Recent Sell-Off: Normal Correction or the Start of Something Bigger?

by: Roger S. Conrad

Is this a normal correction or the start of something bigger? That’s a question many readers are asking in the wake of stocks’ recent sell-off.

The Dow Jones Industrial Average has tumbled roughly 500 points from where it stood at the January 19 close, which was the highest level seen since prior to the fall of Lehman Brothers in September 2008. Other markets have fared worse; China, for example, is off nearly 10 percent year to date.

According to the old Wall Street adage, as goes January, so goes the rest of the year. Happily, that proved spectacularly wrong in 2009. The Dow fell nearly 9 percent in the year’s opening month. By early March, however, the market had bottomed and then went on to rally several thousand points. Those following the “January effect” heeded a sell signal that kept them out of one of the more explosive rallies in history.

There are some real worries in early 2010. According to the US Dept of Commerce the economy grew 5.7 percent in the fourth quarter, its fastest pace of growth since 2003. But the primary reason was inventory replacement and a 13.3 percent jump in business spending on equipment and software. Exports rose 18.1 percent, outpacing even a 10.5 percent rise in imports.

But after showing some signs of life, the housing market’s slide appears to have resumed, with foreclosures on the rise again and property values moving lower. The recovery in industrial activity we saw last summer has apparently fizzled again. Unemployment is still ticking up in many areas, and the national rate is likely to stay well above 10 percent for some time to come. Excluding inventory changes, the economy grew at a 2.2 percent annualized pace, better than the 1.5 percent third-quarter print but hardly torrid.

President Obama’s proposal to freeze federal spending has a great deal more bark than bite, as it would exclude most of the bureaucracy as well as entitlement programs such as Social Security and Medicare. But it’s a clear sign of a growing concern about record federal deficits and the suddenly wobbly US dollar, though the euro is doing even worse amid growing turmoil among European Union members.

The upshot: The economy is still crawling back from the near-meltdown of late 2008. But there’s a long way to go, and there are plenty of challenges ahead that may prolong a full recovery.

Market returns are mainly a function of investors’ expectations and the extent to which they’re exceeded or not. When the bar is set low, as it was a year ago, it doesn’t take much good news to beat expectations and send share prices higher. That was the main factor behind last year’s explosive returns for the overall market.

Unfortunately, over the past year expectations have been ratcheting higher. Meanwhile, the buying wave of late 2009 and early 2010 has reduced the margin for error, and the potential to disappoint has grown. Even companies that have posted robust results--for example AT&T (NYSE: T) this week--haven’t been making positive waves in the stock market. And companies that have failed to match Street expectations have been sold off sharply.

That doesn’t negate the major and growing positives in this environment. Creditworthy companies are enjoying their freest access to cheap capital in decades. That means low-cost funds to finance growth and strengthen balance sheets. Southern Company’s (NYSE: SO) 30-year debt sells for just a 100 basis point premium to Treasury paper, in stark contrast to a year ago, when rate spreads even for A-rated companies like Southern were well over 500 basis points for even 10-year debt.

The financial system, too, is in incalculably better shape than a year ago, when capital ratios were decimated by mortgage security losses and other disasters. It now looks like the infamous bank bailout will wind up costing taxpayers $100 billion at the most, versus a projection last year of $700 billion-plus. And banks continue to repay the money well ahead of schedule.

Companies and individuals that really need money now are unlikely to get it on favorable terms. But that’s always been the case during recessions. Sooner or later, lending resumes as banks get stronger and access to capital improves. The problems of the financial system weren’t created in a day, and it will take months--perhaps years--to repair the damage it caused.

But recovery is happening. And with the Federal Reserve still holding its benchmark federal funds interest rate effectively at zero, the system continues to repair itself, setting the stage for recovery.

Over the past year or so, I’ve written several times that another 2008-style selloff was unlikely, mainly because the primary trigger for that one--a critically weak financial system--no longer exists. Banks are likely to take further hits from real estate, credit card defaults and even business bankruptcies. But unlike in mid-2008, the Fed knows where the bodies are buried in the industry. It’s extremely unlikely it would be caught flat-footed should financial sector conditions slip again.

That doesn’t mean a deeper correction than what we’ve seen in January isn’t possible or even likely this year, mainly because of the steep run-up in the markets last year. But the odds of another full-scale panic such as what followed the near-failure of the financial system in late 2008 continue to diminish.

Even the panic of late 2008 was followed by the rally of 2009. Only two groups of people really lost big: those who abandoned their positions at the bottom and therefore missed the recovery, and those who were holding positions in companies that couldn’t survive the economic stress tests.

Investors who stuck with positions in good companies were able to make back much of their losses just by holding on. And I’ve talked to more than a few investors who had the courage to add to good positions at the bottom and are actually ahead of where they were pre-crash.

That’s definitely food for thought as we wait and see how deep this correction will be. If it didn’t make sense to bail out during the panic of 2008, it certainly doesn’t make sense to run for the hills now, when conditions have improved substantially and the risk of a systemic failure has diminished markedly.

The only exceptions to the selling rule are companies that genuinely stumble as businesses. And after two-and-a-half years of recession, companies that have survived thus far are less and less likely to stumble, particularly with conditions slowly but surely improving.

Even inflation isn’t really a threat, either for the overall market or for income investments that are traditionally interest-rate sensitive. For one thing, income investments are still more economically than interest-rate sensitive because of the continuing fear of a double-dip recession and re-exposure of credit strains.

As long as that’s the case, utilities, REITs and other high-yielding fare will rally on days when the economic news is good and sell off on days when it’s bad. And they’re still untethered from benchmark interest rates such as the 10-year Treasury yield. That means as the economy improves, so will their share prices.

Moreover, although commodity prices have been volatile, the biggest trigger for 1970s inflation--rising wages--is nowhere to be found. Nor is it likely to be anytime soon, at least as long as unemployment remains at such lofty levels. That suggests inflation isn’t going to be much of a factor until the economy picks up more steam. And by the time it does, economically sensitive, high-yielding fare should enjoy plenty of upside.

Eye on Earnings

As long as the underlying businesses of the companies you own remain healthy, the smart thing to do is stick with them. More likely than not, share prices will be volatile and could even head considerably lower in the early months of 2010. But as they proved under much harsher conditions in 2008 and 2009, strong businesses are resilient, and what does go down will almost surely come back up.

The key is keeping an honest inventory of the health of the underlying business for every security you own, be it a common stock, master limited partnership (MLP), Canadian income trust or bond. And the time to make such assessments is at hand: Fourth-quarter earnings season will continue over the next several weeks.

We’ve already seen several companies report results. Some have beaten Street estimates for earnings and revenue, some have fallen short. Meanwhile, investors have been treating almost every report as a disappointment, selling off the leaders and laggards alike.

For our uses, however, the point isn’t really meeting or missing Wall Street expectations. Rather, it’s whether or not the numbers indicate business is still healthy. Payout ratios measure the percentage of profits paid out in dividends. As such, they’re really the first thing for income investors to focus on.

For most common stocks, the earnings-per-share (EPS) ratio is the best way to measure profitability. However, it’s critical to factor out one-time items that may inflate or deflate results. And EPS is meaningless for companies--MLPs, Canadian trusts and rural telephone companies, for example--that “flow through” pre-tax cash flow to investors,. These companies’ key measurement is distributable cash flow (DCF), which takes into account their ability to shelter cash flow from taxes.

However you calculate a payout ratio, the lower the percentage, the safer the dividend is. But it’s only one way to measure a company’s health. The debt-to-capital ratio shows how a company’s obligations compare with its assets. Debt-to-cash flow assesses how obligations compare to the cash a business takes in. And it’s essential to know the amount of debt coming due in two years; refinancing needs will always trump the desire to pay out dividends.

A company that’s restructuring itself may ring up big losses or even sizeable one-time gains as it sheds assets and/or pays off debt. That may produce overall profitability numbers that don’t present a clear picture of its financial strength. That’s why it’s critical to know what the most important pieces of your companies are--as well as how they’re doing. If you’re focused on the wrong thing, you’ll miss the big picture entirely.

That’s what seems to happen routinely with big telecommunications companies. The sector’s large following of Wall Street analysts still seems fixated on what used to be important in this business rather than where it’s going and how the players are getting there.

AT&T and arch-rival Verizon Communications (NYSE: VZ) are in the sweet spot of the explosion of global connectivity. That’s the primary driver of their business in the 21st century. And the key device is the smart phone, which both companies recognized very early in the game.

Both added large numbers of wireless phone customers in the fourth quarter of 2009, adding to strong gains they made throughout the year despite the weak US economy. AT&T gained 2.7 million new users, as it continued to enjoy major success marketing Apple’s (NSDQ: AAPL) iPhone. Full-year additions hit 7.3 million, pushing overall subscribers to 85.1 million. Customer turnover, or “churn,” fell to just 1.19 percent of postpaid users.

Most important of all, average revenue per user rose 2.6 percent during the quarter, as the company continued to sell advanced data services to its customers. Data revenue soared 26.3 percent, a major factor behind the company’s $17.1 billion in free cash flow, up 28.4 percent from year-earlier totals.

Those are explosive numbers, particularly when matched with the company’s continued success converting its local phone customers to its high-speed broadband service. Television subscribers nearly doubled in 2009, and wireline data services rose 18.8 percent. The company was also successful in shaving costs ahead of the loss of local phone business and posted its numbers despite unfavorable conditions in the enterprise market because of the weak economy.

Overall earnings were up 25 percent to 51 cents a share, matching Street expectations. Even that, however, wasn’t enough to head off what was generally negative commentary in the financial media. And the AT&T “analysis” was practically euphoric compared to the generally comments that followed the release of Verizon’s earnings earlier in the week.

Despite not being able to offer the iPhone yet, the nation’s largest wireless company reported strong customer growth; 2.2 million new users bring its total to 91.2 million. Wireless data revenue was up a sizzling 45.9 percent, continuing the robust growth of recent quarters. Retail data revenue per user rose 20.5 percent, and post-paid churn was just 1.06 percent, still the best in the industry.

As has been the case for many years now, Verizon lost more basic local phone connections. But it also continued to grow its wireline broadband FiOS business at a solid rate, despite the weak economy. The company also spent $17 billion upgrading its wireless and wireline networks, which topped the first-ever Zagat Wireless Carriers Survey of providers around the world.

All that, however, seemed to be ignored by journalists who seemed in a frenzy to out-do one another with such “witty” headlines as “Verizon’s Profit Disconnect.” That referred to a one-time charge to earnings of 77 cents a share to account for layoffs of 13,000 workers in the wireline business, which triggered a headline EPS loss of 23 cents. Excluding the charge, profits of 54 cents a share were straight on with Street estimates. Free cash flow, meanwhile, was up 14.5 percent to $31.6 billion.

Results posted by AT&T and Verizon indicate financially strong companies that are managing America’s shift from a 20th century copper-wire communications network to a wireless/wireline broadband one, while increasing their dominance in the industry. Fourth-quarter earnings weren’t immune to the economy’s weakness. But both covered their 6 percent-plus distributions comfortably, backing up recent payout increases. Both maintained extremely strong balance sheets, and both continued to show robust growth in the operations that are the future of their business.

That’s the combination that continues to make both solid attractions to income-seeking investors. That doesn’t make them immune from negative commentary, nor does it mean their share prices are suddenly going to sprout wings. But it does mean they’re resilient, solid holdings for even the most conservative portfolios. And in a dangerous environment like this one, that’s really the only important thing.

Disclosure: no positions