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Sunday, 28 September 2008

Looking Past the Crisis

ByDavid Sterman, Interim Portfolio Manager

If you take a quick snapshot of key economic indicators, you'll see that there is obviously plenty of reason for concern. But a more liquid banking system, falling energy prices and the sheer resilience of the U.S. consumer could set the stage for the next upturn to begin in 2009.

It's an old investing axiom that the market looks six to nine months ahead, so the timing of an economic bottom and eventual turnaround is likely to dominate market discussions in coming weeks and months. Let's take a closer look at the current headwinds and possible eventual tailwinds.

* Technology/semiconductors: Book-to-bill for semiconductors fell to just 0.83 in August 2008, down 37% from August 2007. Flat-panel TVs, GPS devices and iPods were key demand drivers for tech and chips in recent weeks. Those segments have matured, and it's hard to spot the next hot trend. Consumer PC technology is no longer making radical leaps, and consumers are upgrading only when their current systems wear out.

Silver lining: The weak book-to-bill figure could set the stage for lower inventories and firmer prices. And the weak demand environment is fueling rising losses for the smaller niche players; that should finally lead to industry consolidation and also keep the door closed to new tech IPOs.

That creates a little running room for the larger, better-capitalized tech names. Still-strong balance sheets will likely lead to more share buybacks. Valuations are also firmly in check: Tech bellwether Intel trades just above its five-year low.

* Small and medium-sized businesses are having an increasingly hard time securing loans while banks are stressed. These firms are typically the backbone of new job creation, and their cautious stance is likely to keep their employees (who are also consumers) fearful and tight-fisted as well.

Moreover, any small and medium-sized firms that saw a boost in exports due to the plunging dollar could see reduced foreign demand now that the dollar is strengthening. That could explain why capacity utilization figures appear to be softening.

Silver lining: These companies have stayed lean, with a tight lid on head count and inventories, so massive further retrenchment is unlikely, and signs of an upturn could fuel an inventory rebuild in 2009.

* Retail:The upcoming holiday season is likely to be disappointing. Trouble is, many retailers make almost all of their profits in the fourth quarter, so full-year losses appear likely for a growing number of players. Analysts have yet to write off the fourth quarter, and downward estimate revisions appear increasingly likely. Retailer distress could have an ancillary negative impact on mall-based REITs.

Silver lining: The Darwinian nature of retail can provide a solid boost for the survivors. For example, Pier One is poised to eventually boost sales now that Bombay, a key rival, is out of business. In a similar vein, Bed Bath & Beyond is not heartbroken over the implosion of Linens 'n Things.

* Airlines and autos: Weakening business and consumer confidence implies continued sales weakness in the near term for these two industries. Airlines are entering into the seasonally weakest point of the year, so the demand trends are likely to remain uninspiring for the rest of the year, at least.

The domestic auto makers are scrambling to keep up with Toyota and Honda in terms of fuel efficiency. Whether GM and Ford Motor can turn a profit on smaller, fuel-efficient vehicles is also a challenge, especially in the context of high prices for raw materials such as steel.

Silver lining: Both industries have taken a huge amount of costs out of their operations and can now turn a profit at far lower levels of demand -- when that demand re-materializes. Also, $100 oil is a lot less painful than $140 oil, and the moribund global economy implies that we are unlikely to see another demand-driven spike any time soon.

As I've noted in the past, small-cap stocks are often the best way to play a resurgent economy. That may explain why the Russell 2000 has held its own in the recent turmoil.

Is it time to assume that the economy will be on the mend in 2009? No one can answer that. Serious hurdles remain. Interest rates are my biggest concern. Although inflation appears to now be in check, the rising budget deficits and persistently high trade deficits may make it hard to keep a lid on interest rates.

However, if interest rates stay at low current levels, then you should look past the near-term headwinds, as I suggested recently.

2 comments:

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