Looking Past the Current Stock Market Crisis for Strong Financial's
Stock-Markets / Banking Stocks Feb 03, 2008 - 03:16 AM GMTBy: Roger_Conrad
The news keeps getting more disturbing for America's financial system.
Just minutes after the US Federal Reserve slashed rates by half a point this week, the market turned its focus to an announcement by Fitch that it was slashing ratings of major bond insurance group Financial Guaranty Insurance Company (FGIC), triggering fears that it had others in its sights as well. That was compounded by the horrific fourth quarter earnings turned in by rival insurer MBIA, which was forced to defend itself against rumors that it could be headed toward insolvency.
Insured bonds have never been a favorite of mine. For one thing, their lofty ratings—frequently AAA—aren't based on the creditworthiness of the issuer. Rather, they're grounded in the financial health of the insurer, which can be severely compromised if it's forced to make good on too much insurance at once.
For their part, insurers tend to be rather large and solid organizations. But the way they make money is to insure more bonds. And it's now quite obvious many over-reached in the good times to boost earnings and will have to suffer the consequences because times have gotten tougher.
The other reason I've never been a fan of insured bonds is they tend to trade as though they were real AAA debt, just based on that insurance. There's little or no additional yield to compensate for the risks of the underlying issuer.
If Fitch and other credit raters follow through with downgrades of insurers, we're certain to see a corresponding drop in the value of insured bonds. Some estimate that could trigger another $70 billion in writeoffs for banks and other financial institutions. That would further strain equity, which has already weakened gravely in recent months.
The other piece of disturbing news this week was on the employment front, as unemployment insurance claims (UIC) spiked up to 375,000. That was well above estimates of 320,000 to 335,000, and even further above last week's total of just 305,000.
Unlike any other measure of labor market health, UIC is almost never revised significantly, since all it does is measure how many people were first-time filers for government unemployment insurance. In contrast, the widely watched payroll numbers released Friday are based on survey data. They were scary enough, showing the first decline in payrolls in four years, and the market has reacted. But they're also frequently revised wildly and, despite the press coverage, they're not a reliable indicator.
It remains to be seen if the UIC spike represents a blip that will be followed by lower numbers, or the start of a very alarming trend. But if it's followed by similarly high numbers, it's a fairly clear sign that employment conditions are worsening. That would still be a lagging indicator of overall economic health.
But it would be a rather obvious sign that the economy is sinking into recession, if we're not in one already. The fourth quarter drop in GDP growth to just 0.5 percent—from a prior 4.6 percent and against projections of 1.9 percent—would certainly confirm that, though GDP is also based on survey data and is often subject to massive revisions.
On the plus side for the economy, the Chicago Purchasing Managers Index is still in bullish territory at 51.5 percent, though that was also slightly below projections. Durable goods orders also handily topped expectations and were actually up 5.2 percent in December from virtually flat in November. And Consumer Confidence—a measure of the public's willingness to keep spending—also topped projections at 87.9 percent, though it was a bit below the last reading.
The most hopeful sign, of course, is the Federal Reserve's willingness to keep slashing rates in earnest in the face of stock market weakness. We've now seen a full 1.25 percentage point cut in the federal funds rate in less than two weeks. That's the most dramatic reduction I've seen in 22 years in the business. And all indications are we're going to see a lot more action before this is over, particularly in view of the persistent weakness in the US banking system and the recent slide in employment data.
Looking Forward
The least understood truth about the stock market is it always looks ahead, never behind. It's not so much the actual news on the economy that triggers an investor reaction. It's what that news indicates about the future direction and how it could impact investments.
Major stock market rallies frequently begin when the news on the economy is rather grim. Conversely, they typically end when the economic news is good.
One reason is the good or bad news at such times is priced into the market. In the first case, all the buyers are in. In the second, all the sellers are out. Another is that economies have much more room to grow at a sustainable pace when things are bad, and little or no room to accelerate when things are good. And sustainable economic growth is the key to bigger and better returns in stocks.
Here in early 2008, it looks like we're due for some more bad news on the economy. As I wrote above, the financial system looks like it still hasn't fully wound down all of the excesses of recent years, and there could still be considerable writedowns.
However, the key for stocks--including financials--is how much of that is already priced in, and what will have to be priced in going forward. Simply, if stocks are already pricing in a nasty downturn, downside is limited from here, including for the money center banks at the root of the credit crunch. And if things turn out better than the consensus expects, stocks will rally even if the news on the economy seems to get nominally worse.
On the other hand, if the news should bring something out of the blue—particularly a new risk to something perceived safe—we could be headed for another steep downleg. And as the selling into the panic of mid-January demonstrated, not much will be spared the pain.
Of course, the main reason markets are volatile is that no one really knows which of these possible outcomes will prove to be the case. In my view, however, a lot of investor anxieties can be quelled or at least partially salved with a little perspective on market crises.
First of all, this isn't the first time deteriorating economic conditions have occurred. In fact, we've lived through a dozen or so recessions since World War II. We've also seen dozens more periods where the economy slowed markedly but didn't qualify as an official recession, which still had a severely negative impact on stocks.
It's also far from the first crisis in the US financial system since the Federal Reserve began trying to moderate the cycle in recent decades. In fact, we've had some whoppers just in the two decades I've been in this business.
The most recent was the 1997-98 crisis that began in developing Asia but eventually bankrupted Russia, shook the health of the US financial system and sent the stock market tumbling. It was preceded by the Latin American debt crisis, which was proceeded by the infamous real estate/savings and loan (S&L) crisis. The latter required billions upon billions of federal money to fix and eventually wiped out the entire S&L industry.
As I've pointed out previously in Utility & Income, the giant money center banks were at the literal epicenter of these crises. And the US Federal Reserve and Treasury basically had to come along and bail them out with lower rates and even cash infusions in order to preserve the overall integrity of the financial system.
Along the way, many of the names changed. There were mergers and liquidations alike in the banking industry. And in more than a few cases, shareholders were wiped out. But the overall result was always the same: ultimate recovery. The money started doing its work, fixing the credit crunch. The stock market hit an inflection point where all the bad news was in and the mother of all rallies ensued, with battered financial survivors leading the way.
The key questions for investors now are these: Are we at or near that inflection point in the cycle? What stocks--particularly financials--are set to be survivors?
As my colleague Neil George has pointed out in his weekly e-zine Pay Me Weekly, there's plenty more potential for bad news in the financial system. The ticking time bomb of potential defaults as rates on adjustable rate mortgages are adjusted upward has likely been at least partly defused by the Fed's aggressive rate cuts. But if Standard & Poor's and Moody's join Fitch in downgrading bond insurers, for example, we'll see a whole new round of writeoffs that could dwarf even the subprime losses we've seen thus far.
Two areas of particular concern are insured municipal bonds and diversified bond funds, including both open and closed-end fare. Insured munis are typically backed by weaker communities and use their insurance to keep ratings high and payment rates low. Any hint that their insurance is no good will send prices plummeting, with a chain reaction on the financial health of their issuers as borrowing costs rise.
As for funds, the risk is they tend to be black boxes, so you often don't know how many insured bonds they may hold. That's why I prefer to stick with only the simplest of funds, particularly those in the Vanguard family.
Further, as we've seen once again in this crisis, the market isn't very discriminating when it comes to a sector selloff. No matter how well-run a bank is, how conservatively it's run its business or how low its real exposure, the big institutions that run the majority of global investments are still likely to dump it along with everything else.
Wells Fargo shares, for example, sold off sharply in mid-January. That was despite its well-earned reputation for conservative banking, strong fourth quarter loan (up 9 percent) and deposit (5 percent) growth and generally low exposure to the problems besetting its rivals, evidenced by the fact that it's the only major US bank to draw a AAA credit rating.
Obviously, we've seen a very steep rally in financial stocks--including Wells Fargo--over the past couple of weeks, in the wake of the Fed's rate cuts. And, after initial selling on news for the rate cut combined with bond insurance worries, that rally resumed with a vengeance on Thursday afternoon.
Nonetheless, I'm not wholly convinced we won't see another downleg for the financials. And I'm completed convinced that some of these companies are still headed for a lot of trouble. The upshot: It's OK to dabble in financials now but only the highest percentage situations.
In my view, Wells Fargo is one of these. So is Berkshire Hathaway, which is taking advantage of others' weaknesses. It's extremely well capitalized and has numerous other operating businesses to provide ballast if things should get worse.
Another is regional bank Regions Financial. The company is distinct from its rivals in several very favorable ways. First, it sold its subprime origination unit to Barclays in early 2007, virtually eliminating exposure to the ticking time bomb assets that have blown holes in other banks.
It originates all of its own loans, so the company doesn't have to deal with broker-pushed loan portfolios that have crippled other banks. And although Regions does have some exposure to troubled home builder loans, it's only about 7 percent of the total portfolio. Moreover, it's diversified geographically and by loan. Current non-performers in that category are still just 3.6 percent and the bank is aggressively dealing with its exposure.
The bank's growth comes primarily from upselling deposit customers to loans, mortgages and the services of its Morgan Keegan brokerage. The latter actually saw client growth accelerate in the fourth quarter. The integration of last year's AmSouth merger has now been completed ahead of schedule with savings exceeding expectations, which will free up staff to work on problem loans.
If the US economy really goes into the tank, the bank will have to make more adjustments, despite taking writedowns on loans that could go bad in the next 12 to 18 months under conservative scenarios. And it may have to inject more money into certain Morgan Keegan funds as part of a legal settlement with investors.
But Regions hasn't done anything stupid to this point. In fact, they've been doing things like getting customers to convert adjustable rate loans back in the first half of 2007. The company hasn't fallen into any of the obvious traps and its real exposure is basically to macro factors, which it's aggressively trying to manage.
That's basically the hallmark of companies that have outperformed tough times for their sectors and emerged stronger than ever. One group that went through that is utilities. Back in 2001-02, the average Dow Utility fell 59 percent top to bottom. But a handful, such as Southern Company, held the line, in stark contrast to many of the other industry players.
If the economy does turn up, these financials will get their share of the glory. Meanwhile, if things do turn down further, their businesses are the best bets to stay healthy, which is the best assurance their stocks will ultimately recover and then some.
As for other US stocks, I'm increasingly comfortable holding the best of three sectors going forward: utilities, communications and energy/natural resources.
For the first two, it's all about earnings. Utilities held up well in the second half of 2007, with most rallying strongly into the end of the year. The main reason was basically a flight to safety amid growing uncertainty.
That reversed with a vengeance a few weeks into January. With worries about the economy increasing, big money began to pull the plug on utilities on fears that they'd also be affected. In fact, utilities actually began to underperform other sectors.
The good news is strong fourth quarter earnings have largely laid those economy-based fears to rest. Company after company has reported either in-line or expectation-beating results. More important, they've reaffirmed prior guidance for more robust growth in 2008.
Ironically, the strongest results have been turned in by companies most involved in unregulated power markets, where earnings depend to a large extent on the price of the electricity they sell. Power prices, it seems, have thus far been largely unaffected by economic weakness. Unregulated or not, it's still an essential service.
As I've written here, the real challenges for this sector will come over the next three to five years, as utilities attempt to recover massive investment on new power plants and transmission lines to meet a projected 40 percent increase in electricity demand by 2030. That spending is virtually certain to be augmented by the cost of controlling carbon dioxide (CO2) emissions from power plants, particularly the coal-fired units that meet roughly half of America's power needs.
Recovering that investment will depend as much on constant cooperation from state regulators—and to a lesser extent federal regulators—as it will companies' own execution and decision making. And the verdict on success or failure will only play out over a number of years.
That ultimately makes it imperative to select only companies that are most likely to recover investment. For the next year or so, however, most of the industry should continue to enjoy the simultaneous robust dividend growth and credit rating upgrades it did in 2007. And that's extremely bullish for a time when so much else is uncertain.
Earnings are also the key to communications. As I pointed out last week, completely contrary to what became runaway fears on Wall Street, AT&T's fourth quarter earnings contained no negative surprises and little evidence of being hurt by a slowing US economy.
In fact, they demonstrated just the opposite: The company is coming into its own with robust wireless growth, solid wireline profits and expanding enterprise services. We saw almost exactly the same thing this week with Verizon's results, with the company's FiOS broadband sales continuing to run roughshod over far too conservative expectations for growth.
Unfortunately, the only other communications player in the news has been Sprint Nextel, which reported horrific results. This week, the company capped it off by announcing it may write off up to $30 billion in goodwill, a tacit admission of the failure of the Nextel merger. That company's new management, however, has been taking aggressive action to set the stage for a turnaround, and even its shares have shown some signs of life after massive losses.
The rest of the communications industry will be reporting in coming weeks. Next Friday, we'll see the first of the extremely battered rural telecoms report, Windstream Communications. On Feb. 14, we'll get our best indication of how the cable industry is faring, namely if Comcast can best the market's now absolutely abysmal expectations for its business health.
These stocks have rallied somewhat in the wake of the encouraging earnings posted by industry leaders AT&T and Verizon. Once they report what I believe will be their encouraging results, they should rally even more. And in the meantime, this is one cheap group.
As for energy and natural resources, we've been hearing plenty of talk about oil plunging as far as $70 a barrel, should the US economy really drop off a cliff. Even that, however, wouldn't do much to hurt strong energy producers, particularly Super Oils such as Chevron Corp and selected Canadian trusts such as ARC Energy, Enerplus Resources and Penn West Resources.
Simply, none of these companies have been selling oil in recent quarters at anything approaching the currently high spot prices. That's because producers always hedge their output forward to lock in cash flows. It's the only prudent way to run a business. And oil has only been at these prices for a short time.
As earnings at Chevron and ConocoPhillips demonstrate, higher oil prices did give a strong boost to profits, offsetting weakness in refining that was at least partly a result of high oil prices. Chevron, however, sold its oil at an average price of only about $80 a barrel in the fourth quarter. That's still a ways below current prices, providing a cushion against a decline. Moreover, Super Oils would profit in their refining businesses from even a temporary decline in oil.
As for the trusts, ARC, Enerplus and Penn West won't be reporting earnings until later this month. The trio, however, sold oil in the third quarter at more than $20 a barrel below spot prices and still covered their distributions with cash flow by a wide margin. They almost certainly sold oil for a lot more in the fourth quarter, expanding cash flow. And they enjoyed an uplift in natural gas prices as well.
The real danger to oil prices is if a US recession winds up cooling off China's economy and depressing demand there. That can't be ruled out. But it's worth noting that Chinese demand for oil continued to rise throughout the 1980s despite an industry depression elsewhere. And China accounts for a far larger piece of the demand pie today.
Finally, any drop in oil demand as a result of US economic weakness won't be permanent demand destruction. That can only happen when there's real conservation, use of alternatives—and again ethanol is too expensive to fit the bill—and an as-yet unmade discovery and new production of conventional oil reserves on a par with the North Sea of the 1970s. And that's just not going to happen in an environment where people expect oil prices to drop.
In short, a drop in oil during a recession will inevitably be followed by a run to higher highs. Energy producer stocks are already cheap, discounting a big drop in oil prices. If it occurs, downside is limited, particularly in the very solid stocks discussed above. And if it doesn't, these stocks are headed much higher as this economy cycles out.
Finally, natural resources and metals stocks are increasingly interesting for two reasons.
One, like oil companies, they've sold off in recent months because of fears that a US recession will kill off surging demand overseas. That leaves plenty of room for upside surprises when the economy cycles out as well as from merger activity that continues to heat up.
Two, they're major beneficiaries from the decline in the US dollar and the growing threat of more US inflation as the Fed opens the monetary floodgates. That makes the best of them a nice hedge for the rest of the income portfolios.
Gold has now broken out to all-time highs over $900 an ounce. And with more rate cuts ahead—and trading well below its inflation-adjusted all-time high of $3,000 an ounce—there's almost surely more upside ahead.
And aluminum is even more interesting. It's the only base metal that hasn't substantially increased in price during the commodities boon in the last two years. The main reason is over-production in China, which is now moving to shut down inefficient producers by eliminating subsidies. This remains a work in progress, but higher prices are inevitable going forward, as only economic producers survive.
The other side of the equation is Chinese consumption, which looks to stay strong as the country embarks on a new round of massive infrastructure and urbanization projects. In addition, industry reports are indicating that China may become a net importer of aluminum in 2008, adding up to a huge opportunity in a still-depressed market.
The construction sector will be strong in emerging markets, especially China, Russia, and the Middle East, offsetting weakness in North America.
By Roger Conrad
KCI Communications
Copyright © 2008 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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