March 2003
Mostly Cloudy
| "Isn't it interesting that the same people who laugh at science fiction listen to weather forecasts and economists? " |
| -- Kelvin Throop III |
HEN THE BEAR MARKET FIRST began, companies complained of a "lack of visibility". Presumably this meant they were unable to see with any certainty what their coming profit picture would look like. Three years into the bear market, the entire economy is clouded by the prospect of war.
Stocks marked time in the first two months of the year. Volume was relatively low and few investment strategies worked. Everyone, it seems, was waiting for a resolution with Iraq.
Now, market strategists are looking to the past to see how the market might react should Gulf War II become a reality. Most agree that 
uncertainty rather than war itself is worse for the market. Indeed, share prices tend to fall in anticipation and then rise when conflicts actually break out.
That's exactly what happened in Gulf War I when the S&P 500 fell 16% between August 2, 1990 when Iraq invaded Kuwait, and mid-October when the U.S. military build-up began. Stocks were up 12% a month after Desert Storm began.
A popular belief on the street is that as in the autumn of 1990, investors spent January and February discounting the prospect of war. Many also believe that the actual commencement of Gulf War II will send stocks soaring as they did in 1991. If only the clouds of war would part, the outlook would be so much brighter.
More on the Horizon
But is Iraq the only cloud on the horizon? Is that all that's holding the economy back? And what happens after a Gulf War, even a short one?Some investors saw these other clouds, that's why they practically ignored fourth quarter earnings reports. By mid-February with over 80% of the S&P 500 companies reporting, earnings were up 10% year-over-year yet share prices were still falling.
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 Source: Baseline Since emerging from recession last year, quarterly GDP has moved ahead, but not smoothly. Interestingly, it was also choppy coming out of the 1990 recession after Gulf War I. |
Yes, maybe they did they see some clouds -- if not smoke and mirrors. After all, the comparable quarter a year ago was effectively reduced to two months by the terrorist attack, not a hard measure to beat. In addition, even companies meeting or exceeding analysts' estimates for 2002's fourth quarter offered lukewarm projections for the year ahead. Was that really due to Iraq and al Qaeda?
Most concerning was the way in which businesses grew earnings. Those same companies that saw a 10% earnings increase only enjoyed a 4% increase in revenues. If the top line was growing less than half as fast as the bottom, the difference must have come from cost cutting. That's OK for the short-term, but at some point you run out of costs to cut. No wonder so many companies were still downbeat about 2003.
From that standpoint, the recovery is still pretty cloudy, even without the threat of war or terrorist attack. Throw in those and the turnaround grows even more questionable.
Crude oil and especially gasoline have already risen in anticipation of war. Even if Gulf War II is as short as Gulf War I, the oil supply will certainly be subject to disruption. A longer engagement will only prolong the problem.
Unfortunately, even with our "allies" joining in, Gulf War II definitely has the potential to drag on. The actual hostilities may last only a few weeks, but the objective today, to remove Mr. Hussein from power, is much more ambitious than Gulf War I when the allies only had to run an out manned Iraqi army out of Kuwait.
Even if his defense is quickly routed, Mr. Hussein won't be surrendering his sword in a sunny field or signing any accord in a train car. No, just like fellow terrorist Osama bin Laden, he'll be hard to track down. It's quite possible that with the failing commitment from our so-called allies, it will fall on the U.S. to occupy Iraq until a new regime can be put in place. How long will Iran enjoy being our neighbor?
By late February, crude oil was already up 18% since January 1st. Unleaded gasoline jumped 16%, pushing prices at the pump over $2 a gallon in California. Should these prices persist for a prolonged period of time, the tentative economic recovery could be in jeopardy.
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 Source: Baseline The PPI was negative last year, stirring fears of deflation. The past four months saw increases, with January up more than expected. Even if the year ends with PPI up around 2.3% as predicted this will be a positive sign, indicating a possible reawakening of production. |
Economists, however, don't seem overly concerned by this possibility. Although January PPI was up a surprising 1.9%, Decision Economics, Inc. still sees only a modest increase for the entire year, ~2.3%. They evidently don't see a storm brewing in the oil patch.
Gold bugs have been able to keep their favorite yellow metal above the $300/oz level. Nevertheless, despite climbing over 34% in the past two years, only 2% of that gain has come since January 1st. Gold has traditionally been the "antistock", a place of safe haven when equities are volatile, yet recently it's been susceptible to profit taking as the Iraq situation drones on.
Going Nowhere
Aside from gold, investors have also been using Treasury securities as a safe haven. Even though yields are near 40-year lows and inflation is once again stirring, the Treasury yield curve has remained virtually unchanged for the past three months. The spread with high quality corporate bonds has also held steady suggesting that investors are still not willing to accept corporates' higher risk for potentially greater yields.|
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 Source: Baseline The Treasury yield curves have been virtually unchanged for the past three months. Many economists had predicted they would be moving up by now, but few foresaw the current international tensions. |
This wouldn't normally be the case. When inflation heats up, bond investors usually demand higher yields as compensation for the increased risk. When that happens, the yield curve drifts upward.
Also as rates begin to rise (and the economy recovers), bond investors often shift from Treasury securities into corporates with the same maturities. This allows them to pick up some additional yield with little additional risk as the spread with Treasuries compresses.
So why isn't this going on now? The general consensus is that the fear of war and the resulting flight to quality has kept Treasury prices high. Rates could indeed begin to drift up, but that won't happen until those clouds part over Iraq.
Of course interest rates may not be moving because the economic recovery is so sluggish or perhaps even stalled. Think back to those gloomy outlooks given by companies when reporting fourth quarter earnings: Did they signal a sharp economic upturn? Probably not.
And if inflationary pressures really are temporary stemming mainly from the war premium in oil, doesn't that mean economic activity is still tepid? Probably so.
Sure it would be nice to put an end to the confrontation with Iraq and the other terrorists. There's no question the uncertainty of the current geopolitical situation is weighing on the stock market, yet there's no guarantee that an easing of tensions would start the next bull rally.
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 Source: A-T Financial Ever since the tensions started building with Iraq, the Dow Industrials have been range bound. While there have been a number of short-lived rallies and sell offs, the average has remained in a tight range. Investors are understandably reluctant to make a commitment -- one way or the other. |
Geopolitical uncertainty provides a handy excuse for companies with weak returns, but it's improving fundamentals from sustainable operations that ultimately drives share prices. This is as clear as a bell regardless of whatever clouds surround Iraq.
Share prices are now back near their October 2002 lows, offering selective investors -- especially long-term investors -- a buying opportunity. The emphasis here is on "selective" since not all stocks (or industries, or sectors) are out of the dark.
Stocks may still have more to fall before making a sustainable move up, but even in this cloudy environment it's easy to see that those with solid fundamentals and improving top lines offer the best opportunities. Even a quick resolution in Iraq may not be enough to help the others.
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