Stock Market Discounting a Weak US Economy During 2008
Stock-Markets / US Stock Markets Nov 27, 2007 - 12:30 PM GMTBy: Roger_Conrad
December is almost always a great month to be holding utility stocks. Big institutions typically use the time to re-jigger their portfolios to safer fare, and those who've won big during the year will often move to safe havens to better lock in their gains.
The only really bad Decembers for utes have come in the wake of a crisis of fundamentals. One such time was in 1993, as fear and panic began to spread about prospective deregulation. December 2001 was another lousy month, as fallout from the ENRON bankruptcy gripped the industry. And though the worst of the dreadful utility bear market was over by then, December 2002 was no picnic either.
Happily, as we enter the last month of 2007, the only worries for utility stocks are considerably further out. One of these is the cost of complying with almost certain carbon-dioxide (CO2) regulation.
This weekend, one of President Bush's few remaining allies in his fight against the Kyoto Treaty on climate change—Prime Minister Howard of Australia—was defeated in elections. The country's new leader has stated that fighting global warming is a top priority.
I doubt the president will abandon his opposition to mandatory limits on CO2 emissions in his final year in the White House. But Howard's defeat will further spur proponents of regulation here, particularly because the US is now the only major industrialized nation not to sign on to Kyoto or endorse enforceable CO2 limits.
Controlling CO2 emissions will be extremely expensive to many utilities in coming years. As I pointed out in the November issue of Utility Forecaster, coal use for generating electricity is ground zero on this issue. Coal accounts for more than half of America's electricity and more than 80 percent of CO2 emissions produced by generating power.
It's literally impossible to imagine a US economy that's not reliant to a large extent on coal, at least not any time in the next decade. And any transition away from using it will be extremely painful for the country. For one thing, we now import 75 percent of our oil and no longer even meet all of our need for natural gas from North America.
Even leaving out the cost of revamping coal-burning power plants to burn gas, that means greater reliance on imported energy. And this is at a time when oil prices are flirting with $100 a barrel, as demand surges in developing nations and global supplies are increasingly stretched and politically tenuous.
Significant new nuclear generation is at least a decade away. Hydro plants are under attack as never before for the environmental degradation they cause. And sources like wind, geothermal, solar and biomass—although very profitable for those who provide them—are capable of covering only a portion of projected new demand for electricity, let alone replacing any existing baseload generation.
Continuing to burn coal will be increasingly expensive, however, as utilities are forced to buy credits to emit CO2 under the cap-and-trade systems currently being proposed. These credits have the potential to become extremely expensive when demand spikes during summer and winter peak seasons, depending on how legislation is ultimately written.
They'll certainly encourage investment in technology to control CO2, such as “carbon capture.” But again, solutions will cost money.
Where that money comes from is the chief long-term risk for energy utilities. Some will be able to push their costs onto the market as wholesale electricity prices. Some will get back their investment as regulated rate base. Some, however, could wind up eating a good portion of the cost, with potentially disastrous consequences.
The good news is utility investors don't have to worry about these challenges this December. And although some companies are starting to receive less-than-encouraging rate decisions, most are getting what they need to maintain dividends and keep profitability on an upward track.
OUTLOOK CLOUDY
The happy result: We don't have a lot to worry about on the fundamentals front from this sector. And if you've been making wise selections based on the health of underlying businesses, your concerns are fewer still. With the 10-year Treasury note yield hugging 4 percent—and poised to go lower still—volatile interest rates don't appear to be much of a risk either. In short, December should be a solid month for utilities.
The same, unfortunately, can't truly be said about the rest of the market. Tax selling will most likely push down prices of this year's larger losers. That includes some of the real estate investment trusts, major financials and natural gas producers.
Even the best-run companies in these sectors could take a knock, as investors unload in order to get the writeoffs. Those could well be paired with sales of the year's big winners in more volatile sectors, such as natural resources.
This is, of course, normal market action. The best response to it is to see what's most heavily sold on that basis and then make a determination of where the best values are.
In years past, many investors did this kind of bargain hunting in January, after the last possible tax-selling day for the prior year. These days, however, the so-called “January effect” has been occurring earlier and earlier, owing to the fact that the mutual funds that dominate the market are selling earlier. Therefore, we could actually see some of this kind of buying in December.
For long-term investors, it's always best to focus on the health and growth of underlying businesses, rather than playing for a point or two based on short-term trading patterns. But there are a number of very real concerns with far more lasting potential consequences, and they present very pressing questions for the market.
Front and center is the economy. Since midsummer, concerns about a potential recession have ruled the market. News that seems to indicate a descent into a morass has triggered dramatic selling, while more favorable developments have triggered rebounds.
The overall stock market has had a downward bias. But compared to its reaction during the last great financial crisis—the credit crunch of the late 1990s—the reaction in the big averages has been positively benign. In fact, despite the huge down days that have become so common in recent weeks, the Dow Jones Industrial Average is still less than 10 percent from an all-time high. The broader-based S&P 500 is even closer to its record.
Rather, the worst damage in this market has been in specific stocks and sectors. And the biggest casualties have been those that are the most sensitive to economic growth issues, particularly credit.
The stock market always looks ahead, never behind. And what investors are discounting now is the potential for a weakening US economy in 2008. That's what's behind every selloff we see.
It's highly debatable what kind of growth rate is priced in to the stock market now. The drop in the benchmark 10-year Treasury note yield offers perhaps the best clue.
The current rate has now slipped below 4 percent for the first time since early 2005. But we're still a good half point or more above the low point hit in 2003, the last time the economy was technically considered to be coming out of a recession.
Will the 10-year get to that point this time around? In 2003, energy prices were a fraction of today's levels. So were the prices of virtually every other major and minor raw material.
Wage pressures were nonexistent, even in the developed countries where strikes are now increasingly frequent. And the major measures of inflation were at lower levels as well. The US dollar was certainly at a much higher level.
All those factors would seem to argue against a further descent in the 10-year yield. Further, getting the 10-year yield down to the neighborhood of 3.5 percent is an enormous feat.
This market is the biggest in the world, and it takes a great deal of buying power to push prices up and yield down that radically. That will only happen if evidence of an unfolding recession has created enough desire to pull back into the safest of investments.
The constant flow of economic news will provide plenty of clues as to whether the economy is still weakening, stabilizing or even pulling out of its current malaise. This week, we'll see key figures in several areas.
Another confidence reading, as well as data for new and existing home sales, will gauge the health of the consumer. Another installment of initial unemployment claims (UIC)—the only employment indicator that's never revised because it represents a hard number rather than surveys—will give us a read on whether corporations on the whole are hiring or firing. And we'll get a read on corporate health from the purchasing managers index (PMI).
In general, the Wall Street consensus isn't expecting any big moves in any direction. If I were looking for surprises with the ability to shock the market on the recession-fearing downside, the most likely areas are dramatically worse news in housing or with the PMI.
In contrast, the revised numbers for third quarter GDP are likely to get a lot of headlines but little real reaction. Meanwhile, the number that's most important to keep watching—UIC—will also probably be ignored.
UIC has been hanging out around 330,000 for some weeks. To put that in perspective, that figure is usually above 400,000 during recessions. You can call what's going on now a lot of things. But until we get a real move in UIC, this won't be a real recession.
For less economically sensitive fare like utilities, the recession/no recession question isn't nearly as important as the health of the underlying business. As long as a company is running its business well, a slowing economy will attract investors to its stock.
There will be days when investors really run for the hills and sell even utilities. But generally, the path will be forward, even if growth actually turns negative.
On the other hand, there aren't a lot of other stock sectors that share this ability to weather the worst on the macro front. This time around, we've seen the strongest nonenergy-producing Canadian income trusts shine, including the largest, YELLOW PAGES INCOME FUND. Water companies and dominant communications companies, such as AT&T and VERIZON COMMUNICATIONS, have also fared well. So have limited partnerships that are attached to energy infrastructure assets, such as ENTERPRISE PRODUCTS PARTNERS.
Not surprising, a number of fixed income investments have also thrived, particularly as the benchmark 10-year Treasury note yield has declined. Open-end, high-quality and short-term duration funds have performed the best. So have utility bonds and preferred stocks, which have been rightly perceived as less risky than other corporate fare by virtue of dominating essential services.
The best environment for all of these groups in 2008 would be for the economy to stabilize here, at a moderate growth rate and low inflation. Investors would gradually lose their fear of a catastrophe but would still want to stick to more conservative fare. We're already seeing this psychology in action on good days in the market. The broad-based Philadelphia Utility Index is only a couple good days from new all-time highs.
If the economy really goes into a tailspin, not even these stocks will hold up well. But with the Federal Reserve seemingly committed to not allowing that to happen, any damage would almost surely be very short-lived. Meanwhile, we'd continue to collect big distributions.
The worst case for this conservative group is a sharp turnaround in the 2008 economy, along with a spike in inflation. This has been my major worry for income investors over the past several months, as the Fed has wrestled with its course of action.
The recent half-point cut in the fed funds rate seemed to indicate the central bank was willing to move radically in one direction or another, making it likely to repeat then Fed Chairman Greenspan's moves in 1998. Basically, that was a dramatic loosening to stave off financial disaster, followed by a necessary tightening in 1999. The result for conservative income stocks was a major slump.
The good news is that looks a good deal less likely now. Rather, it looks like the Fed is very conscious that moving too aggressively to loosen credit now could create another bubble, just as Greenspan's 1998 efforts did for technology stocks.
Should this credit crunch deepen, it may have no choice but to do so. But it may be willing to tolerate a little more near-term weakness in the name of stability, as long as we don't see mass bankruptcies of banks.
As for the banks themselves, even they appear to be making adjustments needed to survive. It's possible we'll see more writedowns of loans and collateralized asset obligations. And that's likely to keep lending requirements tight, as banks try to shore up reserves. We may even see a bailout of a bank that proves to be particularly credit challenged.
The good news is the Fed looks committed to holding the system together, and willing to do pretty much anything to make sure that happens. The bad news is banks as stocks remain highly vulnerable in this market to more selloffs. And the same goes for other economically sensitive groups like real estate investment trusts and funds that hold obligations of financial companies, particularly closed-end ones.
A key question many investors will ask—particularly going into the teeth of the traditional tax selling season—is whether it makes sense to hold stocks in these areas, despite the high potential for more downside. My answer is yes, with two caveats.
First, any stocks you own in these businesses must be as strong as possible on its numbers. As the blowups at mortgage lender after mortgage lender have shown, business weakness always turns a bad market retreat into a rout. Conversely, if you can avoid real blowups, bad markets generally become bad memories very quickly.
Second, you've got to be ready for more downside. In the financial sector, things have gotten much cheaper very fast.
CITIGROUP, for example, now yields 7 percent and sells for 1.24 times its recently lowered book value. It's still not quite to the depths reached during the 1998 credit crunch but has cut below its 2003 lows; a break below 30 could send it there.
At that point, it would be a no brainer to pick up shares. Panic would be positively palpable at that level, and no matter how bad things get at the bank or the economy in general, there's no way the Fed will allow this bank to fail. We simply don't live in an 1890s world.
For now, momentum all seems to be running in the other direction. Eventually, however, stocks like Citigroup will hit a point where investors will perceive the credit crunch is coming to a close. At that point, they'll see huge value in the financials and the buying will begin in earnest.
That may happen next week or not until halfway through next year. But when it does, these stocks are headed to much higher levels. And it will almost certainly happen before anyone notices.
As long as the sector is getting pounded, not too many investors are going to pay attention to differences in strength between individual companies. Everything is going to get hit.
Strong companies, however, won't wholly blow up and will keep paying big dividends. As a result, their recovery will also be swift when buyers come back.
The best way to hold stocks in a battered sector is as part of a diversified portfolio that includes stocks that are working in the current market. In this case, that would mean utilities, selected nonenergy-producing Canadian trusts, infrastructure-related limited partnerships--particularly those holding pipelines--quality preferred stocks and some bonds--particularly open-end bond funds with intermediate-term duration and high quality.
That way, the gains in what's working will offset the near-term losses in the battered stocks you're holding for value. It will keep you whole financially and emotionally ready to exploit what will eventually be a powerful comeback. I'll have more on the market/economic situation as it unfolds on Friday,
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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