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Jubak's Journal
Recent articles:
• Keep the winners, ditch the losers, 6/27/2003
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| | Jubak's Journal
10 signals to watch in a pivotal 3rd quarter
The quarter starting today will be the year's most important because the uncertainties in the economy are so big. Investors must be watchful and nimble.
By Jim Jubak
The third quarter that begins today will be the pivotal quarter of 2003 for stocks.
If consumer spending holds steady and corporate spending on capital goods picks up so that third-quarter economic growth at least matches the 3.5% consensus projection, then stocks are likely to continue the rally through the rest of 2003. Oh, there will be backing and filling like we saw in the days before the Federal Reserves interest-rate cut, but the major stock market indexes will finish the year substantially above the June highs of 1,690 on the Nasdaq Composite ($COMPX) and 9,320 on the Dow Jones Industrial Average ($INDU). Investors who are already up 22% on the Nasdaq or 8% on the Dow for the year would pile up further gains.
But if disappointing guidance for sales and earnings growth in the third quarter and for the rest of 2003 is just the start of disappointing news, then stocks are likely to pull back big. Giving back a third of recent gains would be the best that investors could expect -- and thats only if the fourth quarter redeems a third quarter disappointment. Instead of extending gains from the June high, the indexes could finish the year just about where they are now (if fourth quarter growth comes through) or even show a loss for the second half.
Lets take a look at where stocks and the markets are now and what to look for in the pivotal quarter ahead.
Markets look ahead, not back
The rally from the lows of March 11 thrust the third quarter into this pivotal roll.
For the quarter, the Nasdaq climbed 21%, the Standard & Poors 500 ($INX) gained 15%, and the Dow rose 12%. (For the period, Jubaks Picks gained 20% after trading costs. For a complete performance report, see the update to this column.)
Ive repeatedly called these gains the result of a rally on hope. Certainly there was nothing in the first-quarter economic numbers to start a market rally: The final revision for the U.S. gross domestic product showed a paltry 1.4% growth and a huge decline in corporate spending on capital equipment. The drop works out to an annualized rate of decline of about 5%. The longer trend showed a 14% decline since the end of 2000. Thats bad news for an economy that needs corporate spending to expand if its going to show sustained growth above 3%.
But the market, as is its wont, decided to look forward rather than backward.
Heres why: - The Fed had cut short-term interest rates to 1.25%, with another cut at the end of the period to 1%.
- The central bank was increasing liquidity by adding dollars to the economy at an annual rate of better than 10%.
- And the Bush administration had pledged a tax cut.
All that stimulus -- plus the end of the big-unit war in Iraq -- was enough to convince some investors that a second-half recovery was more likely than not.
And once the rally started, it fed on itself as upward moves produced shifts in sentiment that led to further moves that brought yet other investors on board. Huge short positions in many of the biggest technology and financial stocks fueled the rally as short-sellers decided to cut their losses. Advisers and Wall Street strategists who had been hugely underweight stocks added to their positions as the rally stretched beyond a second week. Money managers who had been out of stocks rushed back in toward the quarters end trying to catch up with the indexes.
Will the immediate past be prelude?
Which brings us to the start of the third quarter. The monetary and fiscal stimuli that led investors to believe in a second-half rally are still in place. But something may be played out: the huge shifts in sentiment that fueled the second quarters big move.
Sentiment in the latest poll by the American Association of Individual Investors was 71.4% bullish and only 8.6% bearish. Three weeks ago, only 52% of these investors were bullish, and 19% were bearish.
The Investors Intelligence survey of advisers shows a similarly over-whelming bullish consensus: as of June 25, 59% were bullish and just 18% bearish.
The Chicago Board Options Exchanges Market Volatility Index ($VIX.X, news, msgs), which had been stuck signaling an extremely low degree of investor fear in a range between 22 and 24 for much of June, finished the last full week of June at 21.71. Its safe to say that options pricing indicates that investors feel very little fear of a market drop just now.
And that means the third quarter begins with a very high degree of risk -- as well as with basic economic uncertainty. Just as the high degree of fear, short selling and bearish sentiment helped fuel the second-quarter rally on the way up, the high levels of complacency and bullish sentiment provide potential fuel to any third-quarter downturn.
So what do you watch for as this pivotal quarter unfolds?
On the economic front, macroeconomic statistics will help set a general psychological tone, but corporate projections for the third quarter will far outweigh the significance of those lagging numbers. And technical indicators will show how the market is solving its sentiment problem.
Keep an eye on these numbers:
Initial claims for unemployment: Anything that suggests unemployment, a lagging indicator in any recovery, has stopped rising will be a huge plus. Watch to see if the initial claims number can inch its way back toward 400,000 per week, the consensus for break-even on job creation/destruction in the economy. Next data: July 3.
Consumer sentiment/consumer confidence: These must hold up for the economy to stand any chance at a 3.5% recovery in the third quarter. Consumer spending has been holding the fort while corporations have cut back. The troops cant begin to desert before the CEOs join the battle. Next data: July 18.
The Institute of Supply Management (ISM) index: Economists now expect that the June numbers will show that the economy has edged back into expansion after three straight months of contraction. The expected 50.5 reading (anything over 50 signals expansion) would only match Februarys 50.5. So, breaking the downward trend is critical. And trading above 50 could indicate that the economy has some momentum going into the third quarter. Next data: July 1.
Corporate guidance gets off to a slow start this quarter thanks to the July 4 weekend. Only Yahoo! (YHOO, news, msgs) and General Electric (GE, news, msgs) are among bellwether stocks scheduled to report next week. But by the week of July 14, earnings reports, conference calls and guidance will be in full swing.
In general, it will be a bad sign if companies shy away from offering guidance for the second half of the year. Guidance from technology companies is especially crucial since these stocks ran up so much in the second quarter rally on hopes for the second half.
5 bellwether stocks
Bank of America (BAC, news, msgs): Look to see what the company says about demand for business loans. Report date: July 14.
Intel (INTC, news, msgs): Will personal computer demand pick up at all in the second half? Sales should pick up since the second half, and especially the fourth quarter, is traditionally the strongest period for tech sales. But investors will be looking for Intel to say the sales are showing something above the normal seasonal pickup. Report date: July 15.
IBM (IBM, news, msgs): IBMs corporate business, hardware and software, would be among the first beneficiaries of any pickup in corporate spending on information technology (IT). Listen for signs that orders will pick up in the third quarter. Report date: July 16.
Continental Airlines (CAL, news, msgs) and Delta Air Lines (DAL, news, msgs): The airlines are good indicators of consumer and business spending. Look for increases in the average selling price of a ticket; thats a sign that business travel is picking up. Plus watch for anything that indicates the airlines are looking to add, or at least not further cut, capacity in the second half of the year. Report date: July 17.
Nokia (NOK, news, msgs): The cell-phone giants earnings report and guidance will give investors a window into so many parts of the global economy. Is Chinese spending on consumer goods and infrastructure recovering after Severe Acute Respiratory Syndrome (or SARS)? Is anybody in the wireless industry spending to expand their networks? Is global pricing pressure showing any signs of easing? Listen carefully to see if Nokia again raises its projections for global phone sales in 2003 and 2004. Report date July 17.
The current excess of bullish animal spirits doesnt have to end in stock market disaster. A sharp retest of former resistance levels, say at 965 on the S&P 500, that moves the fear level higher could resolve into a further leg upward. Equally a see-saw market could gradually raise the fear level of an index such as the VIX without doing real damage to this rally.
Two key indicators to watch
Volume on down days versus volume on up days. Volume has been relatively light recently on days when the market has sold off. Thats exactly what any investor who believes stocks are moving higher wants to see. It indicates that most investors dont feel a need to join in the selling on dips like these. Equally, the rising daily volume as the market continued to rally was another positive sign. It indicated that climbing stock prices were drawing more investors from the sidelines into the market even as the market climbed. Thats crucial for a continued market advance.
Short interest. The absolute number of shares sold short has continued to rise during the rally, but the short-interest ratio has fallen. That latter measure is important since the ratio compares the number of shares sold short to total trading volume. So a decline in the ratio indicates that short selling has declined as a percentage of total market activity as volume picked up during the rally. An increase in the short-sale ratio caused by see-saw volatility would be good news for those hoping for a higher market in the quarter.
One last bit of advice as you watch all these indicators and signs:
The high levels of bullish sentiment increase the risk in this market. They dont guarantee that the market will take a meaningful tumble. Indicators that are sending warning signs can move still lower and continue to send warning signs for weeks or months.
But the extreme levels of bullish sentiment do guarantee that any downward move in this market has plenty of complacency to feed on, the reverse of the situation that helped drive stocks upward in the second quarter.
To me, that means this isnt the time to be taking on extra risk or hoping to make a killing. In Jubaks Picks, Im going to continue the conservative bent that worked reasonably well in the second quarter. Ill be looking for stocks that havent run away from their fundamentals, companies that show the ability to do better than the economy as a whole, and rewards that are commensurate with the risk Im taking.
Thats not a call on market timing. Just like everyone else watching this economy, I dont know when it will recover or how strong the recovery will be.
But it is a strategy that Im comfortable with, given what I know and what I dont know.
New developments on past columns
High returns in a low interest rate world; 5 keys
Berkshire Hathaway (BRK.B, news, msgs) took a half-step forward in its attempt to acquire Clayton Homes (CMH, news, msgs). In a lawsuit brought by Orbis Investment Management, the Delaware Chancery Court ruled that Clayton Homes must hold an annual general meeting promptly but not before a special general meeting called for July 16 to vote on the deal. Orbis had asked the court to require Clayton to hold the annual meeting before the special meeting, which would have helped the company, a 5% shareholder in Clayton Homes, in its efforts to stop the merger. The court also ruled that its willing to hear a motion for speeding up a class-action lawsuit brought against Clayton Homes that seeks to stop the merger. In separate news, Clayton Homes announced that fourth-quarter earnings will be 5 cents to 7 cents a share below the 25 cents a share earned in the second quarter of 2002. Wall Street analyst had been expecting the company to earn 30 cents a share.
Five stocks that could soar if rates stay low
How long will it take to get rid of excess capacity? A long, long time in the airline industry, according to J.P. Morgan. The company estimates that about 2,000 aircraft have been grounded around the world in the current airline industry slump. About 600 to 700 of those will make it back into service when the slump is over. That, J.P. Morgan estimates, is about 12 to 18 months' combined production of new planes at Airbus and Boeing (BA, news, msgs).
Second quarter (and other) performance numbers for Jubaks Picks
For the second quarter of 2003, Jubaks Picks gained 20% (after accounting for transaction costs). That compares to a 21% climb in the Nasdaq Composite, a 15% gain in the Standard & Poors 500 stock index, and a 12% rise in the Dow Jones Industrial Average. For 2003 to date, Jubaks Picks shows a 20% rise compared to 22% year-to-date gain for the Nasdaq, 11% for the S&P 500, and 8% for the Dow. The one-year figures look like this: 17% for Jubaks Picks, 14% for Nasdaq, 1% for S&P, and -1% for the Dow. And lest I forget, the three-year (really ugly numbers) are: Jubaks Picks down 46%, Nasdaq down 59%, S&P 500 down 33%, and the Dow down 14%. The life of the portfolio record from May 7, 1997, to June 30, 2003, for Jubaks Picks is a gain of 60%. During that same period, the Nasdaq is up 22%, the S&P 500 up 20%, and the Dow up 28%. As is my practice, I will update these performance numbers at the end of the next quarter.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equity mentioned in this column: Berkshire Hathaway. He does not own short positions in any stock mentioned in this column.
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