“Fall Back and Spring Forward”

One of the rituals of autumn is setting back our clocks to return to standard time (2:00 am this Sunday morning).  That extra hour of sleep in the midst of such a busy time is welcome indeed.  Fall, so often, also brings a falling stock market.  The tragedies of September moved that event forward this year. 

Why is fall such a tough time for the market?   The answer, as you might expect, is earnings, or rather the lack of them.  As the year winds down, management teams of companies that are likely to fall short of their year’s earnings estimates choose this time to ‘come clean’ or confess their shortfalls.  Those announcements for S&P 500 companies as of this October 17th according to Thomson Financial are as follows:

Reporting  Negative  On Target Positive

Third Qtr. as of 10/17/01         279           62%            26%          11%

At this point second Qtr. ’01   284           66%            21%          13%

A year ago 10/17/2000            140           58%            30%          12%

As you can see, the majority of earnings announcements have been negative, disappointing investors and causing stock prices to fall.  But, and this is very important, this October has seen prices rise for many of these companies as investors believed their low stock prices (the result of panic selling after September 11th) reflected an unduly negative future.  The market is correcting an overly pessimistic view of businesses in particular and the economy in general.

This month, the market demonstrated rather remarkable resilience in the face of some rather daunting news.  Yesterday, markets fell off as much as 3% in the wake of the news that durable goods orders fell 8.5% to the lowest level in five years.  As investors reminded themselves that it was quite logical that airplane sales and the sales of other large ticket items would quite logically be down significantly in the wake of the events of September, the market began a rather remarkable rally to close up as much as 2.5% in the case of the NASDAQ.  The S&P finished up 1.4% after dropping 1.9% – a full 3.3% move from the bottom.

The Federal Reserve’s ‘Beige Book,’ released on Wednesday, revealed that the Fed remains concerned about longer-term weakness in the economy and will likely continue their rate reductions.  They noted the weakness was probably in effect before September.  They noted that the economy was likely already in recession.  The tragedies likely amplified layoffs that were already planned and are not yet fully recognized in unemployment numbers.

They also noted that some industries were showing signs of rebounding after the attacks.  Discount chains did “much better” than specialty stores, in the weeks after the attacks, the report said.  Reacting to the crisis, Americans bought more “groceries, security devices, and bottled water,” the report said.  “Purchases of insurance also rose.”  Automobile sales, which were “much weaker” in early September, are almost “back to normal” because automakers are offering zero percent financing.  Many cancelled conventions have been rescheduled, demand for security products and data storage devices has risen, and in New York “Broadway theaters have noted some pickup in attendance,” the report said.

As the Fed said in its report, we are likely in recession.  In my view and that of many experts I read, the recession likely started in June or July of this year.  Recessions typically last two to three quarters.  If we are in a typical recession, we are more than half way through it and recovery might begin as early as the first quarter of next year.  But, many would argue, this is unlikely a typical recession.  In the past two years we have experienced economic forces that are not typical, such as Y2K, the dot com mania, the Internet bubble, and terrorism in our homeland.

As I have said before, it is difficult or impossible to assess the risks of terrorism to the economy and markets, but not so the other events just mentioned.  In my opinion, the markets have sufficiently discounted the other economic factors.  Tom Galvin, Chief Equity Strategist at Credit Suisse First Boston, explains the cycle this way:

“A classic paradigm of economics is that businesses in purely competitive industries can expect high marginal profitability to attract additional competitors. Competition applies pressure to produce more efficiently, but can often result in declining margins in the short term when demand weakens and marginal competitors price aggressively in order to gain share. In the long run, however, the marginal players go out of business, capital is allocated more efficiently, and pricing becomes less irrational. Margin pressure is relieved, creating an opportunity for survivors. The 1990s rise in initial public offerings that provided capital to unprofitable business models has taken its toll on everyone’s margins, as demand has slowed in the past year. S&P Industrial after-tax margins fell from their peak of 7% in the third quarter of 2000 to 4% in 2Q01. The silver lining of the recent rise in bankruptcy filings is that they should result in less competition, more rational capital allocation, and healthier market pricing, thereby improving the prospective margin picture.“

At the bottom of recessions, economically sensitive companies’ earnings reach their lowest point.  The demand slowdown associated with the 1990-91 recession saw margins fall nearly 50%.  Between the second quarter of 2000 and the second quarter of this year, S&P margins have contracted 40%.  Following the 1982 and 1991 domestic recessions, profits bounced 19% and 12%, respectively.

Buying companies’ stocks whose profit margins are in their troughs (such as technology consumer cyclicals, basic materials, and capital goods) has proven very profitable historically, especially compared to buying those companies whose earnings were rising during the same period (such as healthcare and consumer non-cyclical).  A study done by CSFB illustrates that 12 months following the margin trough in the fourth quarter of 1991, the groups that faced substantial margin contraction appreciated on average by 17% compared with an 8% move for those whose margins expanded.

That’s more complicated than I wanted to get.  In short, now is a great time to buy!  I believe the economy is at or near its bottom.  The market, in my view, has discounted all the ‘normal’ risks.  Barring significant terrorist events (difficult or impossible to assess), the market will anticipate economic recovery by early spring.