STOCK MARKET REPORT

          Report#21,         5-13-2001,       Page 1 

Next Stop 1600 or 2350 For NASDAQ?

   In our March newsletter, we said  "... At the moment NASDAQ has technical support (+/- 25 points) at 1750, 1600, 1500 and 1350. Which one is going to hold? For now the 1750-1600 zone should provide -at least- a temporary comfort zone, from which the market will attempt to regroup. In our opinion, a sharp “bear market” rally can not be that far from here. Whether it starts from current levels, or from lower ones, it does not matter, because in either case it should be between 25%-35%, which is a very respectable return..." We had our 35% rally, so now, what's next?  We have always believed that fundamental and technical analysis, are complimentary to each other, and investors are well served when they pay attention to both. One of the lessons that we have managed to learn, in all the years that we have been students of the markets, is the following: from time to time, the "technical" picture of the market does not appear to be in tandem with the "fundamental" one, nevertheless, in the end the two always reconcile. If you have any doubt, just examine what happened last year. Stocks with no earnings, no working and proven business model, and without experienced management teams, traded at exorbitant prices purely because of "momentum" - a technical characteristic. In the end, the fundamental prospects -or lack of- had to be reconciled with the fabulous "technical" strength of those stocks. At that point, investors found out that "momentum" comes in two flavors, a positive one, and also a negative one! If the fundamentals are negative, all the "momentum" in the world can not save a stock. Indeed, investors also found out that, in the face of negative fundamentals, stocks develop negative momentum as well, and its only usefulness is to speedily reconcile the technicals and the fundamentals. A sharply reduced price, and an awfully looking chart are the immediate results of the reconciliation. In other words, you get a stock -like ARBA- that goes from 165 to 5, and also you get a horrible chart -implying horrible technicals- to match the horrible fundamentals, case closed! Why are we boring you with all these? Well, because when trying to make sense out of the action of the market, one must ask, if the tremendous technical strength, exhibited by the markets in their furious rally in April, can be supported by the fundamentals. "Pundits" "gurus" etc, have been arguing that after 200 basis points in interest rate cuts, and another one on the way, the economy will turn around in the second half of the year, and corporate earnings will re-accelerate as well. For the sake of argument, we will accept their thesis. Let's say that indeed, the FED works its magic, and the economy does take off in the fall. Even the most optimistic do not see a resumption of a 5%-6% annualized growth any time soon. If the economy was to rebound in the second half, to the tune of 2% to 3% (which is more likely, if it recovers indeed) then historically, economic growth between 2% and 3% has never been anything to write home about in terms of earnings growth. In fact, the SP500 has averaged 3.9% to 4.5% annual earnings growth, when the economy grows between 2% and 3%. If it was to grow any less than 2%, then according to Morgan Stanley, profit growth becomes negative! At the moment the SP500 trades at 22 p/e, contrast this with the average p/e for the SP500 between 1995 and 1998. During those years the economy grew at an annual rate north of 3.5% and the p/e for the SP500 stood at 18.9. So we fail to understand, how the "experts" can justify a p/e of 22 if they are expecting growth less than 3%. They only way current valuations for the SP500 can be justified, is if the economy resumed its growth at an annualized rate in excess of 5%. Even the most optimistic can't find any evidence to make such an assumption remotely credible. Now let's examine the other beast and its prospects, the "beloved" Naz! The NDX, as of Friday's closing price of 1821, and assuming earnings for 2002 grow at the currently estimated rate of 60% (analysts have not adjusted their earnings estimates for 2002!) then we get a p/e ratio of 58, which can be justified if earnings indeed grow by 60% in year 2002. The NDX has a historic earnings growth rate of 30%, so, if the economy recovers fully in 2002, and these companies return to their historic growth rate of 30% at current levels, the NDX trades at 116 times p/e.! God forbid, we get a "slow" recovery, in which these companies grow their earnings between 20% to 25%, then at current prices the NDX is sporting a not so cheap 174 times p/e for 2002 earnings. In other words, at current prices, the NDX has discounted not just the upcoming recovery, but the next TWO recoveries, and has assumed both will be spectacular! If NDX earnings were to grow at 20% to 25% in 2002, fair value for the NDX is around 1200, which is 620 points below where it closed on Friday. If you got confused with all these numbers, just ask yourself this question: will the economy recover so robustly over the next few months, that will allow companies such as JNPR, BRCD, AMCC, PMCS, CSCO, ORCL, JDSU, BRCM, and the rest of their brethren, to grow earnings in 2002 by 60% or better? If your answer is no, then the NDX at 1821 is grossly overvalued! Of course, you got to keep in mind, that absurd fundamentals did not discourage people from buying wildly overpriced stocks in the past, so, why would it be a deterrent now? At this point, the market is on questionable fundamental ground and thus vulnerable to another decline. However, given the high hopes that have permeated on the Street, it could very well continue higher.

Source: Thompson Financial/ First Call

Our Market Positions:
Dow: Neutral ,SP500:Neutral
NASDAQ:Neutral 

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