The Wall Street Journal: Earnings Will Soar, but Markets May Not Get a Lift off: “Undeterred by the recent serious oil-reserve reductions and the management turmoil, he likes Royal Dutch Shell”

INTERNATIONAL TRADER - EUROPE  

By VITO J. RACANELLI

12 July 04

WITH THE 2004 HALFWAY POINT solidly behind us, it's time to review the accuracy of the prophesying done in these pages at year-end 2003. It's a good excuse, too, to dust off the crystal ball again and patch up those predictions that now look a bit ragged.

Back in December, our fearless forecasters suggested European stock prices would rise 15% this year; that corporate profits would increase by the same amount; and that Europe's gross domestic product would expand 1.5% to 2%.

At halftime, June 30, the Dow Jones Stoxx pan-European index of 600 companies was up 5% in local-currency terms. The corporate-profit outlook, on the other hand, appears to have been too pessimistic; in the first quarter, for example, profits were up about 33%. Now analysts are now looking for Continental earnings to grow a heady 23% this year, according to Ozan Akcin of Puglisi & Co. in New York. (That includes goodwill charges last year, which tend to inflate this year's numbers.) And GDP growth appears to be running spot on to the predictions made.

All in all, considering the market remains 40% below 2000 highs and that bond prices have dropped 30% or so this year, equity investors should be happy with these results, but generally they're not. That brings us to the most important concern noted back then, and one looming even more so now: rising interest rates. Investors are kvetching because the major indexes haven't made much hay since May. The Dow Jones Stoxx index, for example, has been stuck inside a narrow band of 230 to 250, and you can blame the market's range-trading malaise on the likelihood that rates will continue to rise through the rest of this year.

Bulls enthusiastically point to the wonderful earnings and also to GDP growth -- about average by European standards, but better than the last few years -- and to the fact that European stocks are inexpensive. They trade at price-earnings ratios of 13 times 2004 consensus estimates and less than 12 times 2005 consensus projections, much cheaper than U.S. P/Es of about 17 and 15.5 times, respectively. All to the good -- but the rate bogeyman is a real one and will probably lead to continued range trading in the second half of 2004.

Equity investors had their cake and ate it too in 2003. That is to say, it was an unusual time, when rapidly improving economic growth was accompanied by very low interest rates for a sustained period.

That's over now. "We are in a phase of real economic growth, which means interest-rate increases," avers Thomas Meier, a fund manager at Union Investment, Frankfurt. "The uncertainty is real....I'm looking for the year to end with a 7% to 8% rise, and that's pretty good."

Yes, the economic data and P/Es suggest stocks have some room to rise. And at the very least, the good fundamentals should ensure that stocks don't go down a whole lot. But previous experience argues against another big move up in the remainder of 2004.

Michael Rachor, a fund manager at Activest, brings the grim history lesson: Over the past 50 years or so, Germany's DAX index has gained value only once in the last 10 periods of rising interest rates. Consequently, he predicts that the DAX won't close above its highest level of the year so far, reached in late January, and sees a market flat or down from here.

Despite the generally improved economic environment, "I'd be surprised if we can overcome a knee-jerk reaction to [rising] rates," adds Luis Arenzana, a Madrid-based hedge-fund manager at Shelter Island Capital Management. A lesser headwind, he adds, is the fact that earnings comparisons in the second half of 2004 will be more difficult, as the recovery was already under way in the corresponding period of 2003.

Much of the second half's progress will depend on the speed and size of the rate hikes by the U.S. Federal Reserve. Europe has it's own central bank, of course, but global equities generally take their cue from the Fed.

Unlike last year's best-of-both-worlds scenario, stocks are currently in a Catch-22 of sorts. If growth continues apace, then rates go up and, since they are much too low, perhaps by more than the market anticipates, contends Morgan Stanley strategist Ben Funnell. And if growth slows, "then how's the market going to go anywhere?"

Funnell expects, "a pretty dull second half," with European equities to churn in place and stocks finishing slightly lower than where they are now.

His crystal-ball picture changes significantly for the better, though, further along: The strategist is much more optimistic about the first half of 2005, when he thinks European equities will rise 20%. He expects two catalysts to emerge. First, the initial phase of rate hikes will have been resolved by then. The energizer, he says, will be a peak in bond yields. "They usually peak somewhere around six months after the first hike, which in this case would be around December," he adds.

The second half of 2004 will also see the market fretting about slowing growth in the U.S., China and Japan, and that will hold back stocks. But fears will fade by 2005, Funnell says. It's clear that U.S. growth will slow in 2005, but it won't fall into recession, he opines.

What to do for now? Funnell advises staying away from cyclical stocks, as they typically underperform after a peak in earnings-estimate revisions. European corporate-profit expectations are rising at the fastest rate in nearly two decades. "That alone tells you" the rate of revisions will slow down or go negative, he adds.

"We would also not own banks or technology, particularly hardware, and instead [we] like oil, food and tobacco shares" in the second half. On his Buy list are BP, Nestlé, British American Tobacco and Imperial Tobacco Group. All four, we'd add, are near 52-week highs and sport dividend yields of 2% to 3%, except BAT, whose yield is 6%. Their price-to-earnings ratios range from 11 to 12 times for Imperial to 19 times for Nestlé.

Union Investment's Meier also likes energy and has what he terms a "strong tech underweight" in his international fund. Tech is overvalued in general and will pay the price as the market retrenches slightly in the second half, he opines. Undeterred by the recent serious oil-reserve reductions and the management turmoil, he likes Royal Dutch Shell because it's both a play on continuing high oil prices and a restructuring story, he says.

Meier also owns Deutche Post and Dutch postal and logistics company TPG, both of which he argues are restructuring stories and don't depend as much on external factors, like the broad economic environment. Meier's picks have average market P/Es, with Royal Dutch and TPG sitting near 52-week highs.

In a similar vein, Activest's Rachor is betting on more defensive sectors and less economically sensitive stocks like French highway manager Autoroutes du Sud and German airport manager Fraport. Autoroutes trades near a 52-week high and has a relatively rich P/E of 17 to 20 times. Fraport is in line with the market on valuation.

He's staying away from cyclical companies like the autos, but he does like the auto suppliers. If that sounds contradictory, Rachor thinks that car makers will continue producing at current volumes, taking price cuts on their wares if necessary instead of reducing production. If sticker prices come down, that will eventually squeeze the auto suppliers' profits, he allows, but it won't be as bad as what the automakers themselves might have to swallow. Rachor also owns French tire maker Michelin and parts maker Valeo. Both sport valuations in line with the European market.

The chances Continental stocks will finish to the upside in 2004 are still good. If it turns out to be just a single-digit rise, many will be disappointed, but they shouldn't be.

The Numbers

The Dow Jones Stoxx index finished at 237.32 last week, unchanged on the week. Dow Jones Stoxx 50, which tracks the biggest European public companies, ended at 2655.89, little moved from the previous Friday.

E-mail: vito.racanelli@barrons.com