The Book of Profits


“It’s been a long, cold lonely winter.” – George Harrison, “Here Comes the Sun.”

We’ve all been fools for love. Take the stock markets. They’re a fool for April. It’s one of the best performing months, in markets both bear and bull. How else to explain last week? Despite every single piece of economic data in negative territory and pointing downward, the “it’s all good” mentality returned.

The centerpiece of the week was a huge rally on Tuesday, set off by the news that investment bank UBS AG (UBS) was taking a $19 billion write-down and allowing its chairman to sack himself. UBS has been writing the book on how to do everything wrong in investment banking, so it’s understandable that the chairman’s departure might cheer the masses. But 19 big ones?

UBS wasn’t alone. Deutsche Bank (DB) announced its own $3.5 billion writedown. Lehman Brothers (LEH), who had loudly been insisting that they had adequate capital, added to the glow by proving it (?) with a $4 billion convertible preferred issue. The issue was oversubscribed, a vote of confidence that the markets took as the proverbial rainbow over the pot of gold. That analysts spent the rest of the week downgrading banks of every type didn’t seem to matter.

The SEC got into the act by playing the role of cooling stream to the panting prey of mortgage-backed-securities, musing that fire-sale prices might not be best practice. In other words, flexibility might be permitted when marking prices to market, especially when the market has disappeared.

April passions aside, it’s understandable to see a violent reaction to the Lehman and SEC actions. Short interest in financial stocks (bets that the prices would fall) had risen to very high levels. Lehman CEO Erin Callan, who put on an impressive media performance the Friday before, had raised the stakes by warning that the SEC was investigating the recent surge of short-selling and rumor-mongering in the investment banks.

So Lehman got a lot of cash and boasted that they could have gotten more, the SEC eased markdown pressure on mortgage-related securities and UBS joined the capital-raising club with a $15 billion rights offering. The UBS offering is only a plan as yet, but the combination added up to a sharp reversal of sentiment against short positions in investment banks. The “kitchen sink” theory was revived (i.e., the banks have now written off every possible problem) and it was time for short-sellers to cover their bets and get out of Dodge.

That became a virtuous circle for the bulls. Short squeezes trigger buying, which makes sector funds go up, which begets more buying and the next thing you know the whole market is out on the dance floor. That’s how stocks such as Ford (F) and General Motors (GM) could rise nearly 5% on a day when they were both reporting double-digit sales declines that widely missed estimates.

Okay, so the investment banks aren’t going out of business and it is the month of April. What does this mean? MarketWeek readers want to know.

It would be foolish to deny the turnabout in sentiment. The simple truth is that we’re more optimistic in the springtime and less so in the fall. Partly this is our own biological clocks, and partly this is due to the nature of the calendar: in the first half of the year, there is less concrete information about the year’s earnings, leaving us free to indulge our hopes. If the hopes get validated, the fourth quarter does well. When they’re dashed, we get market bottoms.

One ‘proof’ that the market is getting better is that many fifty-day moving averages – a widely followed technical indicator – have started to slope upwards for the first time this year. Technicians regard this as an important signal that prices are headed higher. What it really equates to, though, is a conclusion that because we’ve been more optimistic, we should be more optimistic. This is circular logic, but even so should not be dismissed.

Long-term investors do best by investing logically, but traders will go broke in a hurry. As Lord Keynes famously observed, the market can remain irrational far longer than you can remain solvent (an unusual thing about Keynes: he was an economist who made money trading. Economists are usually terrible traders, because they are trained to be rational. Successful trading depends more on interpreting sentiment than logic).

Let’s take a look at the last two bear markets, starting with the ‘90-’92 market. In 1990, the markets started off with a ten percent plunge in January. That sounds familiar. Then prices rallied from the end of February right into mid-April. By the end of March, the S&P was still at a very reasonable 15.7 times earnings. Cheap, by historical standards.

Unfortunately, first quarter earnings got in the way. The real economy will trump the imagined one in the end, and stock prices plummeted. But the rally wasn’t done. Since the price drop didn’t “take out the lows” (fall below the previous low point on a chart), sentiment was shaken but not broken. That sounds familiar today, doesn’t it? Duly emboldened, the markets staged a big 12% rally that took out the previous highs, in theory a major validation of an upward trend.

Unfortunately, companies had to report earnings again in July. That pesky reality. This time the sentiment party was busted, and the markets dove over 20% in the next three months before they finally made a real bottom in October. Cheap got cheaper: those below-average price-earnings ratios fell another ten percent between the spring and fall.

In the bear market that ran from January 2001 to March 2003 (yes, it was that long), the market put on an inspiring spring rally in 2001 of nearly 20%, running from April 4th to May 21st. It was pretty much straight down after that for the next five months, taking out all the old lows.

In 2002, the market put in a double-bottom in February and then tried again. Prices rallied through March up to mid-April. Unfortunately, earnings came along and snuffed out the rally again. This time the markets really slid, taking out the 2001 lows and lots and lots of double-bottoms along the way.

Today’s economy, of course, differs in many respects from those two periods, but they all have one thing in common: recession. Given the increases in unemployment and the decreases in output and sales, it would appear that we’ve entered one. The fashionable cry once again is to “look across the valley.” That’s what traders were doing the last two recessions – until they fell in.

It’s springtime, and the markets like to rally in the spring. Traders were knocking each other over on Friday to proclaim a turning point in sentiment. If only it were so easy. The problem is that earnings aren’t done going down yet, and neither is the economy. One hears it repeated to death that the markets will rally before the economy does. That is so, but it completely overlooks that this would be the shortest recession bear market ever if it went from a peak in mid-October to a bottom in mid-March.

One often hears that the market is a discounting mechanism, but that’s a polite way of saying that it believes that every week’s mood is the future. The markets have a natural upward bias and want to look forward to good things.

The Fed will probably cut rates again at the end of the month, and who knows, maybe that will revive spirits until the next employment report. Traders could even try to put that evil news behind them, at least until mid-July when the next earnings season kicks in. One may as well enjoy the ride and not fight the tape. But we have to agree with Art Cashin, the dean of Wall Street floor traders: we’ve put in an interim bottom, but the recession bottom is still yet to come.

The final market word this week concerns the international markets. When the markets first got a whiff of the credit crisis last August, stock prices hit an air pocket. By September, the hordes of financial advisors earnestly proclaiming international and emerging markets to be a safe haven had become so loud that we called it a contrarian signal. In the September 7th MarketWeek, we wrote that to move into international equities at that point would be akin to paying for a higher spot on the bow of the Titanic.

The first quarter scorecard: according to Lipper and the Wall Street Journal, the average diversified U.S. fund lost 10.1%. Global funds lost 9.6%, emerging market funds lost 12% and China funds lost 21%. European funds were down 9.4%. Safe havens indeed. We also wrote that the “decoupling” theory was just another way to decouple investors from their money. That prediction came to pass.

The Economic Beat

Most of you will have heard about the weak jobs report by now. The loss of 80,000 was much higher than consensus, and the unemployment rate jumped to 5.1%. Not a high number in of itself, but not a good trend either. The losses were widespread. There are three sectors still hiring: government, restaurants and bars, education and health care.

The March data do not include the period that saw unemployment claims spike over 400,000. At this point, the April report is trending worse than the March report. The ADP numbers were once again well off (a prediction of +5,000) and the Trim Tabs prediction dead on (a range of minus 75,000–100,000). Rising unemployment and falling income will not help housing or the stock markets.

There were three monthly survey reports last week: the Chicago PMI, and the ISM manufacturing and non-manufacturing reports. The Chicago report is a survey of area purchasing managers. Although a sub-expansion reading of 48.2 was reported, it beat consensus estimates of about 46 and helped the fuel the day’s rally. New orders increased after two months of contraction. That’s good, but looking through the various categories, especially the drop in backlogs, it may be premature to call it more than a reload after two months of using inventory.

Prices paid increased, which was echoed in the national ISM report the next day. That number was reported as a nearly identical 48.6, also a contraction reading, also slightly above consensus. New orders were reported down sharply, although export orders were up. Commodity prices keep rising, although they are not in short supply. Putting the two reports together, the best characterization of the manufacturing sector now is cautious. The surveys reflect that March headlines weren’t as bad as January headlines, but business is still off.

The theme of a rebound from two months of drawdowns was echoed by the services number. It was about even at 49.6, with a similar recovery in new orders. Like the two manufacturing reports, it reported higher prices. Both ISM numbers reported the lowest March reading since the dreary first quarter of 2003.

Construction spending declined less than expected, providing bullish cheer. The number was pulled up by public construction spending, in particular highways. Heaven forbid that we be accused of cynicism, but I don’t think fixing winter potholes is a sign of a renaissance. Private residential construction was down for the 24th consecutive month.

Mortgage applications dropped sharply. Some hard-core ideologues are trying to pin all the blame for the housing bubble on the Fed’s “irresponsible” interest rate policy. Well, the funds rate is at 2.25%. It was last at that rate in December 2004, when the bubble was just getting going. Thirty-year mortgage rates are back to 5.75%. So where’s my bubble, dude? It couldn’t have had anything to do with (gasp) private sector lenders, could it?

By the way, the Fed raised rates all through 2004, 2005 and 2006. The lending mania didn’t peak until 2007. I guess the lenders didn’t notice. Perhaps it really is the Fed’s fault for not calling them personally and saying, “Hey man, we raised rates.” Or, “Trees don’t grow to the sky.” Yes, yes, it must be the bureaucracy’s fault.

Factory orders declined more than expected, but the new market didn’t care much. The previous week’s durable goods order had removed the surprise element. It was the third monthly decline in a row.

Retail sales appear to be feeble and in real terms, down year-over-year. The data coming out of the weekly chain store reports has been showing steady declines, and the motor vehicles sales report was weaker than expected.

Next week doesn’t offer many reports, which could help spring fever exaggerate the effect of the ones we do get. Pending home sales are on Tuesday and international trade data on Thursday. The latter will probably be overshadowed by the latest jobless claims data and the March sales results from the retail chains. Same-store sales are surely going to be poor, and while I would love to hear an original reason as to why we should ignore them, it’ll probably be, “we already know that” (and don’t spoil the party).

The FOMC minutes are due to be released on Tuesday afternoon. They probably won’t say anything new at all. But give us a bit of nice weather, and our April traders will do their best to translate them into a reason to buy equities. Friday will have import and export price data and another consumer sentiment reading. The Bank of England and the European Central Bank will deliver their latest statements on Thursday; look for a quarter-point cut from the BOE.

StockWatcher’s Corner

Sifting through the rather large wreckage pile of stocks that are off more than 50% from their 52-week highs, we came across Sonus Networks (SONS). At Friday’s close of $3.42, it’s down more than 60% from its high set last June.

Sonus sells VOIP (Voice-over-Internet-Protocol) gear to telecom carriers. That sector has taken quite a beating over the last year. Sonus didn’t help itself out in February by pre-announcing revenues below estimates and saying it wasn’t sure when its option review and 2007 10K (annual business report) would be ready. That took the stock down to about $3.

However, Sonus completed its option review and filed its 10K a week later. Its earnings were better than expected, helping to lift the stock off its low. The company also wrapped up some drawn-out litigation last fall by settling claims.

Although revenue growth has been lumpy as its carrier customers work their way through buy programs, Sonus still grows its revenues nicely every year and its average annual growth rate over the last five years works out to 28%. The company has no debt and had $1.24 a share in cash on the balance sheet as of the end of last year. Operating cash flow has been growing strongly.

IP traffic over wireless and wire lines is growing steadily and will eventually become dominant. Without going into a lot of techno-speak, we think Sonus is well positioned to take advantage of evolving wireline and wireless developments. Carrier IP spending should grow about 20 percent this year.

The main risk to Sonus is that the AT&T (T) and Cingular combination left T being its dominant customer, accounting for 32% of revenues in 2007. Those risks are somewhat balanced by T’s need to support the new spectrum it just purchased, and the data growth that the new iPhone is expected to engender.

If the stock market takes another dip, which we believe likely, the stock could see $3 again. Against that is that at current valuations, Sonus is an attractive takeover candidate. Cisco (CSCO), for example, which is the leader in IP data gear, might want to complement its offering with additional voice-IP gear, and loves to grow by acquisition. In any case, we think that $6 by the end of 2009 is well within reach.

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