First Quarter 1999: Bulls Win as Speculation Overwhelms Deteriorating Fundamentals

The quarter-end rally couldn't quite hold today as the Dow closed at 9,786, after trading at 10,000 this morning (3/31/99). And while the Bulls are clearly able to celebrate strong gains for the first quarter, we believe history will view it as much a Pyrrhic victory, won at a truly great cost as unprecedented speculation wrested complete control of the stock market.

For the quarter, the Dow gained 7% and the S&P500 5%. The economically sensitive sectors performed well, as the Transports rose 5% and the Morgan Stanley Cyclical index gained 4%. Hurt by losses from multinational leaders such as Coke and Gillette, the Morgan Stanley Consumer index declined 1%. The Philadelphia Utility index was clobbered for a 13% decline, with interest rate fears certainly a major factor. The stocks of Banks and many other financial companies were unimpressive, with the S&P Bank index unchanged for the quarter. The brokerage stocks were much the exception as the Bloomberg Wall Street index surged 27% and the S&P Investment banking/brokerage index rocketed 48%. Charles Schwab gained 70%, and now trades with a market value of $39 billion, or more than Merrill Lynch.Schwab's stock value increased $16 billion during the quarter, not bad for a company with 12-month revenues of $3.2 billion and profits of $348 million. With the amazing surge in the popularity of online trading, the stocks of E-Trade, Ameritrade, and Knight/Trimark rose 150%, 290% and180% for the quarter.

The technology stocks had a surprisingly strong quarter, despite rapidly deteriorating fundamentals. The NASDAQ100 gained 15%, the Morgan Stanley High Tech index 17% and the semiconductors 6%. The NASDAQ 100 and Morgan Stanley High Tech indices have 52-week gains of 88% and 71%. For the quarter, the NASDAQ 100 added an astounding $230 billion in market value. Meanwhile, the Internet mania went from unbelievable, to simply unimaginable. For the quarter, the Street.com index of 20 Internet companies surged 58% as the market value of this group surged $92 billion to more than $230 billion. Not bad for a group without profits. Also without profits, the Interactive Week Internet index of 50 companies gained 43% for the quarter while adding $198 billion of market value. The Street.com and Interactive Week Internet indices have 52-week gains of 176% and 194%.

As the quarter came to a close, and with the Internet frenzy running out of control, the IPO market for such companies was working overtime. Yesterday, Priceline.com, which operates a site allowing consumers to bid on airline tickets and hotel rooms, sold 10 million shares to the public at $16. Today the stock closed at almost $83, valuing the company at nearly $12 billion. Last year, Priceline.com lost $112 million on revenues of $35 million. Monday, Critical Path, which lost $11 million on $900,000 in revenues last year providing e-mail services, priced 4.5 million shares at 24. Today, the stock closed at $77, giving the company a market value of more than $2.5 billion. And iVillage Inc., an online service for women that lost $44 million last year on $15 million in revenues, came public at $24. The stock closed today above $100, valuing the company at $2.3 billion. One thing for sure, it doesn't take much of a business to qualify for a multi-billion dollar valuation in this marketplace!

The truly astonishing market value gain, however, was in Microsoft. During the first quarter, Microsoft's market capitalization rose $102 billion and, including the rise in the stock option value, the gain was more than $110 billion; not bad for a company with 12-month revenues of $17 billion and earnings of $6.4 billion. And to put the gain in valuation into perspective, the growth in the total economy's output, or GDP, during the very strong 4th quarter was but $111 billion. America Online, surging 90% during the quarter, increased its market cap by $70 billion. Total revenues for the past year were $3.3 billion with earnings were $281 million. Cisco added $30 billion of market value, although 12-month revenues were less than $10 billion and earnings of about $1.4 billion. Worldcom gained $30 billion in market value, while Yahoo! and At Home added about $10 billion. The NASDAQ Telecommunications index gained 23% for the quarter, adding about $50 billion in market cap, despite a lack of earnings the past year.

Clearly, recent bullish enthusiasm has reached a new pinnacle. As such, it is quite interesting to listen to all the bullish forecasts for Dow 20,000, 36,000, and even 100,000. In last week's edition, Barron's profiled a bullish money manager who has a new book coming out soon. His prediction of a doubling of the Dow in the next 5 years is based on the assumptions of zero inflation and earnings growth of 8% per year, "their long-term trend." Well, the problem is that despite the booming stock market and economy, earnings are not growing at all. Today, in fact, it was reported that while fourth quarter consumer spending surged 5% and the economy grew 6%, profits actually declined 1%. For all of 1998, after tax corporate profits fell 2.2%, the first decline since 1989.

And while the stock market can celebrate a strong quarter, over the coming weeks the story will be told of how companies' actual businesses performed. This will provide quite a contrast to stock prices, as we fully expect that upcoming earnings reports will be dismal and quite disappointing. And we just don't see how stock prices can ignore fundamentals for much longer. Indeed, this extraordinary quarter is most notable for the huge and widening divergence between the performance of stock prices and actual businesses. And, looking forward, a key point to recognize is that with the inevitable slowing of consumer spending and, hence, economic growth, the profit picture will go from bad, to absolutely terrible. Clearly, the bullish analysis simply lacks credibility, as today's record valuations would only be justified with spectacular earnings growth. Today we have anything but this.

Yesterday, Coca-Cola stated that weakness in Russia, Latin America, Japan and Germany would lead to a decline in case sales for the quarter. Analysts now expect Coke EPS to be 28 cents versus last year's 34 cents. And it is not like last year's earnings were that strong. Net income for 1998 actually declined $596 million, or 14% from 1997. Moreover, 1998 net income was only 1% greater than 1996. Yesterday, analysts also cut earnings estimates for Gillette, pointing to the company's huge exposure to weak foreign markets. Keep in mind, Coke and Gillette sell products that are generally not very sensitive to economic downturns. Earnings for capital goods producers, on the other hand, are very sensitive to the global downturn and will certainly be much worse. Caterpillar has already warned that earnings would be 50% below analyst estimates. Estimates now have Caterpillar's first quarter earnings at 38% of 1998's first quarter and 43% of 1997's.

A severe earnings collapse is also developing throughout the technology area. With collapsing prices for PCs, memory and other related components, expect big disappointments for the first quarter and for the rest of the year. Clearly, a debacle is developing in the PC industry. IBM recently released information that showed it lost almost $1 billion selling PCs last year. And today, prices just continue to fall as one can purchase a PC with Intel's new Pentium III processor for only $1500. It was also reported this week that eMachines, a start-up company that began selling PCs for under $600 this past September, is now the 4th largest US manufacturer. This is anything but a bullish development for already squeezed industry profits.

Stock market problems could also come from the continued poor performance of the credit markets. Yields on the 30-year government bond rose from 5.1% during the quarter to above 5.6%. The 10-year bond ended above 5.2%, after beginning at 4.65%, and the 2-year ended at about 5%, after starting the year at 4.52%. As the quarter came to an end, increasing stress was apparent despite Wall Street's continued trumpeting that everything is just rosy.

In sum, despite a very difficult first quarter, we remain very encouraged as fundamentals move rapidly in our favor. With sagging profits, higher interest rates and a continued global financial and economic crisis, the wildly inflated and speculation-dominated US stock market is a definite accident waiting to happen. For us battered bears, this truly is an opportunity of a lifetime. Granted, the bulls again had their way this quarter and were very successful in marking up stock prices into the end of the month. We believe, however, that such "fun and games" will come to an end soon. As always, the degree of excess determines the degree of the following downturn. With this in mind, what we have now is one huge, historic, downturn in the making.

In this type of wild mania, it is particularly instructive to look at Japan, now more than 9 years after its bubble peak. The Nikkei, despite a strong quarter, remains about 60% below its high from 1989. And today, the end of the Japanese fiscal year, the Nikkei closed at it lowest year-end price since 1985.