January 15, 2003
Still One Stock Market Sell Off Away From Recession

Intel reported better than expected fourth quarter EPS and revenues results after yesterday’s close, and for a brief moment investor’s were pleased. However, that Intel also announced that it would cut capital expenditures, from $4.7 billion in 2002 to between $3.2 and $3.9 billion in 2003, was one of the main reasons why tech gave back gains today. As for Intel’s EPS results, the company reported $28.6 billion in revenues and $3.12 billion in earnings for 2002. These results, on the surface, appear strong. However, since Intel has 6.6 billion outstanding shares these numbers translate into nearly a 40 P/E multiple. Quite frankly, if Intel can trade at 38 times trailing earnings and 27 times 2003 why is Wall Street so sure that the maniacal 1990s are over?

Some very intelligent people are quick to assume that the Intel’s deserve ridiculous premiums simply because they are the best in their field. However, if the IT replacement cycle turns out to be nothing more than a pipe dream (if businesses and consumers can continue to make due with their current computers), then where is growth going to come from? Gartner expects (Nov 2002) PC sales to be up 7% this year and AMD, which reports tomorrow, has seen it’s revenues dive by 47% (Dec 2001-Sept 2002).  In sum, Intel has stolen marketshare from AMD and lives inside of a low growth industry.

Selling Margins For Revenues
Earlier this week retail sales arrived up 1.2% (flat excluding autos).

Most economists are quick to recognize that autos should not be ignored because they are large part of the economy. However, that Ford and GM have to sell more automobiles today to make the same amount of money they made yesterday is an economic negative, NOT a positive.  In fact, and not including what appears to be a solid fourth quarter, even as sales raced ahead in 2002 Ford lost money and GM lost equity.

Exactly why any investor or economist should applaud the tough operating environment autos are in is unknown. Think about it: what if the only way Intel and Microsoft could bring about a ‘replacement cycle’ was by hacking prices lower and offering incentives until they are almost profitless – would anyone believe that demand was sustainable and not the result of consumers snapping up bargains once?

Granted, no one knows for sure how long domestic automobile sales can remain robust. Furthermore, there may well be growth opportunities abroad for GM, Ford and others. Nevertheless, what everyone should know by now is that the consumer is being selective: if GM and Ford could raise prices or cut back on incentives they would.

GM

Net Margins

ROE

2002

0.4%

-13.0%

2001

0.3%

3.0%

2000

2.4%

14.8%

1999

2.3%

29.1%

1998

1.9%

19.7%

1997

4.0%

39.2%

1996

3.1%

21.2%

1995

4.2%

29.7%

1995

3.8%

44.0%

   2002 data calculated from Dec 2001-Sept 2002



Basically Ugly
Today’s’ PPI highlighted some lingering deflationary pressures in the economy, and the Fed’s Beige Book continued to suggest that the surprise 50 basis point cut by the Fed last November has done little to stimulate demand. However, although no economic report suggests that the economy is turning around, the latent belief appears to be that stocks can hold gains so long as things do not fall apart.  Two non tech stocks that suggested otherwise today were Alcoa (-4.15%) and Dupont (-3.41%).  Dupont warned that even with an unexpected tax benefit it will miss EPS expectations and Alcoa, a cyclical king pin on the Dow and dividend paying stock, opened the day on sharp weakness.  Dupont rival Dow Chemical had this to say on Monday:

“Dow will put a six-month moratorium on all new or engineering-only capital projects and delay employee awards programs until at least the second half of the year in an effort to "keep money inside our company.””

Quite frankly, if it were not for Bush’s economic stimulus package, a ‘package’ that has sapped focus away from corporate earnings in recent weeks, the markets would likely be in serious trouble. For certain, the notion that if ‘basic materials’ are in a slump the economy is basically in a slump is sound.  Furthermore, no interest automobiles and cheap wireless tech gadgets run by cheap Duracell batteries may be good for the Philip Morris smoking consumer, but these are ugly signs for American businesses.

Current Earnings Season May Be Best This Year
Economists expect a turn around in 2003 and Wall Street does not expect 4 down years in a row...Yet companies like Dupont and Dow are still struggling and aggressively trying to cut costs?

The anticipated uptick in capital spending programs is not materializing as planned, the IT replacement cycle is trying to be brought back by force, and the initial rush into stocks to begin the year may be over.  Add to these new concerns the old – the housing bubble, over leveraged consumer, zero bound interest rate policy, over capacity, etc – and the outlook is not good.

“Stocks had run up a little at the start of the year, and this earnings season is just a reminder that things still aren't stellar.”
Christopher Bingaman, Diamond Hill Capital Management. Bloomberg

If investors need any further reminder that earnings are not ‘stellar’ they are likely to get it in 1Q02 and 2Q03, or when year-over-year comparisons will be a lot tougher than the comparisons now being reported.

In sum, the Stimulus Brothers may be successful in keeping the economy afloat a little while longer, investors may hold onto stocks because they have been conditioned to do so, and geopolitical tensions may subside. By contrast, the U.S. economy could just as easily slip back into recession tomorrow and overvalued stocks could plummet by 30-50%. Only one thing is for certain: another recession will eventually arrive and no Fed Chairman, President, or Wall Street economist is likely to predict it.

BWillett@fallstreet.com


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