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The Stock Market Waits on Washington

While the Standard & Poor's 500 and other equity indexes have managed to put in brief advances in recent weeks, the "500" veered uncomfortably close to the 800 level in January, stoking fear among strategists and analysts that the market will retest the Nov. 20 low of 750 and may not stop there. Indeed, with consumer spending at a standstill, credit still virtually frozen, and job losses accelerating, there's no reason for investors to begin buying just yet.

The 217-point jump in the Dow Jones industrial average on Feb. 6 came as optimism grew that the loss of nearly 600,000 jobs in January—the worst single-month decline in 35 years—was precisely what was needed to convince lawmakers to pass a sweeping stimulus plan now estimated at $827 billion.

But Richard Sparks, senior equity analyst at Schaeffer's Investment Research in Cincinnati, worries that some of the factors supporting the stock market now are based more on hope than on reality. That could hamper any real upward momentum in stock prices, he says.

Senate Package Could Disappoint

The various uncertainties around how big a stimulus package the Obama Administration will get approval for, what it will comprise, and how effective it will be could keep would-be equity investors sitting on their hands—and their cash— for the foreseeable future. Besides an all-out effort to win the support of reluctant Senate Republicans, President Obama has been hitting the airwaves at least once a day with direct updates to the public designed to put pressure on lawmakers opposed to the stimulus package. "The big key in the near term is we need a credible stimulus plan out of the Senate and a credible 'bad bank' plan out of [Treasury Secretary Timothy] Geithner," says Alec Young, chief equity strategist at Standard & Poor's Equity Research.

There's concern the stimulus package that emerges from the Senate will be as disappointing as the House version, which allotted a mere 7% of total funds to infrastructure, with just one-quarter of that to be spent within the next 12 months. The Senate package will inspire more confidence if it has more meat on it, provisions like the proposed tax credit of up to $15,000 to anyone who buys a primary residence in the next year, which was added on Feb. 4 to stoke Republican support, says Young. Things like that could help prevent a drop in stocks to new lows, he adds. The initial "bad bank"proposal in January to remove toxic mortgage-backed assets from banks' balance sheets drew criticism for not specifying where the money to buy the assets would come from and how the unwanted assets would be priced.

"There's a lot of cash on the sidelines and no rush to get into this market," says Young. He also cites the formidable technical resistance in the S&P 500 index between 850 and 900 that is preventing any sustainable gains in equity prices.

Earnings Forecasts Could be Slashed

Even the insistent arguments by optimists for hard-to-beat value in hammered stocks are difficult to believe unless you're confident about 2009 earnings estimates. The consensus view on 2009 earnings per share for the entire S&P 500 index is currently $58. Divide the level at which the S&P 500 closed on Feb. 5, 846, by 58 and you get prices at 14.6 times earnings. "That's not cheap," says Young. "If the stimulus doesn't work, the market could be much lower."

Investors' willingness to believe that earnings will rebound in the second half of 2009 will "pivot on what they hear out of Washington," he says. If consensus on the timing of the economy putting in a floor shifts from this summer into 2010, equity analysts will start slashing their 2009 earnings forecasts, he predicts. "If the perception is that nothing can be done to fix the economy and Obama's approval ratings plummet, value buyers are going to get run over by a truck," he says.

Skepticism toward earnings forecasts is shared by Barry Knapp, U.S. equities portfolio strategist at Barclays Capital (BCS), who participated in a Feb. 6 roundtable that Barclays organized to discuss its equities outlook for 2009. Knapp said he expects to see substantially lower earnings in the first half of this year and projects earnings for the S&P 500 at $46 for the whole year, 21% below 2008 earnings, which in turn were down 27% from the prior year. A dramatic cut in earnings outlooks by analysts will likely send the S&P 500 to new lows, but he predicts it will finish the year at 874, about where it was at the start of 2009.

Steel Capacity Utilization Falling

Take industrial manufacturers, for example. Knapp believes the expected 1.5% gain in industrials' 2009 profits, which analysts forecast before earnings season began, isn't plausible given that year-over-year export growth exceeded 20% in July and fell to -1.7% in November. Contributing to the plunge in exports have been the negative impact of the dollar's rally on U.S. trade since July and the drop in capacity utilization, most dramatically in the steel industry, he says.

He sees a 25% probability that the stimulus package won't revive the economy, in which case he expects the S&P 500 to put in a valuation floor around 640, where the typical recession-discounted buying should kick in.

Although he now favors the investment-grade fixed-income market over equities, Knapp believes there will be a better entry point for U.S. equities by the end of the first quarter or start of the second quarter of 2009, when he expects the stock market to put in a low.

Keep an Eye on Share Buybacks

Investors looking to get back into the stock market need to understand three drivers of equity returns, according to Matthew Rothman, global head of quantitative equity strategies at Barclays Capital. They need to get a handle on valuation, the impact of market sentiment on price momentum, and asset quality, he said at the roundtable. He recommends that people confine their buying to shares in companies that are creating value for shareholders, as measured by the size of returns on invested capital, changes in the ratio of debt to total assets, and what portion of earnings is coming from noncash accruals, such as changes in reserves for inventory levels and bad debts, vs. cash. Investors also need to be careful to distinguish share buybacks funded by the issuance of high-yield bonds from those funded by cash on the balance sheet, he added.

In the last few months of 2008, investors tended to shun stocks that looked cheap, deciding they were cheap for good reason, and lost trust in book-to-price measures. That started to reverse at the end of the year, Rothman says.

Sparks at Schaeffer's points out that market sentiment isn't where it typically has been when stocks have put in a bottom in prior bear markets. Bottoms form either based on panic, as in 1987, or on apathy, where stocks stay in the doldrums so long that it causes investors to lose interest and throw in the towel, as occurred in 2002-2003, he says. Neither of those feelings is present now. Instead, he says he hears a lot of people saying it's time to buy to take advantage of the low stock valuations and that the biggest risk is missing a rally. "Those arguments are not arguments you see at the very bottom," says Sparks. "I say that with the Dow [Jones industrial average] just a touch above 600 points above the November lows."

Market Volatility Should Moderate

In other words, there hasn't been a long enough period of sustained gloom to warrant the view that equities are finding a floor from which to bounce. The other sign that a bottom for prices has formed would be a sustained flow of better news regarding the credit markets and the economy. "That would give us a fundamental catalyst to cause the buying to begin," he says.

Another signal to keep an eye on is market volatility. That should moderate in the first half of this year, now that the excessive deleveraging by mutual and hedge funds has largely run its course and now that investors can be much more certain that the focus of Washington policymakers will be on controlling systemic financial risk, says Maneesh Deshpande, head of U.S. equity derivatives strategy at Barclays Capital. Policymakers were hamstrung by the need to balance their rescue efforts against moral hazard concerns in the closing months of 2008, according to Deshpande, which caused much more uncertainty in the market.

He warns that over the medium-term market volatility is likely to stay high, depending on the impact of the fiscal and monetary policies now being formulated. Deshpande notes there is risk that the stimulus may not fully succeed in re-igniting growth, given the limited experience policymakers have in dealing with the current environment. And how the endgame to the recession plays out also raises concerns. If the economy rebounds too quickly, bringing a higher risk of a surge in inflation, policymakers face the delicate task of withdrawing some of the stimulus measures and at the same time not short-circuiting the recovery, he says.

Signs of a Demand Problem

As for how to gauge the success of the stimulus, aside from moves in the monthly employment data, Knapp at Barclays suggests people watch the auto sector to see whether sales rebound once the credit taps have been turned back on. In December, when the government granted commercial bank status to General Motors Acceptance Corp. and injected $6 billion into the lending giant, GMAC announced it would lower FICO score requirements for borrowers, but auto sales didn't respond in January. In fact, they fell further, proof that there's a demand problem as well as a credit problem, says Knapp.

"The thing to look for when the fiscal relief and tax cuts materialize is: Does it create a demand shock when credit starts flowing again?" he says. With so much riding on the government's gigantic relief effort, equity investors will be anxious to see if the jolt can revive the moribund economy — and the battered stock market.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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