Long economic expansions always include a “weak spot in the middle”, says one respected economist, and US economic growth appears still on course after a classic market correction.
The surprise was the surprise itself. American subprime mortgage concerns were no secret, adjustable mortgage rates were due to reset, Bear Stearns was already bailing out its floundering hedge fund by $1.6 billion (£800m) – so should it have been startling when the risk premium finally resurfaced?
Yet the American equity markets have risen steadily since their March lows. When the Dow Jones Industrial Average topped out on July 19 at a record 14,000, and the S&P 500 at 1553, a price/earnings ratio (P/E) of 17.4% crowned 12 consecutive quarters of better-than-expected earnings results. A pullback to a P/E of 14 or 15 may feel like whiplash but actually represents a more sustainable level in a classic 12% correction.
Although housing starts and new home sales continue to falter, so far the overall economy has not stumbled. The Commerce Department reported that GDP grew an upward revised 4% in the second quarter, with the help of higher defence orders and commercial construction, and an improved trade deficit. Durable goods orders vaulted 5.9% in July, the largest jump in 10 months. Earnings are coming in at 9% for the second quarter, and “likely to average about 5% for the third quarter, probably back up 8% for the fourth quarter. That should only shave about a half point off GDP,” says Dan Genter of RNC Genter, a fund group based in Los Angeles. The early August consensus of 50 top economists for the Blue Chip Economics Indicators Report did not foresee recession.
Nonetheless, the August employment report sent a shiver through Wall Street on September 7, declining for the first time in four years. Four thousand jobs vanished, an especially bitter disappointment, considering that more than 100,000 new ones had been predicted. To make matters worse, the previous two months’ tally of non-farm payrolls was revised downward by 81,000.
Long economic expansions always include a “weak spot in the middle”, reports David Wyss, chief economist at Standard & Poor’s, as he reflects on the contraction in credit markets. “What we have been witnessing is really a good old fashioned run on the banks.” But this time disintermediation has kicked in, and it has become a run on the capital and commercial paper markets.
Hedge funds and private equity firms are still suffering. Many hedge funds, facing redemptions, liquidated their strongest holdings to raise cash, which added to pricing distortions in large caps. For instance, a market neutral fund might have been long a large liquid bank like JP Morgan Chase, while being short some of the riskier lenders. As the dust settles, and vanilla-type paper begins to move again, investment grade firms will probably recoup better than lower-rated counterparts like Ford and General Motors.
It is harder to achieve innovative financing, as the private equity and leveraged buyout (LBO) party winds down. “Creative financing will become the same type of pejorative words as creative accounting did in the late 1990s,” Wyss predicts. Investors are less likely to bid up small and madcap names in speculative excesses, in the hope of private equity takeovers. Already, investors and banks have balked at a $12 billion debt offering to underwrite Cerberus Capital Management’s buyout of Chrysler. All eyes will turn to the $26 billion buyout of First Data, a payment-processing firm. Other LBOs scheduled later this season include Clear Channel Communications and Rupert Murdoch’s News Corporation’s acquisition of Dow Jones.
When the subprime crisis hit, the financials and brokerage stocks initially took the news on the chin, with Goldman Sachs off 23%, Lehman Brothers down 54% and Merrill Lynch beaten up by 29% from their recent highs. In more bad news, more than 35,000 workers were laid off in August from the sector. Financials rebounded 10% in August, however, “as people come to their senses,” says Genter. He says the woes may be protracted among smaller, regional players and those with subprime-related business, like Countrywide, whose mortgage originations will go down, leaving them reliant on interest income. On the other hand, large multinationals, like Citigroup and Bank of America should prosper.
James Berman, president of JB Global, an asset management firm based in New York, likes the prospects for technology. He explains, “there was no real reason for the sell-off in companies like Microsoft, which plunged 6.1%, underperforming the S&P by 4%. Technology and software oriented service providers do not depend on consumer spending, as much as on business capital investment and cycles of software product introductions.” For example, a payroll-processor like ADP benefits from payroll growth and rising interest rates, since it earns from the float it holds from payroll deposits.
Pharmaceuticals were also unfairly ravaged. Pfizer plummeted 8.2% in three months, with Merck trailing the S&P over that period, with a 4.7% loss. “Both those companies have had well publicised problems for some time, and the subprime collapse did little to affect that,” Berman points out.
But all sectors cheered on September 18, when the Federal Reserve brought back the punchbowl, slicing both the fed funds and the discount rates, each by 50 basis points. Although oil and gold have been roaring ahead in September, taking out their old highs, inflation appeared contained: wholesales prices actually fell 1.4% in August, the biggest drop in ten months. The Fed’s statement did not hint at further rate cuts, after such largesse, and some experts like Genter warn that the cuts “may be throwing good money after bad, if they do not solve the liquidity problems”.
Despite a raft of announced layoffs, some positive factors are quietly at work. Most companies are sitting on ample reserves. Corporate insiders have been buying stock at an unusual clip, with the ratio to sales below 10. Equity markets are even recouping most of their credit crunch crisis losses. So who is out there calling for the normal pattern, which would be a retest of the lows?