What the Market Is Telling Us
In the parlance of Thomas Friedman, the world never looked flatter than it did this week. A 9% stock market sell-off in China on Feb. 27 prompted sharp drops almost everywhere else around the globe. Suddenly, money managers and traders, lulled into a trance by seven months of steadily rising share prices, felt like they'd been hit over the head with a best-selling hardcover. With one big thwack, they were reminded that stocks are risky and that emerging markets are riskier.
In hindsight, no one should have been surprised. China surged an amazing 130% last year and 13% in the week ahead of the plunge, as millions of newbie day traders punched in buy orders on rumors about shares they'd never heard of. Stocks zoomed in other overseas markets for half a year; U.S. shares, which have lagged the rest of the world since 2000, rose steadily and with little volatility. Something had to give.
The question is what happens next. This latest episode of jitters could be the opening shock-and-awe campaign of something more lasting. The U.S. economy is suddenly looking weaker than it has in a long time. Fears are mounting that troubles in the mortgage market could spread to other sectors. And profit growth seems to be slowing markedly—a troublesome sign, to be sure.
But a stronger case can be made that Feb. 27 will turn out to be more of a tremor than an earthquake. Notably, U.S. indexes gained on Feb. 28. That's in part because powerful forces are undergirding stocks now in a way they weren't in earlier bear markets. The last bear came on the heels of a long bull market that included the biggest five-year run-up since the 1920s. Share prices are only now beginning to revisit their 2000 levels. The amount of cash sitting on the sidelines is at a record. Individual investors haven't jumped into the market en masse.
What's more, private equity is now a major factor. Buyout firms have raised billions in the past two years. Furious dealmaking is keeping asset prices buoyant and also cutting the supply of shares available to investors. That squeeze is being magnified by activist hedge funds, which are badgering companies into stock repurchases like never before. With the inventory of equities down and so much money already on the sidelines, the market appears to have a steady floor underfoot.
One thing is for sure: Volatility is back. Bulls and bears will battle it out over the next few weeks and months, not only in the U.S. but also abroad. That could actually be good news for U.S. stocks, at least relatively speaking. As fund managers and traders recalibrate their risk appetites, U.S. stocks stand to look more attractive than their overseas counterparts. In fact, the riskier those markets, the safer the U.S. will seem. In short, the world could seem a lot less flat—in a hurry.
The biggest support for the U.S. market has been, and will likely remain, private equity firms and hedge funds. The $45 billion privatization of utility TXU announced on Monday—the biggest of all time—was the second record-setting deal in three months. Eight of the top 10 LBOs in history have been inked since June; in 2006 alone some $420 billion in leveraged buyouts took place, a record. And yet private equity firms still wield as much as $2 trillion in combined buying power, enough to take out fully a 10th of the entire U.S. stock market.
The fuel for all the buying—low long-term interest rates—remains in the tank. In fact rates have been falling in the past few weeks and fell even more Tuesday, making the debt, or leverage, that private equity firms wield even cheaper. "The difference between cost of capital and return on equity is so enormous that if you're a leveraged player you just have to buy," says market watcher Jason D. Trennert of Strategas Research Partners. He goes so far as to suggest that the Standard & Poor's 500-stock index itself, if it could be packaged into a single entity, would be a screaming LBO candidate. Hence what veteran market strategist Edward E. Yardeni has taken to calling the "private equity put"—for put option, a floor price under a security. In this case it's under the whole market.
At the same time activist hedge funds are helping to reduce the supply of shares available to investors by "engaging" companies with lengthy lists of demands that usually include buybacks. They've helped compel 29 of the 30 members of the Dow Jones industrial average to repurchase shares in recent years. According to Thomson Financial, last year's $370 billion in buybacks was more than four times the total of 2003. All told, Strategas calculates that a record $600 billion in U.S. shares were removed from the public market just in the first nine months of 2006. Scarcity bolsters the value of the shares that remain.
There's another important reason why the bulls aren't sanding down their horns: Mom-and-pop enthusiasm for the U.S. stock market has been anything but overwhelming, sparing the market from retail-driven froth. While the so-called smart money is gorging, ordinary investors are only nibbling. Consider an anecdote by way of Michael A. Dubis, a Madison (Wis.) financial planner. After sending clients an e-mail to reassure them following Tuesday's market slump, he reports, "I haven't gotten a single call." Citigroup equity strategist Tobias Levkovich notes that his proprietary blend of indicators had investors in "panic" mode well before Tuesday's plunge; many still haven't gotten over the 2000 bear market.
Meanwhile, individual investors are sitting on mounting cash. Year-end Federal Reserve data showed just under $5 trillion is stockpiled in savings and money market accounts and retail certificates of deposit, a record stash. Contrast that with China, India, and other emerging markets where the equity culture is spreading like locusts. Day trading, a distant memory in the U.S., is surging in exotic locales.
To the extent that U.S. mutual fund investors are interested in stocks at all, they're interested in foreign ones. According to fund-flow tracker TrimTabs Investment Research, last year saw U.S. funds draw just $20 billion in inflows, compared with nearly $150 billion dedicated to hot foreign investments. If there are excesses in global markets, they're far more pronounced overseas than they are in the U.S. And if history is a guide, the U.S. market is where investors will run if and when emerging markets get choppier.
"A Wake-up Call"
There's also a good old-fashioned valuation argument to be made for the U.S. Stocks are trading at 17 times earnings—roughly what they changed hands for in 1995. This is another floor under the market explains Stuart T. Freeman, chief equity strategist at A.G. Edwards & Sons. "It tells you that there are reasons why value investors will step in on rough days at these levels."
That's not to say Feb. 27 wasn't frightening. Chinese regulators jarred investors by raising concerns over the ease with which investors were borrowing money to buy stocks. And former Federal Reserve Chairman Alan Greenspan warned of excessive risk-taking and hinted at the possibility that the U.S. economy might slip into recession by the end of 2007—a prediction bolstered by fresh economic data. Those twin events sent all of emerging marketdom plunging. European stocks slid by 2.6% in sympathy. The Dow's one-day plunge of 416 points was its steepest point loss since the market opened after September 11.
The bears, emboldened by $583 billion in evaporated U.S. market wealth—which wiped out gains for the year—came out of a prolonged hibernation to growl a chorus of I-told-you-so's. "It was a wake-up call from the complacency of a mature economic expansion," says James B. Stack, president of InvesTech Research, an investment advisory service based in Whitefish, Mont. "When you have a market that basically goes up and up over what has been a four-year period, investors tend to lose the perspective that stocks are not riskless."
Over the years there have been far bigger market drops in percentage terms. In 1987 the S&P 500 plunged 21% in a single day; it dropped just 3.5% this time. And the U.S. market is still far from an official correction, much less bear market territory: Through Wednesday, the S&P 500 was down just 4% from its recent high. A full-fledged correction is defined as a 10% slide; a bear market, a 20% drop.
Nevertheless, Tuesday's rout shook investors from a cocoon of complacency. It ended the longest stretch in 107 years that the Dow had not declined by 2% or more in a single day. The last time the market fell 2% was May 19, 2003, two months after the U.S. went to war in Iraq. The pullback had investors contemplating their appetite for global risk and weighing hazards at a time of unprecedented and, some would argue, untested financial interconnectedness.
In some ways, China's one-day descent wasn't so worrisome. Its market is still up 9% this year. Dissecting investor sentiment in Shanghai is a bit like psychoanalyzing a roulette wheel. A return to some semblance of normalcy was very much in order. "People were talking about a bubble, so the government was quite worried before this correction," says Chun Chang, professor of finance at China Europe International Business School. "[The sell-off] was pretty big, but we needed it."
Much more troubling for the bears was Greenspan's speech. The R-word isn't thrown around lightly in market circles; coming from Greenspan (even in retirement) it sounds thunderous. Now the idea that the U.S. is about to fall into recession—its first in six years—is gaining traction. Stockbroker Peter D. Schiff, author of the just-released book Crash Proof: How To Profit From The Coming Economic Collapse and coveter of precious metals, dispenses with euphemism altogether: "We've been like heroin addicts; a recession will be cleansing."
There's no doubt, for example, that the multiyear U.S. housing boom is over. Stock prices certainly seem to augur trouble. Shares of subprime lenders such as New Century Financial and NovaStar have crashed in the past month. Higher up on the lending food chain, British-based banking giant HSBC Holdings (HSBS) recently admitted it's feeling pain. And many major U.S. banks are quietly increasing their loan-loss reserves. Wall Street analysts and economists have emptied boxes of toner cartridge in recent weeks opining on what might lie beneath the balance sheets of banks and brokerage houses. There's growing fear that the subprime rot will spread.
Even if you don't subscribe to this systemic worry, market fundamentalists stand next in line to warn of an earnings slowdown. Corporate profits have increased by double-digit percentages for 19 consecutive quarters. But Deutsche Bank (DB) points out that first- and second-quarter earnings for U.S. companies are expected to grow by less than 5%, year-over-year. And according to Trend Macrolytics, forward earnings growth could clock in at less than 4%. The last time that kind of decline happened was April, 2000, a month after the start of the bear market and 11 months before the economy fell into recession.
What's more, this bull market is getting long in the tooth. The 48 months it has gone without a 10% correction is the second longest in at least 78 years, according to Stack. Bearish hedge fund manager Doug Kass notes that four-year bull markets that follow deep bear markets, like the one from 2000 to 2002, "often morph into disaster." He points to the 1937, 1962, and 1987 crashes, and the fact that the sixth or seventh year of every decade in the 20th century experienced a crash or steep pullback.
Still, the bulls are hardly ready to repent—and apparently with good reason. Expect a two-front war in the coming months. In the U.S. it'll be a contest between recession-spooked worriers and stockpickers with visions of high-priced buyouts. A parallel fight will pit the freewheeling global markets against the safety of the U.S. Indeed, the events of this week just might spark a resurgence in U.S. shares. "Tuesday could be the shot across the bow for the end of the flow of funds to overseas markets and back to the U.S.," says Bernie Schaeffer of Schaeffer's Investment Research. One market-agnostic growth fund manager says he just got those very marching orders from his supervising investment committee: "We're in the process, even if it doesn't necessarily finalize next week or next month."
And that would show that the world might not be so flat after all.