November 18, 2002
Market’s Eye Saddam - Mindful of Forward Earnings

Last weeks developments were a mixed bag.  On the plus side, consumer confidence (initial Mich. Sentiment reading for Nov) rebounded strongly from October, weekly jobless claims dropped, and October retail sales surprised everyone by notching a 0.7% gain (excluding autos).  However, and despite gains in stocks, there were some worrisome developments as well: Industrial production continued to slump by more than expected in October, business inventories were up smartly in September, and producer prices rose by 1.1% in October (or 0.5% excluding Food/Energy).  Incidentally, you would think that the PPI numbers would be welcomed news given that everyone is fearful of the dreaded d word (deflation).  However, and as the negative market reaction following last weeks PPI release will attest to, if producers are paying more there lurks the ominous possibility that consumers will soon be paying more. If there is one thing the fragile U.S. economy can not handle right now it is price inflation at the consumer level.

This week the focus will be on the Philadelphia Fed (Nov), Oct housing starts/permits, and Oct leading indicators.  As well, consumer prices (Oct CPI) will receive special attention in light of last weeks jump in producer prices. Iraq developments will also be in play.

Baghdad or Bust
Although discussing the financial impact of war can sometimes be crass, every investor should be cognizant of the threat.   For certain, as the U.N. begins sending weapons inspectors into Iraq the situation could soon begin to take a more serious tone. 

My personal opinion is that Saddam will not fully comply with U.N. inspection demands and/or some of the findings will lead to a U.S. backed strike.  Quite frankly, it is evident that something is going happen, and the likelihood of the U.S. welcoming Saddam into the International community because he no longer possesses weapons of mass destruction seems very remote. 

As for the financial markets, the initial response to an attack will be negative.  However, if progress is made quickly the impact on stock prices could be quickly be reversed. Historically, the DJIA reacts to ‘crisis’ type situations by declining sharply and then by rebounded strongly. Furthermore, the rebound is often stronger than the initial decline.

As for Saddam wreaking havoc with what weapons he does have and/or the U.S. becoming hated by other Middle East nations (possibly causing disruptions in the flow of oil), these scenarios are certainly plausible yet also remote. It is not a question of whether or not the U.S. will win a war against Iraq, but how long the campaign will last. Furthermore, it is not a question of whether or not the U.S. damages its Middle East relations, but whether the U.S. damages these relations further. Point being, and to be perfectly blunt, the outlook for the global economy, which is currently bleak, will only deteriorate further following an attack against Iraq if other nations get involved. As it stands now, it is most of the world against Iraq.

Obviously, the U.S. must be mindful that an attack against Iraq should only be done with the blessings of the U.N. and international community. To be sure, those that believe oil could head to $70+ a barrel and/or a global depression looms strictly because of Iraq developments must believe that the U.S. will arrack for questionable reasons and/or without the support of the United Nations. If most of the world is against Iraq and the war lingers this would not be a problem. By contrast, if the U.S. (UK) goes it alone and the war lingers there could serious consequences.

Poor Quality of Earnings
It is certainly possible that the markets could end 2002 on a positive note. After all, historically stocks perform significantly better from Oct-May, the markets typically rally around elections, and last weeks retails sales numbers are proof that consumers may keep spending heading into Christmas.

However, what is also becoming evident is that the markets are not in a position to make a strong move to the upside.  To be sure, last week Merrill rated six chip stocks with a ‘sell’ rating, and GE was downgraded. Furthermore, valuations can only be considered attractive given that bond rates are low (the Fed model). Point being, if Wall Street is tagging stocks with sell ratings they are probably doing so because they are making money selling these stocks, and with valuations already at high levels it will take a terrific earnings rebound or drop in share prices for any hint of undervaluation to surface. Incidentally, on the off chance that the U.S. economy does rebound strongly interest rates would quickly rise, which would damage the Fed model theory that stock prices deserve to be higher.

Trading at 20+ times trailing earnings and 16 times 2003 earnings it is clear that the markets are still expensive when looking at P/E multiples (keeping the historical trailing average of 16 in mind). What is also worth remembering is that 2003 earnings estimates will likely be trimmed as 2003 progresses, and the fact that new accounting regulations threaten to make the markets perceptively more expensive using P/Es.  In January the SEC will meet again to discuss Special Purpose Entities (perhaps impacting year-end 03 results), there is international pressure for companies to expense stock options, and discussion of pension related issues is becoming increasingly popular. In sum, expected accounting changes, although being delayed by intense pressure from corporate America, could impact earnings going forward.

What you see is not what you get
As the Bush administration talks about the favorable economic impact of tax cuts more states are desperately trying to trim their deficits. In fact, many states are poised to aggressively raise property taxes, others are eying hikes in public transportation, and many have already taxed Tobacco. Quite frankly, if you smoke, use public transit, or own a house it is unlikely that Bush’s tax cuts will offer any relief.

By the same token, Wall Street is heralding 3Q02 as a great turning point for corporate America. However, those companies that have underfunded pensions, use stock options for compensation, record off balance sheet gains, and leave pesky 1-time recurring charges out of their ‘operating earnings’ are really performing much worse than their operational results suggest.

Those people that believe an attack against Iraq will help push oil prices down to single digits are probably the same people who believe that tax cuts can stimulate a strong recovery and corporate America is earnings lots of money. The reality is that raising Iraqi oil production much above 3 million bpd will be challenging, Bush’s tax refunds are/will be received in one hand and passed out to State’s using the other, and the quality of corporate earnings are in serious question.
 

BWillett@fallstreet.com

All data and information within these pages is thought to be taken from reliable sources but there is no guarantee as such. All opinions expressed on this site are opinions and should not be regarded as investment advice.
Copyright © 2000, 2001, 2002
FallStreet.com