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March Madness Fades
By Brady Willett
"A couple of weeks ago the Street was breaking out the champagne as the Dow Jones industrial average looked set to climb back to the
magical 11,000 level on signs the economy is racing back from one of the shortest recessions since World War II. The Dow may now have a better chance of revisiting 10,000…" Reuters, April 14, 2002
During the month of March a flurry of 'better than expected' economic
statistics confirmed that the 'worst was over'. In fact, the statistics were so convincing of a strong economic expansion that many economists scrambled to raise their 2002 GDP estimates, investors
dumped bonds due to fears of looming interest rate hikes, and talk of a 'double-dip' economic scenario all but vanished.
However, the untold story in March was that earnings estimates didn't
budge: on January 1, 02 analysts expected 1Q02 and 2Q02 earnings to be -6.2% and +8.8% respectively while at the end of March expectations were much the same (-8.6% and +8.8% for 1Q02 and
2Q02 respectively). Furthermore, analyst earnings estimates for full year 2002 actually dropped from Jan 1 to March 22: from +19.2% to +16.7%.
March Madness
One does not require the advantage of hindsight to surmise that the
March rally was not unlike many 'buy the dips' rallies in the late 1990s – lets objectively recall what happened: after each 'better than expected' economic report Wall Street reiterated to investors that
prices had already bottomed, investors continued to peck at beaten down stocks, and both parties completely ignored corporate earnings (valuations). In sum, March was a 'feel good' rally: a rally
supported by a strengthening economy not necessarily strength in corporate profits.
With this in mind, the Dow has now fallen 5% from its March intraday
peak and the Nasdaq has cracked lower by nearly 10%. Moreover, the carnage in share prices has been marked by spectacular losses in many big names (GE, IBM, YHOO), with each drop coming after
earnings related news was disseminated. In essence, reality has begun to set in.
Dow Earnings
Earnings season will heat up this week as more than half of the Dow 30 is expected to report. As it stands now First Call states that analysts are
expecting a 9.2% decline in 1Q02 earnings, or a 15% year-over-year drop when including those pesky goodwill write-downs. Yes, despite the 'rebounding economy' estimates for 1Q02 S&P earnings (as of Apr 5) are
lower now than they were on Jan 1 (-6.2% versus -9.2%).
Financial stocks
Financial stocks were one of the first groups to rebound following 911 and one of the few areas of the marketplace to reach yearly highs (S&P
bank index) during 'March madness'. Furthermore, as other sectors have recently given back gains the financial stocks have been quite stable (the S&P bank index is down 2.6% from its intraday March
peak). With this in mind, if the current correction has more downside financials could be one area of the marketplace poised for a drop (lending no speculations to the interest rate situation).
The situation financial stocks are in is much the same as the broader market – meaning that while prices have rallied near term earnings estimates have not. Since October 2001 1Q02 estimates for
financial stocks (S&P) have fallen from +10% to +6% and 2Q02 estimates while 2Q02 estimates have dropped from +26% to +22% (not including FAS 142). As such, the onus is on investors to 'hold'
until f-earnings post significant gains in 3Q02 and presumably beyond.
Positive earnings results no matter how meager seem to be important in this market. Neverthess, one has to wonder how long
financial stocks can hold on as other areas of the marketplace sell-off and/or as the timetable for the real earnings rebound continues to be stretched out.
Avoiding The Madness
The only way anyone can be guaranteed of knowing when markets
are 'undervalued' is when analysts and investors are underestimating corporate earnings. At first this may appear to be an overly simplistic comment. However, if you take valuations as being
stagnate (say a forward P/E average of 20) then the only way to own an advantage would be to know when future earnings estimates are too low.
In March no one dared suggest that future earnings estimates were 'too low' (the estimates were already perfect!). Rather, people felt so good about the economic rebound that they lost hold of their senses:
they bought stocks believing valuations, not earnings, would escalate.
Such a phenomenon may not repeat itself again until apprehensions over 1Q02 earnings results completely subside. However, rest
assured that the next time stock prices rally even as EPS remain flat something is amiss. If the 1990s taught investors anything it is that stock prices can rally for many years for literally no reason, but
eventually earnings matter.
Brady Willett
BWillett@fallstreet.com
www.wallstreetwishlist.com
April 18, 2002
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