All about investment

By Jeffrey P. Snider

The headline said it all, the unemployment rate increased to a five-year high in August. In the finer print the news was even more ominous. Job losses for June and July were worse than first thought, and in the blink of an eye 58,000 jobs disappeared. And the job losses were not limited to construction or manufacturing jobs. The professional services sector, the one sector many economists have pinned their hopes on, shed 53,000 jobs.

Our economy needs to create between 80,000 and 100,000 jobs each month just to keep pace with workforce growth. The economy has lost jobs for the last eight months, pointing to severe weakness that is just beginning to show itself in a tangible fashion.

For stock investors this means the optimism that sprung from a decline in oil and gas prices was misplaced. And it points to the one event that has been conspicuously missing from the bear market of the past ten months: a panic.

Here are five myths that have fueled optimism and kept the market from panicking:

1. The worst is over for the credit crunch. That may be true for write-downs of illiquid mortgage assets, but the credit crunch is far from over. Trouble started with mortgage-related securities but now is found throughout the credit markets. Witness the Wall Street settlements with municipalities over auction-rate securities. The destruction of that market, and the losses it has created, have little to do with mortgages and everything to do with a malfunctioning credit market. Our economy needs credit to grow.
2. The global economy will bolster exports and keep the US economy afloat. That argument flew out the window on September 3, 2008, when the European Union showed a contraction in the second quarter (-0.2%). That came on the heels of the British government's announcement of zero growth in the UK (which is separate from the European Union). The Chancellor of the Exchequer, Alistair Darling, warned that British economic conditions "are arguably the worst they've been in 60 years".
3. The weak dollar will also boost the export sector. See #2 above. The weak European and Asian economies have helped the dollar strengthen significantly, 8% against the Euro and 13% against the Yen. Slower foreign growth and a stronger dollar will mean slower US export growth, the only sector to show any strength in 2008.
4. The stock market is down over 20% and has a historically low P/E based on 2009 earnings estimates. This is the biggest pillar in the optimists' argument in favor of a stock recovery. Based on bottom-up 2009 "operating" earnings estimates from Standard & Poor's, the market, using the S&P 500 index, is trading very cheaply at 11.4 times earnings. But that multiple is built on a 34% recovery in earnings for 2009, including a decidedly ambitious turnaround of $27/share from the financial sector. Analysts missed their estimates by a wide margin during the 2000-2002 bear market and everything we have seen since last July has shown that they are doing it again. If we use "reported" earnings estimates as a benchmark, which factors in the economy using a top-down approach, we calculate earnings estimates that are 37% less! The P/E on the S&P 500 is almost 20 using this earnings estimate, still well above its historical average.
5. Stock market pain is focused in the financial sector and is not likely to affect other economic sectors. This one is just like Federal Reserve Chairman Bernanke's pronouncement in February 2007 that there would be no spill over from the subprime mortgage area. The bond market is screaming a huge warning to stock investors. Standard & Poor's estimates that 4.9% of all speculative grade bond issuers will default in the next 12 months, with a 20% chance that the default rate will exceed 8%! With a record 23% of all high-yield bonds rated as speculative that is a huge amount of defaults. For stock investors, a bond default is usually the precursor to bankruptcy. A substantial increase in bankruptcies will put real fear into stock investors, a fear that there is no safe place in any stock market sector or industry.

In the past five recessions the S&P 500 has declined an average of 36% peak to trough. It has taken an average of 1.6 years to find that bottom. We are only ten months from the October 2007 peak and the S&P 500 is down only 21%. Previous recession bear markets also featured more than a few panics. Based on those averages, and the five points above, investors should be very cautious in the months ahead.

Jeffrey P. Snider is Vice President and Portfolio Manager for Atlantic Capital Management. For more economic and market analysis sample our research at http://www.client-centered.net

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