Monday, April 30, 2007

How much further do the bulls have to run on Wall Street?

By Stephen Foley in New York

Published: 27 April 2007

Hang out the bunting, prepare the sandwiches and the fizzy pop, get ready for a street party. A Wall Street party. The US stock market is very, very close to reaching an all-time high, and it could break the record at any moment.
But hang on, regular readers will be saying, didn't the Dow Jones Industrial Average power into virgin territory last autumn? Indeed, didn't it just shoot through the 13,000 barrier for the first time on Wednesday?

Yes and yes. The Dow is the most visible measure of the US stock market and has served well as a yardstick for 111 years, but it measures just 30 stocks. The much wider S&P 500 has claim to be the best measure of US equities, and it remains a tad over 2 per cent below its dotcom-era peak. It is this index that Wall Streeters measure their performance against, and it is a record on this index that will trigger the big party.

Either way, though, we are definitely into party season. The stock market is surging, whichever way you measure it. Company profits are growing faster than anyone dared hope. Their profit margins are at 50-year highs. The US economy continues to grow, too, albeit at a slower pace this past year, confounding the sceptics. Corporate executives are confident enough in the outlook to embark on brave merger-and-acquisition deals that boost the share prices of companies likely to be taken over. Lenders are confident, too, and are advancing plenty of money to companies to finance such deals and to hedge-fund investors to play the stock market. Wall Street banks are raking in more money than they ever have before.

And the best thing about this party is that there are so many party-poopers about.

David Tice, investment adviser to Prudent Bear mutual funds, is one. Share prices and other assets have been driven high because of "global liquidity and massive credit that comes from ignoring risks. Credit lending is going to be more restrained in the future. This market is going to go down".

Richard Bernstein, chief investment strategist at Merrill Lynch, often sounds like another. "Valuations are fair, but nothing more. Investors who claim that stocks are immensely undervalued probably are not aware that S&P 500 earnings are the most cyclical in history. Low price/earnings ratios might simply reflect peak earnings rather than value. This was certainly true for the housing stocks during the past year or so."

There are so many warning voices, and they have a coherent case. They argue that the US consumer economy is teetering. House prices in many parts of the country have taken a dive and sales of existing homes fell at their sharpest rate in 18 years last month. Mortgage arrears and now repossessions have been rising steadily, and in the riskiest parts of the mortgage market - the so-called sub-prime market - defaults by the poorest homeowners are running so high that several lenders have gone bust.

Investment strategists at Citigroup, the US investment bank, have an intriguing tool for judging these things, an amalgamation of different measures of investor sentiment which it calls its "panic/euphoria model". It says the tool is very useful in predicting the future direction of the market and guiding what an investor should do: buy when it shows people are panicking about the economic and investment outlook, sell when there is euphoria. It has only recently crept back into neutral territory, after being in "panic" for most of the past six years.

Tobias Levkovich, the bullish chief investment strategist at Citigroup, came back from a tour of European investors this month, with a new list of their worries. "The primary investment concern relating to equities remains the direction of earnings, given that US corporate margins sit at 50-year highs. Investors often cite worries about geopolitics, oil prices, sub-prime credit contagion, housing, twin deficits, negative savings rates, protectionism, terrorism, inflation, jobs and the weak dollar as reasons for holding back from buying stocks, but these catalysts are not the issue by themselves - the issue at hand is that they all have earnings ramifications."

At the start of last month, it was the fear of "contagion" from the sub-prime market meltdown, the fear that major financial institutions would suffer destabilising losses from their dealing with sub-prime lenders, which contributed to the stock market's wobble.

Since then, though, giant banks have promised that their exposure is limited, that their own levels of bad loans are not growing as fast as investors had feared. As in the financial sector, so it is across the rest of corporate America. Most of the country's biggest companies have now reported their profits for the first three months of the year, and they have averaged growth of 11 per cent, exactly the same as in the fourth quarter of 2006. Analysts had predicted a growth rate of barely half that.

In short, the stock market's revival from its wobble in March, the Dow's 126-day progress from 12,000 to 13,000, and its 80 per cent surge since the bear market nadir in 2002 - all has been largely justified by improvements in corporate earnings.

The average S&P 500 stock is valued at a little below 16 times its reported earnings of last year, and at a little over 16 times the consensus estimate of the coming year's earnings. This does not take the market into territory that would be called irrational exuberance.

And the confidence that those estimates of future earnings are sound, if not even conservative, are based on a view of the Federal Reserve's ability to keep the economy on an even keel. A Treasury bond auction yesterday was priced with a yield lower than expected, another example of the market's belief in interest rate cuts soon to prop up a slightly weaker economy.

Even admitting clouds over the US economy, bulls argue that the addition of China, India and other emerging markets to the super-league of economic nations means that global growth can continue without it. More than half of the earnings of the Dow's 30 industrial giants come from overseas, so they are fatter in dollar terms and they are able to offset any US slowdown.

Richard Jeffrey, chief economist at Ingenious Securities in London, said: "Stock markets around the world are telling us two things. First, they are telling us that there is a high degree of confidence that the world's central banks will be able to successfully manage their way through the various issues they face without causing undue turbulence, without inflation becoming a problem or the US economy going into a recession. Second, there is also a recognition that the global economy is no longer so dependent on the US. The American economy is no longer the sole locus of growth, so the impact of a slowdown in the US is not as large as it once was."

There are other factors to be pulled into the mix to explain the outsize performance of the US stock market. The phenomenon of "de-equitisation" is one, which is adding a little scarcity value to equities. Massive share buy-back programmes by cash-rich companies are boosting earnings per share and returns on equity, and as a result reducing their number of shares in issue. And all the while, private equity funds are snapping up bigger and bigger chunks of corporate America. The past year has seen the 17-year-old record for the biggest ever private equity buy-out finally surpassed not once but several times.

Lest we contribute any temptation to euphoria, the final word should go to Merrill Lynch's Mr Bernstein, who adds a bum note related to the weakening US currency. "The dollar is falling, and much of the stock market's rally is simply 'money illusion' - that is, it takes more less-valuable dollars to buy the same asset. In euros, the Dow has been flat for six months. In a global sense, the US stock market's rally is not a growth story."

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