Waiting for the Market's Other Shoe to Drop

 |  Includes: CEG, CWCO, FPL-OLD, GXP
by: Roger S. Conrad

Global stock markets have come a long way from the dark days of early March. The Dow Jones Industrial Average and the S&P 500 are up by nearly half.

Other markets are up even more, particularly in the developing world. And certain sectors--natural resources, for example--have seen better-known names double and more.

This post-crash rally has already undergone several gut checks. One occurred in early summer. Questioning whether the economy was stabilizing or relapsing, many investors started cashing out of positions, and the result was a short-lived but nonetheless sizeable selloff.

Starting in July, the market began erasing those losses. In fact, the surge continued into late August, leaving the averages and indeed many stocks at post-crash highs. But now those concerns are emerging again that the markets have moved too far, too fast and are due for at best a severe pullback, at worst another down leg in the bear market that began in mid-2007.

All bear markets have eventually ended. The Great Depression of the 1930s, however, is well known as a time when massive busts were followed by jagged recoveries, which in turn gave way to renewed routs--with the result that stocks were at even lower levels than before.

The chief fear I’m hearing from many investors is we’re again in such a time. Basically, the theory is we’re going to be stuck in an economic debacle for a long time, possibly many years, and therefore we can expect the same market action as during the ’30s.

In other words, after six months of rally, it’s time for the shoe to drop on this market, and look out below.

Over the past 25 years or so I’ve established whatever credibility I have by focusing on individual companies, mainly the health of their underlying businesses. The idea is that the stock market is a popularity contest in the short-term, where the best stories get the most attention and therefore near-term gains.

In the long haul, however, it’s a weighing machine. And businesses that become more valuable by growing and/or continuing to build a base of valuable assets always gain value, building wealth for shareholders.

This is hardly a novel view of the market and it has plenty of proponents who are better known than I am, from Warren Buffett to energy infrastructure king Dan Duncan.

This outlook does, however, often put me at odds with market sentiment, particularly in volatile and uncertain times like these.

As long as I perceive an underlying business is getting stronger over time, I’m willing to let a position ride, almost no matter what the overall market is doing.

My goal isn’t to beat the averages month by month, quarter by quarter or even year by year. Rather, it’s to build wealth over a period of years.

And that means being willing to hold positions I’m comfortable with though tough times.

When the Macro Is Important

No company or sector is an island. And even the least-cyclical businesses are affected by the ups and downs of the economy.

Regulated electric utilities, for example, provide an essential service. In fact, as the economy has become increasingly electrified year after year, consumers and businesses are increasingly less likely to cut their usage, let alone walk away without paying their bills.

Power companies’ resilience has been particularly apparent during the bear market/recession that began in mid-2007. Despite the worst economy in decades, most posted second quarter results on par with those of a year ago and well within previous management guidance. All but the weakest covered dividends comfortably with earnings and balance sheets have rarely been stronger.

The only real points of weakness have been in the unregulated areas of the business, particularly energy marketing. Players like Constellation Energy Group (NYSE:CEG), which didn’t exit the business in the past few years like the majority of their peers, have been forced to retreat under heavy fire, as business has declined and lenders have become progressively stingier with providing collateral to do trades.

Nonetheless, even the power sector has felt the bite of this recession. Only a handful of companies like FPL Group (FPL-OLD)--which rode the growth of its portfolio of unregulated wind and solar power plants--managed to post significant earnings growth.

And most utilities saw sales slide, in large part due to mild summer weather compared to a year ago but also because of the sharpest slide in industrial demand since the ’50s and an equally dramatic halt in customer growth.

Heavy industry isn’t nearly as important to power utility earnings as it was in prior downturns. For one thing, there are far fewer major factories in the US now than there were in the ’70s, or even in the relatively mild recession of 2001-02.

In addition, heavy industry in many states has either been purchasing energy on unregulated markets or generating its own electricity through a cogeneration process.

The result is losing industrial load has had a progressively lesser impact on utility company earnings over the years. In fact, this time around the majority of companies have been able to offset it with cost-cutting and rate increases to pay for system improvements as well as to meet renewable energy mandates that are now the law in 33 states and the District of Columbia.

As for customer growth, utilities in states such as Florida have grown accustomed to being able to add business year-in. year-out with new connections, as Americans moved into their service territories. Some areas, such as southern Nevada, are still seeing growth. But even there additions have slowed dramatically. And the result is less profit growth for utilities.

If even utilities have felt the bite of this recession, other types of businesses have been hit harder still. And the results have shown up in earnings, particularly the second quarter, following which many, if not most, industries showed decidedly unfavorable comparisons with year-earlier totals.

Comparisons in industries like natural resources are particularly unfavorable, as producers in particular have had to deal with the impact of a 50 percent drop in oil prices over the last 12 months and an 80 percent-plus nosedive in natural gas.

Given the decline in headline numbers, one might ask how anyone could infer any of these businesses are still building wealth. And this is where the “buying the business” strategy gets tricky.

Put another way, it’s pretty easy to tell if a business is getting more valuable and building wealth in good times when everyone’s earnings are rising.

It’s another matter entirely to be able to reach that conclusion when the headline profits per share number may not look so good.

There are plenty of companies that have continued to grow earnings in the bad times. In my universe of companies, reverse osmosis water provider Consolidated Water (NASDAQ:CWCO) turned in blockbuster second quarter numbers, as it completed new plants put them in operation selling water in its Caribbean islands service territory.

For the rest, however, underlying signs of wealth are considerably more subtle. They involve delving below the headlines to ascertain whether or not a company is putting the pieces in place for growth when better times return, how well its business is standing up to economic pressures and how well its financial strategy is preserving cash flow and balance sheet strength.

This is the picture I’ve tried to paint in my earnings analysis, which is highlighted The Roundup that Utility Forecaster and Personal Finance subscribers receive. Companies may not always measure up on the headline number. But as long as they’re holding up on the deeper numbers, they’re still on track to build wealth and I’m going to keep holding them.

This is the on-the-ground approach I’ve been comfortable with throughout my career. It has sometimes been difficult to follow, particularly in tough markets like that of the past year. And I’ve definitely made some mistakes, including with companies I’ve know very well.

UtiliCorp, which later became Aquila, is one painful memory that always brings out my humility. This company grew rapidly throughout the ’80s and ’90s, building a portfolio of strong utility assets and an energy marketing business that was immensely profitable. Unfortunately, it was caught up in the demise of Enron, which basically single-handedly shut down the energy marketing business.

As for my personal investment in this company, it’s been reduced to a small stake in recovering power company Great Plains Energy (NYSE:GXP), a perpetual reminder that I can be just as wrong analyzing a company as anyone.

The UtiliCorp/Aquila experience is a major reason why I also espouse a strategy of broad diversification, with the corollary that I never double down in a position. That’s how I keep the emotion out of my portfolio strategy and can therefore be ready to walk out if a company does falter. And I’ve done that several times in this bear market in the advisories I write.

Focusing on the individual companies also has the benefit of liberating me from the emotional ups and downs of the daily market. And as we’ve just lived through one of the worst periods of modern times for stocks, I’m now pretty confident in my recommendations’ ability to weather the remainder of this recession and bear market.

There is one kind of shoe I don’t want to see drop, at least not while I have bets in the market. That’s a full-scale repeat of what we saw last fall.

It’s Not 2008

It’s become clearer with the passage of time that the entire global economy was on the brink last year following the shocking fall of Lehman Brothers in September. Only the decisive action of the Bernanke Federal Reserve and the Bush administration--in concert with central banks and governments the world over--to inject liquidity into banks and economy put the brakes on the near-total credit freeze and restored stability. And that was not before global economic growth moved into full reverse.

Hindsight is always 20-20 of course, and even if I knew another catastrophe were coming I probably wouldn’t sell all my stocks. Catastrophic events of the magnitude of the 2008 meltdown are, however, definitely worth avoiding. That’s why the key question now is what’s the risk of another one in the near future, the proverbial other shoe?

Economic shocks like last fall’s have been thankfully rare in market history. No matter how severe the underlying crisis, at some point the market has priced in all the bad news that’s likely to occur, and probably a lot more.

In other words, expectations are so low that they can’t help but be exceeded.

At that point the economic news is likely to be horrific, particularly anything to do with employment because layoffs generally follow such shocks. Perceiving nothing to lose, however, investors start to move back into the markets in anticipation of recovery.

Today’s news is hardly encouraging. This morning investors were greeted with a report that US August non-farm payrolls fell by an estimated 216,000, raising the unemployment rate to 9.7 of the active workforce.

Those numbers are based on surveys and are often subject to revisions, sometimes substantial ones. This set of numbers, however, gibes well with the piece of employment data that’s rarely--if ever--significantly revised, unemployment insurance claims, and these have continued to rise in recent weeks.

On the other hand, the consensus of economists was forecasting a drop in payrolls of 225,000. Even the fact that the unemployment rate exceeded the 9.5 percent projection has been viewed by some as an upside surprise, as it’s largely due to the return of some jobless workers returning to the job search.

Viewed overall, these numbers are still more bad news on top of more bad news. For example, we’ve seen some 2 million manufacturing jobs lost in the US since the recession began. The overall unemployment rate is the highest in decades, and the only businesses adding workers are in education and health services.

The key takeaways for investors are, No. 1, that the news isn’t as bad as was forecast and, No. 2, that it’s a moderation of the sharp economic deceleration of late 2008 and early 2009.

In other words, the news isn’t good by any stretch, but it is does better the abysmally low expectations in the analyst community and among investors. And in the final analysis, that’s what’s important for the direction of the market. That’s why some of the biggest stock market rallies historically have occurred when the news on the front pages has been at its worst.

It remains to be seen if employment numbers will really start to improve or just keep beating poor expectations. But as grim as the picture is for most job seekers now, this isn’t the kind of news that’s going to bring down the market.

It’s certainly bad for retailers and other industries that depend on consumer spending, which is directly impacted by rising unemployment. But as bad as it is for families, this is just not the kind of problem that would set off another 2008 meltdown.

What could send the markets into another 2008-style collapse? The most obvious is a renewed collapse of credit markets. We’re still seeing bank failures and as second quarter earnings show, the balance sheets of particularly regional banks are still strained by credit card failures, foreclosures and rising allowances for bad loans.

On the other hand, you have to dig deep into the financial press these days to read about bank failures. That’s because the Federal Deposit Insurance Corporation is no longer having a problem finding buyers for these assets, basically selling them off as soon as they’re seized.

And it’s still difficult to get a loan if you really need one, whether you’re a business or an individual. But credit is now flowing freely as ever to companies and individuals with secure revenue streams and manageable debt.

Recent bond issues by A-rated utilities, for example, have been coming off at premiums to US Treasuries of less than 150 basis points, even for paper as long-dated as 10 years. That’s a stark contrast to just six months ago, when those same spreads were nearing 600 basis points.

Moreover, even some non investment-grade credits are able to borrow at 500 basis point premiums and less, where they couldn’t borrow at all six months ago.

The risk premium required by the market has declined sharply. That’s the single biggest difference between now and during the last credit crunch, and it’s a direct consequence of the strengthening health of the banking system as it recapitalizes.

A year ago the Fed and other central banks were accused of being asleep at the switch, while the credit markets imploded. No one can accuse the authorities of that today after a year of unprecedented intervention in the financial system.

The authorities now know where the bodies are still buried, and that alone makes them far better able to react when there is a problem before it becomes systemic.

There are still some potential trouble spots. One is commercial real estate, where leveraged players are increasingly strained by rising vacancies and falling rents for expiring leases. Another is the natural gas business, where plunging spot market prices are bound to trigger financial shocks for, again, more leveraged players.

Much of President Obama’s initial stimulus package amounted to direct financial grants to strapped state and local governments. That, however, hasn’t prevented these governments from feeling a severe financial pinch from falling tax revenue and increased demand for services from the unemployed.

The result has been an unprecedented wave of cost-cutting, including layoffs. But it may not be enough for some states and cities to meet their obligations, let along balance budgets. And that poses a threat to the municipal bond market, where so-called insurance has largely obscured the real risks to investors.

Finally, an editorial in The Wall Street Journal--misguided, in my opinion--raised the question of whether the Government National Mortgage Association and Ginnie Mae securities were really as strong as advertised. And the Federal Housing Administration has reported that increasing mortgage-related losses has put it in danger of seeing its reserves falling below mandated levels, requiring more funding.

There’s no denying any of these areas has the ability to cause pain as long as this recession lasts. On the other hand, there’s also no denying that credit is again flowing to the creditworthy. That’s already showing up in reduced interest expense for the strongest companies, just as it has for individuals able to refinance mortgages earlier this year.

And with the authorities still ready to throw money into the breach, the odds of another credit freeze are rapidly fading, if not well behind us.

There’s always the possibility of another political event or terrorist strike triggering a selloff. But that’s a reality we’ve been living with not just since Sept. 11, 2001, but really for the entire history of the market.

And such one-off events, although terrible while they occur, rarely if ever have an impact on the long-term value of a portfolio of well-run companies backed by healthy and growing underlying businesses.

We may get a selloff, even a severe one, in coming months. And we could even see the major averages move within range of testing the early March lows. That’s one reason investors should put new money into the market judiciously in increments and only in select stocks.

But the risk of another fall 2008 is now relatively remote. Although we can’t afford to be complacent about anything, that means sticking with balanced positions in strong businesses is still the best strategy for long term investors--particularly for those who have to hang on for income.