Why do some stocks rally in response to bad news and others fall on good news? For the past month, at least, it has had a lot to do with gambling. Dozens of stocks have skyrocketed over the past four weeks, despite some pretty dismal earnings, while other firms with much more respectable results have tread water or lost ground. "It's like the Twilight Zone," said Jeffrey Saut, chief investment strategist at Raymond James. Yet some see this trend as positive, saying the recent stock speculation can be a hallmark of a bull market. "This may be a good thing, because people are becoming more forward-looking," said Ed Peters, chief investment strategist at PanAgora Asset Management. Peters said a bull market, by its very nature, is speculative, as investors anticipate better news in the future and price that in ahead of time. Just how long this current bull market lasts, however, remains to be seen. One stock that epitomizes the current mood on Wall Street is Cisco ( CSCO) competitor Avaya ( AV). The stock has surged 111% over the last month, making it the biggest gainer in the S&P 500 for the period, even though it recently reported a 15% drop in sales for the fiscal second quarter. Avaya also declined to give guidance on the third quarter, saying economic conditions were too uncertain. Still, its loss was narrower than expected in the first three months of the year. In contrast, drug giant Johnson & Johnson ( JNJ) posted a double-digit rise in first-quarter profit and beat analysts' expectations. It also said it should match analysts' estimates for the full year and raised its quarterly dividend by 17% to 24 cents. And yet, shares have fallen about 2% over the past month. Now some might say that Johnson & Johnson hasn't declined as much as Avaya in recent years and that Avaya's bounce isn't meaningful when you consider how much the stock has fallen since late 2000. Some also might contend that Avaya's fundamentals are gradually getting better, but whether those improvements warrant such a huge move in the stock price is questionable. Avaya trades at 67 times 2004 earnings, while Johnson & Johnson trades at 24 times trailing earnings.
Peters of PanAgora said that because Avaya sells for less than $5, speculators have piled in, hoping to make a quick buck. "People will buy these stocks because they think if they do go bankrupt, they haven't lost much,
and if they survive the stocks could pay off a lot," he said. "It's very possible that some people are getting a bit too optimistic and getting in too soon." Another firm that has defied gravity in recent weeks despite posting some weak first-quarter numbers is Delta Air Lines ( DAL). Admittedly, Delta's stock has fallen sharply over the last couple of years, and the firm has been making progress on its restructuring efforts lately, but a 38% jump in shares over one month seems excessive, given the many problems that still exist for the company and for the industry. The carrier reported a wider net loss in the first quarter and said it sees sharply reduced capacity for the rest of the year. "Some of the airlines had a big risk premium built in because of the war, and now that's being unwound," said Peters. Amid all the gambling, cheaper and safer bets such as Starbucks ( SBUX) have languished. In fact, Starbucks has fallen 10% over the past month despite reporting a 64% jump in first-quarter profit and a 7% jump in April's same-store sales. At 37 times trailing earnings, Starbucks isn't cheap, but the company does expect sales to climb 20% this year compared with 2002. Then there's Merck ( MRK), which has risen a meager 2.5% over the last month despite reporting in-line first-quarter earnings and reiterating that it expects earnings growth of between 8% and 10.5% this year. Merck trades at 18 times trailing earnings. Gateway ( GTW), on the other hand, posted a 15% drop in sales in its first quarter and recorded a much wider loss due to a $78 million restructuring charge. The company is expected to lose money through 2004, and yet shares have surged 30% in the last four weeks. Bill Rhodes, chief investment strategist at Rhodes Analytics, said the different stock reactions are logical to some extent, because expectations had been very low for stocks such as Gateway and were relatively high for companies such as Merck. Even though Gateway's results were far worse than Merck's, investors were impressed that Gateway managed to beat estimates and that things weren't as bad as feared. Rhodes said investors have been betting aggressively on very risky stocks, hoping for big returns, but he also noted that short-covering has helped push up volatile stocks, too. PanAgora's Peters noted, "For a bull market, you need people to be somewhat speculative. What you don't want is for them to get carried away like they did in the bubble." When stocks rally too far too fast, a big pullback usually follows. Still, analysts point out that corporate fundamentals generally improved in the first quarter, with most companies reporting better earnings and sales growth. Although some stocks may have overreacted to the news, it's worth noting that the rally in the broader market isn't totally unjustified.