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April 29, 2007

Dead Market Walking
by Michael Panzner

"Dead man walking" is the phrase shouted by guards when a condemned prisoner is taken down to Death Row. The words have also been used to describe individuals who face an unwelcome but unavoidable fate. In other words, although they might be employed or involved in a particular relationship right now, circumstances will soon change -- for the worse.

In many ways, this epithet describes today's U.S. equity market. That is despite the fact that the majority of investors seem to believe that the increasingly exuberant run-up we've seen since the fall of 2002 can only lead to one thing: more of the same.

Yet while optimists might welcome news that the current bull run is four-and-a-half years old, "only three out of the past 15 bull markets have lasted five years or longer, with the average surviving only 3.4 years," according to Jim Stack, editor of the InvesTech Market Analyst newsletter, in U.S. News & World Report.

What's more, "even that's distorted by the longevity of the 1990s bull," the magazine writes. "The median length of a bull market-- the statistical point where an equal number last longer or shorter-- is only 2.6 years."

The current bull market has also been unusually correction-free. Despite the swoon that took place two months ago, share prices have yet to experience a typical, but healthy, pullback. According to the International Herald Tribune, again citing the research of Mr. Stack, "the past four years have been the second-longest period during which the S&P 500 has gone without a 10 percent correction (the longest was a six-year stretch in the 1990s)."

Many of those on and off Wall Street have welcomed the sometimes frantic buying we've seen, especially of late, which has helped push the Dow Jones Industrials Average to 13,000. Even so, the record-setting string of 19 higher closes in 21 trading sessions that has occurred over the past three weeks, coming as it has after a multi-year run, is characteristic of the kinds of climactic blow-offs that investors should fear rather than cheer.

As to why this particular bull market has gone past its presumed sell-by date, the explanations seem to fall into two categories: technical and fundamental.

With regard to the technical factors, many market-watchers argue that, especially in recent years, the equity boom has been aided in large measure by a rapidly shrinking supply of publicly-traded equity resulting from corporate buybacks and a plethora of large-scale, debt-fueled leveraged buyouts.

This week's Barron's, for example, reports that "since September 2005 some $628 billion of U.S. shares have been repurchased" by listed companies, according to data from Thomson Financial. The publication also notes that "last year, U.S. M&A deals jumped 21 percent to $1.45 trillion, about a fifth of those LBOs."

These two developments have undoubtedly been a major positive for share prices. Unfortunately, they have also sown the seeds of their own demise: they set the stage for a coming tsunami of equity supply that will eventually overwhelm the market, most likely sooner rather than later.

As the credit cycle turns, companies that have wracked balance sheets in pursuit of short-term operational leverage will quickly discover that borrowing has become a costly financing alternative. With the debt spigot running dry, many will be forced to try and raise equity capital instead, on increasingly onerous terms.

For the swollen ranks of lowly-rated firms that are up to their necks in debt, selling shares -- as well as various other assets -- will be a matter of survival, often regardless of price.

Meanwhile, frenetically one-sided deal-making by private equity firms and Wall Street bankers will undergo a turnaround, as formerly sanguine players turn into nervous, cutthroat operators looking to cash out while they still can. Suddenly, everyone will understand the maxim that today's LBO is tomorrow's IPO and they will rush headlong, like a herd of elephants through revolving doors.

But dealmakers won't be the only ones switching sides. Heavily-leveraged operators such as hedge funds will be forced to downsize balance sheets and sell risky holdings -- like equities -- as the cost and availability of credit moves against them and volatility-based risk management systems leave them with much less room for maneuver.

The harsher credit environment will also foster a widespread reassessment of risk. Banks will demand more compensation from borrowers in response to regulatory pressures and the fast-spreading, subprime meltdown-inspired contagion. Fixed-income investors will seek returns that more closely reflect the historic dangers associated with financing risky credits and holding dubious instruments.

These adjustments will quickly feed through to other asset classes, especially equities, and will exacerbate a widespread push for sharply higher risk premiums that will already reflect the pressure from rapidly deteriorating economic conditions.

Those who argue that the stock market will continue to rise because of "fundamentals" will no doubt face a rude awakening. For one thing, many of the so-called positives -- fat profit margins, low interest rates (relative to the past few decades, at least), and a Goldilocks economy --represent "old news" that is already factored into prices.

Even aside from that, the belief that companies' bottom lines can grow at the same heady pace they have up until recently seems delusional, at best. Corporate profits have risen faster in this business cycle than in any other over the past half century, and at around 12 percent of U.S. gross domestic product, they are not far off fifty-year highs. To assume that this traditionally mean-reverting series, which has not increased, on average, more than two percent above the rate of inflation over the course of time will continue to do otherwise is a bad bet.

Furthermore, profitability has been boosted in recent years by such factors as labor costs that have lagged overall economic growth rates, low levels of business investment, and juicy returns from high-margin financial activities. All three will likely provide much less of a benefit going forward.

Earnings growth has already shown signs of deceleration, based on data from Standard & Poor's. According to Business Week, "fourth-quarter 2006 operating earnings for the [S&P 500] index increased 8.9 percent over the fourth quarter of 2005, marking the first time that the index has failed to post double-digit earnings growth since the first quarter of 2002. For all of 2006, the index posted a 14.7 percent gain, compared to a 13.0 percent gain in 2005."

The prospect that profits won't be as rich as they have been before now also calls into question another big talking point for the bulls: valuation. With the "E" component of the widely used price-earnings ratio at risk of falling short, what might currently be viewed by some as attractive on a P/E basis could become the best reason not to own equities.

Given recent economic news, that moment of truth is probably much closer than what many optimists might believe. Last Friday, the Commerce Department announced that Gross Domestic Product for the first quarter was a much lower than-expected 1.3 percent. While that does, in fact, represent old news, the pattern of recent quarters lends weight to the idea that the U.S. economy is headed towards contraction.

To be sure, some optimists might challenge this view, clinging on to the misguided notion that the economy is in a Goldilocks state -- not too hot, not too cold, but just right. Many took comfort, for example, from the fact that despite the weak GDP report, consumer spending apparently held its own. With two-thirds of the economy dependent on the purchasing decisions of the Average Joe, it is hard not to feel the same way.

But this is not a forward-looking perspective. The reality is that most people have nothing in reserve, as evidenced by the fact that the nation's personal savings rate continues to hover near multi-decade lows. The bursting property bubble means many prospective consumers can no longer tap the equity in their homes. Meanwhile, many Americans are stretched to the breaking point, with household debt service payments and financial obligations as a percentage of disposable personal income hitting a record 14.53 percent in the fourth quarter, according to the Federal Reserve.

What's more, even though some data give the impression that consumers are still in the game, a slew of anecdotal and industry specific reports, including many that relate to the travel, auto, building materials, furniture, and other sectors, suggest otherwise.

Indeed, several indicators are signaling that a recession is imminent. Among the most recent is one that specifically designed to tell us where the economy is headed. According to the Wall Street Journal, "the Conference Board's index of leading indicators has declined on a year-to-year basis for three consecutive months. That is in spite of the rise in the stock market, which is one of the index's components. [Merrill Lynch & Co. chief North American economist David] Rosenberg says every time it has done that in the past five decades a recession followed, with one exception: 1967. Among the components of the index recently pointing to a risk of recession are capital-goods orders, building permits and the fact that short-term interest rates are higher than long-term rates."

For a long time, any sign of weakness has been seen by the bulls as a plus for stocks, based on the curiously convoluted logic that it would force the Federal Reserve to loosen monetary policy, thus kick-starting another liquidity-driven leg up. However, five decades of economic and market history suggest that recessions are, for the most part, bad for share prices, at least during the first six months -- regardless of what the Fed does.

Based on my own research, over the last five decades the median return of the S&P 500 index three months after a recession has started has been -4.77 percent. After six months, the median loss has been 8.54 percent, or nearly twice as much. So much for the popular notion that a bad economy is good news as far as the stock market is concerned.

Yet even without taking any sort of economic downturn into account, "stocks are extremely expensive right now," notes Fortune. "The S&P is selling at a price/earnings ratio of about 18, based on the past four quarters' earnings. But remember, those earnings stand at a record level. 'That makes stocks look cheaper than they really are,' says Cliff Asness of AQR Capital Management, a highly successful hedge fund."

"To gauge how much you're really paying for a dollar of profits," the magazine writes, "it's more revealing to compare today's prices with average earnings over the past ten years. That formula takes out the big swings in earnings that can make stocks look artificially undervalued or overvalued."

"By smoothing earnings, Asness gets an adjusted P/E of around 25 for the S&P 500. That's well above the historical average of 14 or 15. That's expensive, and buying in at high prices has always been the ticket to low future returns."

So, even though talking heads, Wall Street Pollyannas, and momentum-infatuated traders argue that now is not the time to be worried about the outlook for share prices, the facts say something else. When you read about "Dow 14,000" -- or 15,000, or maybe even 36,000 -- on newspaper front pages or on flickering TV screens, it might make sense to remind yourself what you are seeing.

A dead market walking.

Michael J. Panzner
financialarmageddon.com

Michael J. Panzner is a 25-year veteran of the global stock, bond, and currency markets and the author of Financial Armageddon: Protecting Your Future from Four Impending Catastrophes, published by Kaplan Publishing.

Copyright © 2005-2007 Michael J. Panzner

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