Weekday Commentary from Jim Puplava
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Guest Editorial 4/12
Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Wednesday's Stock Market WrapUp
MIXED MESSAGES
The much-heralded second half recovery is starting to amass a few more critics. The army of disbelievers is starting to grow. If the recovery is supposed to be on track, it certainly isn’t showing up in the numbers. The plethora of earnings reports over these last few weeks is turning out to be less than stellar. In fact, many now question whether Wall Street has been much too optimistic and premature in forecasting an earnings turn around. Instead of a 7-8% downturn in earnings this past quarter, it looks like that number will be closer to 11-12% before this reporting season is over. Companies reporting so far have given no indication that things are about to miraculously improve this quarter. The best that can be said is the downturn in profits this quarter isn’t as bad as the last quarter. Therefore, things must be getting better.
The problems for the stock market lie in market valuations. At the moment they are priced at perfection. Price earnings multiples of 45-60 imply growth rates that are unachievable in today’s highly competitive market. Companies are saddled with high debt, which has increased interest expense eating into the bottom line. In addition to higher labor, raw material, and energy costs, companies lack pricing power in the marketplace. This limits their ability to recoup rising prices thereby reducing profit margins. In addition to lower profit potential the inherent risks in the market place is causing risk premiums to rise with investors demanding a higher return to compensate for additional risks. This translates into lower PE multiples for the same dollar in earnings. The market is resolute in its punishment of companies who fail to deliver high potential earnings growth. This is very much evident in the fall in the markets generals.
The large cap stocks that led the 90’s bull market have all fallen on hard times. If you look at any graph of the market leaders such as IBM, GE, Microsoft, Cisco, and Dell, one thing is obvious -- market capitalization has fallen precipitously. With falling market caps and closer scrutiny of financial statements, companies have been deprived of their main source for growing earnings, which is rising stock prices. In the past, rising market caps reflected in inflated stock prices allowed companies to use their stock as currency for making acquisitions. This became a dependable source of earnings growth. The ability to buy sales and earnings became the chief engine for growth during the final boom years of the 90’s bull market.
Those acquisitions are now starting to come home to roost as one company after another is forced to write off those expensive acquisitions through impairment charges. In addition to higher interest rate expense impairment charges is one of the main factors hurting earnings this year. Without the ability to acquire earnings and with financial engineering now frowned upon by analysts and regulators, an important source of earnings growth has been removed from the market. This makes Wall Street consensus estimates highly suspect. There aren’t any catalysts around that would create the miracles imbedded in the Street’s second half recovery. In fact, the possibility for improvement in earnings has already dissipated. In the last recession, earnings rose slowly until the Fed brought down interest rates. As rates fell, companies refinanced their debt, lowering interest rate costs. This contributed to the boost in profits during the early part of the decade following the 1991 recession.
This option has already been exploited during the unprecedented interest rate cuts of last year. As the Fed cut the federal funds rate 11 times, companies used the opportunity to refinance their debt. In many cases, companies also took on more debt as cash flows dried up from a lack of real profits. Instead of unloading debt, companies actually took on new debt, adding additional interest expenses on to the income statement. The current high level of debt has been one of the main reasons profits have been so dismal outside of the impairment charges from writing off goodwill.
Today was another example of the earnings woes facing major companies. AOL Time Warner reported a loss of $54.2 billion, the biggest in US history, in costs associated with its purchase of Time Warner last year. The loss was up from the $.37 billion the company lost the year before. AOL’s monstrous loss was followed by AT&T, which reported its fifth consecutive quarterly loss. The biggest long-distance telephone company said its losses widened during the current quarter to $975 million from $192 million a year ago. Sales slipped 11% for the fifth consecutive quarter. The company went on to say that long-distance sales would decline by 20% this year. AT&T’s CEO, Michael Armstrong, is trying to pare back the debt from his reckless acquisition spree and prepare the company for a possible sale. It is likely the company may not survive the year before it is sold off to a much stronger and well-capitalized competitor.
Jean Marie Messier, the CEO of Vivendi Universal, faced angry shareholders and protestors at the company’s annual shareholder meeting. The company reported a record loss for 2001 because of acquisitions made over the last year. Shareholders have seen their share price drop over 38% as investors have lost confidence in management’s strategy to boost earnings.
Tensions in the Middle East persist, and the crisis in Argentina is far from being over. Argentine President Duhalde may fix the exchange rate bid for the Argentine peso in an effort to avert a banking collapse. Setting the rate at 3.5 peso’s per dollar would make it more difficult for Argentina to get $20 billion in IMF aid. The government is refusing to cut spending, change labor laws, or take steps to cut the government’s deficit. The government refuses to go on a diet and is looking for outside money to continue its profligate spending.
On the economic front, it looks like the recovery is starting to stall. On Wednesday several economic reports show mixed signs for the economy. Durable goods fell by 0.6% last month versus an expected increase of 0.1%. Excluding heavy spending on defense by government, durable goods actually fell by 1.2%. While inventory levels continue to be worked down, there is no sign on the horizon that businesses are increasing their spending. If it wasn’t for defense spending by government, the declines each month over the last few quarters would be much greater.
Another report out today showed new home sales fell in March following a big surge in February. The Commerce Department reported new home sales fell by 3.1% last month to an annual rate of 878,000 units. Although the sale of new homes is getting softer, economists still hold on to beliefs that the housing sector will remain strong throughout the year. However, experts don’t agree. The pace and sale of new construction isn’t sustainable.
The plethora of worries from earnings to Middle East tensions caused an early morning rally to fizzle. At the end of the day all the major indexes were in the red. The tech-laden Nasdaq came close to hitting a six month low. Volume was moderate with 1.35 billion shares traded on the NYSE and 1.88 billion on the Nasdaq. Market breadth was negative with losers beating out winners by 16 to 15 on the New York Stock Exchange and by a wider 19 to 16 margin on the Nasdaq. Just about all sectors pulled back today led by natural gas, oil, retail and paper. The only standout was airlines, which rose on analysts’ upgrades.
Treasury Market
Government bonds rallied after a tentative start, with the morning's softer-than-expected data giving investors a reason to bid up fixed-income securities. The 10-year Treasury note advanced 14/32 to yield 5.105% and the 30-year government bond rose 22/32 to yield 5.615%.
Overseas Market
European stocks fell, led by Royal Dutch Petroleum Co. and other oil companies, which dropped with crude. Ericsson and Nokia Oyj slid for the fifth day amid concern about demand for their phone equipment and handsets. The Dow Jones Stoxx 50 Index fell for the fifth day, dropping 12.84 points, or 0.4% to 3555.03. Only three of the eight major European markets were up during today’s trading.
Japanese stocks fell led by Tokyo Electron Ltd. on mounting signs that upcoming earnings from major computer related companies won't justify the 25% they gained as a group in the past 11 weeks. The Nikkei 225 stock average fell 0.5% to 11,672.88. The Topix index lost 0.5% to 1098.72.
© Copyright, Jim Puplava, April 24, 2002
