MARKET RALLIES AS ECONOMY WORSENS! January 19, 2001

The Philadelphia Fed released its worst manufacturing report in more than ten years this week. It showed that business activity hasn’t just slowed in its Pennsylvania, New Jersey, and Delaware region, but has collapsed. Its index of manufacturing activity plunged to –36.8, its most negative reading since the 1990 recession.

The Commerce Department released numbers on the still booming housing sector showing that building permits for future construction fell 6.6% in December.

The big-three auto manufacturers announced significant production cutbacks, plant closings, and layoffs, as a result of slowing auto sales.

The growing number of lay-off announcements seem to be across the economy.

Almost all major retailers have warned of slowing sales and expectations of “challenging conditions” for the year ahead. Sears is closing 89 of its stores. Union Pacific, the country’s largest railroad, warned it will lay off 2,000 employees due to lower shipping demand. Internet related companies have been making wholesale lay-offs, and even closing the doors altogether.

General Electric released earnings for the December quarter that exceeded Wall Street’s estimates, but warned it will make significant lay-offs from here on, due to the slowing economy and other factors. Analysts expect a minimum of 60,000 to 70,000 G.E. employees will likely lose their jobs.

The NBC television network, a subsidiary of G.E., said it will reduce its staff by 10% in coming months. NBC’s rival CNN says it will also be laying off close to 10% of its staff.

Heavy equipment manufacturer Caterpillar said its outlook for 2001 is bleak, and it will have to take “tough actions” to cut its cost structure.

Merrill Lynch, Charles Schwab & Co., and Bear Stearns, have all announced lay-offs associated with the plunge in the stock market. Credit Suisse Group, a division of Credit Suisse First Boston, one of the leading firms that bring new companies public in initial public offerings, is expected to eliminate up to 10% of its investment-banking workforce.

The Fed’s surprise interest rate cut a couple of weeks ago, *% instead of the usual *%, and made in a rush, between its regular meetings, caused some economists to fear the Fed must see the economy slowing much faster than previously thought, perhaps into recession. The economic numbers and lay-off announcements this week seem to support that notion.

But the stock market shrugged off the news and rallied. And that’s a potential good sign for investors. A market that goes from ignoring good news to one that ignores bad news is usually a market that’s ready to rally.

Much of investors’ renewed enthusiasm for the market is being fueled by December quarter earnings reports that are flooding in now. More than 680 companies reported earnings this week, and while many were pretty bad, several prominent companies that get the headlines came in with earnings that “beat analysts’ expectations”, and saw their stocks shoot up on the news.

However, there have probably been few times in the past when the slogan ‘Investigate before investing’ was more appropriate than now.

Keep in mind that corporations have been issuing warnings for many months that their earnings would be disappointing going forward. With each such announcement Wall Street analysts lowered their earnings estimates. The result is that most companies now announcing earnings that are meeting or beating analysts’ estimates, are doing so only because those estimates were lowered dramatically.

For instance, Ford stock rose this week on the news that the company’s December quarter earnings came in right on Wall Street’s estimate of 64 cents a share. But how many investors bothered to check back and see that those estimates had been lowered dramatically over recent months, and the 64 cents a share was actually a substantial plunge from the $1.47 per share the company earned in the same quarter last year, hardly good news.

Microsoft shares soared on its earnings announcement that it earned 47 cents a share in the December quarter, meeting Wall Street’s expectations. The excitement spilled over into the rest of the tech sector, which also helped move the overall market up. But the truth of the matter is that this once fast-growing company made 44 cents a share in profits in the December quarter a year ago, and back then had been expected to be making 65 cents a share by now. But the company kept issuing warnings that analysts’ estimates were too optimistic given slowing PC sales, and eventually managed to guide analysts to lower their estimates to only 47 cents. And sure enough, Microsoft was able this week to provide the exciting news that it had met Wall Street’s estimates. But is 3 cents a share more than they were making a year ago a sign this company is still on the fast-growth track, and worthy of a high Price/Earnings ratio for its stock?

Ford and Microsoft are not alone. With the slowing economy and deteriorating corporate earnings, most of this meeting or beating Wall Street estimates baloney is far more a case of how successful the company was in getting analysts to lower their estimates, than with how profitably the company is operating in the slowing economy.

Investors would do well to keep that in mind when tempted to chase the earnings announcements without further investigation.

Sy Harding is president of Asset Management Research Corp., publisher of The Street Smart Report Online at WWW.StreetSmartReport.com, and author of Riding the Bear - How to Prosper in the Coming Bear Market.

-- kevin (ktross@mailcity.com), January 20, 2001