bizzXceleration: Performance, Value and Profit

Markets Realities

Is Market Rally the Real Deal? After a rough start to the year, the Dow Jones Industrial Average has surged close to 11% since March 10. It is down just 8.3% from October's record, a lot stronger than many expected. People like Eric Bjorgen of Leuthold Group, a money-management and research firm in Minneapolis, are wondering whether this rally is something they can invest in for the medium term or just a bear-market bounce that will soon fade. To figure that out, Mr. Bjorgen looked at 10 past stock recoveries. He wanted to know what kinds of stocks usually are strong when the market recovers from serious trouble, and whether those groups are leading today. He discovered some anomalies. Stalwart P/E Shows Stocks Getting Pricey

• Buffett, Trichet: No End in Sight to Market Woes The end to the credit crunch is still not in sight, European Central Bank President, Jean-Claude Trichet and Warren Buffett, the world's most famous stock market investor, warned on Monday.
• Stock Volatility in U.S. Falls to 10-Month Low as Bets on a Rebound Rise

Investors Chase Poor Fundamentals The S&P 500 currently trades at 22.9 times trailing net earnings, but these earnings are somewhat depressed and not representative of normal long-term earnings power. What is more important is that the S&P 500 presently trades at over 20 times normalized earnings (sustainable earnings at normal profit margins). More friendly price/earnings multiples on the basis of “forward operating earnings” or even price-to-peak-earnings are had only on the assumption of a remarkable earnings rebound in the second-half, or a permanent return to the record-high profit margins of recent years. This is a lot like a kid imagining, once airborne on the bike, that a foam pit will suddenly appear to break the impending fall. As of last week, valuations remained unfavorable for stocks. Meanwhile, however, market action continued to hover near the point where speculation could begin to feed on itself. The behavior of trading volume and leadership remains relatively uninspiring, but some popular moving averages have been crossed (such as the 200-day moving average of the S&P 500), which has fed some amount of technical buying. In short, the fundamentals continue to appear very poor, but market action is at something of a crossroads. The reality is that as recessions develop (and I continue to believe the U.S. faces a much more significant downturn than we've observed to date), the data can take months to accumulate to a compelling verdict, and in the meantime, speculative pressures can remain alive.

Oil Companies Threatened by Rising Costs Mask S&P 500's 26% Profit Decline Take away Exxon Mobil Corp., Chevron Corp. and ConocoPhillips and profits at U.S. companies are the worst in at least a decade. Without the $70 billion that oil producers earned in the last two quarters, profits at companies in the Standard & Poor's 500 Index tumbled 26 percent and 30.2 percent, the biggest decreases for any quarter since Bloomberg started compiling data in 1998. Energy companies made up almost half the income growth reported by S&P 500 companies in the first three months of 2008 as oil prices surged past $100 per barrel, the data show. The results leave the benchmark for American equities vulnerable to declines as oil companies' costs balloon and production slips, according to Bank of America Corp., Charles Schwab Corp. and Allianz Global Investors. The industry is getting less profit from a barrel of oil than at any time since 2005, just as the rest of the U.S. economy is sputtering. Still, energy shares posted the S&P 500's steepest gains in the past year, bloating their representation to 15 percent of the index. The divergence in the earnings of oil companies from the rest of corporate America indicates that the S&P 500's two-month, 12 percent rally may not be sustainable… U.S. economic growth ground to a halt in the second quarter, according to economists' estimates compiled by Bloomberg. The last time the U.S. gross domestic product didn't increase was in 2001, during the last recession. S&P 500 index sectors' earnings and stock growth

Credit Morphology

Credit Crisis May Extend Beyond 2009 as Writedowns Grow, Oppenheimer Says The U.S. credit crisis will extend into and even beyond 2009 as banks will write off more than $170 billion of additional reserves by the end of next year, according to Oppenheimer & Co. estimates. ``The real harrowing days of the credit crisis are still in front of us and will prove more widespread in effect than anything yet seen,'' analysts led by Meredith Whitney wrote in a research note today. ``Just as strained liquidity pushed so many small and mid-sized specialty finance companies to beyond the brink, we believe it will do the same with the U.S. consumer.'' Whitney, together with Kaimon Chung and Joseph Mack, cut earnings estimates for U.S. banks ``significantly'' due to ``strained liquidity resulting from shut down in the securitization market'' and on expectations that banks may take provisions of $88 billion in 2008 and $96 billion in 2009. Banks have become reliant on securitization markets to fund consumer lending, Whitney said. With that market shut down in the wake of the credit crunch, banks will struggle to match the funding from their own balance sheets, she added. That will remove about $3 trillion of liquidity from capital markets by the end of the year, and banks' losses will worsen as consumers will be unable to repay debt with fresh loans, she added.

Banks Hide $35 Billion in Writedowns From Income Statements, Filings Show Banks and securities firms, reeling from record losses resulting from the collapse of the mortgage securities market, are failing to acknowledge in their income statements at least $35 billion of additional writedowns included in their balance sheets, regulatory filings show. The balance-sheet adjustments are in addition to $344 billion of writedowns and credit losses already reported on the income statements of more than 100 banks. These companies have raised $263 billion from sovereign wealth funds, their own governments and public investors to shore up capital. The balance-sheet writedowns also reduce equity, which needs to be replenished. Adding the $35 billion leaves the banks with a $116 billion mountain of losses to climb. ``The smart people are the ones who've identified the problems, put them out there in full transparency, and addressed them by raising more capital,'' said Michael Holland, who oversees more than $4 billion as chairman of Holland & Co. in New York. ``There is still billions of dollars of crap out there that hasn't worked itself through the system. Banks need more capital to work that all out.'' Banks Hide and Additional $35 billion in Writedowns

Moody's Stock Suffers Record Plunge on Rating Error Shares of Moody's Corp (NYSE:MCO - News) fell more than 13 percent on Wednesday, the biggest one-day drop since becoming an independent company in 2000, after the rating agency said a computer snafu resulted in incorrect top ratings for complex debt. The Financial Times first reported a coding error resulted in wrong "Aaa" ratings for debt known as Constant Proportion Debt Obligations, known as CPDOs. Moody's shares fell over 13 percent to $37.95 in the largest one-day drop in the stock since it was spun off from Dun & Bradstreet in 2000. A Moody's spokesman in New York said the rating agency is "conducting a thorough review" of its rating methods for European CPDOs specifically, due to the computer glitch. The review of its computer coding does not extend to subprime mortgage debt, collateralized debt obligations or corporate bonds, Moody's said. "Moody's is simply telling the truth slowly, and there's more truth to be told," said Janet Tavakoli, a consultant and president of Tavakoli Structured Finance in Chicago. "Up until now I thought the rating agencies were incompetent rookies in structured products," Tavakoli said. "Now I'm suspicious that they may be crooked."

AAA Express Leaves Municipal-Bond Investors in Dark The question of whether rating municipal bonds on a scale of their own is a scam or not has been percolating in the market now for more than a year. The argument is a simple one and was spelled out in a March 4 letter signed by 15 state and local officials to Moody's Investors Service, Standard & Poor's Corp. and Fitch Ratings. ``State and local governments almost never default on the bonds they issue,'' said the letter. Raise everyone's rating. Now the analysts have weighed in -- as well they might. If everyone, or almost everyone, is rated AAA, why do you need a bunch of analysts? What possible function do they serve? And why do you need three rating companies? The comment is more than simply self-serving, though, and raises a couple of good points. Perhaps the best is the one of timeliness. State and local economies are lagging indicators. The housing collapse, the resulting swoon in property taxes, and the massive layoffs we have seen in financial services are just beginning to tell in Muniland. Maybe, say the analysts, this isn't the best time to see rating standards weakened.

Hedge Funds in Swaps Facing Peril With Fourfold Rise in Junk Bond Defaults CDSs, which were devised by J.P. Morgan & Co. bankers in the early 1990s to hedge their loan risks, now constitute a sprawling, rapidly growing market that includes contracts protecting $62 trillion in debt. The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb. ``The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets,'' Fed Chairman Ben S. Bernanke told Congress on April 2. ``It could also have cast doubt on the financial positions of some of Bear Stearns's thousands of counterparties.''  Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002. On May 7, Moody's wrote that as the economy weakened, high-yield-debt defaults by companies worldwide would increase fourfold in one year to 6.1 percent by April 2009. The pressure is building. On May 5, for example, Tropicana Entertainment LLC filed for bankruptcy after the casino owner defaulted on $1.32 billion in debt. A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader and author of ``Credit Derivatives: CDOs & Structured Credit Products'' (Wiley Finance, 2005). ``This is going to complicate the financial crisis,'' Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default - - this requires proving which bond or loan holders weren't paid -- and the amount of payments due. ``It's going to become extremely messy,'' he says. ``I'm really scared this is going to freeze up the financial system.'' Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it's only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.

Inflation & Dollar

TIPS Show Bond Market Sees Bubble Bursting for Commodity-Driven Inflation Treasury bond traders are telling Americans to stop fretting about inflation. Consumers expect prices to rise 5.2 percent in the next 12 months, according to a monthly survey by the University of Michigan in Ann Arbor, the most pessimistic they've been since 1982. Treasury Inflation Protected Securities, or TIPS, show traders anticipate inflation of about 2.9 percent by January, in line with its average of 3.1 percent the last 20 years. The disparity has never been wider. While consumers grapple with gasoline above $3.70 a gallon, record rice prices and the escalating cost of wheat, TIPS say the commodities market is a bubble about to burst. A commodity slump would worsen losses in the $500 billion TIPS market, where investors lost 2.35 percent in April, the most since December 2006. ``The consumers are more right'' than TIPS traders, said James Evans, who manages $4 billion of inflation-linked bonds at Brown Brothers Harriman & Co. in New York. ``TIPS breakevens have continuously underestimated inflation.'' Evans has been buying TIPS maturing in three to five years. Regular Treasuries are also pointing to a slowdown in price gains. In the last six months, yields on 10-year notes traded below the inflation rate for the first time since 1980. Over the past two decades, yields averaged 2.87 percentage points more than inflation.

Dollar Bind: Gulf Rethinks Currency Ties Last year, Kuwait decided to break from its neighbors and fix its dinar to a basket of currencies.There are good reasons for the Gulf Cooperation Council countries -- Saudi Arabia, the U.A.E., Bahrain, Kuwait, Oman and Qatar -- to move away from the dollar. Inflation is high and getting higher in the region: almost 10% in Saudi Arabia, close to 15% in the U.A.E. and 9% in Kuwait.A stronger currency tends to help fight inflation by making imported goods cheaper. A weak currency does the reverse, and the Gulf countries have tied themselves to the weak dollar. Stronger local currencies could help quiet the Indians, Pakistanis, Filipinos and other imported labor that does the heavy lifting from Kuwait to Oman. They have hit the streets in a couple of Gulf nations to protest rising food costs and the falling value of the dollar-linked salaries they send home to their families. Already, the U.A.E. has frozen prices for bread, rice and other staples.

Argentines Rush to Buy Dollars Barely six years after Argentina committed the biggest sovereign-debt default in history and devalued its currency, locals and Wall Street investors are asking an unsettling question: Is it about to happen again? The short answer appears to be: It doesn't have to happen, but it might. With nearly $50 billion of foreign reserves and one of Latin America's fastest growth rates, Argentina has an array of options to keep its currency stable and meet financing needs in the coming years.Nonetheless, troubling signs of financial panic have appeared. Middle-class Argentines are rushing to cash out savings accounts to buy dollars, a sign they think the government is in big trouble and the currency will plunge. Wary that the rush for dollars would become a full-scale run on the banks, the central bank spent nearly $1 billion to defend the peso in the past two weeks.

Analysis

Finding the Way in Rough Seas Call it the year of the newcomer. More than half of the winners in The Wall Street Journal's 16th annual Best on the Street analysts survey are appearing in the rankings for the first time.What they have in common is that in a turbulent year for the stock market, they made recommendations that would have made investors money -- or allowed them to lose less than they would have otherwise. In this unsettled environment, the top analysts managed to navigate the markets to find stocks that outperformed, even for part of the year, and others that were best to avoid. "Original anticipatory thinking" is among the most important attributes for a research analyst, says Candace Browning, president of global research at Merrill Lynch & Co. "Price anomalies do create opportunities, and you need to jump on those quickly."Some of the best calls last year were sell recommendations, especially in the hard-hit financial and housing-related sectors. Goldman's Ms. Conigliaro says there was greater collaboration than in the past among analysts covering a specific sector and between analysts and big-picture market strategists. She says her firm is using more rigorous models for choosing stocks, geared toward finding companies with the ability to generate returns that exceed the average for the rest of the industry, or the entire market.In years past, fundamental analysis was thought of as "companies first and stocks second," says Margaret Mager, a former Goldman Sachs analyst who resigned early this year to run a retail consulting firm, and a Best on the Street winner for her picks in the clothing and accessories sector in 2007. Now, she says, analysts "cover stocks first and companies second."  See the top five stock pickers in each industry and a ranking of research houses, from the Best on the Street report.