* At Market Close
For Stocks, It's the Worst Yearly Start Ever
By KOPIN TAN
Vital Signs
LET'S BEGIN WITH SOME good news: the designer Miuccia Prada, so visionary she walked men down the runway in Milan last week in fly-less pants and the occasional tutu, plans to take her company public, perhaps as soon as June. Does she expect the stock market to stabilize by then?
Global money managers, presumably still in traditional garb, foresee no such thing in the near-term. They told Merrill Lynch in a recent survey that they have cut their allocation to stocks dramatically. The percentage hoarding cash has jumped to 31% from 21% last month and 17% in October. A whopping 45% say bonds now look overvalued. But, might all the money they've stashed on the sidelines of the equity market one day lift stocks higher?
Last week, futures tracking U.S. home prices predicted a 14.4% slide in those prices this year from their 2006 peak. Only two cities -- Chicago and Denver -- might see peak-to-trough declines of less than 10%, while traders were betting that home values would fall 27% from the peak in Miami (and 19.8% in Los Angeles and 18.4% in Las Vegas). "While the outlook is dire," say Bespoke Investment Group's analysts, "it also means the expectations are already priced into the market."
Widespread acknowledgement of housing and credit woes prodded President Bush to propose a $145 billion economic-stimulus plan. Yet it's a sign of the times that stocks sold off during his Friday speech, with bears fretting that the stimulus might prove too feeble and too late.
Stock benchmarks fell for a fourth straight week, putting the market on track for its worst January ever. The Dow Jones Industrial Average ended the week down 507 points, or 4%, at 12,099. It has fallen 10% in four weeks, and is 15% off its October peak. This is the Dow's worst-ever start to a year.
The S&P 500 ended the week down 76, or 5.4%, to 1325, and has pulled back 15% since Oct. 9. The Nasdaq Composite Index gave up 100, or 4.1%, to 2340, and is 18% off its October high. The Russell 2000 Index of small stocks fell 31, or 4.5%, to 673. Its 21% drop since July 13 puts it officially in bear-market territory.
How afraid is Wall Street? The S&P 500 is at a 16-month low. Only 11% of its components are holding above their 50-day averages. The bond lunge has forced the yield on 10-year Treasuries to a four-and-a-half-year low near 3.6%. One question making the rounds is which benchmark is most negatively correlated to Wall Street bonuses, and thus might make a useful hedge. (The answer, courtesy of Strategas Research: There isn't a perfect hedge, but leveraged bets on gold, or selling financial stocks short might work.)
Option-market sentiment measures registered more fear, but still no surrender. Each time the Dow closed lower this year, it absorbed drubbings of more than 200 points, so it may seem encouraging that by Wednesday, and again on Friday, the beatings have softened to double-digit declines. The bad news: Those came even after the Dow was well ahead earlier in the session; that inability to hold gains is troubling.
Will earnings this week from a broader swath of non-financial companies reassure investors? Not everyone is waiting to find out. "The time comes when enough is enough," says Mike O'Rourke, a strategist at BTIG-Bass Trading, who upped his stock allocation to 50% from 40% while trimming exposure to commodities and cash. The institutional broker had cut stocks from 60% to 40% last June as the private-equity frenzy peaked. But the S&P 500 is now trading at about 15.3 times projected profits of $87, and "for anyone expecting earnings growth here in 2008, the market appears cheaper," O'Rourke notes.
SMART TRADING INVOLVES figuring out the consensus -- and deviations from it. So I was intrigued by a recent Cowen exercise in which sector analysts were asked to list their "top 10 potential surprises for 2008." My favorite is from the battered consumer sector: Private-equity buyers may begin sniffing around specialty-retailer stocks.
Sure, buyout firms -- remember them? -- typically have lusted after department stores with choice real estate. Firms already stressing about debt financing also wouldn't want the added worry of fashion risk.
But never underestimate the lure of a hefty discount. Specialty retailers are now trading as if teens will never buy another pair of dark denims again, and stocks such as American Eagle Outfitters (ticker: AEO), Ann Taylor (ANN), Charlotte Russe (CHIC) and Hot Topic (HOTT)sport enterprise values well below five times trailing Ebitda (earnings before interest, taxes, depreciation and amortization). This compares with 8.5 times EV to Ebitda paid for retailers over time. Also, "many retailers have considerable capacity to add balance-sheet debt" after years of stock buybacks, note Cowen analysts Lauren Cooks Levitan and Paul Westra, adding even recently weakened players have solid cash flow.
Buyout investors have retreated, but pressure mounts with each passing, silent month to put money to work and earn their fee, and a market slide has always improved the hunt. Cowen pegs the odds of "significant private-equity interest in specialty retail" at 30%.
THERE ARE MANY REASONS to like Express Scripts (ESRX). Managing drug benefits for employers is a thriving business, and Express Scripts is the No. 3 U.S. player. Profits have grown with mail orders and as more generic drugs become available. And CVS' acquisition of Caremark underscores the business' appeal. A recession? Bring on the consumers looking to scrimp on prescription drugs.
There is one problem: Each of these reasons has become familiar, perhaps too familiar, to investors searching for a recession-resistant growth stock. Investors have bid the shares up 120% in the past year, and at about 69, the stock trades at 24.2 times 2008 profits -- compared with 23.7 times for the larger Medco Health Solutions (MHS) and 21 times for other health-care-services companies.
Express Scripts pulled back last week after Medco clinched a contract to provide mail-order drugs for HIP Health Plan. JPMorgan analyst Lisa Gill downgraded the stock, worried that certain contracts due to be renewed in mid-2008 "could be at risk." The discounting of generic Protonix, for example, also may prove less dramatic, and the takeover premium in the stock may prove optimistic. The CEO of Walgreen (WAG), for one, recently said he has no plans to buy a pharmacy-benefits manager.
Express Scripts' valuation also is a deterrent. So is its hefty debt load. Long-term debt is about 76% of capital, well above the 18% average of its peers. Benefit-management profits should grow, but upside for Express Scripts may take longer to arrive.
ONCE UPON A TIME, an agreeable date might end with a post-dinner stroll to the local Blockbuster to pick out an agreeable video. But that kind of foreplay will soon be relegated to the realm of nostalgia.
Devotees who worshipped at the annual mecca that is Apple's (AAPL) MacWorld were gushing about a laptop thin enough to fit into a Manila envelope. Less attention was focused on another development: Apple's push to let iTunes customers download movies they can watch on their iPods, iPhones and Apple TVs.
Sure, Apple's movie gallery is thin today, and Napoleon Dynamite doesn't quite ignite on a tiny screen. Analysts had expected a pact with one or two movie studios, but Apple managed to ink content deals with Disney (DIS), Fox, MGM, Sony (SNE), Miramax (DIS), Lion's Gate (LGF), Touchstone, Paramount and Universal. For anyone without a 213 or 310 area code, that's nearly every major studio in Hollywood.
It's far too early to bury the DVD, and perhaps too late to short Blockbuster (BBI) and Netflix (NFLX) -- nearly 37% and 24%, respectively, of their available stock is sold short.
But a movie-rental service from a taste-maker like Apple corroborates the transition toward digital delivery of entertainment, and holds important consequences for cable, telecom, entertainment and technology stocks.
For example, Comcast (CMCSA), which has 1,300 movies on demand, is talking up an aggressive 2009 plan to offer more than 6,000 titles, nearly half in high- definition. Video-in-the-mail pioneer Netflix has a nascent "Watch Now" service, and has teamed up with LG Electronics to develop a set-top box to let consumers stream movies to their high-definition TVs. Even Blockbuster, whose idea of innovation was to drop "Video" from its name, says it is testing technology to enable portable viewing.
We know how long the video-cassette took to die (and some still live on surreptitiously in basements across the country). Conventional wisdom holds that movie studios, which own the content and earn money from DVD sales, will resist digital delivery. After all, the arrival of sheet music, phonographs, radios, televisions, video-cassette recorders and TiVo all met resistance from content owners who argued that the new technology encroached on their property rights. And each time that argument failed.
"Given the enormous time and money spent on fighting innovation in court, Hollywood has an incentive to embrace the inevitable," says Arnie Berman, Cowen & Co.'s technology strategist. "Hollywood could also substantially lower its costs of goods by abandoning physical DVD distribution in favor of video-on-demand and broadband downloads."
Netflix bulls say that most movies worth renting are still on DVD. Blockbuster bulls say that a recession will increase the throngs seeking simpler -- read: cheaper -- pleasures like yet another home viewing of Jaws. Both stocks could run up on short-covering in the near term. But it's a matter of time before every movie from Airplane to Zoolander becomes available on demand.
Who else will be affected as this shift unfolds? DVD retailers from Best Buy (BBY) to Wal-Mart Stores (WMT) could see a franchise threatened. Chip companies like LSI Logic (LSI) that are tied to DVD players could suffer, Berman notes, while communications-equipment makers like Cisco Systems (CSCO), Juniper Networks (JNPR) andSun Microsystems (JAVA) could benefit. Finally, the new revenue stream will escalate the battle between cable companies like Comcast and Time Warner (TWX) and telephone giants like Verizon (VZ) and AT&T (T), all fighting to ensure that you never have to swing by Blockbuster again.
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