Selling smalll-caps to grab after Alibaba shares contributes to weakness in the group.
By VITO J. RACANELLI
Sept. 20, 2014 3:57 a.m. ET
Sometimes all it takes is a word to drive stocks higher, if it comes from the right people.
The simple retention of the adjective "considerable"—as in the Federal Reserve's statement Wednesday that an accommodative policy will be appropriate for a considerable time after its bond-buying program ends—sent the Dow Jones Industrial Average soaring nearly 2% higher on the week. There'd been market chatter that the word might be removed.
Below the headlines, however, the rally was choppier than it looked as big-capitalization stocks sharply outperformed small-caps, which had a nasty fall on the week.
Market excitement came on the much anticipated $22 billion initial public offering of shares in Chinese e-commerce company Alibaba Group Holding (ticker: BABA), Alibaba closed at $93.89, up sharply from the $68 IPO price set Thursday, giving the company a market capitalization of about $231 billion, one of the biggest in the world.
Observers said that part of the small-cap downdraft came from investors pulling money out of smaller social-media and Internet stocks to put into Alibaba. (For more, seeFollow Up.)
Last week, the indexes finished in order of market-cap size. The Dow, home to the biggest industrial stocks, jumped 292 points, or 1.7%, to 17,279.74, a record close and the S&P 500 index rose 1.3%, or 25 points, to 2010.40 on the week, down slightly from its record close of 2011.36 Thursday. Moving down the market-cap ladder, the Nasdaq Composite was essentially flat from the previous Friday, ending at 4579.79. And finally, the Russell 2000 small-cap index fell 1.1%, most of that on Friday, when Alibaba began trading.
The Fed's statement led investors to believe the central bank won't get in the way next year by raising rates too early, says Christopher Zook, chief investment officer of CAZ Investments. Zook, who frets that market complacency is rife, adds that the small-cap action is worrisome: "You can't have a significant rally [from here] if small- and mid-caps aren't rallying."
The large-cap rally could be tied to the rate-hike speculation. Investors might differ on when the first fed-funds rate hike is coming—current market expectations are for about mid-2015—but they agree rates are going higher. Typically, in the six months before and after increases, notes James McDonald, chief investment strategist for Northern Trust, "large-caps beat small-caps once the Fed starts raising rates."
Both Zook and McDonald expect the big-cap stocks to continue outperforming the smaller and momentum-tied names, perhaps even more so if there were a correction. More on this divergence below.
Investors should keep an eye on the nuances of the Fed statement, adds Jason Pride, director of investment strategy at Glenmede. The Fed's estimates for the funds rate moved up again, to a median of 1.38% instead of 1.13% at year-end 2015, and rose also for 2016 and 2017.
Such rises suggest that Fed Chair Janet Yellen might face increasing dissent from both rate hawks and centrists on the Fed's Open Market Committee (FOMC), he says. "The Fed will have to move a little faster than the market expects," Pride says.
That could set off a market tantrum. The next FOMC meeting to be followed by a Yellen news conference is Dec. 17.
Bull Losing His Breadth
The bull market that began on March 9, 2009, was 2,021 calendar days old at Friday's close. It's the fourth-longest in modern history and the fourth-biggest rise, at nearly 200%. Despite such happy tidings, it might surprise readers that the average S&P 500 stock is down some 7.2% from its 52-week high, according to Bespoke Investment Group, an independent market statistics research firm. In other words, the average of the movements of all 500 issues from their respective highs is negative.
For investors who wonder how this is possible with the index at record highs, the S&P 500 index is capitalization-weighted and can be heavily influenced by the largest stocks, which are significantly outperforming smaller stocks this year.
Such divergences can be produced by a combination of both size and sector, as groups go in and out of favor. A particular culprit lately is the energy sector, which has gone from the second-best performer in the first half of 2014, up 13%, to the worst in the second half so far, down 6.5%.
Earlier in the year, small-cap biotech and social media stocks underperformed. Outside the S&P 500, numerous stocks are already in a correction or in bear-market territory, traditionally defined as down 10% or 20%, respectively. Indeed, one-third of the stocks in the Russell 2000 small-cap index are down 10% or more year to date.
The fact that the S&P 500 index is hitting new highs when the average stock is down is worth attending, even if it doesn't set off alarm bells just yet. In essence, there are fewer stocks leading the charge and more laggards.
"Market-breadth leadership is narrowing," notes Paul Hickey, Bespoke's co-founder. "It's not a particularly good sign, but you can have periods of weak breadth going for years [during a bull market]," he adds, which occurred in the two years or so before the 2000 peak.
"Ideally, you'd prefer not to see such a divergence, but it's not terribly alarming," he says. What average stock decline would get Hickey nervous? About 10%, he says.
Bespoke also found the average stock in the S&P 400 mid-cap index has corrected, down 11% from 52-week highs. Among names in the S&P 600 index of small-caps, the average is down over 17%. The bear has already reached one area: The average energy stock in the S&P 1500 index—a combination of all three S&P indexes—is down 20%. Energy small-caps in the S&P 600 index are down an average, and painful, 30%.
As noted, this divergence doesn't mean that the broad market will see a bear market or even a correction. In the past, however, corrections and bear markets have been presaged by a significant narrowing of the leadership. Even if your Ferrari is running well, it pays to look under the hood from time to time.
Contrarian energy plays
Out-of-favor sectors get our contrarian juices flowing, and a couple of oil-patch names that seem attractive are Chesapeake Energy (CHK), with a $16 billion market cap, and similarly sized Weatherford International (WFT). The former, an oil-and-gas exploration firm, has seen its stock drop 19% since June to $24.67 Friday. Meanwhile, the latter, a Swiss-domiciled oil- services firm, is down 11% to $21.85 from $24.50.
Many energy stocks have fallen on weak commodity prices: Oil is off 14% from highs to $92.21 per barrel, while gas prices have fallen about 10% this year. Thanks to the shale exploration and fracking revolution, the U.S. is plentifully supplied with both forms of hydrocarbons. Moreover, not-so-hot expansion of economies outside the U.S. suggests that energy supplies will remain high and demand low in the near term.
What's interesting about these two is that they are self-help candidates whose potential improvements don't rely on commodity prices.
At Chesapeake, the stock drop also derives from a seemingly weak second quarter. The earnings per share of 22 cents was half that expected by analysts. However, excluding a loss on the repurchase of debt, a non-drilling item, EPS would have been about 36 cents. Revenue did jump sharply, up 10% to almost $5.2 billion.
Most importantly, Chesapeake reported 13% growth in production, measured in barrels of oil equivalent. For an E&P firm, such growth is paramount. Some 70% of Chesapeake's energy production is natural gas, but 80% of its profits come from oil production because of the low prices it gets for gas.
Kirk McDonald, an analyst at Argent Capital Management, which began buying Chesapeake shares last December, says he's attracted by several recent changes that could lead to the stock's doubling over the next three to five years.
The arrival of CEO Doug Lawler in mid-2013 was a big catalyst, he says, since he came from Anadarko Petroleum (APC), an E&P firm known for its operating efficiency and land-lease portfolio management. In the second quarter of 2014, Lawler cut capital expenditures by 27% even as the company raised guidance of its daily average production rate by 10,000 BOE, or about 1.5%.
Another factor is robust production growth, which McDonald estimates can sustainably grow at a double-digit percentage rate, a characteristic not easy to find among E&P firms Chesapeake's size.
The Oklahoma City-based firm is cheap relative to peers, a discount that was warranted in the past but not now, as "Lawler whips the company into shape," he adds. Chesapeake's price/earnings ratio is 13 times compared to 18 for its peer group.
The consensus is for 8% net income margins over the next four quarters, compared to a median 18% at peers. There's plenty of room to improve, he adds, and with cost cuts already identified by the company, net margins can about double to 15% in 2018, he projects. Consequently, EPS should more than double to $4 per share in 2018, compared to expectations of $1.77 this year. In the first half, EPS was 78 cents.
One more contrarian sign for long-term investors: Wall Street brokerage analysts don't particularly like Chesapeake, with just 10 of 33 holding a Buy rating.
Weatherford is repairing itself, too. As noted in these pages on April 21, it has suffered mostly from self-inflicted wounds. The stock is higher now versus the $18.21 last spring, but it is off recent highs this year of $24.50.
The company still has doubters but continues to make progress on sales of noncore assets, debt reduction, and resolution of various one-time regulatory violations. For example, says McDonald, Weatherford recently closed deals to sell lower margin businesses such as the pipeline and specialty services unit, and land rigs in Venezuela and Russia.
The sales allow more focus on artificial lifts, where it dominates, says McDonald, whose firm bought Weatherford shares in July. Weatherford is a global leader in its four core units: formation evaluation, well construction, well completion, and lift systems. Shares trade at about 12 times consensus estimates of $1.79 in 2015, lower than its historical median.
McDonald notes that Weatherford was able to raise second-quarter operating margin for core businesses to 16.5% from 15.1% in the first quarter. He expects the margin to increase to 20% long term and the stock to rise to $54 in three to five years as Weatherford makes good on its promises.
And if oil prices happen to defy predictions and turn up, that's just gravy for both these stocks.