Market Wrap Up September 30/04

by Martin Goldberg

Invest in Merck and You Might See a Speculative Gain

This article was composed last night and completed around mid-night. Annotations added tonight and are indicated in blue. Today as you may have heard, Merck announced that they were pulling Vioxx off of the market after a recent long-term study indicated that the drug increased the risk of heart disease. While Vioxx consists of about 10% of Merck’s sales, the stock market delivered a 27% hit to Merck’s stock (This equates to $27 Billion in lost market capitalization). All stocks are speculative – even the bluest of the blue chips. It almost seems impossible to find actual value in today’s stock market, yet I believe that Merck and Company (MRK) is a value investment. At $45/share, it is not a fire sale bargain typical of those favored by value investors such as Warren Buffett, yet it is a fair price. In addition there are several technical reasons why this stock may do quite well in the intermediate term. Investors can buy a stock a little down on its short-term luck underpinned with real long-term value for the long haul. Better yet, if pharmaceutical companies regain their stature as Wall Street favorites, large speculative gains may also be possible. That’s why I’m buying Merck and I will describe my rational in detail tonight.

There was what appears to me to be panic selling today based on the Vioxx news, yet what I think doesn’t count in the short or intermediate run; its what the market thinks that counts. Long-term, the value case still applies to Merck. If the case applied last midnight, the Vioxx news probably is not worth a loss of $27 billion in market cap. To put this dollar value in perspective, $27 billion is the market capitalization of Caterpillar, Inc

(Note: An abridged version of my letter to the editor commenting on technology stock valuations was published in the “Mailbag” section of this week’s Barron’s. If you e-mail me, I will send you an unabridged version.)

Merck – The Anti-Cisco

The table below outlines key fundamentals for Merck, a Wall Street outcast side-by-side with a favored technology stock - Cisco.

	Cisco	Merck
Market Capitalization ($billion)	122	100 73
Price/Earnings (trailing)	26	16
Price/Earnings (forward)	18	13.5
Dividend Yield (%)	NONE	3.4
4-Year Shareholder Equity Growth (Shrinkage)	(2.5%)	17.6%
Percent Wall Street “Buy” Recommendations	61	9
Yearly Share Turnover (%)	182	56
Yahoo Message Board Posts per Day (Average)	1,200	25

The disparity in the valuation is astounding. Technology bulls would argue that Cisco has a higher growth rate than Merck; yet a few short years ago when the US economy suffered a historically mild recession, Cisco lost money. In times such as these, when it appears that an economic recovery may be under way, what is actually cyclical increases in technology companies’ sales and earnings are mistakenly interpreted by Wall Street to be actual “growth.” Therefore the Street routinely awards expanded yet unsustainable price to earnings ratios to technology companies.

The side-by-side comparison in the Table above gives us some clarity as to why Wall Street loves technology companies such as Cisco. Cisco is an object of speculation whose shares are turned over 3 times as fast as Merck’s, and with each transaction someone on Wall Street makes a couple of pennies. Therefore, it is no wonder why 61% of the analysts covering Cisco rate it a “buy.” The active trading in technology companies such as Cisco has the public excited as indicated by the fact that there are almost 50 Yahoo message board posts for every 1 such post for Merck.

For all the good will on Wall Street for Cisco, it is notable that over the last 4 years shareholder equity in Cisco has actually shrunken, whereas it increased by almost 18% at Merck. Why did this occur? Did Cisco pay out most of their earnings toward dividends? Not exactly. Actually it was Merck that paid a hefty and consistent dividend that amounts to a yield of about 3.4%. By contrast, Cisco never paid any dividends through their entire history. A consistent dividend is one metric on Wall Street that cannot be faked.

There is an additional paradox to be found in the Cisco/Merck comparison. Merck is a cash rich company that can finance all of its needs through the money that they earn. As a result they probably don’t get the attention that they deserve on Wall Street. By contrast, Cisco is a deal-doing machine. With every acquisition deal done by Cisco, someone on Wall Street makes money. (It’s a good thing that there is “firewall” between stock research and investment banking or there would be a disproportionate amount of coverage and favorable recommendations for technology companies such as Cisco.)

However, the most important point that I would like to make is that at a forward price to earnings ratio of 13.5 and a dividend yield of 3.4%, a high quality long-term performing company such as Merck is a good value.

TECHNICAL ANALYSIS

Merck Stabilizing

Following is a chart of Merck from the January 2000, indicating that over this time, Merck has been out of favor on Wall Street, yet the downtrend appears to have been broken recently.

In more recent times, the chart of Merck has shown that it is stabilizing somewhat.

Even though drug stocks such as Merck have been out of favor on Wall Street, there is some precedent indicating that drug stocks are capable of impressive recoveries. Below is a chart of Merck from 1991 to 2000 illustrating a similar time when drug stocks were a bit down on their luck and then recovered.

After the downtrend was broken in 1994 the stock made a run from about 13.5 to over 80. Note the similar technical trend between this chart and the first chart above. Can it happen again? On Wall Street, anything is possible.

What If The Market Tanks?

With the Nasdaq showing intermediate term technical weakness, there is every reason to believe that the general stock market is due for either a correction at best or even a crash in the intermediate term. How will a stock such as Merck behave if the bear market were to resume in a big way? Since the leadership of this rally was largely the same as the 2000 bubble, it stands to reason that drug stocks are likely to behave similarly. Below are charts of Merck during the timeframe bracketing the 2000 technology bubble. The first chart is the Merck to Nasdaq ratio. (When the trend is up, Merck is outperforming the Nasdaq.)

The next chart includes only Merck before and after the technology bubble.

The charts above illustrate how well Merck did when the technology bubble busted. An “echo bubble” bursting will likely favor companies such as Merck.

With the Nasdaq showing recent intermediate term technical weakness, how is Merck doing in comparison with the Nasdaq? Below is a chart of the Merck to Nasdaq 100 ratio. When the trend is up Merck is outperforming the Nasdaq.

Merck greatly under performed the Nasdaq during the rally that began in October of 2002. Yet most recently, the Merck to Nasdaq ratio has been in an uptrend since November of 2003, indicating that Merck has been outperforming the Nasdaq over the last 10 months. The ratio now sits at the bottom of an upward sloping trading range as indicated in the chart.

Short-Term – Bullish for Merck

Following is a 3-month daily candlestick chart with momentum indicators.

The stock is showing bullish momentum; but most importantly the long white candlestick suggests that the bulls have taken control of the stock. This signal (along with the positive momentum indicators) suggests that the short-term outlook is bullish. A close below the white candlestick would negate the bullish short-term signal. The short-term bullish signal was negated today, obviously.

Merck is a long term “buy” based on its long-term outlook and value.

Today’s Market

I’m still smiling about my poor sense of timing in posting this bullish article at practically the exact moment that shares of Merck plunged on bad news, and as a result, I’m considering lagging my instincts with my investment decisions for the rest of the year. But, as with any investment, all stocks are speculative and that’s why you need a plan that includes intelligent money management and appropriate position sizes. That is what enables you (and me) to make an occasional blunder as a Merck purchase and live to laugh about it and sleep well the next night.

On the last day of the quarter the stock market was little changed except for the effect of the Merck plunge that caused the Dow Jones Industrial Average to drop by 56 points today. The other indices were little changed. The interest rate on the 10-Year note increased to 4.19%. The short-term picture of the 10-year note is looking as if the price will continue to trend lower as shown in the chart below.

Following the drop from about 118 to 107, the T-Note retraced to exactly the 62% retracement level before starting to head down once again. Momentum indicators are confirming the potential for more downward movement with a price/momentum divergence in the Relative Strength index (RSI), and Rate of Change (ROC). Slow stochastic is indicating a sell signal. Longer term, the price is heading down as indicated in the 2-year weekly chart below.

With Fannie Mae tracing a perfect “flag” pattern, it’s difficult for me to believe that the effects will not be realized in the US bond market. Note that is a well-known technical principle that “the flag flies at half-mast”. This suggests that the drop of FNM from 77.5 to 65 represents only ½ of the short-term drop. Long-term there is no reason to quibble with Bill Gross’ excellent article on the direction of US bond prices which is down and real inflation which is up.

The dollar put out a big red candlestick and is in a short-term trend that agrees with Warren Buffett’s long-term view which is down.

The HUI and XAU were up 2.3 and 3.6% respectively. Gold finished at $418 and silver at $6.88. (Guess my timing was better on that article!)

Enjoy your evening!

Martin Goldberg

Martin F. Goldberg, MS, P.E.
Market Analyst
email mdelmgoldberg@comcast.net