optimists -- and then another stretch of a few down days -- to spit them out again -- before this market decline is ready to call it quits.
So what should you do now? It depends on what you own in your portfolio right now.
Hold onto stocks with strong fundamentals
If I'm right, the kind of stocks in the Dow Jones industrials -- big-company stocks, basic-materials plays, drug companies, the most solid of technology stocks -- is looking at only another 3% or so on the downside. There's no point in selling these. The damage has been done. You can't possibly time the turn precisely enough to make up for transaction costs. So stay put in Dow Jones Industrial Average names like Johnson & Johnson (JNJ, news, msgs), General Electric (GE, news, msgs), 3 M (MMM, news, msgs) and Procter & Gamble (PG, news, msgs). These stocks aren't likely to go down much further if I'm right about the extent of the market decline. And they offer great defense if I'm wrong and we're looking at a more-serious market breakdown through the October 2004 lows. If investors get scared, these are exactly the names they'll be buying to protect their portfolios.
If you're heavily into the more-volatile stocks of the Nasdaq market, I think you're looking at the possibility of a steeper decline from here, maybe as much as another 8%. Even at this late date, it makes sense to go through this part of your portfolio and sell any stocks that look particularly weak on the fundamentals. The bounce from the bottom, when it comes, won't be so strong that it lifts all stocks, both good and bad, enough to make up for taking another 8% or so loss.
That said, don't blindly sell everything with any volatility. Think a step ahead. When the market bounces, the biggest returns won't come from owning the safe big-company stocks like Johnson & Johnson, but in the small- and mid-cap parts of the market. The very stocks that have been beaten up most are the most likely to bounce back highest, especially if the underlying story is fundamentally solid.
Which creates quite a problem, doesn't it? If you want to be completely safe, you move money into the safe, big-cap names that aren't likely to drop much here. You sell the most-volatile stocks you own after they've been punished the most, taking a big loss, and also minimizing your upside in any rally that might be ready to emerge after this downturn is completed.
I advise a one-stock-at-a-time bit of introspection that, to the best of your ability, ignores any losses you've taken on the more-volatile stocks in your portfolio and instead looks for solid fundamental stories that you think the stock market might value when it stops being afraid of its shadow.
How I'll tweak Jubak's Picks
So in Jubak's Picks I'm holding onto Micron Technology (MU, news, msgs) and EMC Corp. (EMC, news, msgs) because I think the fundamental momentum in both businesses will lead to a higher stock prices in the future, and not because I'm down 28% and 10%, respectively, and want to get even. I doubt that Micron Technology will get back to my purchase price of $13.23. But after the solid earnings surprise the company delivered on March 29, I do see the stock climbing to $11.50 or so in any rally. That would be a better than 20% gain from the current price, and it justifies holding onto these shares.
On the other hand, I don't see that kind of potential from its current price in Main Street Banks (MSBK, news, msgs). Rising interest rates will keep a damper on bank stocks like this one in any near-term rally. So even though I'm showing a smaller loss of 16% for this stock versus 28% for Micron Technology, I think Main Street Banks is a sell rather than a hold.
Buy cautiously
And what about buying anything to take advantage of any rally likely to emerge after this decline is over? Remember that the drop isn't over and that the rally isn't guaranteed, and step lightly. You certainly don't want to get trapped by any head-fake rally next week and then suffer big losses in volatile stocks that you added to give your portfolio extra pizzazz.
I'd wait a week to see what develops before I do any buying. And I'd use the time to study names like these: - Chiquita Brands International (CBQ, news, msgs), which just bought the fresh-cut salad business of Performance Food Group (PFGC, news, msgs) in order to extend its fresh-cut business from fruit to other produce.
- Atwood Oceanics (ATW, news, msgs), which owns eight drilling rigs, five of which will come off existing drilling contracts in 2005, in a business where day rates are climbing. For example, the day rate for the company's Seahawk rig under its current contract is $45,900 a day; under its new contract slated to start in the summer of 2006 the day rate will go up to $68,340.
- Corn Products International (CPO, news, msgs), a Jubak's Pick which has been pummeled to a 25% loss for what I believe will turn out to be a one-quarter problem with the cost of corn.
In my next column, I'll actually get to the topic I promised in my last column and take a look at what we can learn about investing for the long-term future from this market decline and the big bomb of March 2000.
Changes to Jubak's Picks
Sell Main Street Banks
I still think this is a stock that will pay off in the long run. As a dominant bank in the Atlanta suburbs, Main Street Banks (MSBK, news, msgs) is positioned to take advantage of the spread of that city. When I bought this stock on Sept. 10, 2004, I thought the financial markets had overreacted to worries that the Federal Reserve would quickly ramp up interest rates. Bank stocks would, I figured, do fine as soon as investors realized that the odds of the Federal Reserve raising rates in 50-basis-point jumps were just about nil. I've wound up being way, way early on that thesis. I've decided to sell this stock now and revisit it in the fall if investors start to rethink their opinion on bank stocks. I'm taking a 15% loss in these shares since I added them to Jubak's Picks on Sept. 10, 2004 at $29.20. (Full disclosure: I will sell my shares of Main Street Banks three days after this column is posted.)
New developments on past columns
8 stocks to watch in a wandering market
On April 14, PepsiCo (PEP, news, msgs) announced first-quarter earnings of 53 cents a share. After subtracting about two cents from one-time events, I get "clean" earnings of 51 cents a share, a penny above Wall Street expectations. Don't pooh-pooh that as just another company gaming its earnings to produce the infamous Wall Street penny earnings surprise. PepsiCo delivered the sales and volume growth to back up the earnings numbers. Volume grew by 4% companywide and revenue was up 7%. The best news came out of the international division, where revenue jumped by 12% and operating profit grew by 20%. PepsiCo will generate better than $4.1 billion in cash flow (after capital spending) in 2005. Look for continued buybacks of shares and a dividend increase to add upward momentum to the shares. And look for an acquisition or two to bolster the Frito-Lay business internationally. As of April 19, I'm raising my target price to $63 a share by December 2005 from the prior target of $62 by May 2005. (Full disclosure: I own shares of PepsiCo.)
Time is ripe for these 7 biotechs
I know from my e-mail that everyone wants news on Cell Genesys (CEGE, news, msgs). After all, the stock is up 8% since the March 31 bottom after falling 44% from Dec. 31, 2004 through the end of March, so something must be happening, right? Well, the truth is there's not much news since December, when the company reported encouraging data on a trial of its GVAX vaccine in treating leukemia. And I hope that I don't hear much out of the company until investors hear good news about the company's more advanced Phase 3 clinical trials of GVAX for treating prostate cancer. That won't happen until close to 2007. So far, the GVAX "platform" has shown exceedingly good results against a wide variety of cancers, but the history of biotechnology is strewn with failed cancer drugs. So investors' willingness to pony up to buy shares of Cell Genesys, when results are so far in the future, has more to do with their attitude toward risk-taking in the general market than with anything to do with this stock in particular. And as we know all too well, investors in the current stock market favor safety over risk. This remains a highly speculative and risky stock that will be either a home run -- if GVAX turns into an effective treatment for one or more forms of cancer -- or a bust. At a price below $5, I don't see any reason to sell these shares -- and in fact, I've bought shares recently at $4.57. Its certainly difficult to put a target price on shares with a payoff so far off, but I think a target price of $9 by December 2005 is in the ballpark. But don't put money into these shares that you can't afford to lose. (Full disclosure: I own shares of Cell Genesys.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Cell Genesys, Corn Products International, EMC, Main Street Banks, Micron Technology, and Pepsico. He does not own short positions in any stock mentioned in this column.
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