The Week Ahead: Walking On Eggshells

by: Markos Kaminis

Ah, last week, where do we begin... So, Alan Greenspan gives a speech to an audience in Asia, and says the economy could fall into recession this year. Most overseas markets didn't even notice, but the hypersensitive mainland Chinese market that sits at lofty heights after rising 130% last year and another 13% in the week just prior, tanked 9% (Shanghai). Now, we can't place all the blame on poor old semi-retired Alan, as the guy needs to keep some sort of income stream going, in this case from the conference circuit and book writing. After all, he can't rely on social security now can he...

Adding to the scare that China's investors were experiencing, there were rumors that the Chinese government might build on a recent trend of restrictive regulations. The word was that a capital gains tax could be instituted on real estate investments, and a hike of interest rates is possible. Several increases of bank reserve requirements have thus far failed to cool economic growth or speculative investment, especially in equities.

The week after, emerging markets remain pretty pricey and still could keep the fire of global correction burning. The wheels have been set in motion, and investor psyche has changed. Already, economic reports are being examined with an intensified focus. Last week's greater than anticipated decline in durable goods orders raised significant concern, while news that Freddie Mac would increase the level of scrutiny it applies to its underwriting further unsettled the financial sector. Now everyone is figuring out what a carry-trade is, and the axis of easel has been pulled out at CNBC to explain it.

Take a breath now. When it's all said and done, we must let valuation guide us. In the end it is valuation that will decide where prices settle. Sure, over the course of the next few months, stocks could trade wildly in either direction, and yes, stocks had gone a long time since any correction, but it is the intrinsic value of stocks that decide the mean that their price trades around over the long term, in our view.

Now, in the short and intermediate term, factors can come to play to create a new norm for valuation. Remember the new economy? The new economy was the justification that investors and economists provided for the market bubble that was busted at the beginning of this century. But, for a while it provided an intermediate-term new norm for valuation that we all accepted, and if you wanted to make money during that bubble building period, you had to buy into it for the intermediate term. Otherwise, you sat by in cash and watched investors in Qualcomm and Cisco get rich while you argued about valuation. Now, if a serious war were to break out as we have argued is more likely than most believe, perhaps then a new intermediate-term norm might apply for valuation, but this time it would be a degree lower.

Still, if I tell you today to buy stocks based on valuation, and tomorrow some event in India leads to a global crash and you are wiped out, it really will not matter to you where stocks are in three months. For most people, investing is a dynamic matter that is reevaluated on a regular basis, not in a year's time. Therefore, it's important to provide people with a short term and long term view. So I'm telling you that based on valuation, stocks do not look expensive to me. The large cap stocks within the S&P 500 Index are priced at about 15X projected 2007 operating earnings. However, I am concerned in the short term about the price of high flying emerging markets, and their ability to impact emerging market economies that are increasingly tied into our own economy. Now, only 9% of Chinese household assets are invested in stocks, so the impact to the Chinese economy of a market crash would not be as big as one in America. Still, I have to argue that 9% is likely important enough to be a problem for Chinese spending, and if a Chinese decline leads the Indian market to crash or the NIKKEI, due to real or psychological factors, it impacts the American market just the same.

I expect we will walk on eggshells for a little while longer, but at some point, barring any further significant scare, we should recover in a meaningful way due to valuation. I expect our economic data will raise concerns in the next month or two, and we could flirt with recession, but Big Ben Bernanke has called the economic direction perfectly up until now, and this past week he suggested we could see a pick up in economic growth in the second half of the year. It's clear that the manufacturing sector has reduced inventory, so the stage is set for manufacturing growth should demand pick up or even just hold steady. Now, let's take a look at the week ahead.

As I publish this, Asian stocks are starting the week off on a very very sour note. Markets from Japan to Taiwan to Singapore are down significantly, so it appears emerging markets and developed markets alike in Asia have contracted the contagion from China. The valuations and recent strong performances in China, India and Vietnam for instance, continue to make them susceptible to a sharp correction, greater than already experienced.

On Monday, the ISM non-manufacturing index will be reported at 10:00 a.m. EST. The service sector drives the American economy, so this data is more important than ISM's manufacturing report from last week. Bloomberg's consensus expects a reading of 57.5, compared to 59.0 in February. Treasury Secretary Paulson begins another Asian tour on Monday in Tokyo. St. Louis Fed Chief William Poole, who last week commented that he felt the economy could grow 3.0% this year, will speak in Chile on the topics of inflation and growth.

Reporting earnings on Monday, look for news from Cooper Company, ADC Telecomm, ABM Industries, Esterline Tech, Financial Fed Corp. and Sykes Enterprises.

Tuesday brings the 8:30 revision of fourth quarter productivity, and Bloomberg's consensus anticipates a reduction to a 1.5% increase, compared to 3.0% reported initially. Unit labor costs are expected to show an increase of 3.0%. At 10:00 a.m. EST, January factory orders will be reported, and the consensus view is for a decrease of 4.5%, compared to growth of 2.4% in December. After last week's poor durable goods orders report, the red flag is already waving on first quarter economic growth. These early reports on Monday and Tuesday will help provide a clearer picture of GDP. On the Fed front, Ben Bernanke will address the Independent Community Bankers of America on government sponsored enterprises.

On the Corporate scene, Estee Lauder is holding an investors day meeting, while JP Morgan holds an analysts meeting. Earnings reports are expected from Brown Forman, Chicos FAS, Copart, Payless Shoesource, CEC Entertainment and Volt Information.

On Wednesday, the Fed releases its beige book survey of regional economic indicators at approximately 2:00 p.m. An hour later, January consumer credit is expected to be reported at $5.0 billion according to Bloomberg, versus $6.0 billion a month prior.

Exxon Mobil will hold a meeting with analysts, while earnings are reported by American Eagle, Saks, Men's Wearhouse, BJ's Wholesale Club, Coldwater Creek, Genesco, Martek Biosciences, Westwood One, K2 Inc. and Neenah Paper.

Overseas, the European Central Bank will meet on Thursday, and is expected to raise interest rates a quarter percentage point to 3.75%. However, by Thursday the global financial markets could dictate a different direction for European rates. The Bank of England will also meet, but is anticipated to keep rates steady this time around. Also, the EU will hold a summit on economic issues with a focus on energy. Treasury Secretary Paulson makes his way to China on Thursday, while President Bush begins a Latin American tour in Brazil.

Major retailers will report chain-store sales for February on Thursday, while several large retail firms report earnings. Expect reports from Costco, National Semiconductor, Urban Outfitters, Tech Data Corp., Quiksilver, Hovnanian Enterprise, Brown Shoe Co., Korn/Ferry International, Wind River Systems, Comtech Telecom, Analogic Corp., Fleetwood Enterprise and Blue Coat Systems.

Three very important data bits hit the wires on Friday morning at 8:30 a.m. February nonfarm payrolls are expected to grow by 95,000 jobs, while unemployment is anticipated to match the 4.6% rate seen in January. Average hourly earnings are expected to show a rise of 0.3% from January. This is an important inflation measure, and a reading too high will throw concern into the already tense market. January international trade is expected to show a deficit of $59.8 billion, versus $61.2 billion in December. Finally, wholesale inventories for January are expected to show an increase of 0.1%, versus a decrease of 0.5% in December.

Following the average hourly earnings figure, Fed Vice Chairman Kohn's speech on inflation should be interesting. The only scheduled corporate news is that Caremark shareholders will vote on a proposed merger with CVS. Considering how Asian markets started Monday, hopefully we will still have some money left by the end of trading on Friday... Hedge, diversify and keep some cash handy!