Are You Ready for the ‘R’ Word?


 This isn't exactly how we like to start the year.

With the Dow Jones Industrial Average off more than 5 percent, it's the worst opening since 1991. We shouldn't lose hope, though. Despite its rocky start in 1991, the Dow ended that year up 20 percent, and the Nasdaq rose 56 percent, according to MSN Money.

We're not predicting that will happen here, but it does suggest that a poor start doesn't necessarily mean we'll end the year that way.

Additional economic data and corporate write-downs are making investors increasingly nervous that we may be heading toward a recession. American Express announced it was "seeing more delinquencies and less activity from consumers, and was reserving $400 million to cover potential losses."

At the high end of the consumer market, Tiffany "cut the top end of its profit forecast because of weak holiday sales," according to The Wall Street Journal. And The New York Times reported that "Merrill Lynch is expected to suffer $15 billion in losses stemming from soured mortgage investments, almost double its original estimate, prompting the firm to raise additional capital from an outside investor."

In our capitalistic society, we can expect the economy to ebb and flow. We will have periods of strong growth and periods of slower growth or even contraction. It's human nature to toggle between unbridled optimism (i.e., the late 1990s) and unwarranted pessimism at the other extreme (i.e., the early 2000s.)

The government does its best to help smooth these extremes, and just a week ago, President Bush announced a governmental stimulus plan that investors may welcome.

As advisers, it's our job to monitor the situation, make adjustments as we deem necessary, and always try to maintain the appropriate perspective. We try to do that through thick and thin markets.

Are we headed toward a recession? According to the Associated Press, an increasing number of economists now say the odds of slipping into a recession are near 50-50. Investment bank Goldman Sachs boldly predicted that we'll enter into a recession in the second quarter of this year, according to a Reuters report.

Whether that occurs this year or next, the reality is, economic ups and downs are a natural part of the business cycle. When optimism reigns and the economy is heating up, we typically see rapid growth with demand outpacing supply, prices increasing and inflation rising.

Conversely, when pessimism reigns and the economy is slowing, we typically see a pullback in consumer spending, rising unemployment and lower corporate profits.

If there's an upside to recessions, it's that they may help eliminate excessive exuberance, establish reasonable valuations and, often, create opportunities to purchase sound companies at a reasonable price.

Technically, an organization called the National Bureau of Economic Research is responsible for dating business-cycle turning points and determining recessions. According to the NBER, the current expansion began in November 2001. That means we've enjoyed more than six years of expansion.

The prior expansion lasted from March 1991 to March 2001, a 10-year period, which was the longest on record.

On a positive note, contractions tend to be far shorter than expansions. According to the NBER, the average contraction since 1945 has been about 10 months long, while the average expansion has been about 57 months.

Only time will tell where we land this year.

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Trying to get a handle on today's stock market is like trying to hit a knuckleball.

For those of you not into baseball, a knuckleball is thrown by the pitcher with no spin. It floats to the batter on a cushion of air, and at the last instant darts up or down, to one side or the other. Essentially, neither the pitcher, the catcher nor the batter has a clue as to the ultimate direction it might take. What could be truer in today's stock-market environment?

At the beginning of the year, we are inundated with financial prognosticators giving us their view on where the market is headed. So, with all this talk of recession, you wonder where the hits will be coming.

When gathering information from the prognosticators, it helps to know where they are coming from: top-down or bottom-up analysts, fundamentalists or market technicians, investors or speculators?

The top-down crowd starts their analysis from a global view. They look at GDP growth at home and abroad, impacts from inflation and interest rates, productivity and, equally as important, the geopolitical climate. The focus then narrows to particular sectors of the economy or particular countries that represent the best opportunities.

A bottom-up analyst wants to put a value on the business as a going concern. What is it worth if broken up and sold? How strong is the balance sheet? How strong is its core business? Does it generate above-average profits, allowing it to have a competitive advantage in its marketplace? And how will it perform in the coming economic environment?

A bottom-up investor is just as likely to select stocks without going through the complexities of the top-down modeling, since he or she is putting a value on it based upon its operating successes, now and in the future.

A fundamentals analyst looks at a business' financial statements, paying attention to debt-equity ratios, cash flow and dividend payments. This study also will take in market analysis and the firm's competitive advantages, in addition to its competitors and management.

In the end, the value of a stock to a fundamental investor can be summed up as the present value (price to pay) for the discounted future value of all projected cash flows.

A technical analyst, on the other hand, is focused on market action and price movement using charts to forecast price trends. A technician believes that the actual price behavior of the market or the investment instrument can be used to forecast future prices since, in his view, the price represents all relevant factors.

Stock traders (speculators) are more likely to be technicians than fundamentalists. Investors are more likely to depend on fundamentals than price movements on a chart. So who has it right?

Consider a few tidbits from the financial press. The S&P 500 was up 9.2 percent YTD (total return) through July 20, 2007, closing at 1534. The headline in Barron's over that weekend stated, "It's Still Time to Buy," forecasting an additional 6 percent rise to 1625 by Dec. 31.

Instead, the stock index fell 4.3 percent to finish 2007 at 1468. The S&P 500 is an unmanaged index of 500 widely held stocks generally considered representative of the U.S. stock market.

As of Labor Day 2007, the S&P 500 had closed the previous week at 1474. Barron's asked eight equity strategists to predict where the S&P 500 would finish the calendar year. Seven of the eight saw a rising stock market by year-end with one prognosticator foreseeing a Dec. 31 value of 1700.

Only Tom McManus (Bank of America Securities) forecasted a falling market, predicting a 1465 stock index value on Dec. 31. The S&P 500 actually finished the year at 1468.

Michael L. Schwartz, RFC, CFS, CSA is a wealth manager and investment advisory representative of NEXT Financial Group, Inc. E-mail him at: [email protected]



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