By Dan Amoss
The big questions of the moment: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: The real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.
So I expect over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are disconnected from reality.
Another big question is how will policymakers respond to a sluggish- to-nonexistent rebound in hiring? The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not — that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it — debased by the Fed’s inflation, of course — back into your other pocket.
The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs.
Where you stand on this question will determine your expectations for the future performance of most stocks. I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.
For example, corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is revealing. In a word, the approach toward capital structure is “defensive.” Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.
Amazingly, credit risk is a quaint, distant memory for most, when it should be the first consideration for shareholders — especially shareholders of highly leveraged companies like banks and REITs. In leveraged companies, shareholders’ claims can evaporate very quickly when asset values deflate and cash flow dries up.
For banks in particular, credit risk often accelerates out of nowhere. Remember how many big-time investors bought stocks like the failed Washington Mutual because it appeared to be “well capitalized”?
It’s shocking how many banks the FDIC still deems to be “well capitalized,” despite the fact that foreclosure activity is accelerating.
Foreclosure activity is crucial to the outlook for bank earnings. Mortgage losses will become a big problem for bank stocks in 2010. Mark Hanson of Mark Hanson Advisors does great work on the details behind the headline foreclosure and housing price statistics — the kind of granular, non-ivory-tower research that’s missing in Wall Street and Washington, D.C. In an update a few weeks ago, Hanson wrote:
The chart below shows the national monthly notice-of-trustee sales (late stage) versus foreclosures (last stage) counts from March through August. In that short six-month period, there have been 390,000 NTSs that have not resulted in a foreclosure (circled in red). Many are on trial [modifications].
If we assume that 250,000 of the 390,000 are presently on a trial and 40% fail, then beginning shortly 100,000 new foreclosures will spit out over a short period of time that will be added to the foreclosures that will occur naturally for reasons mentioned previously. If 60% fail, then the number goes to 150,000. With foreclosures only averaging 73,000 over the past six months, this new stream of foreclosures is significant — it has the potential to double foreclosures over a single month.
The banking system has slowed down the necessary process of “working out” unmanageable debts. Deliberately delaying loan foreclosures and write-offs — whether through government edict or smoothing out loss recognition over time — has the effect of backing up the plumbing in the system of credit intermediation. It’s the post-1990 Japan scenario of sweeping bad loans under a rug because “we can just hold on until asset values come back.”
I’ve written repeatedly about the accounting for — and resolution of — toxic assets throughout the banking system, because I see it as crucial to the outlook for both the U.S. economy and corporate earnings. The longer this is delayed, the more likely the U.S. economy suffers a fate even worse than post-bubble Japan. We have a scenario of defensive, undercapitalized banks, combined with a huge population of effectively bankrupt U.S. consumers. This is a problem that requires comprehensive debt restructuring and resolution before we can have a sustainable economic recovery.
Net-net, the outlook for economic recovery is questionable, at best…which means that the outlook for rising share prices is even more questionable.
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