Sunday, October 07, 2007

An Uneasy System: Stocks Are on the Rise Even as the Economy Loses Steam

By Tomoeh Murakami Tse
The Washington Post
Sunday, October 7, 2007; F01

The economy is slowing, the dollar is falling. Wall Street is laying off workers. Defaults by homeowners are rising. Corporate buyouts have lost momentum.

But none of it has rattled stock market investors. Just weeks after the shock of the summer credit squeeze, they are shaking off one bad report after another, sending shares ever higher. Call them the Teflon investors.

On Monday, the Dow Jones industrial average of 30 blue-chip stocks soared to a new high, even as two major investment banks announced that they lost billions of dollars in the credit market turmoil. Then a positive jobs report Friday gave investors an excuse to buy, and the Standard & Poor's 500-stock index, a broader market measure, surged to a record. But even as investors celebrate, the questions hovering over the economy's future are far from settled.

If you're scratching your head about the seeming disconnect between stocks and the economy, you're not alone. The stock market, after all, is supposed to be a leading indicator of economic performance.

So what's going on? Does the stock market know something the rest of us don't?

The answer, analysts say, lies in a mix of investor optimism about a responsive Federal Reserve, an upbeat outlook for the global economy and not-so-gloomy reports about how badly the credit crunch has affected companies and the U.S. economy.

"The dynamic of the market right now is, 'Yes, we acknowledge there are problems in residential real estate. We acknowledge there are problems in the mortgage industry. We acknowledge that there continues to be tightness in the credit market,' " said Arthur Hogan, chief market analyst at Jefferies & Co. "But not withstanding those issues . . . there's a perception that with a friendly Fed, and no signs of increased spillover from what's happening in residential real estate and the credit markets to the broader economy, that earnings growth can still be robust going into 2008."

But the wild summer, if anything, has shown how fragile such perceptions can be.

The third quarter kicked off strong, continuing a giddy spring during which investors snapped up riskier assets such as shares of small companies and low-quality corporate debt. The Dow closed above 14,000 for the first time July 19 despite signs that easy access to credit, the engine of the economy in recent years, was drying up.

But soon, mounting evidence of weakness in the lending market became too much to bear, and fear overtook all aspects of investing. Stock prices plummeted. Corporate dealmaking ground to a halt.

On Aug. 9, central banks around the world began pumping money into the financial system to keep it operating smoothly. Among them was the Fed, which just days earlier had appeared more concerned about inflation than a credit crunch. With markets still unsteady, the Fed on Sept. 18 cut a key interest rate by half a percentage point, prompting an end-of-the-quarter rally in stocks. The rate influences other short-term rates, including those on credit cards and many business loans.

The Dow, despite falling as much as 10 percent from its all-time high during the credit crunch, finished 3.6 percent higher for the quarter and is up 12.9 percent for the year as of Friday. The S&P 500 rose 1.6 percent for the quarter and is up 9.8 percent for the year. The technology-heavy Nasdaq composite index rose 3.8 percent for the quarter. It is up 15.1 percent year to date.

Money managers said investors should not be lulled into complacency. In many ways, the third quarter was about repricing risk, and it is unclear how far along that process is, especially in the high-yield corporate bond market, they said.

"Investors said, 'Wait a minute. I need higher returns in order to compensate me for holding onto this asset,' " said Brett Hammond, chief investment strategist for TIAA-CREF. "And that leads to more volatility."

Against that backdrop, the prediction of many market analysts -- who for two years had been calling for the return of large, growth-oriented companies -- finally came true during the third quarter.

Mutual funds that invest in large-cap growth funds gained 6.2 percent, compared with 1.2 percent for small-cap growth funds, according to Lipper, a data firm. Larger, stable companies are seen as better able to weather an economic downturn, in part because of they would have less difficulty accessing credit.

Natural resources funds, as well as science and technology funds, fared best among the sector-specific mutual funds, gaining 7.2 percent and 6.4 percent, respectively, Lipper said.

Among stocks, energy and information technology were the strongest performers. Energy, which benefited from higher oil prices, gained 9.4 percent. Tech shares, which returned 6.1 percent, are seen by some as good bets for later in an economic cycle in part because companies use profit to invest in technology infrastructure.

Financial and consumer-discretionary stocks replaced utilities and consumer staples as the worst performers, shedding 4.9 percent and 6.5 percent, respectively. Financials include Wall Street firms and mortgage lenders; consumer discretionary stocks include retailers and home builders.

Meanwhile, consumer staples and utilities, sectors considered to be safer bets because they provide goods and services consumers always need, rose modestly.

The repricing of risk partly reflects what some equity analysts said was a healthy change in focus, away from the premium paid for potential targets of leveraged-buyout deals by private-equity firms to the fundamental value of companies.

Such deals slowed in the third quarter. A total of $86 billion in buyouts of U.S. firms was announced, according to data firm Dealogic. That's down from $249 billion in the second quarter and from $94 billion in the comparable quarter a year ago.

Although the buyout party may be over, major Wall Street investment banks still have on their balance sheets billions of dollars in loans they underwrote to finance deals that were struck in happier times. These are loans that the firms had counted on selling to investors but that may now have to stay on their books.

Many of the banks have already adjusted their books accordingly, announcing they would write down their portfolios of loans when they report third-quarter earnings. Standard & Poor's on Thursday revised earnings estimates for the quarter, saying profit would fall 0.4 percent compared with the corresponding period last year -- the first year-over-year decline since the fourth quarter of 2001.

Write-downs from Wall Street firms, several of which have shrunk their mortgage units and cut hundreds of jobs, have been cheered by the market. The adjustments are seen as part of a painful but necessary cleansing process from the era of excess.

Max Bublitz, chief strategist at SCM Advisors, which manages $12 billion in bonds and other fixed-income assets, said: "I'm not entirely sure a lot of these firms are done with those adjustments."

While the credit woes are far from over, some money managers predicted stocks would finish the year even higher. The fourth quarter is traditionally a strong one for stocks, they said, and equities are one of the few games left in town at a time when many investors are wary of securities backed by mortgages and other assets that gave them such headaches this summer. "A little bit like the cat on a stove, they're not going to invest in places where they've been burned recently," Bublitz said.

Another factor favoring stocks is the overseas economy, which is growing at a faster pace than the United States'. Combined with the weaker dollar, that means domestic companies drawing revenue from abroad get a boost.

"It's the rest-of-the-world phenomenon," said Joseph Quinlan, chief market strategist at Bank of America. "They're growing. We're exporting more. Global growth is allowing the U.S. to work through its soft patch."

But money managers and economists warn that plenty of risks remain.

For starters, some parts of that strong global economy have been showing signs of slowing. Europe's growth has stalled recently. Home prices are falling in England.

And while a weaker dollar bodes well for some U.S. companies, it also means higher costs for raw materials and other imported goods, which could add to inflationary pressure. That could prompt the Fed to reverse course on its interest-rate cut -- never mind that the market is already pricing in additional rate cuts before the end of the year.

Friday's much-anticipated Commerce Department report showing solid job growth in September may reduce the likelihood of further rate cuts. Many analysts think August job data, which initially showed the first decline in four years, played a role in the rate cut. Those figures were revised upward Friday.

At the forefront of the worries is the health of consumers, whose spending accounts for two-thirds of domestic economic growth. Their continued willingness to spend despite falling home prices has surprised many analysts.

But most adjustable-rate mortgages are scheduled to reset over the next several years, which could lead to higher foreclosure rates, lower home prices and less consumer spending.

"We think prices will have to come down 11 percent from their peak," said Sam Stovall, chief investment strategist at Standard & Poor's. "Right now, they're only 4 percent from their peak. How will the average consumer on Main Street take that?"

Christopher Low, chief economist at FTN Financial, said the most important variable going forward is employment.

"If we don't have decent job growth, if income growth doesn't accelerate, then there won't be anything to offset the decline in borrowing," he said. "In other words, if we're going to have an increase in consumer spending going forward, it's got to be honest consumer spending, financed by current quarter income as opposed to borrowing against some future income stream."


Anonymous Mark U Runta said...

Excellent post. I guess in the end it's about earnings and Q3/Q4 results will drive the market.

There has to be an impact of the housing woes, credit crunch, consumer sentiment etc. - so to assume double-digit growth going forward sounds a little optimistic.

There was talk early this year about a correction. We got a correction but bounced right back into record territory. Feels to some degree like another bout of irrational exuberance - I guess time will tell.

3:46 PM  

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