Bulls Keeping the Faith (At Least So Far)

According to Bloomberg, in “Bulls Load Up on Stocks in Worst Rout Since 2002 ,” optimistic investors are undeterred. In general, bond markets downturns precede stock market declines, since equity market investors need to be convinced that the signals from the credit markets are valid. In my youth, the lag was usually four months. And the “Greenspan put” conditioned investors to buy on dips, so we have nearly a generation of investors that have yet to see a credit-driven contraction.

The Journal, by contrast, in “Analysts Debate If Bull Market Has Peaked,” suggested that professionals are deeply divided on the prospects for equities.

The prospects for the stock market hinge on the bond markets. If liquidity returns to the fixed income world, the bulls will be proven correct. But if conditions continue to be uncertain or deteriorating, expect equities to take a toll.

From Bloomberg:

The biggest losses in equity and credit markets in five years are making the U.S. stock bulls more bullish.

The Dow Jones Industrial Average posted its steepest gain since 2003 on July 12, two days after tumbling on Standard & Poor’s plan to cut credit ratings for bonds backed by subprime mortgages. The benchmark for America’s biggest companies climbed to a record the next week, following a decline sparked by losses in Bear Stearns Cos. hedge funds. Some of the world’s largest investors say the S&P 500’s biggest slump since September 2002 last week now offers them even more opportunities to profit.

“You look at earnings, you look at ongoing takeovers, and I’m happy to increase holdings as valuations improve,” said Andy Brough, who helps oversee $7.6 billion at London-based Schroder Investment Management Ltd. “You make money buying shares when markets are falling, and that is what I’ve been doing.”

Money managers say the 4 1/2-year bull market remains intact, even after stocks around the world lost about $2.1 trillion of market value last week, according to data compiled by Bloomberg. Equities are even more of a buy because profits are growing, shares remain cheap compared with earnings and the Federal Reserve isn’t restricting credit, according to fund managers at Schroder, ABN Amro Asset Management, BlackRock Inc. and JPMorgan Private Bank.

Junk Bonds

Stocks tumbled around the world last week on concern higher borrowing costs will slow takeovers, spur defaults and curb earnings. The Dow average fell 4.2 percent to close at 13,265.47. The S&P 500 dropped 4.9 percent to 1458.95. The Dow Jones Stoxx 600 Index in Europe lost 5.1 percent to 372.69, the largest decline since March.

The Stoxx 600 rose 0.3 percent as of 9:18 a.m. in London today. September futures on both the Dow average and S&P 500 added 0.6 percent.

The extra yield investors demand to own U.S. high-yield corporate bonds rather than Treasuries is rising at the fastest pace in five years, according to Merrill Lynch & Co. data. Spreads on bonds rated below Baa3 by Moody’s Investors Service and BBB- at S&P widened 91 basis points last week, or 0.91 percentage point, the most since June 2002, when they surged 109 basis points.

`Extreme Volatility’

The risk of owning corporate debt in the U.S. and Europe has also risen amid concern the slump in securities backed by mortgages to people with poor or limited credit will spread across bond and equity markets. Credit-default swaps based on $10 million of debt in the CDX North America Investment Grade Index rose last week to $81,250, the highest since the index was created in 2004, according to prices compiled by Frankfurt-based Deutsche Bank AG.

Investors are shunning bonds and loans needed to fund leveraged buyouts. About $690 billion of the debt-fuelled takeovers supported this year’s stock rally. Cadbury Schweppes Plc, the world’s largest candy maker, on July 27 became the first company to delay an acquisition because of “extreme volatility” in debt markets.

“This whole subprime issue is of course not positive,” said Astrid Smit, head of investment strategy at ABN Amro, which oversees $260 billion. “But the fundamentals still look good. If you sell equities, what are you going to buy? In the current environment, it is still the preferred asset class to own.”

Smit said some of ABN Amro’s funds were using the pullback to reduce cash holdings and buy stocks. The company is a unit of Amsterdam-based ABN Amro Holding NV, the biggest Dutch bank.

`Heads Taken Off’

Jim Paulsen, who helps oversee $175 billion at Wells Capital Management, is buying shares of financial companies, the worst performing industry in the S&P 500 this year. The S&P 500 Financials Index has plunged 7.4 percent this month, poised for its biggest monthly decline since September 2002.

“The market has chronically wanted to produce a crisis,” said Paulsen, the chief investment strategist at Minneapolis- based Wells. “When you’re seeing financial stocks getting their heads taken off, it’s hard to step in. But there’s a possibility of a good return over the six- to nine-month horizon.”

Bear Stearns, down 24 percent this year, and Lehman Brothers Holdings Inc., which fell 18 percent, helped pace the decline in U.S. stocks on July 10 after S&P said it was preparing to lower ratings on billions of dollars in bonds backed by subprime home loans. The New York-based investment banks are the biggest underwriters of mortgage-backed bonds.

Economic Growth

The S&P 500 and Dow average rebounded the next day as Fed officials said the economy will weather the worst housing slump since 1991. The Dow posted its biggest gain since 2003 on July 12, rising 283.86 points, or 2.1 percent, as economists increased forecasts for second-quarter growth after a government report showed exports climbed to a record in May. Europe’s Stoxx 600 Index also rallied.

“People have taken their eyes off the good news, the fact that the economy seems to be poised to reaccelerate, that earnings have been much better than expected,” said Jack Caffrey, the New York-based equity strategist at JPMorgan Private Bank, which has more than $300 billion in client assets. “This has been something of a gift. You have the chance to buy at particularly low valuations.”

The Commerce Department said on July 27 that the U.S. economy grew at a 3.4 percent annual rate last quarter, the fastest pace in more than a year.

Booming Growth

Better-than-expected profits from Armonk, New York-based International Business Machines Corp., the world’s largest computer-services company, helped propel the Dow average above 14,000 for the first time on July 19, a day after losses at two Bear Stearns hedge funds sent the 30-stock gauge down as much as 1.1 percent. European stocks also advanced after earnings from Walldorf, Germany-based SAP AG, the world’s biggest maker of business management software, beat analysts’ estimates.

Robert Doll, who oversees $1.2 trillion as chief investment officer of global equities at BlackRock in Plainsboro, New Jersey, said some of his funds bought shares of energy producers as the market declined last week.

“Global growth continues to boom,” said Doll, who predicts the S&P 500 will rise another 6.2 percent this year. “The building blocks for this bull market are still there.”

The S&P 500, the benchmark for American equity, is up 2.9 percent this year and the Dow industrials gained 6.4 percent. The Stoxx 600 index advanced 2 percent.

Stocks recovered even more quickly on July 25 from declines sparked by the credit markets. A rally in energy shares and earnings that beat analysts’ estimates from Seattle-based Amazon.com Inc., the world’s biggest online retailer, helped the S&P 500 and Dow average rebound and close higher.

Deal Troubles

Benchmark indexes fell earlier that day after banks hired by New York-based Kohlberg Kravis Roberts & Co. failed to sell loans they provided to finance the $22 billion buyout of Nottingham-based Alliance Boots Plc, the U.K.’s biggest pharmacy chain.

More than 40 companies worldwide have reworked or abandoned debt offerings in the past month. Banks are holding at least $32 billion of loans from buyouts they haven’t been able to sell to investors, restricting funds for new deals.

“As some of these sectors get beaten up it gives you an opportunity,” said Robert Schumacher, who helps manage $135 billion as chief investment strategist at Van Kampen Investments in Oakbrook Terrace, Illinois. He expects the S&P 500 to climb as much as 20 percent in the next 12 months. “This isn’t a systemic problem that the economy can’t overcome.”

`Selling Opportunity’

Investors will face a more volatile market as the sell-off has accentuated price swings. The Chicago Board Options Exchange Volatility Index, derived from the prices paid for options on the S&P 500, climbed July 27 to the highest since April 2003.

Turmoil in credit markets foreshadowed stock declines in the past 20 years. Spreads widened on average six months before European shares reached highs in 1987, 1991, 1998 and 2000, according to Morgan Stanley. Stock market peaks were followed by declines of at least 10 percent in the Morgan Stanley Capital International Europe Index, according to a July 16 report by the New York-based company, the world’s second-largest securities firm by market value.

“We take no comfort from the fact that equity markets have been resilient in the face of deteriorating fundamentals,” Morgan Stanley strategists in London wrote. When the market “does not react to bad news it is a selling opportunity,” the analysts said in the report.

`Warning Sign’

U.S. stocks have also declined following “spikes” in high-yield corporate bond spreads, according to Bespoke Investment Group LLC, a research firm in Harrison, New York. A rise of more than 20 percent in spreads over an average of 103 trading days preceded drops of at least 2.8 percent in the S&P 500 six times since January 1997.

“It’s a warning sign,” said Quincy Krosby, who helps oversee about $330 billion as chief investment strategist at The Hartford in Hartford, Connecticut. “The very initial worry that says, `Take cover’ will show up in the spreads.”

Shares fell the most when price-earnings multiples were high, according to Bespoke’s calculations. The S&P 500 had a multiple of 48.8 when it plunged 23 percent in the seven months ending October 2002 as spreads on bonds with ratings below investment grade widened by 367 basis points. The S&P 500 traded for 27.8 times historical earnings when it slipped 2.9 percent in the almost seven months ended October 1998 as yield premiums widened 407 basis points.

Low Valuations

The S&P 500 is now valued at 15.4 times estimated profit, the lowest since January 1991 when compared with actual earnings, according to Bloomberg data. That’s one reason why any slide in U.S. stocks may be limited, Bespoke wrote in a note on July 24.

Those valuations, coupled with steady Fed interest rates since June 2006, are enough to make stocks a buy, said Walter “Bucky” Hellwig of Morgan Asset Management. The turmoil in the credit market is allowing him to add to holdings in technology, energy, and raw-material shares at cheaper prices.

“In a perverse sense, the widening of these spreads in conjunction with rising earnings makes the stock market more attractive,” said Hellwig, who helps oversee $30 billion in Birmingham, Alabama. “Interest rates are still low, inflation is still low, and there still is global growth and equities are becoming more attractive.”

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