Electronics stocks still underperforming

Electronics stocks listed on the Singapore exchange have been weak for the past year or so, far underperforming the overall market. There are some signs that the business outlook for certain segments of the electronics sector may be improving, but whether electronics stocks can take advantage of this improvement is questionable.

The SGX Electronics Index closed at 136.77 last week. So far in 2005, it is down 16 percent. This follows a decline of 7 percent over 2004.

Contrast this with the overall market. The Straits Times Index is up 4 percent so far in 2005, after a rise of 17 percent in 2004.

Clearly, electronics stocks have badly underperformed the overall market. The recent performance of the sector in the real economy probably justifies this underperformance.

In February, Singapore's non-oil domestic exports (NODX) increased 7.9 percent on a month-on-month seasonally-adjusted basis, reversing a 0.6 percent contraction in January. However, overall NODX was pulled up by non-electronic products, especially petrochemicals.

Domestic electronic exports, on the other hand, fell 3.6 percent compared to a year earlier. This follows a 5.9 percent year-on-year growth in January. The decline in electronic exports was mainly due to weakness in exports of disk drives, telecommunications equipment and other peripherals.

Non-oil retained imports of intermediate goods, a short term leading indicator of overall manufacturing activities, posted a 3.9 per cent contraction on a month-on-month seasonally-adjusted basis in February, reversing a 9.0 percent expansion in January. This is not a favourable sign, although it should be pointed out that the indicator is somewhat volatile.

Manufacturing output in February tells a similar story, with overall output falling 9.8 percent from January on a seasonally-adjusted basis, having already fallen 6.9 percent in January. On a year-to-year basis, overall manufacturing output fell 10.2 percent while electronics output fell 2.4 percent.

A recent decision by disk drive maker Maxtor to close one of its two plants in Singapore will exacerbate the weakness in disk drive production. The company has decided to relocate its low-end production to China, following similar moves by rivals such as Seagate and Western Digital.

Companies in Singapore, however, may not be unduly hurt by the decline in the disk drive industry in Singapore. In a recent report on the disk drive industry, The Edge Singapore cited a March 7 note by OCBC Securities analyst Bryan Yeong in saying that some suppliers to disk drive makers have themselves set up plants in China. Therefore, this retrenchment exercise by Maxtor is expected to be "a non-event for the share prices of its suppliers".

The report in general struck an optimistic note for the disk drive-related companies in Singapore. It said that inventories and selling prices have improved and demand looks set to grow. High metal prices, however, could "throw a spanner in the works" for some of the companies.

Standard & Poor's also has an optimistic view of the industry. In addition to citing the improving trend in inventory level and selling prices, its analyst Richard Stice recently wrote that revenue growth will be underpinned by the expanded use of disk-drive products, with demand in high-end systems being supplemented by new avenues of growth in the consumer-device market.

Elsewhere in the electronics sector, the chip industry remains in the doldrums, although there may be light at the end of the tunnel.

Analysts generally expect 2005 to see essentially flat growth in semiconductor sales. For example, Merrill Lynch recently cut its earnings forecast for Micron Technology and Infineon Technologies and cut its ratings for Hynix and Powerchip Semiconductor from "buy" to "neutral" in the fact of weak demand and falling chip prices.

As a result, chip companies are holding back on investment. The Semiconductor Equipment Association of Japan recently reported that Japanese-based manufacturers of semiconductor equipment posted a book-to-bill ratio of 0.83 in February, down from 0.94 in January, while VLSI Research reported that the worldwide semiconductor equipment industry slid to 0.84 in February from 0.88 in January.

North American-based manufacturers of semiconductor equipment posted a book-to-bill ratio of 0.78 in February, according to the Semiconductor Equipment and Materials International (SEMI) trade group. What may be noteworthy, though, is that this is unchanged from the revised figure in January, suggesting a possible bottom for the industry.

Indeed, although orders for North American-based semiconductor equipment makers in February fell 22 percent over the same month last year, it actually improved four percent over January. In particular, backend bookings were up six percent in February over January.

"Keep in mind that the back-end typically leads the industry recovery," Avinash Kant, an analyst with Adams Harkness, was quoted in EETimes as saying. "While we expect the book-to-bill to stay at these levels (or even decline slightly) for another month or two, we do expect the book-to-bill to start to move up after that."

In another encouraging news recently reported by Bloomberg, ISuppli Corp said that it expected global stockpiles of chips to be "completely cleared out" early in the April-to-June period.

Demand for personal computers, however, is expected to decelerate. Last month, market research firm Gartner reported that it thought that business and home PC replacement activity is likely to decelerate over 2005. More recently, IDC reported that it was lowering its projected PC growth rate to 9.7 percent from 10.1 percent earlier, citing delayed economic recovery in Japan and a cautious outlook in the United States.

While the economic outlook is an important consideration for investors, they also need to be aware of another fact regarding electronics stocks: Many of them are quite expensively valued. Despite falling for the past year or so, electronics manufacturers listed in Singapore are trading at average P/E ratios of about 26, whereas the market as a whole is only trading at a P/E ratio of around 12.

This indicates that even where the outlook for electronics companies may be improving, the outlook for their stock prices may be a different matter. Investors apparently never quite gave up on the sector, looking forward to the eventual turnaround. When it comes, stock prices may not react correspondingly.

A strong bull run for the overall stock market over the next few months would probably pull electronics stocks along as well. Investors who do not see such a prospect for the stock market should probably remain wary of investing in the electronics sector.

Singapore stock market flashes warning

The Singapore stock market, as measured by the Straits Times Index, is up so far this year, continuing the bull run that began in 2003. However, fundamentals do not suggest that this bull run has much further to go, while one particular technical indicator actually seems to be flashing a warning sign for Singapore stock investors.

First let us look at the economic backdrop.

Singapore's manufacturing output fell in January by 7.6 percent from the previous month on a seasonally-adjusted basis. However, the fall was mostly attributed to a fall in output from the volatile biomedical manufacturing cluster, which contracted by 8.6 percent over January last year. The spillover effect on other sectors relevant to the stock market is likely to be minimal.

The purchasing managers' index compiled by the Singapore Institute of Purchasing & Materials Management showed a reading of 51.5 in February, down from 52.4 in January. This indicated that manufacturing growth is likely to continue but at a possibly slower pace.

The dip in the overall PMI was attributed to lower new orders and new export orders, as well as lower levels of production output. The electronics index, however, rose to 53.9 from 52.6 the previous month, with strong growth being registered for new orders and production.

In the US, the PMI monitored by the Institute for Supply Management was 55.3 in February, a fall from January's 56.4. The sub-indices for new orders, production and employment all fell.

The global manufacturing PMI compiled by JPMorgan and NTC Research also registered a fall -- albeit slightly -- to 52.8 in February from 53.0 in January.

Paul Kasriel, director of economic research at The Northern Trust Company, thinks that manufacturing activity may decelerate further. In a commentary on 4 March, he said that the growth rate in global central bank holdings of US securities is relatively highly correlated with the ISM manufacturing index four quarters in the future. With the growth rate in these holdings turning down lately in the face of interest rate hikes by the Federal Reserve, he warned that manufacturing activity, and hence economic growth, is likely to slow down in the US.

Of course, as the US economy goes, so does the Singapore economy. And that bodes ill for the Singapore stock market.

In a weakening economic environment, valuations are not likely to be supportive of the market. In a report on 26 February in The Business Times, Teh Hooi Ling said that dividend yields and price-to-book ratios around current levels have historically been associated with weak market performance over the subsequent year. While the equity risk premium is still high compared to historical levels, she points out that rising interest rates and moderating corporate earnings may actually point to a lower equity risk premium.

Not surprisingly then, perhaps, that in an interview by The Edge Singapore of the managers of the top-performing Singapore funds for 2004 and which it published at the end of last month, none of the managers seemed particularly bullish on the Singapore stock market. And just last week, Merrill Lynch said in a strategy report that "we see the Singapore market trading at about fair value with a six-month target raised to 2,190", which is only 1 percent higher than Friday's close of 2,169.41.

If fundamentals do not look particularly bullish, what do technical indicators tell us?

I mentioned in a previous commentary the divergence between the trends for the large-cap Dow Jones Industrial Average and Standard & Poor's 500 from that for the Nasdaq (see "US stock market bullish but divergence and valuation are concerns"). I said that this divergence could be an indication of an impending market reversal.

The divergence between the large-cap index and small-cap index is even more pronounced in Singapore. In the first half of 2004, the STI gained 4 percent but Sesdaq lost 9 percent. This divergence widened in the second half, with the STI gaining 12 percent while Sesdaq lost 13 percent. In 2005 so far, the STI has gained 5 percent while Sesdaq has lost 3 percent.

Sesdaq had been formed in 1987 as a platform for small companies to raise funds. Over most of its history, Sesdaq tracks the mainboard Straits Times Index quite closely. It participated in the broad bull markets of 1993, 1998-99 and 2003, as well as the broad bear markets of 1997-98 and 2000-03. It did appear to go its own way in 1994-95, when it fell sharply by 58 percent while the STI fell by only 15 percent, but this could be attributed to the naturally greater volatility of small-cap stocks.

And yet, in the two main bear markets that it accompanied the larger market, there had been significant divergences at the start of those declines.

In the 1997-98 bear, the Straits Times Index had begun to fall in January 1997. From the beginning of January to the end of July, the STI fell 11 percent. However, over the same seven months, the UOB Sesdaq index rose a remarkable 37 percent.

In the 2000-03 bear, the STI peaked on the first trading day of January 2000, but Sesdaq had peaked in early July 1999. From the beginning of July 1999 to the end of December 1999, the STI rose 14 percent, but Sesdaq fell 20 percent.

The directions differed in the two examples -- Sesdaq outperforming in one, STI in the other -- but the divergences are clear. Possibly, the 1997-98 case reflected frothy excess, with the small-cap Sesdaq outperforming the STI at the end of the cycle -- remember, this took place just prior to the Asian Financial Crisis. On the other hand, 1999 may have been a case of a chastened and sceptical market giving Sesdaq a miss towards the end of its run-up.

Even the 1994-95 Sesdaq bear might have been a signal of relative weakness in the broader market. Although the STI did not tank until 1997, it mainly traded sideways from 1994 to 1996.

Divergence between the STI and Sesdaq has had a good, albeit short, track record. The current divergence has been unusually long and sustained. Investors should watch it carefully.

US stock market bullish but divergence and valuation are concerns

On 4 March, the Dow Jones Industrial Average hit 10,940.55, its highest close since June 2001, while the Standard & Poor's 500 index hit 1,222.12, its highest since July 2001. The US bull market in equities lives on.

However, some people are nervous.

In a commentary on 1 March for MarketWatch entitled "Testing three-year highs on narrow leadership", Michael Ashbaugh pointed out that while "the S&P and the Dow challenge three-year highs, the Nasdaq isn't even testing two-week highs".

Ashbaugh went on to point out that "the recent Dow and S&P strength comes not only in the face of a weak Nasdaq, but a weakening Nasdaq. Each test of the S&P's three-year highs has been matched by a successively lower level on the Nasdaq".

And although the Dow and S&P went on to make three-and-a-half-year highs on 4 March, the Nasdaq, which closed at 2,070.61, remains almost 5 percent below its high in December 2004.

Ashbaugh explains that the Dow and S&P have actually been propped up by the energy sector. That is why the Nasdaq has not participated. In other words, the recent strength in the market is actually narrowly-based.

Ashbaugh said that in "a perfect world, you would look for more broad-based participation to drive a sustainable move to multi-year highs". Divergence among indices is often a bearish indicator.

At least that is what the Dow Theory claims. The Dow Theory, though, focuses on the relationship between the Dow industrials (as represented by the Dow Jones Industrial Average) and the Dow transports (as represented by the Dow Jones Transport Average).

According to the theory, a bull market is confirmed when both sectors reach significant new highs, while a bear market is signalled when both averages reach significant new lows. Market turning points occur when the two averages trend in opposite directions or diverge.

In a commentary for MarketWatch on 4 March entitled "Dow Theorists smile after Friday rally", Mark Hulbert makes the observation that "Friday's rally was even stronger for the DJTA than for the DJIA, and now both averages are above their late-December levels". No divergence there.

Does this mean that Dow theorists are bullish? According to Hulbert, yes -- at least for the short term. Hulbert makes one caveat: Richard Russell, editor of the Dow Theory Letters, remains bearish for the longer term.

"That's because," Hulbert explained, "by his reading, the original Dow Theorists placed even more weight on valuations than they did on joint new highs among the primary Dow averages. And because the market remains overvalued according to any of a number of fundamental criteria, Russell believes that any bull market we are seeing now comes within the context of a secular bear market that will eventually take the market down to much lower levels."

And Warren Buffett apparently agrees that the market is overvalued. In his latest annual report for Berkshire Hathaway, the billionaire investor said he ended the year with "$43 billion of cash equivalents, not a happy position".

"My hope was to make several multi-billion dollar acquisitions that would add new and significant streams of earnings to the many we already have," Buffett explained. "But I struck out. Additionally, I found very few attractive securities to buy."

That did not stop Berkshire Hathaway from raising its per-share book value by 10.5 percent, close to the 10.9 percent rise in the S&P 500.

Nevertheless, if the great investor has problems identifying good stocks to buy, more ordinary investors would be well-advised to take another look at their holdings or candidates for purchase.

In any case, getting back to the Dow Theory -- which was formulated long before Nasdaq came into being -- one could reasonably ask whether the DJTA is more relevant than the Nasdaq in today's market. And that would of course throw open again the question of whether there is a divergence within the market that is signalling an impending reversal.

The bull market may still be alive, but for how much longer remains an intriguing question.

Bubbles everywhere -- and about to burst?

How do you know when interest rates are too low? When bubbles start to appear in asset markets in the form of prices rising above historical norms. And there are signs that bubbles have indeed appeared, and in assets that are not always considered as part of financial markets. When bubbles are so widespread, investors would do well to watch out for their bursting.

The stock market is one area that low interest rates could have created a bubble. In a recent commentary entitled "Poor start to 2005 for US equities", I had highlighted a CBS MarketWatch article by Mark Hulbert that indicates that the US stock market could be as high as 50 percent above historical norms. Hulbert's conclusion: Stocks aren't cheap.

What sustains the high valuation? By all accounts, it is low interest rates. Low interest rates allow investors to discount corporate earnings at lower discount rates, which inflates stock values.

If interest rates rise in a persistent manner, though, the high valuation may fall. And that is a real danger, with the Federal Reserve currently on a campaign to raise interest rates. Even 10-year Treasuries, whose yields had stayed stubbornly around 4 percent for some time in the face of the Fed hikes, have started to rise over the past few weeks.

Global real estate is another area that many consider to be experiencing a bubble. I have discussed this before in an earlier commentary (see "No bubble in housing?"). And in December last year, The Economist warned in an article entitled "Flimsy foundations" that the "ratios of prices to incomes are now above levels that have proved unsustainable in the past. Taking the average ratio of house prices to incomes in 1975-2000 as a baseline, American house prices are now almost 30% overvalued".

And the bubble may be about to stop expanding. The Economist article had pointed out that house prices in Britain and Australia were already falling. The US may be about to follow suit.

Sales of existing homes and condominiums in the US dipped 0.1 percent in January, while sales of new homes fell 9.2 percent, and the median price of a new home fell 13.2 percent to the lowest level since December 2003. It is not certain, though, that these indicate softening demand for homes, since bad weather could have played a part.

Richard Berner of Morgan Stanley, nevertheless, thinks that demand will indeed soften soon. On 28 February, in a commentary in the Global Economic Forum entitled " Housing -- Bubbly?", he wrote:

Housing fundamentals, in my view, are as good as they get, and activity is likely to decline over 2005 and 2006. Among the reasons: Previously favorable demographics are turning less supportive, much pent-up demand seems to have been satisfied, soaring housing prices have made purchase less affordable, interest rates are gradually rising, and starts are slightly out of line with sales.

The effect of cheap money is not necessarily restricted to housing. Andy Xie, also of Morgan Stanley thinks that even oil is a bubble. In a commentary on 1 March in the Global Economic Forum entitled "Oil Is a Bubble", he pointed out that although rising oil prices have been widely attributed to growing Chinese demand, China is actually still "a low-income economy and cannot sustain its rapid growth at current oil prices". According to Xie, in the short term, the pain of higher oil and material costs in general have been offset by expectations of "massive profits from property inventory in a rising market".

The real driver behind the rise in oil prices to current levels, Xie thinks, is liquidity.

Oil is a bubble because the strong demand reflects the global liquidity bubble. At the same time, financial investors have poured into this commodity... Without the demand from financial investors, the current oil price could be US$15/barrel lower, in my view.

The oil and property bubbles are aspects of the global liquidity bubble that has arisen from the combination of a low US Federal funds rate and the willingness of Asian central banks to accumulate foreign exchange reserves. The property bubble is the primary manifestation of this liquidity. The oil bubble is a secondary aspect. Oil, however, could destabilize the equilibrium through its contractionary redistributing effects...

However, Xie thinks that the property bubble in China is likely to deflate first, and pull down demand for oil in China as a result.

China's property bubble could deflate under its own weight. The number of residential properties under construction exceeds 10 million, or about 8% of urban households. The current average price exceeds 10 times urban household income nationwide and is more than 20 times in many cities of the Yangtze Delta region. The probability that all these properties can be sold at current or even higher prices is quite low, in my view. As soon as property prices begin to fall, the pain from high oil prices will be felt by the economy, and the demand for oil will likely decline sharply.

Cheap money sometimes makes its appearance in places not normally associated with the financial world. The latest issue of the New York Magazine features a story entitled "She Can't Be Bought" that, among other things, describes the huge demand for artworks:

People on Wall Street are seeking contemporary-art trophies...everyone wonders when this bubble will burst. Right now "feels like the last days of the Roman Empire," says private-art curator Todd Levin. "Compared to the eighties, it's a much broader group with much more money"...

If bubbles are spilling over into the art world, it is difficult to avoid the feeling that the era of cheap money has advanced to a rather mature stage.