Weakness behind the autumn bulls

New highs made in the big American stockmarket averages last month masked weaker undercurrents. And investors should not count on earnings coming to the rescue.

The days grow shorter, and the trees start to shed their foliage. If you pass a tree each day, you might not notice a few fallen leaves. Suddenly, you realise the tree is bare.

By a similar token, the new highs made in the major American stockmarket averages last month were masking much weaker undercurrents. At that time the S&P 500 index had risen more than 10% for the year to date; it went on to give it all back by November 21. Late bull markets typically exhibit non-confirmations or divergences, which can be measured by classic indicators like internals breadth metrics. Money flows into narrow, select areas, and large stocks push an index to new highs while small caps lead on the downside.

The advance/decline line, which measures advancers versus decliners each day, peaked in June 2007. Meanwhile, transportation stocks have lagged the industrials, which according to “Dow Theory” suggests the market is not as robust as it might appear. “These yellow caution flags tell us to be on guard so late in the cycle,” warns Andrew Burkly, market strategist at Brown Brothers Harriman, an American investment bank.

This S&P bull has already run 60 months from October 10, 2002 at 776, to double at 1565 on October 10, 2007. In a volatile month, the S&P proceeded to relinquish all of October’s gain, losing 3.92% on the week that marked the 20th anniversary of Black Monday. Now, with a price/ earnings (P/E) ratio at about 16 for 12-month trailing earnings, the S&P looks fairly valued, rather than a screaming buy.

“Compared to bonds, stocks are cheap,” Burkly points out. “The 10-year bonds are yielding 4%, versus equities at 6.25%.”

The P/E multiple might expand if the Federal Reserve reduces interest rates or earnings take an unlikely turn for the better. The economy grew faster than expected, at 3.9% in the third quarter – its fastest clip in a year and a half. After its half-point reduction in September, the Fed cut the discount rate by a further quarter point this month, changing its bias to neutral, while it indicated that growth and inflation appeared “roughly balanced.” However, payrolls came in strong in October, at 166,000 and the unemployment rate held at 4.7%, leaving less justification for further reductions.

The Fed’s commentary has clarified that it had acted to settle market dislocations, especially in commercial paper, and to provide liquidity. “The benefit was as much psychological as functional,” notes Dan Genter, of RNC Genter, an investment manager based in Los Angeles. “[Ben] Bernanke, the new sheriff in town, showed that he wasn’t afraid to deal with a changing situation.”

The collapse in housing and ongoing credit woes could test the Fed’s responsiveness again. Two million adjustable-rate mortgages are due to be reset over the next six months and will not peak until March. Foreclosures are precipitating a downward spiral, as banks sell houses cheaply in their zeal to get them off their books. “Yet housing prices are still about 20% too high,” warns Dirk Van Dijk, director of research at Zacks.com in Chicago. “For decades the median house was valued at just under three times the median income. By late 2005, it had risen to almost five times the amount.”

Even commercial real mortgage issuance, hitherto intact, fell 83% in October.

Could earnings rescue the market? Do not count on it. Earnings projections and results have been steadily eroded across the board. Estimates, projected at 7% when the third quarter began, have slipped into negative territory. Healthcare and technology posted the best gains, at 15% and 12% respectively, according to Reuters estimates, while consumer and financial sectors fared worst, and financials comprise 20% of the S&P. “What worked for the past three years continues, including commodities, energy, materials and industrials, ” says PJ Garner, senior investment consultant at CapTrust in Tampa, Florida. “The question is, will we see rotation into new leadership or remain momentum based?”

Until dipping in November, technology stocks performed handsomely, powered by Apple, Google, Intel, Microsoft and Yahoo, which benefit from international exposure, moderate debt, and their limited exposure to the credit crunch.

Energy and other natural resources sustained their run. “The Chinese are making concrete, steel, and other heavy tonnage, which suck up massive amounts of raw materials, like copper and iron ore,” says Van Dijk.

Earnings of integrated oil companies have been less than stellar. The petrol price has not kept up with crude and downstream margins have been pressured. Prospects look better for natural gas and drillers, such as Andarko, Apache and Devon.

The financials remain at the epicentre of the drama. Major banks have undermined investors’ confidence with a string of warnings. Even chief executives’ heads have rolled at Citigroup and Merrill Lynch. Merrill, Morgan Stanley, Bear Stearns Countrywide, JPMorgan Chase and Bank of America have confessed to a series of write-down announcements.

A consortium of three major banks is working to set up a $100 billion (£49 billion) facility to buy up assets of structured investment vehicles in an effort to spread losses over time. Meanwhile, the volume of Level three assets – those most illiquid and difficult to value – has mushroomed at Merrill, Morgan Stanley and even Goldman, to a substantial multiple of these firms’ equity. “They won’t necessarily be marked down to zero, but it will give a haircut and a big hit to the banks’ capital availability,” says Van Dijk. “And more bodies will be unearthed.”

On the other hand, a firesale in the group may have created a buying opportunity. Citigroup, Bank of America and AIG are yielding nearly 6% in dividends. Take a worst-case scenario for Citigroup, of $30 billion in writedowns. Most will be off balance sheet and unrealised until they are sold. Right now, the bank has $24 billion in free cash flow, $10 billion of which goes to the dividend. Genter sounds a more calming note: “The numbers sound staggering, but less scary in the total scheme of things.”