FOOL ON THE HILL
A 2003 Rebound?

Wall Street, the White House, and the Fed are (once again) peddling a rosy story about a forthcoming economic recovery that will lead to a boom in earnings, and investors are (yet again) falling for it, bidding stocks up dramatically. Whitney Tilson questions the recent technology stock rebound and the prediction that the economy will bounce back strongly in 2003.

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By Whitney Tilson
November 20, 2002

As stocks continue to rebound strongly from the five-year lows reached in early October, I'm (to quote Yogi Berra) getting d�j� vu all over again.

Dead cat bounces have happened so many times during this painful, grinding bear market that you'd think people would learn; but hope springs eternal. Even in the face of substantial evidence that the economy is weak, there are few signs of a recovery (in fact, there's more evidence that the economy will weaken further, in my opinion) and, equally importantly, stock valuations remain quite high.

Bulls seem to be heartened by the recent Fed interest rate cut, but after 11 cuts failed to prevent the worst bear market since the Great Depression, why should the 12th trigger a turnaround? (Bill Mann entertained the same question weeks ago.) The 50-basis-point move, double what the market was expecting, was a sign of desperation, in my opinion.

I wrote a similarly pessimistic column last December, at about the time stocks peaked during the post-9/11 rally. (Since then, the S&P 500 is down 20.5%.) It's remarkable how similar the story is today. Let's cut through the fervent hopes and look at the evidence.

Consumer spending
Six weeks ago, I wrote, "Consumer spending accounts for roughly two-thirds of the nation's economic activity and has almost single-handedly kept the economy afloat, yet there are alarming signs that consumers are pulling back, either because they are shopped out, fearful, or forced to by job loss, mounting debts, and so forth." In spite of the lower interest rates and rising home prices, which continue to fuel consumer spending, some statistics show a quickening of this trend. For example:

  • A Conference Board survey finds consumer confidence plunged to a nine-year low in October (though it's risen slightly so far in November).

  • Economists expect personal consumption to grow just 1.1% in the fourth quarter, the slowest rate since 1993.

  • With unemployment up to 5.7%, there are now 1.2 million more people unemployed today than a year ago.

  • Though retail sales were up slightly in October, surprising many, this appears to have been an anomaly, as sales are weak again so far in November. Many retailers have recently scaled back expectations or reported weaker-than-expected earnings (e.g., Wal-Mart (NYSE: WMT), Federated (NYSE: FD), Kmart (NYSE: KM), Costco (Nasdaq: COST), Home Depot (NYSE: HD), and BJ's Wholesale Club (NYSE: BJ)).

  • Despite continued margin-killing incentives, such as 0% financing deals and cash-back offers, auto sales tumbled 27% year over year in October to the lowest monthly selling rate in four years.

Business output and spending
Business spending is, if anything, even worse. According to The Wall Street Journal:

The Federal Reserve on Friday said U.S. industrial output fell by a surprising 0.8% in October, the third consecutive month of declining output, after declines of 0.2% in both August and September. As a result, factories and other industrial operations are now running at just 75.2% of their capacity, down 0.6 percentage point from the prior month and 6.7 percentage points below the sector's 1967-2001 average.

The Commerce Department reported that factory orders fell 2.3% in September, following a 0.4% decline in August. While some viewed a Commerce Department report that business inventories climbed 0.5% in September as a bullish sign, the same study also found that business sales fell 0.5% that month, suggesting the rise in inventories could have been the result of weakening demand for goods, not a sustained effort by companies to restock.

And the Institute of Supply Management Index slipped to 48.5 in October, down from 49.5 in September and 50.5 in August. Readings below the 50 mark indicate a contracting factory sector.

Valuations
The fact that there is a cloudy outlook (at best) for the economy does not, by itself, mean stocks are a bad investment. In fact, some of the best times to invest in the market have been when the outlook was bleakest.  But at previous market bottoms, stocks were certifiably cheap, trading at single-digit P/E ratios with huge dividend yields. Today, in contrast, the S&P 500 is trading north of 18 times next year's earnings (if you believe estimates of $50, which I don't), meaning that valuation levels are closer to previous market peaks, not troughs.

The technology sector
I am particularly bearish on the outlook for tech stocks. I said it last December (the Nasdaq is down 33.2% since then), and I'll say it again:

While the stock market remains richly valued overall, the absurdities are greatest -- where else? -- in the tech sector. Demand is dismal, and excess inventories and pricing pressure remain at alarming levels. I try to avoid making short-term stock market predictions, but I'm going to violate my rule: This tech stock rebound is the ultimate dead cat bounce, and the Nasdaq will soon be headed lower -- just as it did after the failed rallies in the summer of 2000, January 2001, and the spring of 2001. [We can now add the failed rallies at the end of last year, as well as in May and August of this year.]

Fred Hickey, author of The High-Tech Strategist newsletter (and, in my opinion, the best tech analyst out there), wrote in his latest letter:

Bear markets serve to clear out the excesses associated with bull markets. A remaining excess of the stock market mania of the '90s is the still grossly overpriced big-cap tech group. Too many investors, particularly institutional investors, are hiding in the likes of Intel, Dell, and Applied Materials.... Bear markets never end with the past bull market's leaders selling at price/earnings ratios of 40 and higher.

In less than four weeks, the fourth-quarter preannouncement period will be upon us, yet there's no sign business has improved at all, and thus no justification for the wild optimism assumed in current earnings estimates.

To see what Hickey's talking about, let's look at his analysis of Intel (Nasdaq: INTC) (the story's the same for Dell (Nasdaq: DELL), Applied Materials (Nasdaq: AMAT), IBM (NYSE: IBM), and many others).  He writes:

Three weeks ago, Intel unloaded a bomb on investors -- a 15% earnings-per-share miss and a warning of lower results for Q4 and Q1 2003. Nevertheless, Intel's stock has soared 42% from its low in mid-October, bringing Intel's P/E ratio to 38 times 2002 estimated results and 31 times estimated 2003 earnings. There was no cause for optimism sounded by Intel management.

Based on Intel's sour comments, analysts now expect first-quarter 2003 revenues of $6.5 billion, essentially the same level it reported in the first quarter of 1997 -- six full years ago. Due to Intel's significantly higher cost structure, earnings will be over 55% lower than in Q1 1997. Sales growth in Q1 1997 was 39% year over year, and earnings per share soared 116%. On the day the company reported those stellar 1997 Q1 results, its P/E ratio was 20. In Q1 2003, analysts expect revenue to show negative 4% year-over-year growth and negative 20% earnings-per-share growth. That must be why Intel's P/E ratio is nearly two times that of the 1997 Q1 level.

Conclusion
While I am moderately bearish on the overall stock market over the next year or two, I'm nowhere near as pessimistic as the legendary Bill Gross, manager of the largest bond fund in the world, Pimco Total Return Fund, who argued in his November Investment Outlook that the S&P 500 is 30% overvalued. I think he's mistaken in extrapolating from this year's and next year's cyclically depressed earnings, and stocks will prove to be a better investment over the next 10 years than bonds or housing. But in the case of most tech stocks, buyer beware!

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money-management firm. He did not own shares of the companies mentioned in this article at the time of publication. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.