Company Focus--7 hidden market signals to watch now
As an avalanche of earnings news descends, read between the lines for real clues about the direction of the economy and market. Here are the details that really matter. By Michael Brush If the rush of negative news this earnings season gives you a headache, here’s simple way to ease the pain: Ignore it. Yes, earnings are bad, but so what? We knew they would be. But as you’re ignoring the profit numbers, there are some details you should be paying attention to. To steal a phrase from Defense Secretary Donald Rumsfeld, we'll call them “snippets of intelligence.” Here are the key “snippets” to keep in mind this earnings season when searching for clues about the direction of the economy and the market: Snippet # 1: Watch sales, not earnings Cost-cutting is once again propping up corporate earnings this quarter. So earnings don’t tell us much about the economic trends that hold the key to the future of the stock market. To get the 411 on the economy, it’s best to watch sales trends instead. Sales at S&P 500 companies actually advanced a healthy 10% last quarter. “With numbers like that, to us it doesn’t seem that things are so bad,” says Alex Motola, of Thornburg Investment Management in Santa Fe, N.M. “But we’re looking for follow-through this quarter.” He says anything above a 5% gain for S&P 500 sales is a good sign. “That would be big,” says Motola. “That would tell us that despite all these concerns about the economy and the consumer, companies are still performing.” As for the cost-cutting, it will gain significance in due time. “All the cost-cutting means the earnings leverage will be huge when the economy picks up,” says Timothy Ghriskey, of Ghriskey Capital in Greenwich, Conn. Snippet # 2: See if recovery hopes are postponed -- again Like a promise never kept, that hoped-for economic revival “two quarters from now” keeps getting postponed. Will companies deliver the same bad news this quarter? “I’ll be listening to all the leaders . . . to find out if they see any change in the outlook for the second half of the year,” says Hugh Johnson, chief investment officer at First Albany. He thinks companies will keep postponing the optimism, and the second half will be bleaker than people now expect. One reason: Worries that oil prices may hang in the $25 to $30 range because of supply problems in Venezuela and Nigeria. If he’s right, don’t expect much pizzazz in the stock market -- especially as we move toward the seasonally weak late summer and autumn months. Capital spending forecasts will be key to watch, because companies need to start spending to rev up an economy still supported mainly by the consumer. The three sectors whose capital spending guidance you should follow the most are technology, industrials and basic materials, says First Call’s Chuck Hill. Analysts are currently looking for a healthy 53% gain in third-quarter tech earnings over the prior year, says Hill. And they’re looking for 24% gains in basic materials and 7% gains at industrial companies. To get a sense of whether these forecasts will hold up, listen closely to big players in these fields such as Hewlett-Packard (HPQ, news, msgs), DuPont (DD, news, msgs), Dow Chemical (DOW, news, msgs), International Paper (IP, news, msgs), Alcoa (AA, news, msgs), General Electric (GE, news, msgs), Honeywell (HON, news, msgs) and United Technologies (UTX, news, msgs). If the forecasts fail, expect trouble. “It’s the postponement of Nirvana to the next time level that will really crunch the market,” says market analyst Phil Erlanger of Erlanger Squeeze Play. As for the all-important consumer, major retailers such as Wal-Mart Stores (WMT, news, msgs), Target (TGT, news, msgs) and J.C. Penney (JCP, news, msgs) already release sales data on a weekly or monthly basis. So you won’t need to wait until May, when retailers report quarterly earnings, to get a read on consumer strength. Investors can get some insight on trends in home mortgage refinancing -- a big supporter of consumer spending in recent times -- from conference calls of big mortgage players in the field like Washington Mutual (WM, news, msgs). Snippet # 3: Watch credit quality In a sinking business climate, before many other signs of economic weakness emerge, companies and people often have trouble paying their debts. That’s why Mark Petrie, of Hokanson Capital Management in Encinitas, Calif., will be listening closely to what banks say about growth in nonperforming (read: dud) loans, and reserves against that bad debt. Capital One Financial (COF, news, msgs) and MBNA (KRB, news, msgs) are great proxies for the quality of consumer debt, says Petrie, noting that they're the two largest credit-card issuers in the nation. FleetBoston Financial (FBF, news, msgs) and Bank One (ONE, news, msgs) have big exposure to commercial credit and consumer debt, as well. Regional banks also play a big role. For economic forecasters, what all these banks say about bad debt means more than their earnings. Snippet # 4: Focus on the fear “As always, the key is not what the news is, but how stocks react to it,” says Erlanger. In a twisted sort of way, bad is good. To set the stage for a meaningful stock advance, Erlanger would like to see bad news create deep fear near term -- preferably this earnings season. “Part of the purpose of a bear market is to create a foundation of doubt and that 'wall of worry' that the market can climb,” says Erlanger. “Bearish sentiment is the fuel for a bull market.” To measure investor fear, Erlanger follows a few volatility indices; these are tools that measure anxiety levels by tracking stock-option volatility. Higher numbers mean more anxiety. Erlanger would like to see the Chicago Board Options Exchange (CBOE), Nasdaq Volatility Index ($VXN.X) climb back to the 70-80 range. It recently was around 40. He’d also like to see the CBOE Volatility Index ($VIX.X) in the 50-60 range. It was recently below 30. Even an intraday move into these ranges would be enough, he calculates, to produce a "healthy" base of fear. Short selling also has to increase. Snippet # 5: See if guidance keeps flowing High-profile companies from McDonald’s (MCD, news, msgs) and Sun Microsystems (SUNW, news, msgs) to AT&T (T, news, msgs) and Mattel (MAT, news, msgs) have suspended earnings guidance. Take it as a bad sign if more companies follow their lead. “Let’s face it, if the guidance were good news, they would give it,” says Erlanger. No one formally tracks the number of companies suspending guidance. So you’ll have to rely on anecdotal reports. Snippet # 6: Watch transportation stocks As arcane as it sounds, the behavior of transport stocks such as CSX Corp. (CSX, news, msgs) in the rail realm, Airborne (ABF, news, msgs) in air freight and Continental Airlines (CAL, news, msgs) can tell you a lot about whether we are headed toward stronger economic growth. That’s why the Dow Jones Transportation Index ($DTX.X) will be watched closely by John Hussman, an economist whose Hussman Strategic Growth Fund (HSGFX) has advanced an impressive 47% since its launch in July 2000. The results of transport companies -- and how their stocks trade -- tell you a lot about the outlook for the economy for three reasons, says Hussman. First, of course, transport companies link producers and customers. Second, they use a lot of energy. So how their stocks behave can give you a read on the market’s outlook for energy prices. Third, transport stocks -- especially the airlines -- have a lot of debt. So how these stocks act tells you a lot about the market’s attitude to bankruptcy and loan-default risk. Since markets anticipate news, you’ll see transport stocks advance ahead of clear signs of improvement in any of these areas. But early hints of improvement may flow out in conference calls by transport companies. “If we were to see strength in the transports, particularly if it were accompanied by a decline in oil prices, that would be a fairly good signal that the market climate has shifted to a more constructive tone,” says Hussman. Snippet # 7: Seek proof that the war really did hurt business About 80% of the companies that used this excuse were probably fibbing, figures John LaForge, a money manager with the Phoenix-Hollister Value Equity Fund (PVEAX). Some, though, really did see orders decline because of uncertainty during the war in March. You’ll be able to spot them because in their conference calls they’ll say orders picked up again in April. LaForge says this will play out in areas where fundamental demand is strong but where buyers had put off orders to hit their first-quarter profit targets. A likely hunting ground: companies that sell equipment used in video on demand, which is becoming more popular among customers of cable companies such as Comcast (CMCSK, news, msgs) and Cox Communications (COX, news, msgs). Phoenix-Hollister has a position, for example, in Concurrent Computer (CCUR, news, msgs), which sells servers used in video on demand. Says LaForge: “In March their customers told them, ‘We don’t want to buy now because we want to make sure we make our numbers, but come April we are going to buy.’” You’ll know for certain April 24, when Concurrent releases its first-quarter earnings. It’s no sure thing that concerns about geopolitical tensions are behind us. “Historically, the war effect lifting the market is based on the euphoria of seeing peace,” says Ghriskey. “But if the mop-up effort in Iraq becomes ugly, and if North Korea becomes ugly, then there are more problems ahead of us in the economy and the market.”
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column.