By Andrew Bary, Barron's | 23 January 2008
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The obvious risk is that 2008 earnings disappoint and that profits actually could fall from 2007 levels if the economy sinks into recession. Collective earnings per share for the 500 companies in the S&P were $88 in 2006 and for last year were expected to hit around $93 before banks and securities firms began taking huge mortgage and credit-related charges in the fourth quarter. The final 2007 number could be in the range of $87. Even if S&P earnings for 2008 fall to $85, from the current projection of $100, the index is trading for a moderate P/E of 15.
"A full-fledged recession is now priced into the bond market and is increasingly priced into stocks," says Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. Bulls point to the so-called Fed model, which compares the earnings yield on the S&P 500 and the yield on the 10-year Treasury note. That indicator is now screaming "buy" for stocks, with the forward earnings yield on S&P now topping 7%, double the 3.6% rate on the 10-year Treasury.
Wall Street could get some help from Washington. Congress and President Bush are rushing to produce an economic stimulus package that could total $150 billion, including tax rebates that may put cash into consumer pockets this spring. That could help beleaguered retailers like Macy's (ticker: M), J.C. Penney (JCP) and Sears Holdings (SHLD), some of which have seen their stock prices halved from the peaks reached last year.
[The Fed funds rate was reduced by 75 basis points] leaving the key rate well below the 5.25% that prevailed before the Fed began easing this past August. Stock-market history, however, isn't encouraging about the near-term outlook. A bad January generally doesn't bode well for the rest of the year. As of Friday, the Dow industrials were down 8.8% in 2008 to 12,099. Many down Januarys have heralded bad years for stocks, but not always. Bulls can take heart the Dow ended 2003 with a 26% gain despite a 2.7% drop in January. See table: Once Mighty, Now Fallen
How much more could the major averages fall? The small-stock Russell 2000 index, now down 12% for the year, already has fallen from its July 2007 peak into bear-market territory, defined as a drop of 20% or more. The S&P 500 now is down 15% from its October high. The average peak-to-trough move in recession-related slides since 1950 has been 25.6%, according to Citigroup strategist Tobias Levkovich. This suggests a further potential drop of about 10%, but that assumes a recession, which is still widely considered to be no more than a 50% probability.
A bullish Levkovich carries a 1675 target for the S&P 500 for year-end 2008, which would mean a 27% gain from Friday's closing level. If the upside for the S&P 500 is 25%-plus and the downside is 10%, the stock market's risk/reward looks pretty favorable. Among the few prescient Street seers is veteran Byron Wien, the chief investment strategist at Pequot Capital. At the start of 2008, Wien predicted that the S&P 500 would drop 10% this year, that earnings would decline and that the country's first recession since 2001 would prompt the Fed to cut short-term rates to below 3%. "We're beginning to see some bottoming signs," he said Friday. "We've switched from complacency to concern but not to capitulation yet."
Shifting Fortunes: How some major markets did in local currencies in 2007, and how they've fared this year.Value-oriented investors are getting excited because there are now plenty of inexpensive stocks, measured either by earnings or book value. There were more than 50 stocks last week within the S&P 500 trading below 10 times forward earnings, including insurers Chubb (CB) and Allstate (ALL), oil refiners Tesoro (TSO) and Sunoco (SUN), retailers J.C. Penney and Macy's, and many major securities firms, including Lehman Brothers (LEH) and Morgan Stanley (MS).
About 40 companies in the S&P 500 now trade below book value, which often can provide a floor underneath stock prices. Nearly all the major home builders, for instance, are trading below book. Lennar (LEN) and Pulte Homes (PHM) now fetch about 50% of book value, while Toll Brothers (TOL), the high-end specialist, trades for 80% of book.
A housing recovery could be a year or more away, but the home builders seem to be discounting a dire financial outlook given their current share prices. The combined market value of eight big home builders, Lennar, D.R. Horton (DHI), Toll, Centex (CTX), NVR (NVR), Pulte, KB Home (KBH) and MDC Holdings (MDC) stands at less than $20 billion, down from $80 billion at the peak in 2005.
Regional-bank shares have been pummeled in the past year, falling an average of 35%. The result is that dividend yields on many bank stocks are 5% or higher. Big regionals like Wachovia Bank (WB), at 30.80, yields 8.3%; Wells Fargo (WFC), at 25.48, yields 4.7%; and giant Bank of America (BAC), at 35.97, yields 7%.
The investment community is worried that rising credit losses will depress banks' 2008 profits and potentially prompt dividend cuts, as happened at Washington Mutual (WM) and Citigroup (C). If the credit situation proves manageable, though, regional banks could have a lot of upside potential in 2008.
WaMu, whose shares have fallen 69% in the past year owing to major mortgage woes, rose a point Friday to 13.55 amid takeover talk. The rumored potential buyer is JPMorgan Chase (JPM), whose CEO, Jamie Dimon, once again stirred the deal pot when he said last week that he was "open-minded" about acquisitions.
JPMorgan, which has been relatively unscathed by credit problems, is one of few potential buyers of any size in the battered financial sector. That gives Dimon plenty of leverage if he decides to pursue a deal. Potential targets include WaMu, SunTrust Banks (STI) and even Bear Stearns (BSC).
 | Expect Dimon to tread cautiously in the deal arena, knowing that bad deals, like Wachovia's purchase of Golden West Financial in 2006, can prove damaging. Dimon also knows that merger integrations can be difficult and distracting for buyers. That means any deal likely will have to be compelling strategically and financially for JPMorgan to pursue it. Takeover arbitragers, meanwhile, are hurting because share prices of the remaining targets of sizable leveraged buyouts have come down lately as the Street wonders whether private-equity firms will back out of deals, as Cerberus did recently with United Rentals (URI). There are four big LBOs that have yet to close: Alliance Data Systems (ADS), Clear Channel Communications (CCU), BCE (BCE) and Harrah's Entertainment (HET). Alliance Data was a big casualty last week, falling 9% to 62, leaving it way below the deal price of 81.75. |
| Unhappy Precedents: Measured by the S&P 500's movements during the past nine recessions, the stock market has fallen on average of 25.60% from its peak prior to each downturn to its trough during the recession. | The stock got as low as 47.50 before a company spokesman said Thursday that it isn't discussing a renegotiation of the buyout price and that financing is in place. |
The Street fear is that Blackstone Group (BX), the private-equity buyer of Alliance Data, may want to walk away from the deal because it's paying a rich price, and its investment in the $6.5 billion transaction likely will be underwater from day one. If the deal breaks, Alliance Data could trade at 40, meaning Blackstone arguably is paying double the market's assessment of the company's value.
The $27 billion Harrah's deal is set to close this month, but shares of the big casino operator ended Friday at 87.68, more than $2 below the deal price. Casino shares have been crunched lately on economic concerns, meaning that the buyout group, including Apollo Management, seems to be overpaying, based on the valuation of comparable gaming companies. Takeover arbs are betting the Harrah's deal gets done, but if it comes undone, the stock could trade below 70. Clear Channel, the big radio operator, finished Friday at 33.55, almost $6 below its takeover price of 39.20.
So far this year, investors have been ruthless in punishing many of the highfliers from 2007. Infrastructure plays, casinos, fertilizer companies and energy-service providers all have been crunched lately (see the table of a dozen of 2007's winners and how they've fared in 2008). Schlumberger (SLB), the leading oil-service company, got whacked Friday, falling $3 to 79.52, after reporting mildly disappointing fourth-quarter profits and dampening expectations for 2008. Schlumberger now is down 29% from its fall peak of 112.
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Trouble Across the Board: The Dow Industrials are off 8.8% so far this year, the S&P 500 is down 9.8% and the Nasdaq Composite has lost 11.8%.
One of the few big stocks to rise in Thursday's rout was Berkshire Hathaway (BRK-A), whose Class A shares finished Friday at $131,200, down 0.7% on the week. Berkshire is benefiting from its safe-haven status, its cash-rich balance sheet with $40 billion in cash, and expectations that CEO Warren Buffett will find opportunity in the current financial distress.
So far, a patient Buffett is willing to wait for what he calls a "fat pitch," or an unusually attractive investment opportunity. Buffett likes financial travail because bargains can arise, and Berkshire is one of the few companies with the capacity to capitalize on them. Daring individual investors with cash on hand can put on their Warren hats because the recent market rout may have created one of the best buying opportunities in years.
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Normxxx
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