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"Without a Clear Path" on Wall Street

Investors need to have patience in a stock market that will move sideways until corporate earnings come in stronger. That's the message from Paul Cherney, market analyst and columnist for Standard & Poor's, whose charts show no clear direction at the moment.

Cherney sees caution on first-quarter earnings, especially in tech, as the main factor holding back an uptrend in stocks. People worry about the quality of accounting, and in addition, tech companies such as PeopleSoft have been warning of earnings disappointments. The real improvement in tech, Cherney says, awaits a resurgence in corporate capital spending.

The S&P 500 stocks are still overvalued by the standards of history, he observes, and he considers this one of the reasons why the Federal Reserve's series of interest-rate cuts didn't produce the market bounce that might have been expected, and also a reason why the market will continue to move sideways for now.

Cherney made these and many other points in a chat presented Apr. 4 by BusinessWeek Online on America Online, in response to questions from the audience and BW Online's Jack Dierdorff and Karyn McCormack. Following are edited excerpts from this chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Paul, the broad market made a stab at starting back up today. Will the strength return and continue?

A: We are at a natural spot on the charts for an attempt at a reversal and a move higher. However, caution ahead on first-quarter earnings is preventing a two-fisted commitment to the long side. The bulk of earnings start around the 15th of the month.

Q: The software sector really got hit hard this week after PeopleSoft (PSFT) and Check Point (CHKP) warned. Are there any groups showing technical strength now?

A: The groups which had been good performers in the first quarter are now seeing profit-taking. Unfortunately, there has not been enough of a trend developing at the beginning of this second quarter to make a good guess as to whether money is going to start shifting into growth. We are in transition without a clear path yet.

Q: This question must be on many investors' minds: Is it safe to stay in the market with the turmoil in the Mideast? I note S&P just reduced its recommended allocation of stocks from 65% to 60%.

A: If the situation over there is going to escalate, it will only magnify the downside to a limited extent. An awful lot of selling has occurred over the last two years, and even though the upside is doubtful, due to caution and concerns about the legitimacy of balance sheets, I think the downside is limited, and the market will probably trade sideways until confidence returns with earnings.

Q: Besides earnings, are seasonal factors also tugging at the market? What about forecasts for higher interest rates?

A: I've studied interest rates in the markets, and while the initial shock of moving higher in rates can cause weakness and sideways price movement, ultimately equities adjust to the new, higher rates and trade in a normal fashion. So it's the anticipation of higher rates that can weigh on the market, but unless rates shoot to double what they are now, their effect is not long-lasting.

Q: Here's a series of questions on what to watch: What charts are most revealing? Index? Specific sectors?

A: I represent the top-down view in terms of the market. I look at the indexes and the internal measures of volume and breadth, and the volume that moves into price change. It's easier to buy a stock that moves up when the market is in a positive trend. Right now, the trend is sideways.

Until I see a more defined trend to the upside, I feel that the markets are at the whim of three- to five-day trends, and people are more likely to take profits sooner these days. So in terms of my market view, it's sideways until we get a break to the upside.

Q: When you are evaluating a stock, what aspect of its performance do you put most weight on?

A: The volume moving into price. Those two factors are the basis of my intraday observations and my end-of-day observations. If price advances, and volume is not consistently rising also, then there are fewer people in attendance at the party, and it only takes a few to leave to kill the fun. A good book to read, which I have only 60 pages left to finish, is Trading on Volume by Donald Cassidy.

Q: Returning to earnings for a moment, am I wrong that there is more nervousness right now than there was earlier in the year on earnings? If so, why?

A: The big problem with earnings right now is in the tech arena, as demonstrated by recent warnings from headline tech stocks, like PeopleSoft. The worries are twofold. Number one, how valid are the numbers that the companies produce, what kind of accounting tactics are they employing to produce pro forma numbers?

Two, valuations in the tech area, even though they have come down precipitously, remain at the high end of historic normalcy, and it will take tremendous improvement in earnings in the tech sector to bring the long-term investors back into this area. When I look at a chart like PeopleSoft or Microsoft, to me they look like they will go back to retest their September lows.

Q: Do you see PSFT having bottomed and moving back up?

A: No. My worry right now is that attempts to rally will not be able to get above the 27-32 area, and I think the odds are good for a retest of the September lows, which would mean under 20.

Q: How about that 3M surprise today? What do you see in the charts for MMM


A: The chart doesn't look bad. This was a pretty good performer in the first quarter, and it represents a classic target for buyers in anticipation of emergence from recession. If it can garner good volume and move back above 119, it might attract enough momentum to retest the old highs from this year, but watch the volume. Read Cassidy's book.

Q: What's your view of the small-cap biotechs? The BTK index? [The Amex biotech index.]

A: Right now, the BTK is searching for a bottom, and until I can see a reversal, and at least a move back above 500, I would be an observer, not an investor.

Q: How do the auto stocks look?


[General Motors] is getting a lot of good press, and between GM and Ford (F), I'd rather own GM. I'm a real believer that you don't try to pick bottoms in stocks that are heading down. I might call bottoms in the major indexes, but I have so many other peripheral measurements that I can refer to. Will Rogers said it best: "If you want to make money in the markets, it's easy. Buy a stock that's going up. If it don't go up, don't buy it."

Q: How does the chart look on AMAT

[Applied Materials]?

A: This industry group [semiconductors] was surprisingly one of the best performers in the first quarter, and many people use it as a leading indicator for the tech-heavy Nasdaq. Prices have stopped going down, and anticipation of greater demand for equipment has kept this stock well-bid. It's in an uptrend -- the chart looks positive.

Q: Bristol-Myers Squibb (BMY) also issued an earnings warning last night. Did BMY hit bottom, or will it go lower?

A: This chart is ugly, and what you want to see is an ABC pattern before you can commit anything to it. An ABC pattern is: A low is set (we might have that right now). A rebound occurs. The rebound will run out of momentum, and prices will retrace. In an ideal ABC pattern, that retracement should find buyers above the lowest low. When prices advance past the first reaction-rebound high, that represents the potential bullish break to higher prices. Patience is a virtue.

Q: Any thoughts on AOL

(AOL Time Warner)? I've been buying AOL below 25, hoping for a nice pop.

A: Here's another case of a stock that looks like it's trying to base. Your hope might be rewarded, but at this point, even a bounce from here looks doomed to hit resistance at 25.50 to 27.50. I would prefer to see it break out of its base near 28 before committing to it. I don't like to pick bottoms in stocks -- I like to see them rise and then hook into them then.

Q: I bought LU

[Lucent Technologies] at 50! Do you think it will be back someday?

A: Nope. The chart looks terrible. I can't give you financial advice, because I'm not a financial adviser. I don't think, though, that very many people would argue with my saying: Sell the stock, take the loss.

If you really like it, and you think that it WILL come back eventually, then wait 31 days so you sidestep the "wash sale" rule, and then reestablish your long. This way, you at least can offset some capital gains with your capital loss, and by reestablishing your position, you can participate in the upside (if there is any).

Q: Do you think the S&P is still overvalued historically?

A: Yes. On a trailing basis in the fourth quarter, the p-e ratio was 46. Enormous. If you are of the New Age and prefer to look at the p-e based on projected earnings for 2002, the p-e is 22. These are both at the upper edge of the envelope, which is something I related to my readers in March, 2001, as the primary reason why the Fed's rate cuts were not translating into the usual robust gains that they historically produce. This is one of the main reasons why I remain in the sideways camp until I see something technically bullish. I think we are sideways -- limited downside, limited upside.

Q: Paul, I have 1,400 shares of SUNW

[Sun Microsystems] with a cost basis of $5.50. Will the Sun ever shine again in the near term?

A: Right now it's retesting the lows from September. This is a company that should do well once there's an inkling of an increase in capital spending. Of the technical stocks that I have looked at recently, to me this chart has upside potential. Even if it just went back to retest the highs from November and December, it would represent a good gain. The downside looks limited.

Q: Finally, Paul, in this sideways market, what's the best thing for investors to do?

A: Have patience. Nothing lasts forever. For mutual-fund investors, this is an ideal time to be dollar-cost averaging, and when your quarterly statements come, file them without opening the envelope.... I'll use a four-letter word: Let's HOPE that the markets can get back on track. The huge pile of cash on the sidelines represents tremendous buying power, but it won't come in until there's a clearer vision of improvement in earnings. That WILL occur sometime in the future. Patience is a virtue.

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