Market Outlook

[Brandonf]

By Brandon Fredrickson & Anthony M. Tsung

I. General outlook:
Current credit markets have dampened earnings outlook for companies this quarter and they are expected to decline further in Q4 2007 and going into Q1 2008, it will be an even more volatile environment. What is interested to see is the lack of urgency in the markets and the complacency that seems to exist in the face of heightened inflation on a global scale.
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To begin, let us look at the S&P 500 index, where we are near our 2000 peaks of 1487 levels.

n order for this market to break to new highs and sustain such an appreciation we must have sound foundations to build such a move; however we lack the appropriate content in this market to go forward and be bullish.
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Earnings have slowed drastically with operating earnings per share in the current S&P 500 earnings come in at -8.48% and annual earnings per share declining -27.76% in the current quarter.
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In sector by sector breakdown, it can be noted the deceleration in company profits as we head into year end 2007. In terms of aggregate dollars, operating earnings came in at $186 billion versus $207.2 billion in 2006 in the year ago quarter. Excluding the GM write down of almost $39 billion, and homebuilders, consumer discretionary actually grew by 4.8%. What investors should focus on is the record buyback of shares that is actually supporting this rally, or perhaps prolonging it beyond its appropriate length; preliminary numbers according to the S&P indicated near record buybacks this quarter of the $158 billion posted in the second quarter. But, as learned in accounting, EPS is increased when shares outstanding is diminished. And this is what the buybacks are doing; they are decreasing the supply of stocks, and increasing the multiples analysts use to project price per share targets for companies [case in point: SHLD ; Sears Holding Corporation]. Another question we must ask ourselves is: Is this really the most efficient use of capital to buy back shares instead of investment in opportunities? And if companies would rather buy back shares avidly instead of reinvestment in operations and research, what does that say in itself of valuations and the “content” of the company? These are self-fulfilling questions with obvious conclusions. These buy backs do not increase the content or value of the underlying security, but simply valuations in terms of dollars. The qualities of companies have declined as we have reached new highs in the current markets. Also, in looking at the 52 week high list of companies making price appreciations individually to new heights, you are seeing companies that are 5-8th tier in their market segment, with poor fundamentals and profits to support such a high price appreciation in their underlying equity. More notably, you no longer see brand names of companies who are in the 1st-3rd tiers of their market segment experiencing such rampant price appreciation. You are seeing a shift in quality at the top: from high to low. What you are also seeing in the market is a shift of allocation to defensive sectors, with companies such as Proctor and Gamble, Kimberly Clark, and Altria [a.k.a. Phillip Morris] outperforming. Ideally, in a bullish market environment, you do not want to see such a movement in these stocks. These companies generally do not take lead unless a bear market is formulating or is already taking place. _

 

[Brandonf]

continued....

II. Quality of Earnings and what is moving:
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In addition, Energy earnings are down, not because of high crude prices. They no longer matter materially for earnings as capacity by refiners cannot take advantage of higher crude prices. To be in crude, one must simply buy the futures contracts and earn the price appreciation from those contracts there. The costs of transportation are also rampant, thus diminishing overall profit margins. In addition, you are seeing companies such as FedEx decrease their estimates citing rising costs and the impact on the bottom line.
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More notably, with recent earnings reports by that of Coach and JC Penny, both strong leaders in their retail market showing much signs of weakness. The issue here is with misplaced expectations on retailers with inventory planning as well as diminished and lackluster demand by the consumers._
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What investors should also focus on are the Titans of global growth. Such companies to me are Tyco, General Electric, MMM and Honeywell. The point here is to not look at their earnings overall but more in general, their segment breakdown. And if you look closely you would see that the segments that typically do well at the end of an industrial bull cycle are profiting immensely.

III. Real Estate : Further _Turmoil of Mortgages in Prime markets
The reason why Real Estate has much more to drop, and investors may have overlooked this issue is the unexpected rampant rise in monthly mortgage payments in prime markets. For example, [and this is from a real life example],_ say a home owner pays $600,000 for a house, and is a stated income loan, which 98% of the loans brokers have done in southern California, Sacramento, and the San Francisco bay area have been stated income loans. Also in Florida, 80% loans is stated income loans. Las Vegas is about 80% stated income loans. But these loans no longer exist. There use to be firms on Wall Street willing to buy these pools of stated income loans. But now there are only 2 banks: Washington Mutual, but at the first quarter of 2008, they are no longer buying them. The other company is Downing Financial Savings and Loans. And their financials are terrible, and charge huge interest rates regardless. So few desires to do business with them. Best case scenario 1200 to 2800, but the more likely scenario is 3300 a month. But this is a best case situation. But few would be able to do this. You are going to see loan payments increase by several hundred percent points. I would expect New York (New Jersey), Chicago, Boston and other areas, where houses are more expensive than middle income families. Their only option is renewable and adjustable stated income negative amortization loans. And this traps them. When they have to renew their loans, they have to get to something real. When some families are forced to show their “books”, and then the banks don’t provide them the loan because they see through the “stated income”, and refuse to lend someone money for a home worth $600,000 with their income of $50,000 but they falsified their stated income, due to prior financial situations that allowed them to do so, the bank will foreclose on their home. The best possible situation is that the bank does allow the individual to obtain the loan, perhaps through negotiations and other collateral, but this inevitably would still be harmful for the economy, as the price increases for mortgages would diminish the assets that would be potentially utilized for the consumer economy.
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[Brandonf]

IV. Inflation, de-pegging of the US Dollar, and high Cost of Capital/Oil?:
Inflation may be higher than the federal chairman and economists have been expecting, and this disparity will show itself in the market, if not already. In addition, the rampant inflation may be on a global level, and not constrained simply to the United States. America may be experiencing higher inflation as a side effect of high inflation on a global level, which seems to have been produced by low rates on a global level and the industrial development of emerging market economies that has carried global growth. _

A notable example is Singapore with its latest GDP rising 8.9% in the July-September from the year ago period, fueled by a 17.7% rise in their construction sector. Even more notable is the expected inflation by the government doubling from the current 1-2% in 2006- 2007 to 3.5-4.5% next year, and 5% in 2008. What we are seeing here is a rampant rise of inflation and the cost of living in these Asian countries.
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The latest inflation reading from China indicated a 6.5% growth in October from the year earlier. Within this inflation report, food prices rose 17.9%, pork up 54.9%, fresh vegetables rising 29.9% and eggs up 14.3%. This is not concentrated in China alone. Even its neighboring country Taiwan is facing such a dilemma, causing political disturbance in its upcoming presidential election. The leak of inflation is more widespread, and to my surprised has been largely ignored by the governments around, which continue to insist on cheap money in the system by keeping rates low to continue growth at a large cost. This is also neglecting the rising cost of healthcare for developing nations. Especially with China earning $2 a day, health costs can easily cost $3, which is excluding the rise of food; the basic principle to survive.
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Even in Hong Kong, you are seeing inflation accelerating in October to a nine year high; rising 3.2% from a year earlier, and doubling more than the 2.7% median that was expected. What you are seeing with countries excluding the coveted China growth engine is that the weak U.S dollar and the rising Yuan [China’s currency] is creating higher inflation through higher import prices in Hong Kong. Especially with higher oil and food prices, inflation will accelerate.
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Looking onward to the greenback; how about the U.S. dollar situation? Not only that, the price of oil, though rising five folds in U.S. dollar denominated terms have only risen three folds in terms of the euro. Euro prides itself in trade with countries from China, Russia, Middle East and other countries with strong natural resources. But what happens when China has misguided the investment public about their inflation and when prices for food rise beyond a point where you are forgoing consumer spending globally to pay for meals? The outcome is that interest rates have to rise, and we have to face the consequences of easy currency and loan terms in both business and consumers._ Not only that, we have the oil countries meeting in the first week of December to discuss the economic climate, with the falling U.S. dollar being a main focus—undoubtedly. Should they de-peg from the U.S. dollar, you will see the U.S get hurt only, while Europe will experience little to no effect economically. Even if they don’t publicly announce this, it will be seen in the market undoubtedly in a “behind the scenes” move. You cannot retain your credibility as a political leader with your nation’s inflation running rampant with 14% headline growth, which is what these oil countries are experiencing._
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[Brandonf]

continued....


US Agriculture and the link to Global Inflation:
What you are seeing on a global level is the cost of living rising, potentially, beyond the threshold that emerging countries can sustain. To go on a micro level, you still have a majority of the people in China living in the country side on $2 a day. And despite aggregate wealth improving the cost of healthcare and other amenities remain at staunching levels that deplete the profits of a single family.
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Also, the U.S. may be the cause of this global economic inflation. We are seeing population growth the strongest in Asia and Latin America, and the exportation of goods overseas increasing from $51 billion in 2000 to $78 billion in 2007._ U.S. food trades since 2000 have been far more dramatic. Global Agricultural trade expanded less than 25 percent has already grown by 505 in the first part of this decade spurred by rising incomes in emerging markets. As a result, the share of U.S. exports destined for emerging markets climbed from 30% during the early 1990’s to 43% percent as of 2006. Mexico and China account for 25% of U.S exports triple that of their share in 1990. More notably, and of great concern is that emerging countries share of global GDP has risen from 43% in 1996 to 50% in 2006.

As you can clearly see there is a link between America’s agricultural exports and global inflation. Take note of the rise of commodity, [and we see this with the cost of capital with Smithfield Foods Inc [Symbol: SFD], a food company that deals with the production of hog, pork and beef worldwide.] The cost of production of food is increasing, in much due to the extensive and naïve use to bio-fuels and ethanol as a poor alternative for high oil prices as the cost of producing ethanol does outweigh the profits. In reference back to the link between the United Sates agricultural control and emerging market reliance on U.S. farmed goods, [Remember that the share of U.S. exports is 50% to emerging markets.] with higher demand stripped for domestic ethanol and global ethanol use, we are going to see immense and sustained high commodity prices for food [farmed goods overall] as supply remains tight and will remain tight because of this ethanol theme that has captured the American desire to find alternatives to oil, and this fixed desire, may blind proper cost and risk controls on decisions regarding this alternative such as Ethanol.__
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V. Technology Fall out: CSCO was the Leader Not GOOG
Technology has also been a conversation of late in the markets with technology getting the most damage in this market pull back. Investors seem to be overwhelmed by the price appreciation in Google to assume they are the market leader of this technology rally. What is truly occurring is that Cisco was the market leader and sparked the entire tech rally. Google is a secular technology phenomenon on its own accord and independent of other sectors. It was not until the summer of 2006 [around July], when CSCO began to beat estimates in that given quarter and provide strong support for higher earnings growth as the result of emerging market demand overseas and domestic strength did the technology sector begin to take form in a bullish rally. Subsequently, when CSCO failed to provide promise to the future and praised moderate growth and tepidness among the slowing growth exhibited by overseas demand and a languishing U.S. economy did the technology sector lose steam entirely. It was dependent on CSCO providing the “light at the end of the tunnel”, and not supported by the likes of Google or even Apple for that matter. This is a point that investors have overlooked due to the immense prosperity of the more “appealing” technology companies. It can be inferred from the price action in the markets that investors had the mind set that “if Cisco is growing 25% +, and they are of the old technology age “1999 era”, then the rest of technology must be doing fabulous.” This is causing “group think” in the markets. The reason why I am pointing this out is that technology is a growing industry, and unlike the technology bubble, there are real profits driving these companies. Overseas investments in wireless infrastructure are very real, and it will certainly take much time for the technology bubble collapse in 2000 to trust technology in any way. This certainly provides much value to be had, and real value too, with investors.

VI._________ Industrial Production and final comments:
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Industrial capacity utilization just above 80%, which is where companies spend additional capital; which is perceived as good right? Before one jumps to conclusions we must use empirical evidence to back our convictions, going back as far as 1952, had you bought the S&P when the capacity utilization rate was less than 81.5%, you had an annual rate of return of 20.4%. This is compared to when capacity utilization is greater than 88.5%, and this may be sooner than the investment public thinks, the S&P has returned a -6.3%._ Evidence of the industrial sector continue to spend when the business cycle proves otherwise is shown by recent profits by Tyco, General Electric, and to an extent, Deere and Potash Corp. I simply want to focus on Tyco more, and in their recent earnings—broken down by business segment, you see their flow controls division increase their backlog by over 40%. Investors must realize that the flow controls segment is actually the type of business that we see at the end or at the peak of the industrial cycle.
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In conclusion, I see the S&P 500 fall beyond expectations given and written about in the current market place. What we will see here is a rise of delinquencies, rising global inflation, rising foreclosures and a slowing earnings environment that provides no “ammunition” for the S&P 500 to break above the 2000 levels we are seeing right now in the current market. We are exactly where we were post the 2000 bear crash, and I believe investors must position their portfolio well and take into account the bear market we are about to approach.