News Article
BusinessWeek.com
October 17, 2006
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Dow Stumbles in Bid for 12,000

Core PPI unexpectedly surged 0.6%, while industrial production dropped more than forecast. Earnings remained in focus

Stocks finished lower Tuesday, though off their their weakest levels, as the Dow stumbled in its bid to crack the 12,000 mark. An unexpected increase in a closely watched inflation gauge and a surprisingly steep drop in industrial production offset some solid corporate earnings. Traders were looking ahead to Wednesday's consumer inflation numbers, expected to be mild, says Standard & Poor's Equity Research.

The Dow Jones industrial average slipped 30.58 points, or 0.26%, to 11,950.02, pulling back from Monday's all-time closing high of 11,980.6 and new intraday record of 11,997.09. The broader Standard & Poor's 500 index fell 5 points, or 0.37%, to 1,364.05. The tech-heavy Nasdaq composite dropped 18.89 points, or 0.8%, to 2,344.95, hampered by weakness in semiconductor stocks.

NYSE breadth was negative, with 21 issues declining for every 13 advancing. Nasdaq breadth was 18-11 negative.

A report on wholesale inflation weighed on stocks Tuesday. The producer price index (PPI) fell 1.3% in September on a 22.2% drop in gas prices, but the core PPI, which excludes food and energy, climbed a surprising 0.6%. "The markets will focus on the jump in the core number," says Action Economics.

Some analysts say rising inflation might mean the Federal Reserve isn't done raising rates. "I still think that upside inflation risks dominate, and the Fed may still have work to do," says Richard Berner, Morgan Stanley's chief U.S. economist. "Among the reasons: inflation expectations are elevated and edging higher, slack in the economy has dwindled, and costs are accelerating."

Still, the PPI report doesn't change expectations for Wednesday's consumer price index (CPI) data, other analysts say. "The heavy discounting of vehicle prices over the past two months did not seem to have a significant effect in the core CPI, and therefore this month's rebound also seems unlikely to push the relevant CPI components significantly higher," says Goldman Sachs.

In other economic data, industrial production fell 0.6% in September, a much larger drop than expected, after an upwardly revised flat reading in August. Capacity utilization fell to 81.9% from 82.5%

Meanwhile, the National Association of Home Builders' housing-market index bounced to 31 in October, snapping a 12-month decline from 68 a year earlier and a downwardly revised 30 in September. Wednesday's calendar holds the release of September housing starts.

On the company side, Johnson & Johnson (JNJ) was higher after the health products maker posted a 9% rise in third-quarter profit, beating analyst expectations.

Fellow Dow member United Technologies (UTX) was lower despite a 21% jump in third-quarter profit, which topped Street estimates. The company also warned that a slowing housing market could dampen its 2007 earnings.

Shares of Merrill Lynch (MER) rose after the brokerage said its third-quarter earnings more than doubled.

Dow components Intel (INTC) and IBM (IBM) were set to report earnings after the close, along with Internet bellwether Yahoo! (YHOO) and phone maker Motorola (MOT).

In analyst calls, Intel was lower as Goldman Sachs downgraded the chipmaker from buy to neutral on valuation. Separately, Cowen downgraded Yahoo! from outperform to neutral, but shares of the company rebounded in the final hour.

Companies set to post quarterly results Wednseday include Apple (AAPL), eBay (EBAY) and J.P. Morgan (JPM).

M&A activity also remained in focus Tuesday. Chicago Mercantile Exchange Holdings (CME) reportedly agreed to acquire CBOT Holdings (BOT) in a roughly $8 billion share swap that would a giant global derivatives exchange.

Elsewhere, Wal-Mart (WMT) edged lower amid reports the company has agreed to buy a shopping chain in China for about $1 billion.

In the energy markets, November West Texas Intermediate crude futures fell $1.01 to $58.93 a barrel of ahead of Wednesday's weekly inventory report.

European markets finished lower, breaking a nine-day rally. In London, the FTSE-100 index fell 65.6 points, or 1.06%, to 6,106.8. Germany's DAX index dropped 71.44 points, or 1.15%, to 6,115.1. In Paris, the CAC 40 index was down 58.99 points, or 1.1%, to 5,302.99.

Asian markets ended mixed amid North Korea nuclear worries. In Japan, the Nikkei 225 index shed 81.17 points, or 0.49%, to 16,611.59. In Hong Kong, the Hang Seng index nudged higher 4.64 points, or 0.03%, to 18,014.84. Korea's Kospi index lost 5.42 points, or 0.4%, to 1,351.3.

Treasury Market

Treasury yields slipped following the soft industrial production data, recovering from early lows on the solid NAHB report. Bond traders expect milder inflation data tomorrow, says Action Economics. The 10-year note edged up in price to 100-24/32 for a yield of 4.77%, while the 30-year bond nudged higher to 93-23/32 for a yield of 4.9%.

News Analysis
BusinessWeek.com
October 16, 2006
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Getting Your Parents' Finances in Order

You and your parents can achieve peace of mind by following these helpful tips for dealing with everything from wills to insurance

The upcoming Thanksgiving holiday can be more than a chance for families to get together over turkey and mountains of mashed potatoes. It's also a reminder that while Mom and Dad may still be very much a part of the celebration, they might also be worrying about their nest egg. With the holidays approaching, the best gift of all for your parents might be to help them achieve peace of mind by making sure their finances are in order.

Parents of all ages have a host of complex financial needs, from managing their retirement accounts to estate planning. Such sensitive subjects shouldn't be broached with a mouthful of stuffing. Try setting aside some time on one of the other 364 days of the year to make sure these needs are all met. "Most parents want the gift of time, so planning the time to help them is the real value and what they'll appreciate most," says Patricia Konetzny, a financial planner in Maynard, Mass.

It's a two-way street. Being financially secure also happens to be one of the best gifts parents can bestow upon their children, financial planners say. "If we give them everything they want but become a burden in the future, we haven't really given them anything," says Linda Leitz, owner of Colorado Springs-based Pinnacle Financial Concepts and author of The Ultimate Parenting Map to Money Smart Kids.

Here's what parents should have in place to simplify their financial lives for themselves and their loved ones.

1. Prepare for the worst.
Wills may never be a pleasant subject, but they are a must-have for all adults. Find an attorney to put together a will as well as trust and power-of-attorney documents for your loved ones. Without a will, assets get distributed based on state law rather than according to wishes of the deceased.

If your parents already have wills and other estate-related documents, be sure you and your folks know where they're located. Also ask your parents when they last had their wills reviewed. If it has been more than three to five years or there has been a major change in their financial situation, it's time for a check-up, says Susan Elser, a fee-only financial planner in Indianapolis.

In addition to the typical estate documents, your parents should also have a letter of intent. Courts may look to such letters for guidance, though they typically aren’t legally binding. If your parents don't have a letter of intent, help them make one. It should use simple, everyday language that will make it it easier to have their wishes carried out in case the formal documents are unclear. "Sometimes an individual's desires are muddled in the legalese," points out Adam Leavitt, president of Red Rock Financial Advisory in Tulsa.

2. Name names.
What's in a name? Quite a lot, it turns out. It's a good idea to double-check who is designated as beneficiary on retirement accounts and insurance policies. "Qualified retirement account beneficiary designations cannot be overridden by a will," says Don Martin, owner and founder of Los Altos (Calif.)-based Mayflower Capital. "So if the owner forgot to change the name of the beneficiary to the desired person, then the funds will go to an unintended beneficiary,"

Such a review is particularly important for parents who have divorced and remarried, Martin says. And if someone who was widowed forgets to update beneficiary designations, then their previously deceased spouse's estate would inherit the retirement account. That adds an extra layer of taxes, fees, and hassles.

Trouble can occur even when both parents are still alive and have remained married. Parents who name as a beneficiary in their wills a trust for a child must also change the beneficiary forms for their retirement accounts and life insurance policies. "Otherwise, upon their deaths, the trust won't get funded," says Elaine Scoggins, president of Tampa-based Scoggins Financial.

3. Collect Records.
Many people can barely keep their own files straight, so imagine the challenge of sifting through someone else's during a time of crisis. "Frankly, the administrative specifics after death are more time-consuming and emotionally draining than the 'official' topics," says Mary Clair Allvine, a financial planner with Chicago-based Brownson, Rehmus & Foxworth and author of The Family CFO.

Ask your parents to provide a list of their investment, bank, and insurance accounts, along with contact information and account numbers. Also find out where they keep important documents and assets. Dave Ragan, a financial planner at Denton (Tex.) -based Grunden Financial Advisory, recommends every family have an "I Love You Book." This binder or notebook would include such information as all bank accounts, credit cards, liabilities, assets, and doctors.

What about parents' safe deposit boxes? Parents should "consider giving an adult son or daughter a second key and access privileges to the box," says Mathew Gelfand, president of Bethesda (Md.)-based MDG Financial Advisors. He cautions that this may require a visit to the bank. Moreover, many financial planners suggest moving securities out of safe deposit boxes and into brokerage accounts.

The Internet era has brought with it a proliferation of passwords. These, too, should be kept in a safe place where children can find them if necessary. "Since many people have a variety of online accounts, access to passwords may become critical in a time of emergency," says Penny Marlin, president of Delray (Fla.)-based Marlin Financial.

4. Ensure they've got the right insurance.
Insurance needs differ from person to person, but it's worth a moment to check whether your parents have the policies they need. Parents who qualify should sign up for the new Medicaid prescription drug benefit plan (see BW Online, 05/05/06, "New Medicaid Complications"). Some planners also recommend picking up supplemental health-care insurance.

Long-term care insurance (LTC) may be right for many parents. "Parents over 60 should certainly consider themselves candidates for good LTC coverage," says Wexford (Pa.) financial planner Robert Choiniere. He suggests children think about funding the LTC, because it can help prevent the erosion of the estate they will presumably inherit.

As for homeowner's insurance, make sure the properties your parents think are covered actually are. Mark Gleason, a financial planner with Burbank (Calif.)-based Wescap Management Group, recalls a recent case of fire on a property with two dwellings. "It turned out the insurance only covered the one dwelling that didn't have the fire," he says. Planners also recommend owning an umbrella policy, which offers extra liability insurance in case of auto accidents or lawsuits.

Then there's life insurance. Older parents who don't need their policies should either give them to their children or sell them to a third party, Gleason says. Both options are typically better than simply surrendering the policy and cashing it in, which given the lowest expected value.

5. Check their retirement accounts.
After talking about wills and beneficiaries, asking your parents about IRAs and such should be a snap. Parents over age 70 need to be making their required distributions from IRAs and pension plans. If they're still working, they should fully fund their 401(k) plans up to the level of the employer match. Many planners also recommend Roth IRAs for those who qualify.

Just as with insurance, investment needs will vary. "The main question is: Do they need income from their investments to live on?" asks Argyle (N.Y.)-based financial planner Marjorie Randles. If so, they need to invest in income-producing securities. She uses iShares exchange-traded funds, like the iShares Dividend Index Fund (DVY ), which has a relatively low 0.4% expense ratio.

Still, even older parents should be sure their portfolios are not too conservative. As with any investor, their assets should be diversified across a number of different asset classes. "They may still live a very long time, and growth above the inflation rate should be a part of the portfolio objectives," says Gleason.

Many planners also suggest keeping a cash account for emergency expenses. It should contain at least three months of living expenses, they say. Depending on the economic environment, it might take too long to sell off real estate or other assets, so ready cash can be used to help pay debts, taxes, or deal with any other unexpected costs.

Talking with parents about important financial matters can be easy to put off. But get over your discomfort and sit down with them. You'll be thankful you did—and they will, too.

News Analysis
BusinessWeek.com
October 13, 2006
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Yum! Growth with Global Flavor

The restaurant operator's stock has soared as international expansion fuels strong earnings. Next up: 14,000 Taco Bells for China

Nothing whets Wall Street's appetite like a positive earnings surprise. On Oct. 11, Yum! Brands (YUM ) reported a 12% jump in third-quarter profit, beating analyst expectations. and raised its full-year earnings forecast. Shares of the Louisville (Ky.) fast-food chain operator climbed to a 52-week high a day later, before settling at $59.08, up 8.2%.

Some traders may have even stopped by a Yum location on their lunch break, since the company's restaurants are seemingly everywhere. Spun off from Pepsico (PEP ) in 1997 and formerly known as Tricon Global, the company owns and operates more than 34,000 quick-service restaurants worldwide, including such chains as KFC, Pizza Hut, and Taco Bell. More than 11,000 of those stores are in its international division.

Yum's exposure to overseas markets should keep profits cooking despite a slowing U.S. economy, some analysts say. At the same time, lower gasoline prices and strong branding initiatives could help Yum's domestic stores withstand a tougher consumer outlook. Ongoing stock buybacks and dividends may also support the shares.

STRONG CASH FLOW.  For the third quarter, Yum posted earnings of 83 cents per share, ahead of analyst estimates of 75 cents. The company also lifted its earnings guidance for 2006 to $2.89, for growth of 14%, from its prior forecast of at least $2.83. "The power of our global portfolio and international scale and growth makes us not your ordinary restaurant company," said David Novak, Yum's chairman and chief executive, in an Oct. 12 conference call.

Following the earnings announcement, Goldman Sachs (GS) raised its earnings estimate and price target for Yum stock. "We continue to believe companies that offer global diversification, strong free cash flow, and flexible capital structure remain the best investment opportunities in the restaurant industry," Goldman Sachs analyst Steven Kron, who has a buy rating on the stock, wrote in an Oct. 11 report. (Goldman has an investment banking relationship with Yum.)

International business has already given Yum's performance a boost. Third-quarter operating profits rose 26% in the company's expanding China division and 22% in other international areas, compared to 1% U.S. profit growth. The strong earnings report came the same day another fast-food giant, McDonald's (MCD ), raised its third-quarter profit outlook due in part to rebounding sales abroad (see BusinessWeek.com, 10/12/06,"A Golden Month for the Golden Arches").

MAINLAND MOMENTUM.  The nearly 1,700 KFC restaurants in mainland China represent a key growth opportunity for Yum, according to industry observers. "It's a very large and increasingly affluent market," says Malcolm Knapp, president of New York consultancy Malcolm M. Knapp and founder of the Knapp-Track casual-dining research service. "They really have their act together there, and that should just continue."

Yum isn't stopping there. In the conference call, Novak announced plans to open 14,000 Taco Bells in mainland China. Along with a proposed 2,000 Pizza Huts and various other locations, Novak projected a total of 20,000 Yum restaurants in mainland China, though he did not provide a schedule.

Yum's shares are up 33.6% from their 52-week low, reached Aug. 1. The rebound comes as the large-cap Dow Jones industrial average hit new all-time highs. Yum's stock price jumped 3% on Oct. 4, amid a restaurant-sector rally on strong September sales reports. Two weeks earlier, the company said it expected a 2% decline for the month in U.S. same-store sales, a key retail metric, but a 10% gain in its international division.

MORE SHARE BUYBACKS.  In addition, Yum has taken steps aimed at increasing shareholder value. On Sept. 14, the company's board approved an additional $500 million stock buyback, on top of another $500 billion authorized in March, and also approved a dividend of 15 cents a share. The share repurchases will reduce share count by 6% this year, following a 2% reduction last year, Novak said. Stock buybacks can boost per-share earnings by reducing shares outstanding (see BusinessWeek.com, 8/28/06, "Buyback Binge: Bane or Boon?").

Merger-and-acquisition activity has also nudged Yum shares toward their current highs. On Sept. 12, Yum said it completed a buyout of the remaining 50% of its British Pizza Hut joint venture from partner Whitbread. The deal was valued at $184 million, plus $25 million of assumed debt.

While Yum has enjoyed growth internationally, trends have been softer for its U.S. restaurants. On Oct. 12, UBS (UBS) lowered its estimates for fourth-quarter earnings and for same-store sales (sales of units open at least a year), citing slower sales. Nevertheless, UBS analyst David Palmer has a buy rating on the stock. (UBS makes a market in Yum securities.)

Still, the company's recent U.S. troubles shouldn't offset its upbeat outlook over the long haul, some analysts say. "We are confident in the international business long term, and we believe the problems faced by the U.S. business can be fixed through more aggressive promotional and brand management efforts," says JP Morgan (JPM )analyst John Ivankoe in an Oct. 11 note. Ivankoe has an overweight rating on the stock. (JP Morgan has an investment banking relationship with Yum and makes a market in its securities.)

However, some analysts express concerns about Yum's valuation. Indeed, the stock was fairly valued ahead of the latest gains, according to Cowen analyst Paul Westra, who has a neutral recommendation on the stock. (Cowen seeks to do business with companies covered in its reports.)

Yum still must solve the challenges facing its U.S. restaurants, and Novak's bold plans for China will certainly meet obstacles, as well. Still, the company's exposure to this growing market could be a good option for investors nervous about a slowing domestic economy.

News Article
BusinessWeek.com
October 12, 2006
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Dow: Next Stop, 12,000?

The blue-chip average topped 11,900 Thursday on good news from McDonald's and Costco. The Fed's Beige Book report showed continued growth

Wall Street touched another new milestone Thursday, as the Dow industrials passed 11,900 for the first time en route to a new all-time closing high. The blue chip benchmark ended the session within 53 points of the 12,000 mark. Stronger-than-expected earnings reports and the moderate tone of the Federal Reserve's Beige Book report helped cheer investors.

On Thursday, the Dow Jones industrial average rose 95.57 points, or 0.81%, to 11,947.7, its best-ever close, after reaching a fresh all-time intraday high of 11,959.63during the session. The broader Standard & Poor's 500 index added 12.88 points, or 0.95%, to 1,362.83. The tech-heavy Nasdaq composite climbed 37.91 points, or 1.64%, to 2,346.18.

NYSE breadth was decidedly positive, with 26 issues advancing for every 7 declining. Nasdaq breadth was 23-7 positive.

Recent economic figures suggest a bullish scenario for economic growth and inflation, some analysts say. "The market's really in a sweet spot in terms of the economic data, and it's driving prices higher," says Chris Johnson, managing quantitative analyst at Schaeffer's Investment Research.

The Fed's Beige Book report provided the bulk of the upbeat economic news Thursday. The report showed continued economic expansion, with tight labor markets in some districts. Its moderate tone was in line with expectations and less hawkish than the FOMC minutes released the previous day, says Action Economics.

The Fed's report noted "few signs of increased pricing pressure" and "generally modest" wage growth, analysts noted. This benign outlook suggests the Fed can successfully guide the economy to a soft landing, says Standard & Poor's Equity Research.

Elsewhere on the economic front, the U.S. trade deficit unexpectedly widened to a record $69.9 billion in August after a $68 billion deficit in July. Jobless claims rose 4,000 to 308,000 in the week ended Oct. 7, from an upwardly revised 304,000 a week earlier.

On Friday, retail sales numbers may give investors further clues on the health of the economy. September retail sales are expected to rise 0.2%, holding flat excluding automobiles, according to Action Economics. The economic docket also holds August business inventories and September trade prices.

In corporate news Thursday, McDonald's (MCD) was higher after the fast-food giant said third-quarter sales would be better than forecast following a 7.7% increase in September same-store sales.

Shares of Costco (COST) rose as the wholesale club operator's fourth-quarter results topped Wall Street expectations. In August, Costco lowered its fourth-quarter earnings forecast, citing markdowns on big-ticket items like furniture and big-screen TVs.

Among other stocks gaining on stronger-than-expected quarterly earnings were motorcycle maker Harley-Davidson (HOG ) and fast-food chain operator Yum! Brands (YUM ).

Beverage maker Pepsico (PEP) reported a 71% jump in third-quarter profit, but shares fell after initial gains as the company's full-year outlook missed Street projections.

Companies set to report earnings Friday include Dow component General Electric (GE ).

In the energy markets, November West Texas Intermediate crude futures rose 27 cents to $57.86 a barrel, after a weekly report showed larger-than-expected increases in oil and gasoline inventories alongside an unexpected decline in distillate supplies.

European markets finished higher. In London, the FTSE-100 index rose 47.8 points, or 0.79%, to 6,121.3. Germany's DAX index added 40.83 points, or 0.67%, to 6,160.28. In Paris, the CAC 40 index was up 48.32 points, or 0.91%, to 5,361.51.

Asian markets ended mixed. In Japan, the Nikkei 225 index slipped 31.76 points, or 0.19%, to 16,368.81. In Hong Kong, the Hang Seng index edged up 10.3 points, or 0.06%, to 17,873.09. Korea's Kospi index gained 6.29 points, or 0.47%, to 1,331.78.

Treasury Market

Treasury prices drifted ahead of Friday's retail sales report. The 10-year note was little changed at 100-24/32 for a yield of 4.78%, while the 30-year bond was also flat at 93-22/32 for a yield of 4.91%.

News Analysis
BusinessWeek.com
October 11, 2006
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Nightmare on Wall Street

With Halloween approaching, here are five factors that experts say could frighten the markets, even as the Dow hits all-time highs

On Oct. 9, North Korea spooked investors by announcing its first successful test of a nuclear weapon. Asian indexes tumbled, while European markets fell at the outset before finishing mixed. In the U.S., major indexes gained slightly despite overnight losses (see BusinessWeek.com, 10/9/06, "Dow Hits New High Despite North Korea Tests").

North Korea's nuclear saber-rattling might not have been enough to derail the Dow Jones industrial average's recent run toward record heights. Still, stocks face more than enough potential bogeymen to keep investors up at night.

In the spirit of the upcoming Halloween holiday, this week's Five for the Money looks at five factors that experts say could make mischief for the markets.

1. Haunted Housing
To be sure, the slowing housing market is already giving investors frights. The PHLX Housing Sector index is down 17% for the year through afternoon trading Oct. 11. Federal Reserve Chairman Ben Bernanke recently said he expects the housing downturn to shave 1% off economic growth this year and possibly next.

But what if housing's horrors turn out to be even worse than expected? An unexpectedly sharp slowdown could be a downside risk for the market, analysts say. Worse, the unpleasant surprises may have already begun. "Although our outlook for housing has been among the pessimistic of economic forecasters, the correction thus far has been deeper than we expected," Goldman Sachs (GS ) economist Ed McKelvey says in an Oct. 9 note.

Since 1994, the Standard & Poor's 500 index has tended to follow the direction of the National Association of Home Builders' housing market index about a year later. Recent declines in the homebuilder confidence gauge may suggest tough times ahead for stocks, according to Liz Ann Sonders, chief investment strategist at Charles Schwab (SCHW ). Sonders suggests investors remain about 5% underweight on domestic equities in favor of cash.

"There is still likely more pain and suffering to come before we can close the books on this housing cycle," Sonders says in a Sept. 21 report. "And the harder housing falls, the harder it will be for the economy to land softly."

Still, some see the weakness confined to housing, while others maintain the worst could be over (see BusinessWeek.com, 10/10/06, "The Dust May Be Settling for Homebuilders"). Gains in nonresidential and public construction spending have offset the drop in residential construction, according to Ed Yardeni, chief investment strategist at Oak Associates. "Will the housing market lead to an economy-wide recession?" Yardeni asks in an Oct. 10 note. "Not in our forecasts."

2. Earnings Fears
These have been fat times for corporate profits. The S&P 500 recently posted its 17th consecutive quarter of double-digit percentage earnings growth, a streak S&P projects will continue in the third and fourth quarters. While Wall Street expects the celebration to roll into 2007, a slowing economy has made some analysts skeptical (see BusinessWeek.com, 9/15/06, "Both Can't Be Right").

Declining commodity prices and cooling economic growth may cause earnings to decelerate next year, analysts say. "Nominal growth is poised to slow quickly, and with it, the revenue gains of many firms, particularly commodity producers who have enjoyed stunning price gains," says Citigroup (C ) senior economist Steven Wieting in an Oct. 9 note. "We continue to expect a 7.4% gain in S&P 500 EPS in 2007 after a 15.4% rise in 2006."

Disappointing quarterly results from Alcoa (AA) may signal trouble for stocks even sooner. Announced Oct. 10, the aluminum giant's earnings shortfall "questions the sustainability of the recent rally, especially with the Dow at all-time highs," according to market-analysis outfit Briefing.com.

3. Recession Risk
If weaker housing or slower earnings growth sound scary, just imagine the market implications should the economy fall into outright recession. Stocks' recent gains notwithstanding, some forecasters say a hard landing is more likely than investors might suppose (see BusinessWeek.com, 9/18/06, "The Gloomy Side of the Street").

The Treasury yield curve is one indicator of possible economic weakness, some analysts say. In afternoon trading Oct. 11, the yield for the 10-year Treasury note was more than 50 basis points below the federal funds rate. "Every time this relationship inverts by more than 100 basis points, we're faced with negative year-over-year job growth and a recession," says Jack Ablin, chief investment officer at Harris Bank.

Bond investors may be well aware of the slowing economy, but a strong corporate bond market suggests they're not predicting a recession just yet, other analysts say. "The Treasury market has been absorbing economic volatility for years now; there is no reason to think that will change," says Brian Reynolds, chief market strategist at M.S. Howells.

4. Inflation Anxiety
Some investors are already looking forward to the possibility that the Fed will cut interest rates sometime next year to spur economic growth. The market will begin to price in this prospect during the fourth quarter, says Jeff Kleintop, chief investment strategist for PNC Advisors (PNC ), in his most recently monthly outlook.

However, there's a risk that the Fed will not cut rates as soon as investors hope, other analysts say. A lack of a rate cut by early 2007 is a serious possibility, and it would hurt both stocks and bonds, according to David Rosenberg, North American economist at Merrill Lynch (MER ).

Fed officials continue to express worries about inflation, which would suggest holding rates steady. The minutes to the Fed's most recent monetary policy meeting, released Oct. 11, indicate many policymakers remain "quite concerned about the outlook for inflation." On Oct. 9, San Francisco Fed President Janet Yellen said, "Core consumer inflation has been uncomfortably high recently," though she projects inflation to decline in the medium term.

Other analysts also tend to see inflation waning next year. But there may be a rise in labor costs or a rebound in commodity and energy prices, according to Sandra Lawson, senior global economist at Goldman Sachs, in an Oct. 11 dispatch. Either way, inflation is one monster that isn't easily swept under the bed.

5. Geopolitical Hobgoblins
In a recent survey, economists named terrorism as the biggest short-term risk facing the U.S. economy (see BusinessWeek.com, 8/29/06, "10 Threats to the U.S. Economy"). While stocks have shrugged off recent terrorist incidents, the broader threat of violence from the Middle East and, most recently, North Korea, still looms as a possible overhang on the market (see BusinessWeek.com, 9/11/06, "September 11's Lessons for Investors").

Conflict with Iran is one worry, says PNC's Kleintop. Indeed, much of stocks' recent rally has followed the August ceasefire between Israel and Iran-backed Lebanese militant group Hezbollah. Energy prices have also tumbled since the ceasefire.

On the other hand, some analysts say it would take a particularly dramatic event for fears of terrorism or rogue states to further impact the market. "The threat of terrorism is alive and well, but until there is another massive attack on U.S. soil, it is unlikely to kill the present risk preference of world financial markets," says research group Ried Thunberg.

While some of these worries could prove to be just ghost stories, investors should be aware of the key risks to their assets. Here's to hoping the only scary things this Halloween season are those bratty teenagers with the shaving cream cans.

News Articles
BusinessWeek.com
October 9, 2006
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Dow Hits New High Despite North Korea Tests

Pyongyang conducted a nuclear test, flouting international warnings. Deal news was also in focus

Stocks finished modestly higher Monday as the Dow Jones industrial average touched a new intraday record, recovering from early worries sparked by North Korea's underground nuclear test as the energy and materials sectors helped support the broader market. The economic calendar was empty for the Columbus Day holiday.

The Dow Jones inched higher 7.6 points, or 0.06%, to 11,857.81, paced by Caterpillar (CAT), after briefly surpassing Thursday's record 11,866.69 close and setting a new all-time intraday peak of 11,857.81. The broader Standard & Poor's 500 index rose 1.08 points, or 0.08%, to 1,350.66. The tech-heavy Nasdaq composite advanced 11.78 points, or 0.51%, to 2,311.77, helped by Google (GOOG ) on reports of a possible YouTube acquisition.

NYSE breadth was positive, with 20 issues advancing for every 13 declining. Nasdaq breadth was 18-12 positive.

Investors were eyeing the North Korea tests Monday. In the energy markets, November West Texas Intermediate crude oil futures rose 20 cents to $59.96 a barrel amid the North Korea news and reports of imminent OPEC production cuts.

Deal activity was also in focus. Cablevision (CVC) was sharply higher as its controlling Dolan family offered to take the cable TV operator private in a deal valued at $7.9 billion.

Regional banker Mercantile Bankshares (MRBK ) was sharply higher on an agreement to be acquired by PNC Financial Services (PNC ), the holding company for Pennsylvania's largest bank.

In earnings news, Powerwave Technologies (PWAV ) was sharply lower after the wireless gear maker cut its revenue guidance for the third quarter.

Shares of Johnson Controls (JCI ) was higher as the auto parts supplier projected 14% fiscal 2007 growth despite a slow start in the first quarter.

On the analyst front, Advanced Micro Devices (AMD ) was lower despite UBS upgrading the chipmaker's stock from reduce to neutral.

Meanwhile, Citigroup raised its rating on AT&T (T ) from hold to buy while lowering fellow telecom Verizon (VZ ) from hold to sell, citing greater earnings power for AT&T in the next three years.

Elsewhere, Target (TGT) was modestly lower after the discount retailer reportedly sent a letter to major movie studios warning them that movie downloads could hurt Target's DVD sales.

Looking ahead, Alcoa (AA ) kicks off third-quarter earnings season Tuesday, followed by earnings reports from Costco (COST ) and PepsiCo (PEP ) on Thursday.

The week's economic calendar includes a report Friday on retail sales. The docket also holds the Federal Reserve's Beige Book report and the minutes from the Fed's Sept. 20 monetary policy meeting, along with data on September import prices and August international trade.

European markets finished mixed. In London, the Financial Times-Stock Exchange 100 index rose 29.7 points, or 0.49%, to 6,030.9. Germany's DAX index edged down 1.42 points, or 0.02%, to 6,084.4. In Paris, the CAC 40 index crept higher 2.68 points, or 0.05%, to 5,284.74.

Asian markets ended sharply lower on the North Korea news. Japan's Nikkei 225 index was closed for a holiday after it on Friday declined 13.27 points, or 0.08%, to 16,436.06. In Hong Kong, the Hang Seng index slid 228.15 points, or 1.27%, to 17,675.24. Korea's Kospi index tumbled 32.6 points, or 2.41%, to 1,319.4.

Treasury Market

The Treasury market was closed for the Columbus Day holiday. On Friday, the 10-year note ended at a yield of 4.7%.

News Analysis
BusinessWeek.com
October 9, 2006
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After the Dow Record: Gloom or Boom?

Big-cap stocks should continue to outperform in the wake of the Dow's all-time high, analysts say. But a slowing economy could pose pressure

By now, Wall Street is probably running out of unpopped champagne bottles. On Oct. 5, the Dow Jones industrial average closed at a new all-time high for the third consecutive trading session. The broader Standard & Poor's 500 index cruised to its best levels since February, 2001.

Stocks have slipped a bit since, but blue-chip indexes remain near historic peaks, buoyed by falling energy prices and growing optimism that a housing slowdown won't derail the economy. On Oct. 6, the Dow closed at 11,850.21, just below its record finish of 11,866.69. The S&P 500 ended at 1,349.58. Already, some on the Street predict the Federal Reserve will begin cutting interest rates next year.

Investors who remember what happened the last time the Dow reached all-time highs can be excused for feeling a little nervous. The blue-chip benchmark's Jan. 14, 2000, peak didn't just precede a dramatic market downturn. It marked the start of nearly six years of large-cap underperformance (see BusinessWeek, 4/17/06, "Blue Chip Blues").

This time, however, many bulls and bears agree that market leadership has finally shifted to stocks of big companies (see BusinessWeek.com, 10/2/06, "Small Caps: Out in the Cold"). The question is whether the Dow will pace the market higher through a mild economic slowdown, or whether the economy is poised for more drastic weakness. While analysts say this might be a good time for investors to reallocate part of their stock holdings toward large caps, some cautious investors may want to reduce their overall equity exposure, too.

THE BULLS' OUTLOOK.  The bulls see historical patterns working in their favor. The S&P 500 has rallied during the fourth quarter in 16 of the last 18 years, for an average gain of 5%, notes Jeff Kleintop, chief investment strategist at PNC Wealth Management (PNC ). This year, the resolution of midterm election uncertainty and a continued downtrend in energy prices may help ignite the fourth-quarter fanfare, Kleintop says.

Though the blue chips may be at record highs, the "irrational exuberance" of the tech-bubble years simply isn't there, others say. At the S&P 500's all-time high in March, 2000, the forward price-to-earnings ratio for the index was 26, compared to a p-e of 15 now, observes Brian Gendreau, an investment strategist at ING Investment Management (ING ). Gendreau expects the rotation into large caps to continue. "Someday a new high is going to be a peak," he says. "But I don't think we're there yet."

Chris Johnson, managing quantitative analyst at Schaeffer's Investment Research, suggests that investors will be taking their money off the sidelines and bringing it to the big caps. Johnson's down on tech giants like Microsoft (MSFT ) and Apple (AAPL ), but he favors telecom stocks like AT&T (T ) (see BusinessWeek.com, 9/22/06, "Breaking Away from 'Over Loved' Stocks"). "Nobody likes to be missing out on a party, and the party right now is with the Dow," Johnson says.

THE BEARS' PERSPECTIVE.  Nevertheless, the bears have their own historical trends to tout. The Dow is at the top of a three-year trading channel, during which each short-term peak has been followed by a decline, according to Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics. Ritholtz adds that an economic "soft landing" is a rare occurrence, and says investors should prepare for a downturn before getting excited about potential Fed rate cuts.

Jay Suskind, co-head of capital markets at Ryan Beck, agrees there's a real chance of this soft landing turning hard. "I would suggest taking a little money off the table," Suskind says. "I think the market's really ahead of itself."

In the Treasury market, an inverted yield curve—when short-term rates are higher than long-term ones—continues to herald gloomy tidings. The yield curve has a perfect track record for predicting recessions when it remains inverted for three months or more, notes Liz Ann Sonders, chief investment strategist at Charles Schwab (SCHW ), in an Oct. 2 report. "The rally has been built on the back of a 'Goldilocks,' or soft-landing scenario," Sonders says, arguing that slowing corporate profits may darken that rosy picture.

BIG CAPS IN ANY CASE.  Rising costs and slowing economic growth will put the brakes on earnings, concurs Richard Berner, chief U.S. economist at Morgan Stanley (MS ). Overseas business may ease the pain, but not enough to stop profits from falling, according to Berner. "While I've been incorrectly expecting earnings growth to fade for a while, this time it's for real," he says in an Oct. 6 note.

Quincy Krosby, chief investment strategist at The Hartford (HIG), also sees earnings slowing. She says this acceleration and increasing risk aversion will prompt investors to keep rushing to the relative safety of big caps. Meanwhile, Thomas McManus, chief investment strategist at Banc of America Securities (BAC ), is another market watcher predicting slowing earnings and continued large-cap outperformance.

The shift to big companies' stocks may be just one more reason to consider low-cost index funds. "The financial markets have experienced a virtually unprecedented period of market breadth, which has greatly benefited active managers," says bearish Richard Bernstein, chief investment strategist at Merrill Lynch (MER ). "We think that period might now be coming to an end."

Ultimately, this isn't 2000. While the Dow's record highs do mark a psychological milestone, this time analysts say blue-chip stocks should continue to outperform the broader market. How long they can keep it up may depend on who's right about the economy.

News Article
BusinessWeek.com
October 6, 2006
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Stocks End Lower on Weaker Employment

September nonfarm payrolls rose less than expected after an upwardly revised jump in August. Also in focus: GM, Google

Stocks finished modestly lower Friday, though off their weakest levels, as investors weighed a labor report showing an unexpectedly small increase in September payrolls. The Dow Jones industrial average was coming off three consecutive all-time closing highs.

The Dow slipped 16.48 points, or 0.14%, to 11,850.21, pulling back from Thursday's record 11,866.69 close and new all-time intraday peak of 11,870.06. The broader Standard & Poor's 500 index fell 3.64 points, or 0.27%, to 1,349.58. The tech-heavy Nasdaq composite lost 6.35 points, or 0.28%, to 2,299.99.

NYSE breadth was decidedly negative, with 21 issues declining for every 12 advancing. Nasdaq breadth was 17-13 negative.

A mixed report on the labor market was in focus Friday. Nonfarm payrolls rose a meager 51,000 in September, less than half the projected number, after a big upward revision to 188,000 in August. Average hourly earnings rose 0.2%, while the unemployment rate fell to 4.6% from 4.7%.

The report was stronger than it appeared on first blush, analysts say. "The headline job figures was well below consensus, but we wouldn't necessarily term this report 'weak,'" says Action Economics.

The release of September retail sales highlights next week's calendar. The economic docket also includes the Federal Reserve's Beige Book report and the minutes from the Fed's Sept. 20 monetary policy meeting, along with data on September import prices and August international trade.

Third-quarter earnings season also kicks off next week. Alcoa (AA ) is set to post quarterly results Oct. 10, followed by Costco (COST ) and PepsiCo (PEP ) on Oct. 12.

In corporate news Friday, General Motors (GM) was down on reports Jerome York, ally of billionaire investor Kirk Kerkorian, is quitting the company's board after alliance talks with fellow automakers Nissan (NSANY ) and Renault broke down.

On the upside, Google (GOOG ) was higher as the Internet search giant was reportedly in talks to buy online video outfit YouTube for about $1.6 billion.

Elsewhere, Micron Technology (MU ) was sharply lower after the flash-memory product maker posted a 47% increase in fourth-quarter profit, below analyst expectations.

M&A activity also continued to percolate. Cell-phone tower company Crown Castle International (CCI ) agreed to acquire smaller rival Global Signal (GSL ) in a $5.8 billion deal.

Communications equipment maker Avaya (AV ) was down on news it will take a $54 million charge in the fourth quarter related to job cuts.

Shares of Chattem (CHTT ) surged on news the company is acquiring five over-the-counter brands for $410 million from Johnson & Johnson (JNJ ) and Pfizer (PFE ).

In the energy markets, November West Texas Intermediate crude oil futures fell 27 cents to $59.76 a barrel as traders shrugged off talk of production cuts.

European markets finished mixed. In London, the Financial Times-Stock Exchange 100 index slipped 3.3 points, or 0.05%, to 6,001.2. Germany's DAX index rose 10.54 points, or 0.17%, to 6,085.82. In Paris, the CAC 40 index shed 6.47 points, or 0.12%, to 5,282.06.

Asian markets ended modestly lower. Japan's Nikkei 225 index declined 13.27 points, or 0.08%, to 16,436.06. In Hong Kong, the Hang Seng index edged down 4.28 points, or 0.02%, to 17,903.39. Korea's Kospi index was closed for a holiday after it on Wednesday tumbled 22.22 points, or 1.62%, to 1,352.

Treasury Market

Treasury yields climbed on the upward payrolls revision. The 10-year note fell in price to 101-13/32 for a yield of 4.7%, while the 30-year bond dropped to 94-25/32 for a yield of 4.84%.

News Analysis
BusinessWeek.com
October 5, 2006
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Harmonic Hits a High Note

The networking and video systems maker's stock led the S&P 1500 index in the third quarter. But is the picture as bright as investors think?

Harmonic's (HLIT ) stock has been making some sweet music in recent months. During the third quarter, the Sunnyvale (Calif.) tech outfit's stock outpaced the rest of the Standard & Poor's 1500 index, surging 64%. While investors may be singing the stock's praises, some analysts remain hesitant to join the chorus.

On Sept. 27, Harmonic shares hit a 52-week high of $7.75, a gain of more than 100% since the stock bottomed in mid-June. The share price has slipped modestly since then, finishing at $7.50 on Oct. 5. The stock's rebound has come over a period when small-cap issues have lagged as the blue-chip Dow Jones industrial average hits record levels (see BusinessWeek.com, 10/2/06, "Small Caps: Out in the Cold").

An improved earnings outlook, a key product launch, and a potentially lucrative acquisition have helped Harmonic's stock price hit its recent high notes. Still, analysts question whether Harmonic's good news is already priced into its shares. It might not be time yet for shareholders to take profits, but potential investors shouldn't count on Harmonic to keep up its hot streak indefinitely.

A BETTER QUARTER.  The year has been an eventful one for the company, which supplies broadband networking and digital video systems to satellite, cable, telecommunications, and broadcast companies. On May 4, Harmonic named Patrick Harshman, previously an executive vice-president, as its new president and chief executive. Harshman succeeded retiring CEO Anthony Ley, who has stayed on as nonexecutive chairman.

The company was coming off lackluster first-quarter results, with some analysts lowering their second-quarter forecasts (see BusinessWeek.com, 5/16/06, "More Losses for Harmonic").

Then, on July 26, Harmonic reported that its second-quarter loss narrowed to $200,000, from $2.2 million a year earlier, on sales of $53.3 million. While the revenue number came in below Harmonic's target, the company projected sales of $135 million for the second half of the year, topping Street estimates. Harmonic also detailed ongoing cost-cutting measures.

UPTURN POTENTIAL.  One source of additional revenue should be Harmonic's new compression technology for high-definition (HD) video. The company unveiled its Electra 7000 HD MPEG-4 encoder on July 26, in a move that could help it make up ground against MPEG-4 HD video compression leader Tandberg, based in Norway.

Along with Harmonic's Internet Protocol TV (IPTV) business, the new offering may lift shares further in the months ahead, some analysts say. "We continue to see potential for an upturn over the next few quarters," says CIBC World Markets analyst Ittai Kidron, who has a sector performer rating on the stock, in an Aug. 22 note. (CIBC makes a market in Harmonic's securities.)

Shares got another boost following Harmonic's $45 million purchase of privately held Entone Technologies' video networking software business on Aug. 22. The deal comes as bigger players such as Cisco (CSCO ) and Motorola (MOT ) have been buying similar video-on-demand tech players. The Entone unit could add $15 million to $20 million to Harmonic's 2007 top line, according to UBS analyst Nikos Theodosopoulos, who has a neutral rating on the shares. (UBS has an investment banking relationship with Harmonic and makes a market in its securities.)

GROWING APPETITES.  In addition, the company is likely to announce new business from satellite operator DirecTV (DTV) "in the near future," according to Friedman Billings Ramsey research analyst Brian Coyne, who has a market perform rating on Harmonic. (FBR makes a market in Harmonic's securities.) A Harmonic spokeswoman declined to comment on DirecTV.

Going forward, constraints on cable bandwidth could provide Harmonic with an opportunity, as consumers' appetite for high-definition video and video-on-demand services increases, says Merriman Curhan Ford analyst Tim Savageaux, who has a buy rating on the shares. "We believe cable operators will increase spending on network infrastructure over the next few years after several years of declines," Savageaux wrote in a July 27 note.

He's not the only analyst bullish on Harmonic. On Sept. 15, Thomas Weisel analyst Jason Ader raised his recommendation on Harmonic shares from peer perform to outperform. Shares finished the trading session up 2.8%. A Weisel spokeswoman declined to provide Ader's research, citing company policy, while Ader was unavailable to comment.

Nevertheless, others continue to see some hurdles ahead for Harmonic. Operating expenses would still have to fall significantly for the company to achieve "meaningful profitability," Cowen analyst John Anthony says in a July 27 report. Anthony has a neutral rating on the shares. He adds that the "timing and magnitude of potential benefits from new products still remain uncertain." (Cowen makes a market in Harmonic securities and seeks to do business with the companies it covers.)

TEMPERED OPTIMISM.  The real question is what Harmonic will do from here, according to FBR's Coyne. He says the company's business is by nature inconsistent, with two or three strong quarters typically followed by two or three weak quarters. He also points to growing competition in the video compression space from companies like Atlanta's privately held EGT.

Coyne expects Harmonic's performance to revert to the mean, as it has done in the past. "They've gotten back on their feet and they're executing again, but I'm very hesitant to say that they're on a whole new track here," he says.

In a July 26 conference call, Harmonic head Harshman said the company's growth strategy would address the big trends in on-demand video, HD programming, and multiplatform video delivery. "With our deep customer relationships, outstanding technologies, a strong balance sheet, and a proven financial performance, we believe Harmonic is an increasingly strong strategic position to capitalize on the emerging opportunities ahead," Harshman said.

The burgeoning on-demand video market stands likely to become a profitable opportunity for the right tech outfits (see BusinessWeek.com, 11/21/05, "The End of TV (As You Know It)"). Wall Street will be watching to see whether Harmonic can improve its bottom line as it tries to stave off the competition.

News Article
BusinessWeek.com
October 3, 2006
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At Last, the Dow Hits Its Mark

Investors toasted the blue-chip benchmark's ascent Tuesday, but nagging questions on earnings and the economy remain

Wall Street set another bull-market milestone Tuesday afternoon, as the Dow Jones industrial average reached a new all-time high en route to its best closing level ever. Major stock indexes finished higher as investors weighed a drop in oil prices and a chipmaker's revenue warning.

The Dow Jones industrial average rose 56.99 points, or 0.49%, to 11,727.34, a new all-time closing high, after touching a record intraday high of 11,758.95. The broader Standard & Poor's 500 index added 3.83 points, or 0.29%, to 1,334.11. The tech-heavy Nasdaq composite gained 6.05 points, or 0.27%, to 2,243.65.

The Dow hit its previous intraday peak of 11,750.28 on Jan. 14, 2000, and set a closing high of 11,722.98 the same day. The benchmark had been flirting with record levels since Sept. 28, when it briefly bobbed above its old closing high.

NYSE breadth was only slightly positive, however, with 17 issues advancing for every 16 declining. Nasdaq breadth was 16-14 negative.

The latest blue-chip breakthrough came as investors debated whether the economy is headed for a hard or soft landing (see BusinessWeek.com, 10/3/06, "Is the Economy Headed for a Fall"). A report Friday on payrolls and unemployment could shed some new light on that quandary.

Meanwhile, Kansas City Federal Reserve President Thomas Hoenig was set to speak about the economy after the close. Data releases due Wednesday include August factory orders and the Institute for Supply Management's services index for September.

A steep drop in oil prices prompted lower inflation expectations and raised hopes for consumer spending, some analysts say. "On a very short-term basis, an investor would be encouraged by the fact that oil is breaking down below $60," says Joe Battipaglia, executive vice president and chief investment officer at Ryan Beck. Gold futures were down $21.80 to $581.50, as the precious metal is often seen as a hedge against inflation.

Still, the longer-term outlook remains muddied by concerns over a slowing economy, according to Battipaglia. "There's a big leadership change here from small caps to large caps, from value stocks to growth stocks, and from cyclicals into defensive," he says. "When those transitions occur, the handoff isn't always smooth."

In the energy markets Tuesday, November West Texas Intermediate crude oil futures fell $2.35 to $58.68 a barrel, a seven-month low, ahead of an report Wednesday expected to show a jump in fuel inventories. Energy shares like Exxon Mobil (XOM ) were lower as Merrill Lynch downgraded the sector to underweight.

Among other stocks in focus, Boeing (BA ), Wal-Mart (WMT ), J.P. Morgan (JPM ), and Disney (DIS ) paced the Dow higher. Intel (INTC ) pared gains in the final hour on a report the European Union is considering antitrust charges against the company.

Fellow chipmaker Marvell Technology (MRVL ) weighed on the Nasdaq. Shares of the company fell sharply after Marvell lowered its third-quarter revenue guidance and said it would have to restate past financial results over stock-options accounting issues.

Automakers posted relatively solid September sales results. General Motors (GM ) reported a 3.1% drop in U.S. vehicle sales, while Ford (F ) said sales rose 5.2% from a year earlier. DaimlerChrysler (DCX ) posted a 2.3% sales decline. Toyota (TM ) reported a strong 25% sales increase, offsetting the other automakers' weaker-than-expected totals, says Action Economics.

Elsewhere, Sony (SNE ) was lower amid reports of erratic performance by the electronics maker's hotly anticipated PlayStation 3 video game console.

In earnings news, Pepsi Bottling Group (PBG ) was down after the Pepsico (PEP ) distributor posted a 1% rise in third-quarter earnings, in line with analyst forecasts, and affirmed its full-year guidance.

Drugstore chain Walgreen (WAG ) was higher after the company posted 8.5% higher September same-store sales.

Coffee giant Starbucks (SBUX) was higher as the company began selling warm food in 200 of its New York area stores and introduced new maple-flavored products for its fall menu.

Shares of Pier 1 Imports (PIR) sank after the retailer discontinued its cash dividend, in a move the company said will improve near-term liquidity as it executes a turnaround strategy.

European markets finished modestly lower, but recovered from their worst levels of the session. In London, the Financial Times-Stock Exchange 100 index fell 20.7 points, or 0.35%, to 5,937.1. Germany's DAX index slipped 7.24 points, or 0.12%, to 5,992.22. In Paris, the CAC 40 index lost 23.34 points, or 0.45%, to 5,219.79.

Asian markets ended mixed. Japan's Nikkei 225 index edged down 12.2 points, or 0.08%, to 16,242.09. In Hong Kong, the Hang Seng index gained 63.48 points, or 0.36%, to 17,606.53. In Korea, markets were closed for a holiday after the Kospi index on Monday added 2.81 points, or 0.2%, to 1,374.22.

Treasury Market

Treasury yields drifted higher, with the economic docket quiet ahead of key reports due later in the week. The 10-year note edged down in price to 102-02/32 for a yield of 4.61%, while the 30-year bond inched lower to 96-00/32 for a yield of 4.75%.

News Analysis
BusinessWeek.com
October 2, 2006
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Small Caps: Out in the Cold

While the blue-chip Dow sees record highs, stocks of small companies are singing the blues. Is this the end of the sector's outperformance?

Shed no more tears for the blue chips. Sure, shares of America's largest companies underperformed the broader market for more than six years (see BusinessWeek, 4/17/06, "Blue Chip Blues"). Recently, though, the biggest U.S. stocks have enjoyed a long-awaited rebound. One blue-chip barometer, the Dow Jones industrial average, bobbed above its all-time closing high in intraday trading on Sept. 28 and 29.

HOW LONG A SLUMP?  These days it's the small companies singing the blues. The Dow has edged up 0.3% since hitting its peak for the first half of the year on May 10, while the broader Standard & Poor's 500 index has gained roughly 1%. Over the same period, the small-cap Russell 2000 index has declined 7.2%.

Are small caps just hitting a short-term slump, or has the tide finally turned? Much depends on how long small companies can keep putting up strong earnings numbers. It's also unclear whether the cooling housing market will disrupt the economy's oft-touted "soft landing" (see BusinessWeek, 10/9/06, "U.S.: Consumers Aren't Sweating the Housing Slump Yet"). Nevertheless, slowing economic growth could bode poorly for small-cap stocks, which tend to underperform when times get tough.

If large caps are indeed back in the driver's seat, Wall Street is getting what it has long wanted. Analysts started calling for a blue-chip comeback at least two years ago, but the market has consistently poured cold water on their plans. According to Russell Investment Group, investment managers have picked large-cap growth as their most favored asset class in every quarter since Russell launched its survey in June, 2004.

SMALL CAPS, BIG RISK.  Small caps started to lag at a time when investors faced a dizzying array of risks (see BusinessWeek.com, 6/14/06, "A Summer Slump for Stocks"). The Federal Reserve was hiking interest rates to guard against inflation, while the housing slowdown was beginning to spark recession fears. Oil prices soared above $78 amid violence in the Mideast.

At the same time, investors shifted their assets from aggressive stocks to more defensive, conservative securities. Small-cap stocks typically bear more risk than their larger counterparts, so their prices suffered. But so did emerging-market stocks and other economically sensitive issues.

Many of the worries that prompted this flight to quality have faded in the meantime. While housing remains a huge question mark, crude oil futures have dipped below $63 a barrel, and Mideast tensions appear to have cooled. On Aug. 8, the Fed paused after 17 consecutive rate hikes, and the central bank took another pass at its Sept. 20 meeting. Many analysts are forecasting rate cuts for next year.

TOO PESSIMISTIC?  "Here we are at the cusp of the big fourth-quarter selling season for the holidays, and it looks like things might be much better than this pessimistic view the market took a month prior," says Ryan Crane, chief investment officer at Stephens Investment Management Group and manager of the Stephens Small Cap Growth (STSGX ) and Mid Cap Growth (STMGX ) funds. "If we have this soft landing, then I think small-cap growth is going to be exactly where you want to be when everything rallies."

In addition, small-cap stocks could enjoy surprisingly solid earnings. Small companies will no longer have to absorb the fresh one-time costs of the Sarbanes-Oxley corporate-governance legislation or the new stock-options accounting requirements, which whacked previous quarterly results, says Mary Lisanti, president of AH Lisanti Capital Growth and manager of the Adams Harkness Small Cap Growth fund (ASCGX ). "Small caps usually do not underperform large caps until the earnings growth of large caps starts exceeding small caps," Lisanti says.

Such optimism might be premature, others say. Wall Street is overestimating 2007 earnings growth and revving up for possible rate cuts without first pricing in the risk of a recession, according to Sam Stovall, chief investment strategist for S&P Equity Research. "The market is getting enthusiastic about taking an antidote to a poison it has yet to ingest," Stovall says. "We have to start worrying about a recession before we get excited about getting out of a recession."

EXPECTATIONS STILL HIGH.  Jay Rushin, a portfolio manager at AIG SunAmerica Asset Management (AIG), agrees that the market has yet to price in the possibility of markedly slower economic growth next year. He expects large caps to outperform at least through the end of 2006. "Maybe six months from now when we're closer to a Fed rate cut, then that's going to be a more bullish time for stocks," Rushin says.

While profit expectations have come down for the second half of this year, they may still be too high for 2007, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup (C ). "Small-cap stock prices do not yet fully appear to discount a likely slowdown in earnings growth," Levkovich notes in a Sept. 28 report. He says earnings disappointments are most likely from the capital goods, commercial services and supplies, energy, and materials sectors.

Investors will know soon enough whether small companies' earnings remained strong in the most recent quarter. Third-quarter earnings season kicks off in earnest when Alcoa (AA ) reports Oct. 10. September retail sales figures, due Oct. 13, could shed more light on the situation for small caps.

POSSIBLE GAINS.  In the short run, at least, contrarian indicators suggest small-cap shares could be poised for gains. "Small caps are heavily shorted at the stock level," says Mary Ann Bartels, chief U.S. market analyst at Merrill Lynch (MER ), in a Sept. 25 report. "We look for small-cap stocks to rally further in the short term."

Even if small caps do continue to trail their larger peers, some individual stocks should continue to outperform. Doug Pyle, manager of the Excelsior Small Cap (UMLX ) fund, likes such retail names as Columbia Sportswear (COLM ), Talbots (TLB ), and Cabela's (CAB ), plus tech outfits like Varian Semiconductor (VSEA ) and Cabot Microelectronics (CCMP ). "Having some exposure to the asset class is important," Pyle says.

Indeed, diversification across all asset classes is one of the first rules of savvy investing. Still, while no one knows how much earnings will slow, now may be a good time for investors to tweak their asset allocations to prepare for possible weakness in small caps.

News Article
BusinessWeek.com
October 2, 2006
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Stocks Slip amid Data, Oil Decline

Crude futures tumbled near $61. A manufacturing report fell unexpectedly, while construction spending and pending homes sales rebounded

Stocks finished lower in light trading Monday, as investors digested tumbling oil prices, a tech bellwether's analyst downgrade and some M&A news. A report on manufacturing activity was weaker than expected but stronger than some feared, while construction and pending homes sales posted surprising gains. Traders were taking profits amid the absence of last weeks' end-of-quarter portfolio adjustments and the Dow Jones industrial average's failed test of record highs, says Standard & Poor's Equity Research.

The Dow slipped 8.72 points, or 0.07%, to 11,670.35. The broader Standard & Poor's 500 index fell 4.52 points, or 0.34%, to 1,331.33. The tech-heavy Nasdaq composite dropped 20.83 points, or 0.92%, to 2,237.6.

NYSE breadth was slightly negative, with 18 issues declining for every 15 advancing. Nasdaq breath was 20-10 negative.

Oil prices resumed their recent downtrend. In the energy markets, November West Texas Intermediate crude oil futures closed down $1.88 at $61.03 a barrel as expectations for ample supplies persisted even after Venezuela and Nigeria agreed to cut output to keep up prices.

A heavy slate of economic data was also in focus Monday. The Institute for Supply Management's (ISM) index of manufacturing activity unexpectedly slipped to 52.9 in September from 54.5 in August. The soft reading follows a sharp decline in the Philadelphia Federal Reserve's index and a surprising jump in the Chicago purchasing manager's index.

However, the new orders and production components of the ISM report showed little or no change. "Overall, therefore, the report suggests relatively little change in the pace of manufacturing activity," says Goldman Sachs.

Separately, construction spending bounced 0.3% in August, its best showing in five months, after an upwardly revised 1% drop in July. The National Association of Realtors' index of pending home sales rose 4.3% to 110.1. Both figures were stronger than expected, says Action Economics.

A busy calendar could keep investors cautious this week, some analysts say. "Protecting profits for the year may behoove investors rather than taking big gambles," says Action Economics.

September auto sales highlight Tuesday's eocnomic docket. Data releases due Wednesday include August factory orders and the ISM's services index for September.

In corporate news, Apple (AAPL ) was lower after Citigroup cut its recommendation on the computer maker from buy to hold.

Meanwhile, Wal-Mart (WMT) was lower after the retail giant over the weekend said September same-store sales rose 1.8%, below the midpoint of its forecasts. The company is also reportedly capping wages and using more part-time workers.

Deal activity grabbed some of the spotlight. Harrah's Entertainment (HET) was sharply higher as the casino operator said it received a $15 billion buyout offer from private equity firms Apollo Management and Texas Pacific Group.

Shares of Myogen (MYOG ) surged as fellow drug-researcher Gilead Sciences (GILD ) for $2.5 billion in cash, or $52.50 per share.

Elsewhere, LCA-Vision (LCAV ) was down sharply after the laser-correction outfit late Friday lowered its full-year outlook.

European markets finished slightly lower. In London, the Financial Times-Stock Exchange 100 index edged down 3.3 points, or 0.06%, to 5,957.5. Germany's DAX index slipped 4.87 points, or 0.08%, to 5,999.46. In Paris, the CAC 40 index was down 6.88 points, or 0.13%, to 5,243.13.

Asian markets ended higher. Japan's Nikkei 225 index gained 126.71 points, or 0.79%, to 16,254.29. Korea's Kospi index added 2.81 points, or 0.2%, to 1,374.22. In Hong Kong, markets were closed for a holiday after the Hang Seng index on Friday advanced 12.48 points, or 0.07%, to 17,543.05.

Treasury Market

Treasury yields slipped after the ambiguous economic reports. The 10-year note rose modestly in price to 102-02/32 for a yield of 4.61%, while the 30-year bond edged up to 95-30/32 for a yield of 4.76%. An intermediate-term uptrend that started in July is keeping sellers from getting the upper hand, says S&P.