Fourth Quarter Earnings Will Be Horrible, But We Already Know That

Aluminum giant Alcoa (AA) kicks off fourth quarter earnings season after the closing bell today and there is little doubt that they will be the first in a series of profit reports over the next few weeks that will be absolutely brutal. Fortunately, most investors already know that, so the market’s reaction is unlikely to mirror the dramatic sell-off we saw in October and November. The fourth quarter could prove to be the weakest quarter of the entire recession in terms of GDP growth (a 5 or 6 percent decline is both possible and probable), which would imply that corporate profits have no chance of exceeding expectations this quarter.

The key, however, is not what the numbers are but rather how the market reacts to them. With sentiment so negative on the earnings front, there will be instances where stocks actually do not drop, or even rise slightly after poor profit reports are announced. Since the stock market is forward looking, a company reporting a lousy number, if no worse than expected, will actually bring smiles to investors’ eyes because it alleviates the concern that things could be even worse than many believe they are.

How the market reacts during this earnings season will be very telling for the near-term dynamics of Wall Street. If numbers come in weak as expected, but not a lot worse than the already low expectations, technical analysts will be quick to point that out as a positive sign. This would be a key signal that the market has reached a short term bottom. Such action would tell me that the market is truly looking ahead to possible economic stimulus and other actions that could help make the fourth quarter the worst quarterly GDP reading we ultimately see.

Conversely, a poor market reaction to these profit reports could mean a retest of the November lows. The market has done pretty well in recent weeks as it looks ahead to an Obama administration, but its patience will certainly be tested over the next couple of weeks. Personally, I think we will see a modestly negative reaction over the short-term, only because we have already seen a decent level of bargain hunting prior to earnings season.

Full Disclosure: No position in Alcoa at the time of writing, but positions may change at any time

No, It Is Not A Bull Market

I have heard it twice on CNBC already this morning, and the market has not even opened yet. For some reason people are claiming that since the market is up more than 20% from its lows that we have entered a new bull market. This idea that any rise of at least 20% constitutes a bull market is just plain silly. If a stock falls from $10 to $1 and rebounds to $1.20 it’s a new bull market? Oh, please! Sorry folks, but there is no bull market in stocks, or oil, or anything else that has been crushed in recent months but has recouped a small portion of the losses.

El Paso Debt Deal Shows High Yield Market Isn’t Dead, Just Expensive

To get an idea of how bad the high yield debt market is right now, one need only look at what price El Paso (EP) had to pay this week to issue $500 million worth of senior notes. El Paso is a solid company and should not have trouble selling debt. Their hybrid business model; energy pipelines coupled with exploration and production, makes their cash flow more predictable than more narrowly focused energy companies.

Still, El Paso is paying 12% interest and even with such a coupon rate, could not sell the notes at par. Instead they discounted them to entice buyers, who will earn 15.25% by holding to maturity. Why did EP sell such expensive debt? They have more than $13 billion of debt, with more than $1 billion coming due in 2009, and wanted to refinance until 2013.

Hopefully deals like this will continue. While they do not represent bargains for issuing companies, an increase in corporate debt offerings will be crucial for getting improvement in the corporate debt market. Once it becomes more clear that companies can issue new debt (even at high prices), the pressure on common stock prices of highly leveraged firms will abate, removing one of the largest elements of fear in today’s equity market.

Full Disclosure: Peridot was long shares of El Paso preferred stock at the time of writing, but positions may change at any time

Financial, Retail Weakness Mask Underlying Core Profitability

Simply judging from the stock market’s performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.

As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.

The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980’s. It is a gift for long term investors.

When Markets Are Oversold, Not Much Needed For 500 Point Rallies

Today is a perfect example of why I do not recommend that long term investors, regardless of how afraid they are right now, sell their stocks into oversold equity markets to minimize short term pain. When sentiment is so negative, the mere nomination of a new Treasury Secretary can result in a 500 point Dow rally within hours.

All of this announcement did was lift some uncertainty from the market, but traders hate uncertainty. Does it matter that Geithner was one of the two or three people most talked about for this job? Not at all. All that matters is that now we know who it will be.

Now, does this mean we won’t be down 500 points on Monday? Of course not. The point is, when markets are down so much and have priced in so much negative information, it does not take much to get a massive rally. Imagine what would happen if economic data begins to improve sometime next year?

Unless you are psychic it is very difficult to get out of the market and get back in time to catch most of the rebound. With electronic trading and instant dissemination of information these days, the market can move a couple thousand points in a matter of days (which nowadays is a 20-30% move). The odds are against you being able to get back in fast enough, which is why I don’t even try.

With Share Prices Depressed, Dividend Yields Highest Since 1994

During the last couple of decades dividends have not really been a core focus for investors. That has been partly due to the fact that companies have been paying them out at historically low rates. Did you know that over the very long term dividends have represented about 40% of an investor’s total return in the equity market? With the average large cap dividend rate below 2% for much of the last decade or two, many investors probably were not aware of that.

With stock prices down so much in the last year, dividend yields are creeping back up. The indicated rate on the S&P 500 today is about 2.8%, the highest since 1994 when the index was paying out 2.9%. We are still below the historical average for payouts (about 4%) but the trend is in the right direction.

I bring this up because as contrarian value investors add fresh funds to their portfolios and hunt for bargains in this market, dividends could very well play a bigger role than they have in recent years. Getting paid to wait for stock prices and the economy to recover (by collecting meaningful dividend payments along the way) is another way for investors to capitalize on the value in this market.

During the most recent bull markets, a yield of 3% was considered pretty darn good, but now investors can find much better payouts and do not always have to sacrifice the quality of company they invest in to secure above-average dividend yields. As you search for value during this bear market, keep in mind that dividends can significantly boost total equity market returns and such yields are getting easier to find nowadays.

Why Perma-Bears Are Coming Out Of Hibernation

Well, aren’t you glad October 2008 is over? After all, the 17% drop in the market was the worst month in 21 years (Crash of 1987). Given the tremendous drop in stock prices, we are beginning to read about many perma-bears who have turned bullish, which is quite a good sign for investors (this week’s Barron’s includes an interview with Steve Leuthold of Leuthold Group, another so-called perma-bear who is bullish on stocks).

First, what is a perma-bear? The nickname has been given to investment strategists and managers who seem to be permanently bearish. Why do they rarely sing the praises of the stock market’s prospects? Did they have a bad experience and simply have yet to get over it? Hardly.

Actually, perma-bears do turn bullish every so often, it just takes a lot for that to happen. The reason is because perma-bears typically only want to invest heavily in stocks when prices are extremely cheap, typically in bear markets. You see, outsized market returns are attained the easiest when prices are depressed, so perma-bears are more than willing to forgo owning stocks in size until prices are dirt cheap. As a result, they are not bullish very often because bull markets last far longer than bear markets and economic expansions last far longer than recessions.

Since investing when stocks are dirt cheap is a proven winning strategy, why do perma-bears get so much heat? Well, the simple explanation is because since the first stock market opened for trading, in any given year stocks have risen about 80% of the time. So, if four years out of every five are going to see stock prices go up in value, perma-bear detractors would argue that only investing during the depths of bear markets, while a profitable strategy, misses out on many years of market gains.

Fair criticism? Sure, but it depends on your viewpoint. Proponents of long term investing would argue that one would be better off not trying to time the market and accept that during any five year period, they expect to make money during four years and lose money during one. Statistics have shown that strategy pays off handsomely over the long term.

Perma-bears are a little more difficult to please. They realize that the average bear market results in a 30% loss, and such a hit requires a 43% rise just to get back to where they were before the drop, so they prefer to try and avoid such a painful decline, despite it being temporary in nature. By only investing when stocks are dirt cheap, they are able to reduce the chances they incur sizable losses. As a result, the perma-bears missed much of the last bull market (stocks rose for four straight years heading into 2008, just as market history would have predicted).

So, what should we conclude when the worst month for stocks in 21 years has resulted in several well-known perma-bears coming out of hibernation and recommending investors buy stocks? It means that for the first time in a long time, stocks are at the low end of their historical valuation range, which usually equates to an excellent buying opportunity. The perma-bears are getting another opportunity to come out of hibernation and play, which bodes well for all of us.

Watch the 2002, 2008 Intra-Day S&P 500 Lows

The forced selling and mass liquidations are continuing, with the pre-market futures trading limit down this morning. October has always been the most volatile month of the year, and investment fund fiscal years end a week from today (as opposed to a normal December year-end).

Don’t fool yourself into thinking the market action here is based on fundamentals, because everything we are seeing is simply irrational behavior based on forced selling. Buyers are balking because once things become irrational, there is no inherent floor to prices.

If you want to watch specific levels, the 2002 S&P 500 low was 768. The 2008 low so far was 839. The S&P 500 closed at 908 yesterday, and traded limit down (60 points) to 855 this morning. If we don’t hold those levels, another round of computerized sell programs will likely hit the market. The support there should be strong, but in this market, who knows what will happen.

Update: 10:00am — Here is a graphical representation of the last two decades:

Analysts Still Nuts With Their 2009 Earnings Projections

One of the reasons sell-side analysts on Wall Street are usually pretty bad at picking stocks is because they are reactionary, not anticipatory. Remember, the market is forward-looking, so what already happened is irrelevant.

Here we are, in a recession, and by most accounts the economy will stay bad well into 2009. And yet, the consensus estimate for 2009 S&P 500 operating earnings stood at $100.90 as of 10/14. That compares with a 2008 estimate of $75.94, which means the sell-side is projecting earnings growth next year of 33%. Absolutely nuts, right?

The problem is that analysts won’t ratchet down their numbers until the companies actually come out and give specific 2009 guidance (they wait to be spoon-fed it, rather than anticipating it ahead of time like the market does). In such an uncertain economic environment, firms are uneasy about projecting earnings for this quarter, let alone next year. As a result, we have everyone on Wall Street well aware that 2009 earnings for the S&P 500 will be nowhere near $101 (hence the market has tanked), except the analysts won’t tweak their official forecasts ahead of time.

Look, how long the bear market lasts will likely depend on how long the economy stays weak, but how far the market ultimately falls during the bear market will depend, in large part, to how far earnings fall. As you can see below, S&P 500 operating earnings peaked way back in 2006 before oil prices spiked and hurt many companies who have oil as a major input cost.

S&P 500 Operating Earnings:
2005A: $76.45
2006A: $87.72
2007A: $82.54
2008E: $75.94
2009E: $100.90

Obviously the 2009 number is crazy, but how far will earnings drop? The headwind is the recession we are facing, but with that we are seeing commodity prices come crashing down. That will help profit margins at most companies because their expenses will drop alongside their revenues.

Even if we see a recession during most of 2009, earnings might hold up better than some pessimists think. If that is the case, it should put a floor under stock prices next year, even if we hover along that floor for a while. So, the thing to watch is not whether $101 of S&P 500 earnings is doable in 2009 (it isn’t), but rather if we can manage $70 to $75, which would make some of the more dire predictions of $50 or $60 overly pessimistic.