U.S. Economy: Widespread Recession or Financial System Crisis?

Most of the steps taken by the Federal Government so far have been an attempt to prevent the current financial market crisis from getting worse, which would undoubtedly spill over to Main Street and the rest of the economy. The reason why there is a debate about whether we are in recession right now, or whether we will fall into one next year or not, is because the problems thus far are contained to a few areas. If those problem spots can be resolved to any measurable degree, we could get a quick economic and market recovery. If they spread, we are in for a prolonged and expanded downturn.

To see exactly how well most areas of the economy are holding up, we need to look no further than a breakdown of S&P 500 earnings by sector. Below is the breakdown of earnings from 2006 through current 2009 estimates:

Notice what while S&P 500 earnings will be down this year, for the second straight year, eight of the ten sectors are expected to have earnings gains for the third consecutive year in 2008, as well as further gains in 2009. This data shows exactly how much impact the financial sector’s woes are having on the market. The consumer discretionary sector is an obvious casualty of such fallout, but everything else is fairly strong.

Personally, I think 2009 earnings estimates remain too high, though they have come down some already. Although I think the odds are remote, it is easy to see that, when one assumes the financials will rebound sharply, such a high S&P earnings number is possible in 2009 because the other sectors remain on firm footing.

Our economy is not yet in a widespread recession. Financial services are in trouble and are spilling over to the consumer sector. It might not be very comforting, but if we can get the financials consistently back in the black, even if they earn half the amount they did a few years ago, the economy and markets could hold up okay next year and beyond.

Short Selling Ban Is Dramatic, But U.S. Can’t Allow Firms To Fail For No Reason

The SEC’s 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let’s be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company’s fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It’s that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don’t have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they’ll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country’s largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won’t be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

Newsflash: SEC Might Slowly Start to Enforce the Law

From MarketWatch:

“The Securities and Exchange Commission said Tuesday that it will try to limit so-called “naked” short selling of shares in Fannie Mae, Freddie Mac and big brokerage firms. The SEC will issue an emergency order stating that all short sales of shares in these companies will be subject to a “pre-borrow” requirement, said Christopher Cox, chairman of the SEC. This will last for 30 days, he said. The SEC is also planning more rule-making focused on short selling in the broader market, Cox said.”

Is this some sort of joke? Naked short selling is illegal, and for good reason. Short selling involves borrowing shares from holders who are willing to lend them out, selling them, and promising to repay the shares at some point in the future. So called “naked” short selling, or selling shares without actually borrowing them, is illegal because it can result in constant selling pressure due to the sale of more shares than are available for sale.

Now the SEC is saying that “naked” shorting will be illegal for 30 days for certain financial stocks. Seriously? So they are admitting that “naked” shorting is running rampant (a position that has been claimed for years) and they have not been enforcing the law? Add that to the list of reasons why this market could be taking it on the chin. First the SEC eliminated the “up-tick” rule, and now they are allowing “naked” shorting. Shameful…

General Electric Earnings Could Initiate Oversold Bounce

General Electric (GE) will be the first important report of second quarter earnings season. After last quarter’s shocker, a stabilizing picture at the industrial conglomerate could very well help this market get a much needed and long overdue oversold bounce. With sentiment so low right now, even generally in-line earnings might be enough to halt the market’s slide.

Coming into this earnings season, consensus estimates call for S&P operating earnings of $88 for 2008. Interestingly, that would match the market’s 2006 level, and represent an increase of 6% over 2007. A huge headwind for the market has been the fact that earnings estimates coming into the year were way too high and downward revisions have been continuous. Stock prices will have a hard time rebounding until earnings stabilize.

Amazingly, estimates for 2009 are still way too high. Analysts right now are sitting at $109 for the S&P 500 next year, which I think is insane, quite frankly. If those numbers prove accurate this market will be off to the races by the first half of next year. That aside, if second quarter earnings are okay (not far below current estimates) hopefully we will get another short term oversold bounce, much like the two we have already seen during this year’s market ugliness.

A better report out of General Electric would go a long way to getting the ball rolling in that direction (GE reports before the market opens on Friday).

Full Disclosure: Peridot clients were long GE at the time of writing

With Negative Sentiment Soaring, We Might Be Starting A Bottoming Process

One of the stranger things about 2007 was the huge discrepancy between different areas of the U.S. stock market. Despite widespread problems, the stock market didn’t fare badly unless you looked under the hood. The S&P 500 finished the year up 5%, hardly indicative of the issues we are facing. In fact, of the market’s ten major sectors, only two of them trailed the S&P 500 index’s return last year. Financial services (-21%) and consumer discretionary (-14%) stocks were correctly pricing in a recession (or something that feels like one) but the other eight sectors just kept humming right along.

Well, it appears we are now getting a more realistic reaction in the market to the economic challenges we are dealing with. We’ve dropped 10% in less than 3 weeks, and the selling has been much more widespread. Realistically, we were due for this type of action. That said, the negative sentiment in the market right now is deafening. We won’t know how bad things really are until fourth quarter earnings reports and first quarter outlooks are given out over the next 2-3 weeks, but stock prices are starting to price in some really bad stuff. Many contrarian sentiment indicators are signaling we could be starting a bottoming process.

Since nobody can predict when the market will stop going down, I’m not going to waste my time (or yours) hazarding a guess. I will say this, however. Investors should pay close attention to this month’s earnings reports and conference calls. Stock prices are now being driven by fear, and I think many of them are not reflecting what is likely to happen as we navigate through 2008. We could certainly fall another 5%-10%, after all things are not good and I’m not trying to say they are, but we should still be getting ready to pounce.

Personally, I am not going to be doing any meaningful buying until I see these earnings reports and listen to quarterly conference calls. But after that, I think it might be time to dip a toe in the water with cash positions. Even if we keep heading lower short term, a year or two from now I think it will pay off in spades.

Earnings Estimates for 2008 Appear Overly Optimistic

Although fourth quarter earnings reports just started to trickle in, consensus estimates call for 2007 S&P 500 profits to be essentially flat with 2006. Given the huge year-over-year declines in the financial sector, the largest piece of the index, this is not very surprising.

What is surprising is that analysts are projecting 2008 earnings to grow by more than 15%. We all know that analysts are rarely spot on with their forecasts, but the possibility of this number being accurate seems even less likely than normal. While the market’s P/E using the current forward estimate (less than 14) is not high by any means, bullish investors hoping for a solid market gain this year (at or above historical averages) likely need strong earnings growth to make the case.

Given the economic backdrop right now, a less impressive year in the market (more in line with last year) seems like a more reasonable expectation. As far as the economy goes, 2008 probably will be more of a “sorting out” year than a “snap back” one. As a result, I think the return of double digit earnings growth for the S&P 500 likely won’t return until 2009 at the earliest.

Third Time’s A Charm?

Earnings season officially kicked off this afternoon, with Alcoa (AA) reporting fourth quarter numbers. Given the worries about the economy, these profit reports obviously carry as much as weight as anything in determining market direction, but they also come at a time when the S&P has once again dropped down to a support area between 1350 and 1400. Since I am not of the belief that the Fed can cure all of our ills on its own, the next few weeks are crucial to whether or not we can maintain these levels again, or if a wider bear market (not just in financials and consumer discretionary stocks) awaits us.

Putting the Correction in Perspective

November has been the worst month for stocks in several years. The S&P 500 is now negative for the year, and sits 10% below its high and 8.5% lower this month alone. Not only do long term investors like myself take a multi-year outlook of the future when investing money, but it also helps to put things in perspective by looking back at where the markets have come from in a multi-year scenario. Much like a student who gets a C on a tough exam might be in fine shape if previous grades in a semester have been all A’s, investors need to realize that markets don’t go up all the time, just as good students can’t possibly ace every test.

Stock prices rise, on average, 75 to 80 percent of the time in any given year. After four magnificent years of gains in the market, we are overdue for some poor performance. We might finish down this year, or next year, or both, but regardless, take a look at how far we have come over the last five years:

We can’t possibly expect gains like this to continue indefinitely. Even a pullback to something like 1,300 on the S&P 500 index would simply be a normal, healthy retracement after extremely large gains. Perspective like this is important when markets are rattled, as they clearly are right now. I don’t know how long the correction will last, or how low we will ultimately go, but I will remind people that these types of moves are normal, and are required to maintain a healthy marketplace.

As for how to approach new investments in this type of environment, I don’t think meaningful changes need to be made. When fear of the unknown grips markets in the short term, as is happening right now, long term investors simply need to ignore the short term noise and focus on long term fundamental stories. Investment themes need to be able to weather your view of how the world will look five years from now, not five hours from now. If you invest in a company that has a bright long term future, and pay a very reasonable price for it, the odds are in your favor that you will make good money over time. And that fact won’t change based on anything that happens today, next week, or even in 2008.

The Implications of Negative Earnings Growth

Undoubtedly, the underlying driver of the U.S. stock market in recent years could be summed up in two words; earnings growth. Equities now face a hurdle, however, as third quarter profits for the S&P 500 could very well decline year over year for the first time in five years. The implications for the market are pretty important.

At the outset of the year, market forecasters were calling for low to mid double digit returns for the market, supported by rising earnings and slight multiple expansion. It was my view that multiple expansion was unlikely (due to a lack of low P/E ratios to begin with, coupled with decelerating economic and earnings growth rates), so market returns would more likely track earnings advances, which would put us up in the mid to high single digits for the year. The S&P 500 is slightly above that pace right now, but it will likely be an uphill battle from here.

The reason is that without multiple expansion or earnings growth, there is no way for the market to advance meaningfully, by definition. The end result is likely to be a range-bound market as judged by the major indices. In fact, as the chart below shows, we have already begun to see this scenario take shape.

S&P 500 Index – Last 6 Months

From an investor perspective, this infers that stock picking will be all that more crucial to achieve investment gains. Not surprisingly, I would suggest focusing on individual situations where either multiple expansion or earnings growth are largely assured. The ideal investment candidate would be set up nicely for both, which would allow for solid gains regardless of whether or not the overall market advances meaningfully in coming months.

Examining Dualing Market Outlooks

Does anyone else find it pretty strange that two people can look at the exact same set of data and reach two dramatically different conclusions? I’m speaking of market strategists who try and determine if the overall equity market is overvalued or undervalued. The bulls think we are 20 or 30 percent undervalued and the bears see the exact opposite scenario. How can people differ that much on the outlook for the domestic stock market? It’s not like we’re are trying to value a single company, where I could understand widely varying outlooks. The stock market as a whole can’t be overvalued and undervalued at the same time.

The key to analyze this dichotomy is to look at the S&P 500 P/E ratio, which is the most widely used metric to value the overall market. This isn’t as simple as it sounds though. You arrive at different numbers depending on if you use the trailing twelve month (TTM) P/E or the forward P/E. Personally, I use forward P/E ratios when valuing stocks, because equities are claims on future earnings, not profits already earned. However, the most bearish market strategists use trailing numbers because doing so results in higher P/E ratios, which imply higher valuations. For the purpose of this piece, I’ll use TTM P/E ratios, mainly because historical data is easier to find.

Another point of contention is which earnings calculation to use. The two most commonly cited are operating earnings and GAAP earnings. Operating earnings are meant to gauge how much cash a firm’s operating businesses are generating, whereas GAAP numbers are really more of an accounting standard and don’t always reflect true profitability. For instance, one of the biggest contributors in GAAP earnings is stock options expense. Accountants insist that companies issue GAAP income statements that place a value on expenses incurred by issuing stock options, even though no economic cash cost is incurred.

Currently, the P/E on the S&P 500 index is anywhere between 15.4 (forward operating earnings) and 18.0 (trailing GAAP earnings) depending on which of the four measures (forward vs trailing/operating vs GAAP) you use. I don’t think we need to agree on which P/E to use to analyze whether or not the market is wildly overpriced or underpriced. For the most part, the bears think P/E ratios should be lower, or will be lower shortly. The bulls think if P/E multiples do anything, they should go up, not down.

Keep in mind, I am referring only to those people who think the market is meaningfully mispriced right now, say by 20 percent or more in either direction. I fully understand that this is only a subset of all market pundits. I’m simply interested in looking at the dichotomy that exists between them.

Let’s take a look at an interesting chart that should shed some light on this debate. The graphic below shows the historical trailing P/E of the S&P 500 index (blue) along with a five-year moving average (black).

As you can see from the chart, the stock market typically trades at a P/E of between 10 and 20. Depending on which number you use, we are currently either right smack in the middle of that range, or on the upper end of it. If you are using P/E ratios as your yardstick, you really can’t make a compelling argument that stock prices are dramatically too high or too low.

The real question in this analysis, if we assume the historical range is a pretty good guide to stock market valuation, is whether we should be closer to 10 or 20. How much investors are willing to pay for equities can depend on many variables, but the most important ones are interest rates and inflation. Don’t take my word for it though, both logic and historical statistics back up this assertion.

Since stock prices reflect future earnings discounted back to present day values, there is a negative correlation between interest rates and stock prices. When rates are low, investors are willing to pay higher multiples of earnings, and vice versa. Inflation measures have the same effect on demand for equities. When inflation is high, the “real” (net of inflation) return on stocks goes down or becomes negative, which crimps investor demand for equities, lowering multiples.

Since the economic backdrop is crucial in determining the appropriate valuation level for stocks, the fact that the United States currently is operating a growing economy in a low interest rate, low inflation environment sheds a great deal of light into where stock prices might trade. The middle or upper end of the historical range is not only not unrealistic, but it makes a lot of sense.

Making the argument that P/E ratios should be dramatically higher is simply not prudent given the historical data. Defending a P/E toward the low end of the range also isn’t very compelling given the current economic backdrop. As a result, I think a simple look at history, coupled with a basic overview of current economics, shows that the market is neither wildly overvalued, nor wildly undervalued.