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Jubak's Journal
Recent articles:
• Today's high yield, tomorrow's headache, 7/10/2003
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| | Jubak's Journal
Can the rally survive earnings season?
The next few weeks are make or break. If news is good enough to keep the cash flowing in, momentum is likely to matter more than fundamentals.
By Jim Jubak
By many fundamental measures such as price-to-earnings and price-to-sales ratios, stocks are currently overvalued. Thats even if the economy is set to stage a second-half recovery that sees growth climb to the neighborhood of 3.7% in the third and fourth quarters.
But these fundamental measures dont matter one whit if the flow of cash into the market is all that counts, as a growing number of Wall Street analysts argue. Consider the following trends:
- The Federal Reserve has been increasing the cash in the economy at an annualized rate of about 10% recently. That means theres more money to go into financial assets.
- Much of the $2.2 trillion in money market mutual funds, according to the Investment Company Institutes latest count, is earning 1% or less.
- In April, $12.6 billion in cash flowed into U.S. stock mutual funds. May brought in another $12.6 billion in cash.
- A Bear Stearns analyst who follows real estate investment trusts (REITs) just raised his price target for the 10 REITs he follows despite a run-up in REIT share prices, despite weak property fundamentals, and despite no real evidence of an economic turnaround. None of that matters, the analyst wrote, because stock prices in the group will be supported by money flows into higher yielding instruments.
If cash flow into the stock market is all that counts, stock prices will keep going up from here in spite of their already impressive rally, in spite of disappointing news on earnings, and in spite of continued uncertainty about the economy.
And if cash flow is all that counts, the way to make money is to forget about valuations and follow momentum strategies that put your cash into the stocks that have been the hottest.
Thats a chilling thought for anyone who believes that the Feds 1998 decision to pump extra liquidity into the economy after the Asian financial crisis and after the Long-Term Capital meltdown helped create the bubble in stocks that broke in 2000.
The next few weeks pose a major test for this nothing matters but cash flow school. Driving the test will be three questions:
Do economic fundamentals matter?
If the guidance on the third quarter and the second half of 2003 from companies reporting second-quarter earnings is disappointing, and stocks pull back significantly as a result, investors will know that economic fundamentals do matter. A pullback here could be healthy if it resets the currently overly bullish levels of sentiment, puts some fear back into the market volatility index readings from the Chicago Board of Options Exchange ($VIX.X) and tests major support on stock indexes, especially the Nasdaq Composite ($COMPX). The markets will have pulled back from a potential revisit to bubble land.
Is a market bubble developing?
If the earnings guidance is disappointing and stocks go up anyway, then its time to worry. Theres a distinct possibility that a bubble, obviously much smaller than in 2000 but still dangerous, is forming.
In this scenario, stocks would continue to rally, perhaps even more furiously than they have to date. And the stocks that would move up most strongly, and give investors the largest profits, would be the same momentum names that have starred in this rally so far Yahoo (YHOO, news, msgs), eBay (EBAY, news, msgs), XM Satellite Radio (XMSR, news, msgs), and Genentech (DNA, news, msgs), to name a few.
Momentum investors who recognized that the key to profit is getting out as fast as the momentum begins to falter would do well as long as the party continued. Investors who got sucked in from the sidelines in the later stages of such a rally and didnt recognize the signs of a momentum breakdown early enough would take yet another round of losses. These losses would be especially large if
- The momentum rally continues longer than anyone looking at the fundamentals would expect.
- The rally generates gains large enough to make fundamentally inclined investors abandon their discipline again to buy in during the end stages of the momentum rally. Again.
Will good news draw new cash into stocks?
If the guidance actually confirms the second-half recovery hopes that ignited the current rally, the cash now on the sidelines thats so far resisted the Feds pressures to re-enter the market is likely to come rushing back into stocks. This kind of fundamental good news would put a new valuation floor under this rally and justify stock prices moving up from here. Thats especially true in the technology and financial sectors where companies have so much upside leverage that any real recovery will produce earnings growth that outstrips the gains of 20% or so in earnings that are currently built into the Wall Street consensus.
Until we know what the fundamental guidance will be for the third and fourth quarters and until we see how stock prices react, this will remain a very uncertain time for stocks. The market could easily see a reversal of the rally or an acceleration of the recent upward trend -- and the same fundamental news could, in my opinion, trigger either of those very different results depending on the degree to which cash flows have overwhelmed all other factors driving the market.
Fortunately, for those investors who hate suspense, we should soon have enough clues to give a solid indication of what drives this current stock market at this stage in what began as a rally on hope. Yahoo! (YHOO, news, msgs) reported Wednesday (and fell nearly 8% when the company met analyst expectations) and General Electric (GE, news, msgs) reports today before the market opens. Intel (INTC, news, msgs) reports Tuesday, and IBM (IBM, news, msgs) follows on Wednesday. Both reports come after the market closes. (For those who want to keep track of when earnings reports are due, check MSN Moneys earnings calendar..)
The reaction to the news from those companies should tell us a lot about where we go from here. And help investors gauge how much risk and volatility lies ahead in this stock market.
New developments on past columns
High returns in a low interest rate world; 5 keys
The tide in Berkshire Hathaways (BRK.B, news, msgs) battle to acquire Clayton Homes (CMH, news, msgs) may have turned this week. A long list of investors, such as Orbis Investment Management, Cliffwood Partners, Brandywine Asset Management and Third Avenue Management, has weighed in against the deal arguing that Berkshire Hathaways offer is too low. But on Monday, adviser Institutional Shareholder Services recommended that its clients vote to accept Berkshire Hathaways cash offer of $12.50 a share. Clayton Homes Chairman James Clayton and the Clayton Family Foundation, who together own about 28% of the company, also support the deal. Berkshire Hathaway needs to a better than 50% majority in the vote scheduled for July 16 to complete the deal. The stock traded at $13.04 at noon on July 10: The market it seems is still hoping that Berkshire Hathaway will be forced to up its offer or another bidder will emerge.
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 equities mentioned in this column: Berkshire Hathaway. He does not own short positions in any stock mentioned in this column.
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