Experts Talk Stocks, Earnings, Claims, China

By BusinessWeek staff

The stock market continued its recent retreat on July 7, with major equity indexes lower as traders anticipated a painful second-quarter earnings season. Market players were also buzzing about the Group of Eight meeting in Italy, upcoming data releases—including weekly initial jobless claims on July 8—and continuing ethnic violence in China.

What did market pros have to say about these and other topics on July 7? BusinessWeek compiled these comments from Wall Street economists and strategists:Nick Kalivas, MF Global Research

The market is in the process of repricing the outlook for profit growth, and it will take robust earnings numbers in mid-July to bolster investor interest in stocks. Furthermore, the market has lost confidence in the politicians, and the environment remains hostile to business. Recent press on the Justice Dept.'s antitrust investigation on telecom names Verizon Communications (VZ) and AT&T (T), and talk of commodity market regulation has hurt prices. In addition, credit is starting to weaken and signals a pickup in risk premium.

The bull story rests in the fact that stocks are cheap to cash, and the economy is stable according to comments from Alcoa (AA). Alcoa's CEO said demand was picking up because of restocking and events in the auto industry. He indicated that China had clearly bottomed, and demand had made a trough in Europe and the U.S. Further there is talk that the White House is backing a health-care plan run by the private sector as opposed to a pure government option. Some see this as positive political news, but government oversight is still present in the process and industry.Edward Yardeni, Yardeni Research

"Sell in May and go away" seems to be working this year. I'm still rooting for an inverted head-and-shoulders formation. It won't happen unless the fundamental picture shows an upturn in earnings. I expect that there will be plenty of positive earnings surprises during the Q2 earnings season this month, as there were during Q1. It should be the same story: Cost-cutting should boost margins, offsetting some of the weakness in sales.

Nevertheless, we are forecasting $14.00 per share in operating earnings for the S&P 500 during Q2, down 29.2% year-over-year. We are projecting another year-over-year decline of 8.5% in Q3 before earnings rebound 205.8% in Q4. We are encouraged to see that S&P 500 forward earnings have turned up during the past few weeks, and so have the analysts' consensus estimates for Q2, Q3, and Q4.Michael Englund, Action Economics

A plunge in initial claims in the first half of July—and likely starting with [the July 8] claims report—appears likely given the early plant closings for the automakers in May and June that front-ran the seasonal factors. An underlying better tone in claims in these months was cloaked by the atypically early auto plant closings. The absence of substantial new plant shutdowns starting in the July 4 week should now allow the claims figures to make up for lost time.Marc Chandler, Brown Brothers Harriman

The news stream from China has been anything but good. Chinese President Hu Jintao left the G8 meeting to return home as riots in the capital of Xinjiang province escalated. Meanwhile, reports emerged that China had detained Stern Hu, the head of Rio Tinto's (RTP) iron ore operations in China, on allegations of stealing state secrets. The country also failed to sell all of its 28 billion yuan (US$4.1 billion) one-year bond auction, selling 27.5 billion yuan of notes. Additionally, new lending more than doubled in June from a month earlier raising concerns about the rapid growth of credit and the possible emergence of an asset bubble.

[Wednesday's] news developments could shift the international agenda. Hu's return underscores the seriousness the country is placing on domestic developments relative to the international agenda. Until April, international gatherings were dominated by an agenda to encourage China to make its currency more flexible. Since the April G8 meeting, China has wrested control away from the complaints about its currency and toward international reform of the currency markets. With President Hu returning home, the fire from the currency market issues will likely be damped and replaced by talk of riots and the implications of an arrest of an international executive. At the same time, concerns about a possible bubble after new loans exploded will add to concerns about China, providing some support for the U.S. dollar.Diane Vazza, Standard & Poor's Ratings Services

Pay-in-kind notes, also known as PIK toggle notes, became popular at the height of the easy-money conditions in 2006-07. As companies' earnings and the overall economy deteriorated this past year, issuers turned to in-kind payments to conserve cash. Indeed, a sample of 53 PIK toggle notes, with $32 billion in total principal outstanding, issued by companies that currently are not in default reveals that 23 are paying in-kind or have announced that they will pay in-kind on a future coupon, while three are splitting interest payments between cash and additional notes. We also have identified an additional 10 companies with PIK toggle notes that have either filed for bankruptcy or exchanged their PIK notes.

Default risk is high, and recovery prospects are low among our sample of PIK issuers…The vast majority of PIK toggle note issuers are private companies, with a large share having some private equity (PE) involvement. Indeed, PIK toggle notes were a favorite for PE firms to add debt at the bottom of the capital structure, with proceeds often used to finance a special divided to the PE sponsors.

PIK toggles offer issuers the ability to conserve cash. Nevertheless, a number of highly leveraged issuers of PIKs have filed for bankruptcy protection or have defaulted on one or more of their outstanding notes.

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