Telecom Zaps Hopes for Rally

The "a-rally-is-coming ... any-day-now ... we-really-mean-it" crowd suffered another blow today.

The Dow Jones Industrial Average managed to close above its intraday low of 10,109.24 but still lost 1.1% to 10,139.69. The S&P 500 shed 1.5% and the Nasdaq Composite lost 2.1%. Today's losses wiped out the gains posted by the Dow and S&P last week; gains cited by optimists as evidence a rally was beginning.

A profit and cash-flow warning late Friday by WorldCom (WCOM) and Ericsson's (ERICY) lowered guidance today were the main catalysts for the selloff.

WorldCom shed 33% and Ericsson lost 22.6%, while the Nasdaq telecommunications index lost 7.1%. (Lucent (LU), which posted a wider-than-expected loss and announced more job cuts, nevertheless rose 4.7% as investors grasped for the slim reeds of hope.)

Much of the bulls' recent hopes have been based on lackluster volume on down days and the continuing strength of the advance/decline line. The former argument remains intact, but the latter was undermined today. In NYSE trading, 1.17 billion shares were exchanged, 10% below the six-month daily average, according to Bloomberg, while declining stocks led advancers 19 to 11. Losers led 23 to 12 in over-the-counter trading where 1.5 billion shares changed hands.

New 52-week highs bested new lows 168 to 20 in Big Board trading and by 171 to 61 in over-the-counter activity. Still, the "underlying strength" argument was further damaged by the performance of small- and mid-cap indices. The Russell 2000 index fell 1.3%, while the S&P MidCap 400 index lost 1.4% and the S&P SmallCap 600 fell 1%. Some of the notable stories among smaller-caps were big losses suffered by Manhattan Associates (MANH), NeoPharm (NEOL) and Spiegel (SPGLE).

Weakness in big-caps such as WorldCom -- which had a $17.6 billion market capitalization prior to today's losses -- dominated today, but the action in mid- and small-caps may be more telling. Those areas have outperformed for the past three years, and their supporters see continued gains while others believe big-caps are going to retrieve the leadership mantle. (Those are the folks expecting rallies in the big-cap dominated averages.) But if today's action is any indication, there really may be nowhere to run, nowhere to hide within U.S. equities.

In a nutshell that's the message of some recent commentaries by Thomas McManus, equity portfolio strategist at Banc of America Securities.

In a recent report "Is there any value in 'value?' " McManus argued that "much of the value has already been sapped from [small- and mid-cap] stocks." Because earnings have declined over the past two years, "recent performance has come at the expense of attractive valuations in the sector."

The median price-to-earnings ratio of the 1700 stocks in the Value Line Arithmetic index was recently 21 vs. 12 to 13 in early 1999, McManus noted. Furthermore, once-premium earnings yield -- 52-week forward earnings estimate divided by the current price -- of mid- and small-cap value stocks has been "sharply cut back as the stocks have outperformed company earnings," he wrote.

Finally, the strategist noted inflows into small- and mid-cap value funds have only recently risen dramatically, despite (literally) years of outperformance. Such inflows are often harbingers of a top in a given sector or fund group. I know this is the "little guy is left holding the bag" argument, but history has shown it to be accurate.

Today, McManus reported on the historical lackluster performance of stocks in general from May through October. "Sell in May and go away" being the resulting truism. I detailed these seasonal factors on April 2 when the folks at Stock Trader's Almanac issued a sell signal based on them.

McManus was traveling today and couldn't be reached for additional comment. But suffice to say he was early among his peers in favoring value stocks over growth. Furthermore, at 50% stocks, 45% bonds and 5% cash, his recommended allocation remains among the most cautious of so-called major strategists.

Thumbing a Nose at Rally Hopes

As noted above, trading volume didn't increase dramatically today and major averages remain above their Feb. 22 intraday lows of 1074.39 for the S&P 500 and 1696.55 for the Comp. That's going to stiffen the upper lips on the "there's a rally coming" crowd.

Phooey, said Rick Berry, formerly of Centennial Capital Management in Atlanta and now an independent analyst, who today reiterated a call made here on Jan. 14 that "you've seen the highs for the year." (The Dow has since traded modestly higher, but the Comp and S&P have not.)

"To be talking about a rally at this point is totally ridiculous," Berry declared, arguing that both fundamentals and technical analysis suggest otherwise.

Regarding fundamentals, he noted P/E ratios are high while first-quarter earnings reports indicate current estimates remain too high -- suggesting valuations are even more egregious.

Technically, the analyst's main point is that the Nasdaq has broken the weekly uptrend line from its September low with the S&P 500 and Dow poised to follow suit.

Berry does not foresee the Comp revisiting 1800 this year and forecast its "next stop" is 1500.

For the S&P 500, any close below 1106 will break its weekly uptrend line, he said, making a reversal of today's close of 1107.83 critical. Berry sees a short-term "head and shoulders pattern" for the index with the neckline at 1080 and the top of the head at 1170. If support at 1070-1080 is broken, his next target would be 990.

The Dow -- "the least important average" -- broke its weekly trend line at 10,250 today and Berry foresees the index finding support at 9500 but ultimately trading as low as 8500.

Noting this column's propensity for musical allusions, Berry offered two to sum up the current environment: Won't Get Fooled Again by The Who and Where Do We Go From Here? by the Alan Parsons' Project.

Certainly, that's not pleasant stuff for those who are long stocks. Then again, waiting for the much-anticipated rally hasn't been very pleasant either, as today's action so clearly demonstrated.

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