|
MARKET BEAT/by Tom Petruno ([email protected])
for Friday, April 8, 1994
copyright Los Angeles Times
(This column, written for the do-it-yourself investor in
individual securities and mutual funds, is available for a
limited time by free e-mail subscription as part of an
experiment by the Times in electronic distribution. To get
on the list, mail [email protected], with SUBSCRIBE in the
subject field. Send comments to [email protected].)
Market-Indexed Bank CDs
May Be Too Good to Be True;
''Derivatives'' for Mom-and-Pop?
With some investors fleeing the stock market in the wake of
its recent wild swings, a few banks think they have created
an attractive alternative: So-called stock market-indexed
CDs.
The idea is that you sign up for a normal CD, say of one-
year or three-year term. Instead of earning interest,
however, you get a percentage of any stock market gain
during the CD's term. If the market falls, you get no
return--but your principal is 100% guaranteed (and federally
insured, up to the usual limits).
If this sounds too good to be true, it may be. Despite their
market link, these CDs aren't necessarily pure proxies for
stock ownership. Your return, even in a strong bull market,
may not be even close to what you'd earn owning real stocks.
But conserative savers who find current CD yields still too
abysmally low, and who think the stock market has more life
left in it, might consider stock CDs for a small portion of
their short-term savings. Just don't rely on them for
income, because they may produce none.
And if you're interested in these hybrids you might want to
act fast, because as stock market volatility increases the
banks may be forced to reduce the payout on future stock
CDs.
In Los Angeles, Glendale Federal Bank and Great Western Bank
have been heavily promoting stock CDs, with mixed results.
Nationwide, these hybrid CDs are being offered by
NationsBank, Mellon Bank and Citibank, among others,
according to Bank Rate Monitor newsletter in North Palm
Beach, Fla.
Here's how stock CDs work: You give the bank, say, $10,000
for three years. The bank agrees that at the end of each
year, it will pay you a share of any gain in the stock
market, most likely as measured by the Standard & Poor's
index of 500 blue chip stocks.
Your money isn't invested in stocks, however. It stays with
the bank, probably to make real estate loans. With the
interest that the bank would otherwise have paid you, it
plays the stock market via option contracts--or it pays a
Wall Street brokerage to do the same.
With a ''call'' option on the S&P 500 index, the bank can
essentially own the right to buy a large basket of stocks in
the future, at a set price, for relatively little money down
right now. If the stock market goes up, so does the value of
the call. If the market goes down, the call expires
worthless.
Hence, the bank can make a pact to pay you a rising return
in a rising market, or no return at all if the market drops.
Your principal, meanwhile, isn't at risk.
So let's say the S&P 500 index, which closed Thursday at
about 451, rises 10% over the next year, to 496. You'd earn
10% on a stock CD, right?
Not necessarily. The formula most banks use to calculate
your return is based on the average monthly performance of
the S&P index for each 12-month period. For the sake of
illustration, say the S&P goes nowhere for 11 months, then
suddenly jumps to 496 in the last month. Multiply 451 times
11, add 496, and you get 5,457. Divide by 12. The average
S&P index for the period would be 455.
Your stock CD return for the year thus would be about 0.9%--
less than one-tenth the actual market gain, and well below
the 2.5% to 3.5% you might have earned in interest on a
normal CD.
If the S&P were to rise steadily over the 12 month period--
say, five points a month--your CD return in this example
would be about 6.1%, versus the market's actual 12.2%
return. But this bull market is now 42 months old, so the
odds of a steady upward trend from here are low indeed.
More likely, many Wall Streeters say, the market's recent
volatility is a taste of what's to come. And if that's true,
these stock CDs may soon become less appealing even for
savers who think the risk-reward equation is fair.
Why? As market volatility increases, so does the cost of
option contracts on the S&P 500 and other stock indexes.
That makes it more expensive for the banks to play the
market.
If their costs go up, they will most likely reduce the
guaranteed ''participation rate,'' meaning the percentage of
any market rise that they'll share with you, on future stock
CDs they agree to initiate. (Terms on existing such CDs
wouldn't change, of course.)
And if volatility increases too significantly, chances are
these CDs will fade away, as they did for a long time after
the 1987 stock market crash (yes, this is their second
incarnation). A volatile market costs the banks too much to
hedge, and probably would cause many investors to shun
market-related investments anyway.
A few additional considerations to keep in mind, if you're
shopping for a stock market-indexed CD:
*TAXES. Any return on your CD will be taxed as ordinary
income. In contrast, long-term capital gains on actual
stocks or stock funds are taxed at a lower rate.
*EARLY WITHDRAWAL PENALTIES. They're steep--up to 20% of
your principal in the first year. Ask the bank to compare
the penalty on stock CDs with the penalty on a normal CD, so
you can see the difference.
*RISK. Banks play the options market to produce the return,
if any, on your stock CD, which means you're a party to a
''derivatives'' transaction--those hybrid securities that
have been so much in the news lately for their alleged risky
nature.
However, it's the bank's money at risk, not yours: Your
principal is 100% federally insured. But if the bank should
fail, it isn't clear that federal insurance would cover any
stock market-linked gain you're entitled to.
|
|
MARKET BEAT/by Tom Petruno ([email protected])
for Monday, April 11, 1994
copyright Los Angeles Times
(This column, written for the do-it-yourself investor in
individual securities and mutual funds, is available for a
limited time by free e-mail subscription as part of an
experiment by the Times in electronic distribution. To get
on the list, mail [email protected], with SUBSCRIBE in the
subject field. Send comments to [email protected].)
Subscribers please note: Tom Petruno will be on vacation the
rest of this week. His column will resume April 20.
The Silence of the Optimists?
A Lack of Negative Earnings
''Pre-Announcements'' Raises
Hopes for Strong Profits
That noise you don't hear is the sound of corporate
America warning about disappointing first-quarter profits.
Typically at this time each quarter, Wall Street is hit
by a barrage of earnings ''pre-announcements,'' whereby
companies swallow hard and admit that their profits in the
just-ended quarter won't meet expectations.
But this time around, ''there's been a definite falloff
in the number of [negative] pre-announcements,'' says Ben
Zacks, head of earnings-tracker Zacks Investment Research in
Chicago.
More prominent, instead, have been the positive earnings
pre-announcements: General Electric, brokerage Charles
Schwab & Co. and truck engine maker Cummins Engine, for
example, all issued upbeat first-quarter earnings forecasts
last week.
And computer workstation giant Sun Microsystems, which
last Monday warned that first-quarter sales would be below
expectations, surprised Wall Street on Wednesday by
reporting that earnings came in above expectations despite
the sales shortfall.
If the good news so far foreshadows the general tone of
first-quarter earnings, the end result could be much-needed
support for the stumbling stock market.
Stung by rising interest rates, investors have been
struggling to find a reason to hold on to stocks, let alone
to buy more. Wall Street's optimists have been arguing
vociferously that the bull market isn't dying, but is
merely in transition--from being driven by low interest
rates to being driven by rising corporate earnings.
If that's true, the best thing for stocks would be for
the bond market to remain relatively calm this month while
strong quarterly profit reports grab the business headlines
day after day.
In theory, earnings ought to be pretty good. The economy
surprised nearly everyone with the strength of its advance
in the first quarter, even in the face of the Northridge
earthquake, and lousy weather in much of the country.
Booming sales of homes, cars, computers, machinery and
other big-ticket items should translate into higher profits
not only for the companies that produce them but for the
myriad supplier businesses.
Yet Wall Street analysts, apparently choosing to play it
cautious on the economy despite evidence to the contrary,
continually chipped away at their earnings estimates as the
quarter progressed, Zacks says.
That has been the pattern of the last five quarters, he
says: ''The analysts lower their estimates going into the
reporting period. Then the numbers come in slightly better
than expectations, and [the analysts] start raising their
numbers again'' for the next quarter--at least for a month
or so.
Tallying up analysts' estimates for the blue-chip
companies in the Standard & Poor's 500 index, Zacks says
the average S&P company is expected to report first-quarter
operating earnings (i.e., results before any one-time gains
or losses) up 11.7% from a year earlier.
At the end of January, the analysts had expected S&P
operating earnings to rise 15.7% for the quarter, Zacks
says.
''Expectations are fairly moderate'' now, agrees Melissa
Brown, who tracks corporate earnings trends for Prudential
Securities in New York. ''So it's seems unlikely that we'll
have a lot of negative surprises'' as the numbers are
reported, she says.
And if analysts have again been too cautious, the stock
market could benefit as higher-than-expected profits force
investors to reconsider stocks' prices relative to
potential earnings power in an expanding economy.
Abby Cohen, investment strategist at Goldman, Sachs &
Co. in New York, is one of the earnings optimists. She
expects S&P 500 operating earnings, which jumped 16% last
year, to rise 12% this year and another 10% in 1995 as the
economy continues to grow.
While Wall Street's bears believe the stock market will
be strangled by rising interest rates, Cohen notes that
rates don't rise nonstop, even in a healthy economy. Once
the bond market settles down from the selling frenzy of
recent weeks, she expects investors to focus again on
stocks' individual fundamentals.
And on that count, she says, there are still plenty of
reasons to feel good about the market.
''It would be extremely unusual to see the market peak
when we have a couple years of earnings growth still
ahead,'' she says.
Unless, of course, stocks have become overvalued. That's
the bear case: Even though earnings are going up, the 42-
month-old bull market has already factored higher earnings--
even into 1995--into stocks' prices, the bears say.
Therefore, there is nothing for Wall Street to look
forward to except the next recession and the next cycle of
lower earnings. Add rising interest rates to the equation,
and you get falling stock prices even as earnings surge in
1994, the bears contend.
In Wall Street jargon, the term for that is multiple
compression: Stocks' price-to-earnings multiples, or P-Es,
slowly shrink because stock prices (the numerator in the
equation) go down while earnings (the denominator) go up,
at least in the near term.
Or to put it another way, investors lower their
valuation of stocks, or what they consider a fair price to
pay relative to longer-term earnings expectations and to the
returns on competing investments, such as bonds and money
market accounts.
''People are worrying that what we get in earnings
[growth] will be lost in valuation as interest rates go
up,'' says Prudential's Brown.
But Cohen and other bulls didn't consider stocks to be
overvalued before the recent dive in prices. Thus, they
argue, today's lower prices are an invitation to buy, not a
warning of worse to come.
Based on Goldman Sachs' earnings estimates, the average
S&P 500 stock sells for 14 times 1994 operating earnings.
Historically, the market's P-E has averaged 16.4 in periods
when inflation ran at 3.5% or less annually, Cohen says.
So if you believe, as she does, that inflation (and, by
proxy, interest rates) will remain subdued, the stock
market could advance 17% from current levels and still not
exceed historic ''fair'' valuation levels.
Of course, it's easy to talk about fair valuation for
the market as a whole. But most portfolio managers aren't
buying the market--they're buying individual stocks.
That's why so much may ride on the first-quarter
earnings reports that will swamp Wall Street starting this
week: If the individual numbers aren't good enough to make
shareholders want to hold on--after the turmoil of the past
few weeks--the market's slide may resume, and what had been
a long-overdue ''correction'' in prices could rapidly become
something far worse.
The lack of downbeat pre-announcements so far is
certainly encouraging. But earnings-tracker Zacks adds a
caveat: There's a chance that many companies with bad news
to release didn't do so early because they feared they
would accelerate the recent stock selloff.
Overall, Zacks looks for strong quarterly earnings gains
from auto, semiconductor, bank and industrial companies,
while results from energy, airline, drug and food companies
are expected to be weak.
And watch out for restaurant companies, he says: They
may have been hit hardest by weather- and earthquake-related
problems in the quarter.
at their earnings estimates as t
|