U.S. Economy: Widespread Recession or Financial System Crisis?

Most of the steps taken by the Federal Government so far have been an attempt to prevent the current financial market crisis from getting worse, which would undoubtedly spill over to Main Street and the rest of the economy. The reason why there is a debate about whether we are in recession right now, or whether we will fall into one next year or not, is because the problems thus far are contained to a few areas. If those problem spots can be resolved to any measurable degree, we could get a quick economic and market recovery. If they spread, we are in for a prolonged and expanded downturn.

To see exactly how well most areas of the economy are holding up, we need to look no further than a breakdown of S&P 500 earnings by sector. Below is the breakdown of earnings from 2006 through current 2009 estimates:

Notice what while S&P 500 earnings will be down this year, for the second straight year, eight of the ten sectors are expected to have earnings gains for the third consecutive year in 2008, as well as further gains in 2009. This data shows exactly how much impact the financial sector's woes are having on the market. The consumer discretionary sector is an obvious casualty of such fallout, but everything else is fairly strong.

Personally, I think 2009 earnings estimates remain too high, though they have come down some already. Although I think the odds are remote, it is easy to see that, when one assumes the financials will rebound sharply, such a high S&P earnings number is possible in 2009 because the other sectors remain on firm footing.

Our economy is not yet in a widespread recession. Financial services are in trouble and are spilling over to the consumer sector. It might not be very comforting, but if we can get the financials consistently back in the black, even if they earn half the amount they did a few years ago, the economy and markets could hold up okay next year and beyond.

Short Selling Ban Is Dramatic, But U.S. Can't Allow Firms To Fail For No Reason

The SEC's 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let's be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company's fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It's that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don't have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they'll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country's largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won't be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

Newsflash: SEC Might Slowly Start to Enforce the Law

From MarketWatch:

"The Securities and Exchange Commission said Tuesday that it will try to limit so-called "naked" short selling of shares in Fannie Mae, Freddie Mac and big brokerage firms. The SEC will issue an emergency order stating that all short sales of shares in these companies will be subject to a "pre-borrow" requirement, said Christopher Cox, chairman of the SEC. This will last for 30 days, he said. The SEC is also planning more rule-making focused on short selling in the broader market, Cox said."

Is this some sort of joke? Naked short selling is illegal, and for good reason. Short selling involves borrowing shares from holders who are willing to lend them out, selling them, and promising to repay the shares at some point in the future. So called "naked" short selling, or selling shares without actually borrowing them, is illegal because it can result in constant selling pressure due to the sale of more shares than are available for sale.

Now the SEC is saying that "naked" shorting will be illegal for 30 days for certain financial stocks. Seriously? So they are admitting that "naked" shorting is running rampant (a position that has been claimed for years) and they have not been enforcing the law? Add that to the list of reasons why this market could be taking it on the chin. First the SEC eliminated the "up-tick" rule, and now they are allowing "naked" shorting. Shameful...

General Electric Earnings Could Initiate Oversold Bounce

General Electric (GE) will be the first important report of second quarter earnings season. After last quarter's shocker, a stabilizing picture at the industrial conglomerate could very well help this market get a much needed and long overdue oversold bounce. With sentiment so low right now, even generally in-line earnings might be enough to halt the market's slide.

Coming into this earnings season, consensus estimates call for S&P operating earnings of $88 for 2008. Interestingly, that would match the market's 2006 level, and represent an increase of 6% over 2007. A huge headwind for the market has been the fact that earnings estimates coming into the year were way too high and downward revisions have been continuous. Stock prices will have a hard time rebounding until earnings stabilize.

Amazingly, estimates for 2009 are still way too high. Analysts right now are sitting at $109 for the S&P 500 next year, which I think is insane, quite frankly. If those numbers prove accurate this market will be off to the races by the first half of next year. That aside, if second quarter earnings are okay (not far below current estimates) hopefully we will get another short term oversold bounce, much like the two we have already seen during this year's market ugliness.

A better report out of General Electric would go a long way to getting the ball rolling in that direction (GE reports before the market opens on Friday).

Full Disclosure: Peridot clients were long GE at the time of writing

Merrill Lynch Somehow Cuts Target Price on GM by 75% in 1 Day

Academic studies have found that Wall Street analyst stock recommendations trail the market and do so with more volatility. As a result, investors who use sell side research should be careful to pay attention to certain data points that analysts have spent hours putting together, but to completely ignore price targets and ratings and instead coming up with their own opinion on the ultimate value of a stock.

The latest example that illustrates this point is the call we got out of Merrill Lynch today. ML's auto analyst downgraded shares of General Motors (GM) from "buy" to "sell" and slashed the price target from $28 to $7 per share. That's right, this analyst thinks GM is worth 75% less than it was 24 hours ago.

As for how to value GM, I think it is simply too difficult to do so. It is nearly impossible to estimate future legacy costs, and trying to figure out what a reasonable profit margin on cars should be is simply a guess because they are not even making money at all and their competitive position has deteriorated since they were last in the black.

Besides, if an analyst can tweak their model and get $28 one day and $7 the next, that is a pretty clear signal to me that valuing GM right now is just not something anyone can do with a large degree of confidence.

Anybody think GM is a buy at 10 bucks? If so, why?

Full Disclosure: No position in GM at the time of writing

Market Action Shows How Much Negativity Is Priced Into Stock Prices

One of the most important things to know about investing is that the stock market is a discounting mechanism. That does that mean? It means that expectations for future events are reflected in stock prices ahead of time, before the events actually occur. People who try to guess what the headlines next week are going to be, and invest accordingly, might not make any money in the market. Remember, stock prices go up or down not based on how well the underlying companies do, but rather how well the companies do relative to the market's expectations.

I bring this up because today's market action shows us that a lot of bad news has already been priced into equities. UBS (UBS) reported astonishing writedowns of $19 billion and Lehman Brothers (LEH) raised $4 billion of capital even though they claim they don't really need it. Pretty bad headlines, but the Dow is up 260 points as I write this. Last month when Bear Stearns (BSC) nearly went belly-up the market reacted by dropping 1%, and has risen ever since. Many might have expected a far worse reaction to such startling news.

Now, this is not to say we are completely out of the woods and the market will soar from here. In fact, I think we will be range-bound for the foreseeable future. That said, it appears that things would have to get significantly worse for the market to take a huge hit from current levels. Hopefully first quarter earnings reports won't have any big negative surprises. If that is the case, those who are claiming we are in a bottoming process might be right, in the short term anyway.

Full Disclosure: No positions in the companies mentioned at the time of writing

Differentiating Between Trading and Investing

John writes:

Hi Chad,

How do you differentiate between "trading" and "investing"? I'm always curious to hear what people think is the difference.

Thanks for the question, John. I don't think there is too much of a debate over the difference, and my views likely aren't much different than most, but I'm happy to give my personal thoughts on the topic.

The main difference between "trading" and "investing" is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future. If they pay a reasonable price, and their analysis of the business prospects are correct, they will make money over time (regardless of overall market environment) because over the long term both valuation and earnings determine the value of a business, and thus the per share price of a company's stock.

Furthermore, since investors are willing to take a long term view (years rather than days, weeks, or even months) on an investment, they are likely to buy more shares as a stock drops in price. The main goal is to minimize one's cost basis in order to maximize profits over time. Temporary drops in share price aren't likely to change an investor's opinion of a stock's long term investment merit, unless of course the fundamental outlook changes in a meaningful way.

Conversely, traders are short term oriented. They tend to care very little about valuation or the long term earnings power of a business. Since they won't own the stock long enough for future business fundamentals to influence share price, they are more likely to use chart patterns and follow the momentum when buying stocks.

Since traders are more like speculators (making educated guesses as to short term price movements) than investors are, they are likely to use stop loss orders to limit downside risk. If a trade goes against them, they cut their losses quickly and look for other opportunities. Even if the market reaction in the short term is illogical and unsubstantiated, since they aren't willing to hold the stock long term and wait for the inefficient market to correct itself, they can not afford to wait things out until cooler heads prevail.

Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in. Over time, the economy grows and corporate earnings grow, hence stock prices rise over long periods of time. Thus, investors (who by definition are long term players) have the odds stacked in their favor.

Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don't have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back. Now, I grant you that traders aren't at a statistical disadvantage, so the comparison isn't perfect, but whether or not the market goes up or down tomorrow is pretty much a coin flip, so traders' odds are about 50/50, although they try and boost those numbers with technical analysis, momentum trading, etc. Much like a trader's stop loss order will limit losses in the market, many gamblers will come to a casino with a certain amount in their wallets, to ensure they don't incur severe losses.

Casinos and investors know very well that in the short term they might lose money to a hot table or an analyst downgrade, but over time they feel comfortable because they know the odds are in their favor to make money. They are patient enough to wait for their payout, whether it comes from the 5% edge at the roulette table they operate, or long term earnings growth generated by a publicly traded company they have invested in.

Traders Bracing for Retest of January Lows

Regular readers of this blog know that I am a fundamental-based investor. As a result, over the long term the two key determinants of future stock price performance that I focus on are earnings and valuation. Although I strongly believe that technical analysis only works over short periods of time, in the absence of new material information, enough people read charts (especially traders, as opposed to investors) that they can predict near term market movements due to thousands of people acting on them in the same manner simultaneously.

I bring this up because when we got the huge leg down in January, which served as a short term bottom after the Fed temporarily rescued us with an emergency rate cut, traders were adamant that we did not see capitulation (Bernanke didn't let that happen) and would have to retest the lows after an oversold bounce. Sure enough, we got a bounce up toward 1,400 on the S&P 500, moved along in a narrow 1300-1400 band for a little while, and now are moving back down to the lows, as the chart below indicates.

Let's give the chartists credit for their call. Market bottoms often look like the letter "W" on a chart, a pattern I have noticed since I started following the markets. The next step is to see if we in fact retest the lows (we are a few points on the S&P away from the closing low of 1310 as I write this, but still a few percentage points away from the intra-day lows of 1270).

If we get a retest, followed by buying interest sparked by all those chartists salivating at a potential double bottom formation, we could certainly have another bounce in coming months. Depending on the economic and earnings picture at that point, it could very well give investors a chance to take some chips off the table. That is only one possible scenario, but it is the one bulls should be hoping for.

UPDATE: 12:20PM CT
The S&P 500's closing low was 1310.50 on January 22nd. Today the index hit an intra-day low of 1310.49 and has since bounced about 4 points.

Beware of Phrases Like "Cheapest in 20 Years"

This week's Barron's highlighted shares of entertainment giant Disney (DIS) as being the cheapest they have been in 20 years. I just wanted to remind people that arguments like this in general don't really make much sense. This is not about Disney itself (it is not an overvalued stock) but rather the whole idea that bulls on certain stocks like to look at one particular period in the past, and assume that those conditions should apply today.

These days you hear people say that certain stocks or sectors (or the market for that matter) haven't been this cheap since the early 1980's, and thus conclude they should be aggressively bought. What they fail to mention is that the period from 1982 through 1999 was the greatest bull market the U.S. stock market has ever seen, and P/E ratios were in a historically high range during that time. Therefore, investors should not assume that those valuations were "normal" and therefore should and will always be applicable.

The Barron's piece suggests that Disney's current forward P/E of more than 14 (the current market multiple) is too low because the stock typically trades at a 30% premium to the market. Again, just because a stock traded at a 30% premium a long time ago, that multiple does not stay relevant forever. P/E ratios are largely based on future growth expectations. If Disney is going to grow earnings less robustly over the next two decades than it did over the last two, it stands to reason its P/E should be lower.

My point is not to bash Disney specifically (no meaningful opinion there), but to remind investors that current valuations are based on investor expectations of the future, not historical data. Surprisingly, many people still look at average P/E ratios from the past 10 or 20 years to determine where a stock should trade today, but I would caution you to pass on that type of valuation methodology.

Full Disclosure: No position in Disney at the time of writing

A Fresh Look and a Possible Anecdotal Contrarian Indicator

Over the weekend I hope to update this blog's template to make it organized a little more efficiently. I'm not a web designer, and don't hire one, so every once in a while the site gets unappealing in my eyes and I try to refresh it a bit. I'm just letting you know so if you visit here over the weekend and things are screwy, you'll know why and that it will be fixed shortly. And please give suggestions if you think improvements to the layout can be made.

On an unrelated anecdotal evidence tangent, I got a call today from a client who requested I slash their financial services exposure by 50% (it had been a market-weight allocation -- 18%). This type of anecdotal evidence often serves as a contrarian indicator, so I am interested to see if financials bottom out here in coming weeks and months. I got the call at 2:43pm central time, when the Financial Select Sector SPDR (XLF) was trading around $26.70 so we can track this random indicator. Maybe it signals capitulation, maybe not, but it's always amazing to see how many times capitulation indicates that a bottom is near, even in something as random as this situation.

Have a good weekend!