Saturday, 20 October 2007

Black Monday 2.0?

By now you've probably read a dozen articles chronicling the meltdown in stock markets 20 years ago yesterday. Whilst the Dow Jones industrial (INDU) average had it's biggest fall on Friday for a while, the 2.6% drop pales in comparison to the more than 22% drop 20 years ago.

That 22% drop on October 19th 1987 occurred on a Monday, the preceding Friday, a sell-off had begun. So what does yesterday's sell-off signal for the coming Monday? Nothing, I'm just screwing with people's minds.

Apparently in the US markets on Friday investors got spooked by earnings. In particular, Caterpillar, Wachovia, 3M and Honeywell.

Caterpillar (CAT) posted 3Q07 earnings growth of 21% and stated that:

"We continue to see remarkable growth outside of the United States with particular strength in key industries like mining, oil and gas, electric power and marine engines,"
So why did the shares fall almost 5%? For one thing the company dropped their forecast earnings for 2007 to between $5.20 - $5.60 per share from $5.30 - $5.80 previously. However the comments by the company probably had more impact stating that they didn't see any improvement in 2008, warning that the economy will

"grow well below potential" at 1.5%, even lagging the current year. "Our outlook reflects U.S. housing, nonresidential contracting and quarrying declining further," "For the major U.S. machinery end markets, only coal mining shows a reasonable possibility of improvement from 2007." Furthermore, the Federal Reserve's move to cuts interest rates has not "removed all financial market stresses," Caterpillar said, adding that it expects another rate cut this year.

For some reason analysts were surprised by this. You see it doesn't jibe with their goldilocks scenario that sees moderate earnings growth for the remainder of this year and then accelerating again into 2008 on the back of a strengthening US economy and strong global growth.

Wachovia (WB) missed analysts expectations of $1.03 per share for 3Q07 coming in at $0.89 per share. In line with other banks they hiked their provisions for loan losses considerably (almost fourfold from a year earlier) to $408 million.

Despite posting slightly better than expected earnings and raising their FY07 earnings forecast 3M's (MMM) shares were hit hard because of concerns over declining margins in the flat-screen television business.

Amazingly it seems people are surprised that flat screen TV's are going to get cheaper and that as a consequence, operating margins for companies like 3M who make the optical film used in liquid-crystal displays are going to shrink. Go figure?

Then there was Honeywell (HON) which posted 14% earnings growth for the third quarter and upped their FY07 earnings forecast. However margin concerns plagued the stock ending down almost 4% on the day.

On the surface, none of these results are disastrous, even despite Wachovia's earnings decline and rising bad debts, their underlying banking business is performing solidly. However, there are a few themes emerging from these earnings reports, that I have been nattering on about for a while, that market analysts have been seemingly oblivious to.

Firstly margin erosion. Company profit margins are at historic highs and as history tells us they will eventually revert to more normalized levels. Thus earnings projections based on current profitability levels are fraught with danger.

Secondly in the financial sector, certain business segments that have enjoyed huge growth in recent years, such as the RMBS market, have not only dried up but as Citigroup's chief financial officer Gary Crittenden, said earlier in the week,

"Many parts of the fixed-income market and many types of investment vehicles such as CDOs have shrunk dramatically, and we're not optimistic that they will regain a foothold in the market."

Even the big players that made billions out of this industry are doubting that these market segments will return to anything like previous levels.

Thirdly, despite the mantra repeated by analysts that housing is only 5% of the economy, it is clear that the slump in residential investment is having an effect on the wider economy as highlighted by CAT's outlook for the domestic US economy.

Following on from that point the current robust commercial real estate market is showing signs of weakness as expressed by the likes of Honeywell and again Caterpillar.

Most of these points still seem to be lost on analysts. Forecasts show they still expect double digit earnings growth for the S&P 500 in 2008. One of the few analysts that seems to be in touch with these realities is Michael Metz, chief investment strategist at Oppenheimer holdings.

In an interview on Bloomberg, Metz cautioned that credit market problems have not been resolved, that housing remains a major problem which will spill over into commercial real estate and that corporate profit margins have peaked calling double digit earnings growth expectations for 2008 "completely unrealistic." Click on the image below to listen to the interview.