Despite Yesterday's Rally, We're Still In Trouble

Includes: AGG, DIA, SPY
by: Michael Panzner

There was back-slapping all around following yesterday's allegedly important close above 13,000 in the Dow Jones Industrials Average, and bullish commentators were out in force. Yet not too many were addressing the issues that some skeptical old-timers might have focused on.

Like, for example, the fact that what is supposedly driving this market higher -- fat profit margins, low rates (relative to the past few decades, at least), and an economy that is apparently in a Goldilocks-like state -- represents "old news" that is likely already factored into prices.

Or that the frenetic burst of buying we've seen recently, coming as it has at the end of an almost correctionless 5-year bull run, is characteristic of exhaustive short-covering blow-offs that should be feared rather than cheered.

Or that the real reason for the continuing run-up in stock prices comes down to the fact that it is a double-B bull market -- one built on debt-fueled corporate buybacks and leveraged buyouts -- that is anything but investment grade.

Aside from that, though, is the antiquated notion, based on the reality of the past few decades anyway, that aggregate stock prices discount the future, as a Breakingviews commentary from yesterday's Wall Street Journal seems to makes clear.

The stock market used to be full of nervous souls. Hence, Nobel laureate Paul Samuelson's famous quip that it had forecast nine of the last five recessions. This reputation for jittery anticipation is at risk.

There are plenty of signs that the U.S. economy is slowing. Yet the Dow Jones Industrial Average is flirting with record levels. Stocks, it seems, are no longer a leading indicator but a lagging one.

The list of woes afflicting the economy keeps getting longer. Home sales fell faster last month than at any time in the past 18 years. New-housing completions fell by 20% in the first quarter. Business investment has also declined. Retail sales are slowing and exports have slipped. Analysts have slashed their expectations for earnings growth of S&P 500 companies in the first quarter from 9% at the beginning of the year to a mere 3%. Equity strategists at Dresdner Kleinwort expect the U.S. will enter a full-blown "profits recession" -- two consecutive quarters of declining profits -- in the second quarter.

Economic growth slowed to 1.5% in the first three months of the year, estimates Merrill Lynch. In February, the Conference Board's index of leading indicators dropped below its level of a year earlier. A negative reading by this measure has accurately anticipated every recession over the past 40 years. The inverted yield curve (a situation in which long-term interest rates are lower than short-term rates) has often suggested the U.S. economy is set to contract.

This negative information isn't reflected in the stock market. That's because investors aren't so concerned about the outlook for profits. All they care about is that buyouts and buybacks should continue to buoy the market. In aggregate, probably more than $200 billion worth of shares were retired by these means in the first quarter. These purchases were largely funded with borrowed money rather than earnings.

The stock market, however, can't remain disconnected from the economy indefinitely. Debt-financed stock repurchases depend on low interest rates, according to London-based economic consultants Smithers & Co. But the interest rates companies must pay on their debt are likely to rise if profits go into decline. If that's right, investors could be the last ones to know when the next recession finally arrives.

That's what happens in a double-B market: people start believing in all sorts of junk. Until, of course, it's too late.


No doubt some believe the only reason why I focus on the negative at Financial Armageddon is because I have written a book (with the same name) about the serious economic and financial threats we face in future. Even if that were true, many of my posts include insights from those, like central bankers, who generally don't stand to benefit from espousing a downbeat view -- unless, of course, they hope to avoid getting the blame when it all goes horribly wrong. Which is why this report from the Financial Times, "Bank Fears Threat from Credit Standards," is yet one more reason to be concerned about where things are headed.

A surge in cheap corporate lending with looser credit standards "has increased the vulnerability of the [global financial] system", the Bank of England will warn on Thursday in its strongest comments to date on financial stability.

The Bank also cautions against weakening standards of risk assessment when bank loans are repackaged and resold to new investors, such as pension and hedge funds. In its twice-yearly financial stability review, it says the recent turmoil in the US subprime mortgage market illustrates a problem that original lenders, which sold off the default risk, often allowed their standards to slip.

"Similar problems in a more significant market, such as corporate credit, could have more serious consequences if credit quality were to deteriorate," the Bank says, but it insists the UK financial system remains highly resilient, underpinned by a benign global economic outlook.

Its concerns relate to the consequences of an unforeseen shock to the global economy, world politics or a large financial institution. It is worried that other big financial institutions could find themselves over-exposed in the event of serious turbulence on global markets.

The Bank's concerns accord with those of Larry Fink, the chief executive of BlackRock, the $1,000bn-plus fund management group, in a Financial Times interview on Wednesday. He said lending to highly indebted companies was becoming lax in ways similar to those that have undermined the US subprime mortgage market, making the leveraged loan market "tomorrow's problem".

"If I was the chairman of the Federal Reserve I'd be paying more attention to that because, to me, this is going to be tomorrow's problem," Mr Fink said. "Standards have deteriorated to levels that we never even dreamt we would see."

The biggest reason for weakening lending standards were plentiful liquidity and consequent strong investor demand, Mr Fink said. But he warned many investors were moving into illiquid "alternative" investments such as hedge funds and private equity.

Aggressive lending is also supporting the private equity industry and Mr Fink said that any credit slump would have a knock-on effect on private equity groups such as Blackstone, which is planning a public offering. He said Blackstone, where he once worked, was highly diversified and "uniquely qualified" to go public.

It may not be bullish, but it is reality. Ignore it at your peril.