The Valuation Monster Rears Its Ugly Head

The market is a fickle beast. Just as investors seem to be satisfied with recent economic data indicating a slowing economy, the valuation rules change. Here we are almost through a fairly decent earnings season and investors are already starting to fret over third-quarter earnings, as if they can hardly believe the market's current multiples. Enough of these worrywarts, let's step back and put things in perspective.

I remember valuation concerns back in 1993 when the Dow Jones Industrial Average (INDU) was racing towards the then psychologically important 4,000 level. People were nervous and doomsday prophecies were running rampant. "We were at 3,000 only last year, how high can it go?" But as more and more 1,000 point levels were subsequently breached in the coming years, the same question played on everyone's lips, "How high can it go?"

While valuations might have risen 10-fold, computing power has increased over 100-fold. What's more, entire new lines of business have sprung to life. As such, entirely new valuation metrics needed to be invented to attempt to value these new enterprises. Under the new paradigm, formerly outrageous P/E ratios became acceptable. Its no wonder some people are nervous.

Despite the high valuations, I hardly believe investors are factoring in all the possibilities that such phenomenal technology will bring to our lives. We simply aren't that smart. In the meantime, we have a strong economy, and by many accounts a fairly valued market. It might slow down a bit in the near-term or maybe even stop altogether (unthinkable I know). Nevertheless, the market will make the next quantum leap to another equally ridiculous valuation level. Furthermore, it will probably happen too soon for the investing public and they will be wringing their hands over equity valuation in the years to come.

Okay, enough of my chastising, let's get to today's activity. The Nasdaq Composite Index (COMPX) finished lower. The COMPX couldn't find any footing, as it shed 93.51 points to close at 3759.99 with 1.34 billion shares changing hands. Declining issues outpaced advancing issues 23 to 15. 99 stocks found new lows as only 46 managed to capture new highs.

Meanwhile, the INDU eked out a 2.93 gain to close at 10,908.76. NYSE declining issues edged advancing issues 14 to 13 on volume of 941 million shares.

As for the broader and smaller markets, the S&P 500 Index (SPX) lost 12.63 points to close at 1460.24, while small-cap Russell 2000 (RUT) moved lower by 5.85 points to 501.65.

For you coupon clippers, bonds put in a strong showing today in anticipation of good economic news tomorrow from the PPI and Retail Sales reports. Yields are continuing to drop, given the reduced likelihood of a Fed rate hike at the August 22 FOMC meeting. The Fed Fund Futures are now trading at levels that indicate only a 10% chance of a rate hike this month. However, some bond market analysts have suggested that the more tangible threat is a campaign of rate hikes after the November election. Nevertheless, the 30-year bond traded up 23/32, lowering its yield to 5.67% from 5.72% yesterday. The 10-year note added 10/32 to yield 5.75%, down from 5.8% yesterday.

In stock news, Kmart (KM) reported that its second-quarter profits tumbled 83%. It appears that the stock, trading at just over $7, has pretty much vanished off the radar. Kmart has fallen 46% this year.

Kmart shouldn't feel like the only retailing pariah, though, most retailers traded lower on a slew of third-quarter earnings warnings. Heck, even the king of all retailers, Wal- Mart (WMT), extended yesterday's selling on a profit-warning announcement.

Dell (DELL) reported earnings of $0.22 a share, a penny ahead of analyst expectations. Revenues rose 25% year-over-year and higher-margin business lines such as servers and storage products exhibited strong growth. Shares are down $1.50 to $40.25 in after-hours trading.

In IPO news, Orient-Express Hotels (OEH) went public today, generating $190 million dollars. The stock closed up $.75 to $19.75. Agatha Christie was sadly excluded from the IPO. Meanwhile, Large Scale Biology (LSBC) took in $76 million, The stock opened at $27 and traded down from there to close at $21.87. Evolve Software (EVLV) also put in a strong showing, doubling its IPO price of $9 to $18 by day's end.

High Speed Access Corp (HSAC) was the recipient of $75 million from Vulcan Ventures and Charter Communications, both Allen- controlled entities. The stock surged 18% to $5.94. Paul Allen seems to bring the Midas touch to any company he touches.

Immunex (IMNX) shares dropped 12% after American Home Products (AHP) filed to sell 50 million shares. IMNX also announced a secondary offering of 20 million shares. That's a lot of shares to absorb in a stock that normally trades between 5 and 6 million shares a day.

In silicon tech news, the Philadelphia Semiconductor Index (SOX) has made a very interesting chart of late. The index confirmed a double top in late July when the index sunk below the valley created by the two peaks. The peaks are at the 1270 level and the valley is at the 1070 level. We expect to see prices move in the direction of the reversal at least the distance from the valley to the peak. That would put us at 870, which leaves more room on the downside. Keep an eye on this formation to see what happens.

Lilly (LLY) and Sepracor (SEPR) continued their downward spiral today in light of the prospect for generic Prozac to hit the market within a year. Let's be reasonable people. Let's assume that the $2.6 billion in sales that Prozac generates all goes to the bottom line. Furthermore, let's assume that all revenue from Prozac will be eliminated in the years to come. Finally, let's assume these cash flows would have persisted indefinitely, rather than end in 2003 (at the latest) when the patent protection expires. So, let's simply erase $2 billion in expected future cash flows. The only question is what discount rate do you apply to the cash flows. Well, a general rule of thumb for equities is between 12-15%. We'll play devil's advocate and use 15%. The formula $2,600,000/.15 indicates that we would pay $17.3 billion for this revenue stream. The stock sold off over $35 billion in market value. Can anyone say over-reaction?

I reserve the right for one more rant before I sign off. The SEC today approved a rule that is supposed to eliminate selective disclosure that favored information flow to Wall Street Analysts. The ruling requires companies to release material news to everyone at the same time. What does this ruling mean to the little guy? My guess is absolutely nothing. Investment bank research is largely a homogenized product. Let me say however, that some analysts do an excellent job of synthesizing information and assembling accurate valuation models. Their industry expertise is a valuable asset to many investors. Not nearly as valuable, however, as calling up the CFO of Widget.com and gleaning some important corporate events. This information is then usually disseminated to the firms' best clients, prior to the analyst publishing his findings. So the little guy gets screwed anyway.

In Friday's action, the market will be keeping an close eye on tomorrow's PPI and Retail Sales numbers.

Trade wisely.

Chris Pikul
Assistant Editor

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