When Gravity Pulls Down the Big Guys, Ground Has to Tremble

The laws of gravity still work in financial markets, and on some level that ought to be comforting to investors--even if for right now it feels terrible.

The Dow Jones industrial average’s 247.37-point plunge on Friday, to 7,694.66, was the market at its devilish best: Just when many traders and investors were trying to steal away for a summer weekend--if they weren’t already on vacation--stocks staged their biggest one-day decline since 1991.

Moreover, the tumble occurred despite another week’s worth of data that ostensibly left the “nirvana” case for the economy intact. Inflation remains subdued. The pace of growth still is moderate. And wasn’t the federal budget just balanced, and the capital gains tax rate just slashed?

All true. Even so, cracks have been appearing in this 7-year-old bull market’s armor in recent weeks, and you didn’t need an electron microscope to see them. They are serious enough to raise the possibility of a market decline at least as bad as the near-10% drops of the spring and last summer. (The Dow already is down 6.8% from its record high.)

And if far too many smug investors believe they won’t be fazed by a near-10% drop, it’s likely the market will stage a decline that will faze them. We’re overdue, anyway.

What happened to nirvana? For starters, long-term Treasury bond yields hit an 18-month low of 6.30% on July 31, only to quickly shoot higher, supposedly on worries about faster economic growth. At Friday’s yield of 6.54% on the bellwether 30-year Treasury bond, it’s hard to label the reversal in rates so far a catastrophe for stocks--but it has been enough to change some investors’ mood.

Also, the United Parcel Service strike, as James Flanigan details elsewhere in this section, has raised the possibility of a slowdown in the seemingly relentless efficiency drive of U.S. corporations. If workers in an increasingly tight labor market are able to dictate more of the terms of their employment, it’s conceivable--though certainly not assured--that corporate profits could be hurt.

Meanwhile, the previously almighty dollar has begun to sink versus European currencies in recent days on hints that Germany may be on the verge of raising interest rates. And in Southeast Asia, economic woes have forced one country after another into currency devaluation mode over the last six weeks, the net effect being that exports from those nations to the United States are getting much cheaper and therefore more competitive with U.S.-produced goods.

Yet all of this combined still might not have been enough to halt the powerful stock market advance that has entranced Wall Street since mid-April, lifting the Dow from a low of 6,391.69 on April 11 to a peak of 8,259.31 on Aug. 6, a 29% gain.

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But if this market has an Achilles’ heel, it may have been revealed last week.

For much of this year, and indeed for much of 1995 and 1996, investors have put their faith in a select group of blue-chip stocks with sterling reputations for dependable earnings growth. Whatever else was happening in the market or the economy, owning these blue-chip multinational giants was a “sure thing.” They seemed generally incapable of disappointing their investors.

Then came Coca-Cola’s announcement on Aug. 8 that its earnings in the current quarter would basically be flat with a year ago. That set the tone for the Dow’s 156.78-point plunge that day.

And on Friday, another of the market’s blue-chip darlings, Gillette, warned analysts that they should slightly reduce earnings estimates for 1997, because of weaker-than-expected overseas sales growth for the company’s Braun appliance unit.

Neither company is suddenly facing some massive challenge to what are in both cases dominant global franchises. It isn’t as if people have stopped drinking Coke or stopped shaving with Gillette blades. Instead, both of the companies appear to have been victimized largely by foreign currency fluctuations (i.e., the recently strong dollar), which are at worst a transitory problem.

But because investors had pushed Coke, Gillette and a relative handful of other blue-chip multinational stocks to stratospheric prices relative to earnings per share, the stocks had become accidents waiting to happen.

Coke, at its recent record-high price of $72.63 a share, was valued at 43 times the $1.68 a share that analysts had, on average, expected the company to earn this year.

Stock price-to-earnings ratios are a subjective thing, of course, but a rule of thumb is that when a stock’s P/E begins to exceed the company’s annualized earnings growth rate, the risk in owning the stock begins to rise sharply.

At 43 times earnings, Coke was selling for more than twice its expected annual earnings growth rate of 15% to 20%. Gillette, likewise, at its recent peak of $106.38 a share, was priced at 41 times expected 1997 earnings.

Obviously, this was no secret to anyone. In fact, almost any money manager on Wall Street would agree that Coke and Gillette were “high.” The only question was who would be the first to sell. The game had become so enriching--Coke and Gillette seemed only to go up, and never down--that most money managers were understandably reluctant to leave the party.

But “trees don’t grow to the sky,” notes Donald Yacktman, a veteran money manager in Chicago. A hackneyed line, for sure, but still a good one never to forget when watching stock prices.

The game of playing blue-chip stocks had become one of pure momentum in recent months: Those shares were going up until they stopped going up. And once they stopped, it was virtually certain that momentum would begin to work on the downside, because short-term market players were likely to rush to cash in some of the enormous paper profits that had been built into the stocks.

That’s where we are today. The biggest problem this market faces isn’t fundamental. As Stan Nabi, vice chairman of money manager Wood Struthers & Winthrop in New York notes, there is no recession on the horizon, interest rates and inflation remain low, and corporate earnings overall still appear likely to rise at a healthy pace in coming quarters.

“The only problem we face is the rich valuation in the market,” specifically in many blue-chip shares, Nabi says.

And that problem is in the process of being fixed, albeit painfully: Stock prices of Coke and Gillette have already fallen 19% from their recent peaks. Many other blue chips also are down far more than the 6.2% drop that the Standard & Poor’s 500 index has suffered from its peak.

The question is how far these stocks have to decline before buyers are eager to step in again. Even with their declines so far, it’s hard to argue that any of them are “cheap” as yet. And if the momentum game took them to absurd heights, on the downside it could make them cheaper than they deserve to be, if investor psychology turns rabidly negative.

The other problem with these stocks is that they are such major components of broad-market indexes like the Standard & Poor’s 500 that their continued decline could make the market overall seem much weaker than it really is.

This could prove to be the biggest test yet of the market-indexing wave that has pulled so many investors into passively managed funds that simply replicate the S&P; 500.

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Or perhaps, as Nabi believes, we are in the midst of nothing more than a “garden-variety” correction. The Dow and the S&P;, he says, should pull back about 10% all told, then stabilize--just as they did last summer and again in the spring of this year.

Every pullback in stock prices is painful, and inevitably many investors begin to worry that they are witnessing the beginning of “the big one.” For nearly seven years, however, the market has denied those who have expected another crash every time stock prices turned weak.

This time? Who knows. For individual investors, the best advice never changes: Confidence is OK; complacency is not. Know what you own, and why you own it, and how much of a temporary paper loss you can stand.

Also, never underestimate the ability of other investors, particularly herd-following institutional players, to take things to the extreme. But rather than curse their silliness, be thankful for the opportunities it can present.

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Still Too High?

Major growth stocks have led the market’s decline over the last week, as Coca-Cola and Gillette have warned that earnings will be less than expected in the near term. Even though many of the stocks are down more than 10% from their 1997 highs, most still sell for high price-to-earnings ratios relative to estimated 1997 earnings per share. A sampling:

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52-week Fri. Pct. P/E on Stock high close chng. ’97 EPS* Nike $76.38 $59.50 -22.1% 20 Gillette 106.38 85.88 -19.3 33 Coca-Cola 72.63 58.75 -19.1 35 Colgate-Palmolive 78.63 65.25 -17.0 27 Merck 108.13 90.88 -16.0 24 General Electric 74.63 63.38 -15.1 25 3M 105.50 91.50 -13.2 23 Warner-Lambert 147.25 128.00 -13.1 40 Procter & Gamble 155.13 136.56 -12.0 25 Microsoft 150.75 132.88 -11.9 42 S&P; 500 960.32 900.81 -6.2 20

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* P/E is stock price-to-earnings ratio based on Wall Street analysts’ mean estimates of earnings per share (EPS) for 1997. Estimates are for calendar 1997 except for Nike, Procter & Gamble and Microsoft, whose fiscal years end mid-1998.

Sources: IBES Inc., Times research