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Jubak's Journal
Recent articles:
• 10 microcaps for macro profits, 10/28/2003
• The threat of the job-is-worth-less recovery, 10/24/2003
• Why 'bad' news may help stocks, 10/23/2003
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| | Jubak's Journal
5 market shockers lurking in the shadows
Some scares, investors have learned to expect. But these 5 scariest scenarios haven't even raised a goose bump on Wall Street yet.
By Jim Jubak
Boo!
Next time some ghost or goblin jumps out of the shadows at you, think about what Halloween teaches us about investing.
Nothing is truly scary unless its unexpected.
Thats how the financial markets operate. Events that are highly anticipated fail to move the markets much because they arent surprising. In fact, theyre often completely priced into the market. Investors have had time to hedge their bets, to move to the sidelines, to take out one kind of insurance or another. The 8-year-old skeleton that cant help giggling gives an approaching adult so much warning that the victim has to pretend to be scared.
Right now, I think the market is pricing in a long list of possible scares: A 10% (or more) correction because valuations are so high and sentiment so bullish; weaker economic growth in the fourth quarter; a move by the Federal Reserve to raise interest rates in the first half of 2004; continued weakness in the dollar as budget and trade deficits mount; an escalation of the violence in Iraq to a true guerrilla war and even the possibility of another terrorist attack on U.S. soil.
But what about the stuff thats got real potential to put the fright in the market because its not on anybodys radar screen? Not outlandish stuff -- like a comet striking Earth or cold fusion turning out to be a cheap, practical energy source or Wall Street analysts suddenly deciding to deduct options from their earnings estimates for technology stocks. Rather, Im talking about events that could take place this year that dont yet have a place on the Wall Street consensus list of worries.
Heres my Halloween countdown of financial fright, a list of the top five really scary things that could move the stock and bond markets in the next 12 months.
Counting down:
Something goes wrong in the Middle East; energy prices spike hard
Its almost a certainty that something will go wrong in the Middle East in the next 12 months. None of the regions huge problems from Israel to Iran look anywhere near even a temporary solution. And anything that puts a crimp in world oil supply would come at a time when the United States, Europe, and Japan are all trying to produce sustainable economic recoveries.
A hike in oil prices would certainly put a twist in Wall Streets shorts, too, because the consensus assumes energy prices will fall in the months ahead. But despite its high surprise value, this possibility ranks far down my Halloween countdown of financial fright because anything short of a shut down in oil production in Saudi Arabia, Iran or a couple of the major Persian Gulf states wouldnt be enough to send oil prices higher at a time when OPEC (Organization of Petroleum Exporting Countries) is trying to enforce lower production quotas. And even that kind of event, given the current global surplus in oil supply, would probably have to come at a time that by chance coincides with trouble at a big oil producer outside the region. Such as No. 4 in my countdown.
Russian economy stalls; robber barons bring down Putin
Last weekends arrest at gunpoint of Mikhail Khdorkovsky, the president of Yokos, Russias largest oil company and the countrys richest man, was a reminder that the war between the Russian government and the business oligarchs who control much of the economy isnt over.
President Vladimir Putins government only last week announced plans to investigate and possibly revoke oil development licenses held by Yokos and foreign oil companies such as Exxon Mobil (XOM, news, msgs) and Royal Dutch/Shell (RD, news, msgs). The arrest seems to be a reaction to Khdorkovskys recent heavy spending and active lobbying for opposition candidates in Parliament in the run-up to the December parliamentary and the March presidential elections.
The danger is that a return to open warfare between the government and the business oligarchs would damage the economy enough to send Russias credit rating tumbling again. And that could ripple out through the bond markets as lenders scrambled to dump or hedge large positions in Russian debt. The last time that happened, the Federal Reserve had to step in to guarantee the liquidity of the markets. And remember that Russia is now the worlds largest exporter of oil.
The Fed cant safely deflate the fixed-income bubble
The Federal Reserve's press release after its Oct. 28 Open Market Committee meeting certainly reassured the stock market. The Committee believes that policy accommodation can be maintained for a considerable period, or, in plainer English, the Fed will keep short-term interest rates at current low levels for quite a while yet.
But that guarantee that interest rates will stay low is also an invitation to financial speculation in the bond market. Speculators can borrow money at something close to the current 1% federal funds rate and buy 10-year Treasury bonds that yield 4.29% without worrying that Alan Greenspan and Co. will do anything in the near future to drive down the price of those bonds.
Its a license to print money, and the more an investor borrows -- the more a portfolio is leveraged -- the greater the potential profit. See the nasty surprise ahead? So how does the Fed cool down this speculation without driving up interest rates and hurting a still-fragile recovery? And if the Fed cant dampen speculation, the inevitable unwinding of these leveraged positions could produce some nasty surprises.
The recovery turns out to be a bust
If you told Wall Street that economic growth next year would be below the 6% projected for the third quarter of 2003, no one would be particularly surprised.
Just about everyone expects growth to slow next year. Most forecasts range from a pessimistic 2.5% to an optimistic 4.5% for the first half of the year. But no one really is expecting growth to actually stop. Thats a nightmare not even on Wall Streets list of bad dreams. But it is still a real possibility. Overall capacity utilization -- the percentage of potential capacity thats actually in use -- remains stubbornly low at 74.7% in September. Thats not so far above the 74.1% in June that marked a 20-year-low.
Some worrying signs in the September economic numbers suggested that the stimulative effects of the Bush tax cuts and the mortgage refinancing boom had just about run their course. And because job growth has been so slow to pick up, I think consumers are feeling a bit shaky right now. That makes consumer confidence and sentiment potentially volatile. The odds of the economy stalling are relatively low. Lower than for the fright that Ive ranked at No. 3, for instance. But I think those lower odds are more than offset by the potential power of this surprise. If the economy stalled, the consensus opinion on Wall Street would be genuinely shocked.
The Chinese financial system implodes
I put this No. 1 because, on current evidence, its not farfetched and because everyone from Wall Street to Main Street is focused on the problems created by Chinas startling economic success. Because the Chinese economy is growing so fast and because the Chinese have slapped stringent controls on the export of profits out of the country, China is awash in cash. Too much cash.
According to the Financial Times, Chinese banks had $520 billion more in deposits at the end of 2002 than they could lend. Chinese banks have never been models of lending -- too many loans have always gone out the door to questionable-but-politically-connected businesses or to technically bankrupt state-owned enterprises -- but recently the banks have been pressing money on any borrower still breathing.
In response, the Chinese central bank has begun to try to tighten monetary policy. On Sept. 1, the central bank moved to require banks to keep 7% of capital in reserve instead of 6%. Financial history suggests that tightening by a central bank when the money supply has run away like it has in China is extremely tricky. As our own Federal Reserve knows, its tough to deflate a bubble. The result is much more frequently a loud and surprising pop.
Dont let any of my five frights drive you to a cave or over a cliff. The odds are that none of them will actually come to pass by Halloween 2004. But its just because theyre unlikely events that they have such potential power over the financial markets. And because they have such potential power, its good to include them, as low probability events, in your financial thinking.
And if you cant think outside the box at Halloween, when creatures are rising from their tombs and prying open the lids of long-buried coffins, when can you?
New developments on past columns
10 microcaps for macro profits
My mistake. In my due diligence for to pick the microcap stocks for my final list of 10, I concentrated on the business internals of these companies and didnt check recent news events as thoroughly as I should have. So Silent Witness (SILW, news, msgs) wound up on my list because everything about its business looked great to me. And to Honeywell International (HON, news, msgs) too, it seems. On Oct. 10, that company announced an all-cash deal to buy Silent Witness for $8.53 a share. That certainly caps the potential gains in Silent Witness, which recently traded at $8.57 a share, unless another, higher bid emerges. The stock is not a buy at this price, in my opinion. I regret the error.
3 stocks to navigate a tricky quarter
Good news and bad news out of the Oct. 21 earnings report for HCA (HCA, news, msgs), the countrys largest hospital chain. First, the company reported earnings of 60 cents a share, excluding a one-time gain, for the third quarter. That was well above the 38 cents earned in the third quarter of 2002 but those numbers included about 22 cents a share in one-time losses on the companys insurance portfolio and in costs related to a federal investigation into Medicare overcharges. The company also lowered earnings estimates for all of 2003 to $2.56 to $2.60 a share (Wall Street consensus was $2.80 a share) and for 2004 to $2.85 to $2.95 a share (consensus was $3.06). The good news? The stock dropped just 5% on the news over the next two days and then started to rebound. To me, thats an indication that investors were pretty much prepared for HCA to cut its forecasts, even if Wall Street analysts were, and that value investors picked up shares on the dip. As of Oct. 31, Im keeping my target price of $54 a share by September 2004.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control positions in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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