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Is the Stock Market a Value Trap? Part 2


Understanding "acceleration station."

Editor's note: Prof. Rob Roy also contributed to this article. This is also Part 2 of a two-part article. The first section can be found here.

Has the 'Perfect Storm' Formed for Earnings?

I believe strongly that the Perfect Storm has formed for earnings both in the U.S. and Europe. While many like to blame the stock market decline solely on rising energy prices, I believe it may be the tipping point that sends emotions from denial all the way to capitulation.

Well-managed companies like UPS (UPS), FedEx (FDX), Best Buy (BBY), Nike (NKE), Fortune Brands (FO) and many others have issued profit warnings lately, mostly blamed on rising oil rises. One can only wonder what will happen to the earnings of lesser companies and to their stock prices.

We're now starting the second stage of the Credit Crisis. Up until now, this crisis has been mostly reflected in the stocks of financials and quasi-financial companies like General Electric (GE), Caterpillar (CAT) and others that rely on a steady stream of borrowing. However, the spill-over into other industries is now beginning as job losses, energy costs, inflation, healthcare, pension, and increased cost of borrowing create the Perfect Storm against earnings power.

Consider the case of General Motors for a moment. Outside of GM's 'legacy issues,' like health care for millions of people, consider what else GM faces. Its cost of borrowing, based upon recent trades in the open market for its debt, is north of 20% per annum. Yes, 20%.(How do you make a profit when you have to pay 20% to fund the company?)

Its mix of business is heading away from SUV's (down 40% year-over year) to smaller, more fuel efficient cars, which have far lower price tags, and far lower profit margins. GM's manufacturing infrastructure doesn't handle this change in a very dynamic way, and the change over to smaller vehicles will be extremely costly.

The company is hopelessly over-leveraged. The economy is slowing in its key markets: the U.S. and Europe. The perfect storm has most definitely formed for GM- it's over-leveraged, can't finance itself, and it's facing rising delinquencies at its GMAC subsidiary. In addition, GM will receive many SUV's that will be turned in as leases expire over the next several years and there will most likely not be a buyer for these vehicles at anywhere near the assumed resale prices when the leases were originally written. Sadly, GM, a notable icon of the manufacturing era of the U.S., is in my opinion a "dead man walking."

Yield of General Motors 7 ¼% due 2013

Click to enlarge

The $64 billion question is whether GM is alone. Its situation may be one of the most tenuous and it has absolutely nothing going for them. I can't imagine any foreign automobile manufacturer wanting to acquire it, and a private equity deal or LBO is also out of the question.

Taking a look at the generic yield spreads of BBB-rated financial companies versus Treasuries paints another lousy picture. While the Fed is trying to pump liquidity into the system, it's slowly becoming less potent. The market is forcing those that can borrow to pay up, and pay up a lot. What many do not hear about on a daily basis is that the financing door has already shut on companies like Keycorp (KEY), Fifth Third (FITB), Regions (RF) and most likely, Lehman Brothers (LEH), Merrill Lynch (MER) and Morgan Stanley (MS). My guess is that when many of these companies report their earnings (or lack thereof) and 'fess up to what is actually on their balance sheets in accordance with 'Basel II', we may be in for some more nasty truths.

Basel II was introduced in June 2006. According to the BIS (Bank for International Settlements):

"The Basel II Framework describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rule-making and adoption procedures. It seeks to improve on the existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the Basel II Framework is intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a result, it is intended to be more flexible and better able to evolve with advances in markets and risk management practices."

You can read the entire Basel II Framework here.

Once we see what is on their balance sheets, I believe that capital will be even less available to finance these companies. Since the Credit Crisis began, many major financial concerns have seen their debt ratings slashed from AA to BBB, and the chart further below shows just how much spreads have increased versus Treasuries since that time. To be honest, I think that this graph actually understates the amount companies would be forced to pay if they had to come to market now as these are just 'quotes,' not where bonds would actually trade if you were unlucky enough to own them and need to sell.

Most players that bought corporate debt in the post-Bear Stearns environment, when the Fed attempted to embolden investors and sound the 'all-clear' signal are now seriously under water and the count of potential buyers continues to shrink. This is a vicious cycle that will eventually affect most all industries, both here and abroad. Again, welcome to Acceleration Station.

10 Year BBB Rated Financial Debt Spread vs. 10 Year Treasuries

Click to enlarge

What are Stocks Really 'Worth' and Where Might We Be Headed?

When I consider the actual trailing earnings per share number for the S&P 500 of roughly $61 per share, and then attempt to factor in the slowing global economy, rising credit costs, falling profit margins, and lack of credit availability, I believe that earnings will eventually settle around the $50 per share area. I come to this conclusion by assuming that many of the smaller financial institutions will eventually be gobbled up by larger, healthier institutions and that their earnings will not grow for several years.

Further, the Treasury Department has signaled over the past couple of days (both Secretary Paulson and Undersecretary McCormick) that no broker/dealer is 'too big to fail', which suggests that they are either a) Telling us they expect the weaker players to be absorbed by those with deposit bases (banks), b) They have come realize that there is no saving folks like LEH, who were hopelessly mis-managed through the times leading up to and during the present Credit Crisis, or c) some combination of both.

I vote for 'c.' Investment banks like LEH simply cannot be left alone as they are so intertwined with the rest of the financial system. While they should be allowed to fail, I would more likely expect to see further shotgun marriages, like JPMorgan (JPM)/BearStearns.

Add to the equation that beginning in November 2008, broker/dealers and banks will need to come clean and show more transparency in regards to their positions in CDS (Credit Default Swaps). While lots of folks, myself included, are looking forward to more transparency, I find it highly likely that we may suffer from the "law of unintended consequences"-Are you really sure you want to see what is on their books?

Adding to the likely decline in the constituents that make up the S&P 500 is the fact that the consumer is over-leveraged and without an asset (like homes) to tap for much needed cash. The tax rebates have come and gone and yet the economy stays weak. The U.S. has lost jobs for six straight months which is a streak of bad data that I do not expect to reverse any time soon. Add to this relentlessly higher energy costs which is likely to change consumer's habits for years to come, and we have a recipe for poor results in the 'consumer discretionary' arena.

Consumer discretionary could hurt tech stocks (how many Blackberrys, iPods, and plasma TVs does one need?) and most other non-essential items. Since the consumer is nearly 70% of American Gross Domestic Product (GDP), I can envision retail and tech earnings going lower and staying lower for several years until the consumer can slowly repair their balance sheets.

A 'back of the envelope' calculation leads me to an S&P 500 earnings number that would hover in the $50-60 per share area, which in turn, leads to a potential index price target of 650-900 (650 comes from 13 x $50 and 900 comes from 15 x $60) on the S&P 500.

A move down to this level could perhaps occur into the "presidential cycle" low in the end of 2010 (equity markets have a habit of bottoming in the end of a second year of presidential terms). A possible trace-out of this kind of move is shown below using Fibonacci levels.

Fibonacci Retracement Chart of the S&P 500

Click to enlarge

Unfortunately, this second wave of the Credit Crisis is likely to be swifter and cause previously unknown levels of pain for average Americans. It's been said to me that credit (the ability to borrow) is like the oxygen in a consumer-driven economy. When the credit is cut off, the consumer dies and everything that the consumer preciously purchased, used, or even aspired to will suffer negatively. The pain first started with the highly paid on Wall Street, but will now flow down Main Street.

I'm doing my best to anticipate this chain of events and to preserve capital while I await the next period of great opportunity. It isn't pleasant to be right about these events but I'd rather acknowledge the challenges, sidestep the pain train and be prepared to take advantage of the opportunity of a new day with most or all of my capital still intact.
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