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Remember those simpler times in the markets, a couple of weeks or a month ago, when investors' sole day-to-day focus was on whether the officials of 17 European Union nations could begin speaking the common language of steroidal money-printing to bandage a gaping wound in the banking system?
Those were the days. In the latter part of September, a few worry beads have been added to investors' collection, the largest being a variety of market signals auguring heightened risk of a synchronous global economic downturn.
Make no mistake, Europe's "All My Problem Children" soap opera hasn't been canceled and is still central to market fortunes. Just look at the assault on Morgan Stanley (ticker: MS) last week, its shares dropping 10.5% Friday alone. And credit protection on its debt is getting more expensive than that on Italian banks, on speculation that it has outsize risk tied to Continental banks. Morgan Stanley has persistently denied it has unmanageable exposure to European institutions.
Yet all the euro-debt drama has been compounded (or perhaps has merely served as catalyst) for a swift and nasty jump in implied recession possibilities evident in multiple asset classes. Most obviously, the U.S. equity market shed $2.5 trillion in value last quarter, with most of the pain felt by cyclically attuned sectors. The Chinese stock market sank to 14-month lows as indications of some credit indigestion arose there. Copper prices, the revered barometer of global economic forces, dropped 25% in September.
Of the five indicators used by Bank of America Merrill Lynch economist Gary Bigg to compute recession probabilities over the next 12 months, two are above 50% -- the Standard & Poor's 500 index (59%) and the University of Michigan Consumer Sentiment Survey (75%). It's certainly worth noting that these are the two elements perhaps most driven by emotion and headlines versus hard economic data, the others being the Treasury yield curve, investment-grade bond spreads and unemployment claims.
No economist with a vote in the standard forecast surveys is predicting a recession outright, which isn't as reassuring as it might be if this group tended to outrun economic reality. Deutsche Bank Asia strategist Ajay Kapur points out that the macro investment trade of the moment is "binary." If this is a market scare such as 1998 or late 2002, then it would be a good buying chance. But Kapur took the other side of the coin last week, suggesting that it's an early leg of a broad recession in the U.S. and elsewhere. He bases it on a selection of forward-looking clues, including downward corporate-earnings revisions.
Meantime, though, the most recent readings on the domestic economy make it appear stable, if far from booming, a mini-trend that will require this week's employment reading to either be ratified or vetoed.
Few professional investors deny that recessionary pressures have risen, but many will argue that such an outcome is "priced in" to equities. The S&P 500's 16% slide in a bit more than two months has certainly gone a fair distance toward discounting a much weaker macro backdrop, but it almost certainly hasn't fully priced in the kinds of earnings declines a recession typically causes.
The "stocks are cheap" argument generally relies on the achievability of current and rooted-for company earnings, and the comparison of stocks to other things universally declared expensive, such as Treasuries and high-grade bonds. We've all seen the studies of the dozens of big stocks yielding more than government bonds. That's one reason, perhaps, that dividend stocks rank as a "crowded trade" by the quantitative strategists at Bernstein Research. Ned Davis Research shows stocks to be quite attractively valued versus Baa-rated corporate debt, too. Yet, as Randy Forsyth discusses on page M11, the best risk-adjusted values might be in the high-yield debt sector, barring a 2008-style meltdown.
Optimists will argue that S&P 500 earnings for 2012 could go from the current $110 forecast to, say, $85, a 20% drop that a mild recession might drive, without requiring stocks to fall much. They slap what Wall Street treats as the Biblically allotted earnings coefficient of 15 on $85 and -- look at that -- the index would be at 1275, 12% higher than it is today.
But the market doesn't proceed by the tidy algebra of the ninth-grade chalkboard or the smooth function keys of the Excel spreadsheet. One reason it has paid to buy stocks mid-way through a recession, after all, is that they typically overshoot fair value to the downside.
This isn't to say all the market indicators will be borne out in their apparent foreshadowing of recession. It's impossible to know whether the industrial commodities (and even gold) have been caught up in what would appear to be redemption-fueled selling by fast-money fund managers. The severe buckling of a bunch of big, hedge-fund-packed momentum stocks of late suggests this has been at work into quarter's end.
And even as the risk to profit forecasts looms darkly, the market doesn't get anywhere in a straight line.
Despite the worrisome tape action, investor psychology is slowly becoming dour enough to be vulnerable to "upside surprises" in the data.
Investors pulled $60 billion from stock funds over two months, even before scary September began.
According to TIM Group, 36% of sell-side traders' suggested trades to clients were short sales last quarter, on par with the third quarter of last year and the first two quarters of 2009. And corporate-insider sales continued to evaporate last week.
Without clearly showing rampant bearishness, all this reflects a Wall Street mood that at least reflects the recent market tenor and the headlines, and implies lots of pent-up buying power, to be catalyzed by who knows what.
So if progress somehow breaks out on a European bank backstop, or we get a string of merely OK economic numbers here, that vaunted pre-election year-end rally of Wall Street lore could be a pretty impressive one (even if it can't carry us fully out of the woods).
IN DOWN-TRENDING MARKET periods that spare few stocks, the 52-week-high list can serve as a good tickler file for a decent story, or at least a small window showing what's working in the economy at the expense of most everything else.
One stock that was among the handful of 52-week winners last week is Liquidity Services (LQDT). This little, low-key $900 million company used to be a lot littler and more obscure, its shares having risen 130% this year.
What could a firm called Liquidity Services possibly do in this economic and market environment to merit such investor ardor? Does it help liquidate wounded hedge funds? Or provide emergency overnight funding to European banks? Could it play some role in servicing the money-printing machines operated by central banks? Perhaps the liquidity it provides is after-work cocktails in the world's financial districts?
No. Sadly, in a way, Liquidity Services operates online auctions for surplus and salvaged goods. And its core customers, in addition to discount stores and transportation-equipment dealers, are municipalities and government agencies. So, it's the strapped public sector figuratively selling its silverware and furniture that helped Liquidity Services post a forecast 40%-plus gain in per-share earnings in the quarter that ended on Friday.
The company has also been rapidly consolidating its industry, with five completed or pending acquisitions in the past five years, including the recently announced purchase of Jacobs Trading, which helps Wal-Mart off-load stale or unwanted inventory.
While acknowledging that stocks that act strong in lousy markets are to be respected rather than reflexively scorned, this one seems to have become a bit over-appreciated and richly valued in the short term.
On both a trailing and forward basis, Liquidity trades above 32 times earnings. All seven Street analysts who cover the stock rate it a Buy, even though the price has already either breached their target, or is within a couple of dollars. And substantial sales of the stock in the second quarter by the top three institutional holders were followed by a barrage of selling by top executives last month.
All are cause more for caution than celebration, despite the stock's winning way.
THANKS TO ALL THE SALTY Barron's readers who wrote in to sharpen my description of "nautical twilight" from last week as a metaphor for today's markets.
This time of day, it turns out, is not when total darkness obscures the horizon at nightfall or before dawn, but the fleeting in-between period when the horizon remains vaguely discernible at the same time that the brightest planets and stars are visible, allowing for a re-setting of navigational bearings. It looks about the same whether right before nightfall or immediately preceding sunrise -- making it still a pretty good analogy for the confusing state of markets right now.
E-mail: michael.santoli@barrons.com
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