Stocks Will Continue to Erode In This Busted Economy

by: Alan Brochstein November 24, 2008 | about stocks: AAPL / ABT / AMGN / AVZ / BAC / COP / CSCO / CVX / FL / GE / GLD / GOOG / HPQ / IBM / INTC / JNJ / JPM / KO / MCD / MRK / MSFT / ORCL / PEP / PFE / PG / PM / T / TBL / WFC / WMT / WSM / XOM    

Alan Brochstein

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As a warning to the reader, my attendance at a Metallica concert a few days ago may be contributing to the extreme angst I am feeling. The concert, by the way, was really great, especially for my son and his friends. While some of the lyrics are downright depressing ("waiting for the day that never comes", "growing darkness taking dawn"), truthfully, I couldn't really hear them.

I feel like the guy who had the winning lottery ticket but lost it. I was as bearish as one could be late last year and early this year, but I succumbed way too early to the bottom-guessing game. Despite the horrific market, I was doing all right through the end of September.

October and November, however, have spared very few stocks: Nowhere to hide. So I was right, then I was wrong. Being wrong is OK, but staying wrong isn't, so I am struggling with how to look forward in an environment that appears to be very different than any of us has ever experienced. It is extremely important that we separate our emotions from logic at times like this and not try to find some pattern from past history to attempt to address these unique circumstances.

I have seen so many articles discussing whether this economic crisis is going to be as bad as the Great Depression (mainly ones that say no), but very few questioning whether it could be worse. It could.

Will it? I don't know, and none of us does, but one can't just assume that it won't. Yes we have a lot of safety nets, but, due to the fact that they are provided by a heavily indebted entity itself, they may not be as secure as one might think.

As you might conclude after reading my recent discussion of GM, the problems we face are bigger than our government. Our Financials and many other companies are so leveraged (tons of debt compared to equity) that investors are rapidly beginning to fear that the bondholders are really not likely to get paid in full. This is becoming a self-fulfilling prophecy as investors scramble for cash, eroding asset values in that process. The debt burden exists on all levels - the individual, companies and local, state and federal governments. And beyond our borders.

Stocks are getting pounded for lots of reasons. Many believe the massive decline is a function of an imminent decline in earnings (or loss generation), which is part of the story. Another important part, though, is that stocks are easily sold. One of their greatest attributes, their liquidity, is becoming one of their greatest liabilities.

It's not just stocks. Have you seen what is going on in the world of art? Despite the big rally, Friday, gold, the traditional safe haven, has been in decline. Almost every single commodity is in free-fall as well. Commercial Real Estate is in a hard to document crash due to the lack of transactions, but the evidence is clear in the decapitation of the CMBS market and the incredible erosion in REIT valuations.

None of this is news, and one can easily dismiss these observations as being "priced in", perhaps even "overpriced in". I am not short and hope that I am wrong, but I think that this march towards zero will continue for quite some time. I would like to see the market move from such an oversold position so that I could incorporate my views into my own investment strategy and feel more confident about the odds, but that seems to be a universal hope. A client of mine suggested that it is "too late to sell", but is it?

For stocks not to get worse, something has to break the downward spiral of deflation. At the individual level, consumers are in a real jam in aggregate. As unemployment increases, disposable income will go down. As credit continues to contract and as individuals begin to start or to increase their rate of savings and pay down debt, consumption will continue to go down.

This process is rather new, and one should not expect that years and years of overconsumption can be quickly fixed. In turn, this puts pressure on government (lower sales tax, income tax, property tax) and on the corporation.

Corporations are moving to conserve cash. Ones with challenged balance sheets will need to sell equity to meet future debt obligations, as they can't count on earnings. Other companies have begun to suspend share repurchases (not all, but several), and I expect that more will do so.

Yes, falling prices should induce more repurchases, but not in a deflating economy. Why not keep that cash to acquire one's stock or that of another company later? Dividends are being and will continue to be sliced. The cycle is vicious and will take a lot of time to resolve. We have moved WAY beyond this being a housing problem.

With credit contracting for individuals, stocks lose their appeal as an investment. With diminished credit, one has to have CASH to pay for automobiles, college education or other big ticket items. This year we learned that even "cash" is not cash (the auction rate securities).

Bonds, too, are rapidly losing their allure as credit deteriorates. As the crisis deepens, we should expect to see significant defaults in the municipal market. With T-Bills yielding essentially zero, clearly cash is already at a premium. The government has had to increase the protections for other types of cash, like bank deposits or even money-market funds. Can it back-stop all investments?

Looking at corporate balance sheets and valuations, one would think that there is absolutely no connection any longer. Why are so many smaller companies trading at significant discounts to their tangible equity? What is the market saying?

Traditionally, there have been investors, whether mutual funds or private equity investors that would buy these companies trading at such deep value. I am not talking about microcaps - but rather companies with significant brand value like Foot Locker (FL), Williams-Sonoma (WSM) or Timberland (TBL).

Where is Warren? Oh yeah, buried in Goldman Sachs (GS) and General Electric (GE). With so many smaller companies dropping towards or below tangible book value, is it unreasonable to assume that the market ultimately can't "afford" to support larger companies at this type of valuation?

I believe that part of the reason is that investors are beginning to realize that assets carry hidden liabilities. Falling prices mean inventory is worth less. Rising debt defaults mean receivables aren't as collectable. Falling values also mean property, plant and equipment might not be worth as much as the balance sheet implies. The debt is the debt, but the assets aren't really what they appear.

Looking at some of the largest companies, I am worried about the downside if they trend towards tangible book value. First, many of these companies have been acquisitive over the years and have a lot of goodwill and intangibles, which makes that "real" equity number even lower. Second, the premiums are still pretty high:

These are all of the S&P 500 companies with market cap in excess of $50 billion, (click on chart to enlarge) ranked by market cap. These 28 companies make up 43% of the value of the S&P 500. I included a column called "leverage", which is Assets divided by Equity. The higher that ratio, the more obligations or liabilities the company has.

I would expect that high leverage and a high valuation relative to tangible book would suggest challenges ahead. The median valuation is almost 4X (and 3X book value), while the presence of several companies with negative tangible equity reduces the average significantly. If we are in for a period of falling tangible equity (losses) and difficulty repaying debt due to a lack of capital, clearly these companies could fall significantly.

The government will be trying to extinguish fires on multiple fronts for some time. There are so many companies that are "too big to fail" that the government will be expending significant resources restructuring these entities.

Next, it will be propping up municipalites and states, who will experience falling sales tax and be fighting with consumers over property taxes. Then, the consumer himself will be counting on the benevolent uncle in so many ways: Fix my mortgage, pay me unemployment benefits, give me a tax break.

All of this adds up potentially to federal debt like we have never seen before. I expect to see a massive transfer of wealth from the wealthy to the indebted via either inflation or confiscatory wealth taxes. Yes, ultimately, our government may choose to tax savings or assets (property taxes) in order to encourage spending. In an environment of high taxes, inflation and possibly even wealth taxes, stocks could be a very dangerous place to be.

As I said before, I hope I am wrong. I have tried to remove the emotion from the argument and to extrapolate the current facts as I understand them. If you are bullish, I think you need to have a good answer to the following question: Who will buy the stocks and why will they part with cash to do so? Why buy a stock, when you can buy debt at such a steep discount?

Debt is rapidly becoming the "new equity", with significant price appreciation potential. I certainly can see a big rally in the near-term, maybe even over the balance of the year. One contributing factor could be reallocation by pension funds, who have seen their equity exposures drop as a percentage of their overall holdings. Absent that dynamic, the market is moving away from the long-successful mantra of "buy the dip" to "sell any rally". One of my clients is "averaging out" of the market, and I can't blame him. Yes, it can get worse.

Disclosure:  Long CSCO and TBL, and CVX, CSCO and TBL are members of one or more of my model portfolios.

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This article has 16 comments:

  •  
    Nov 24 02:46 AM
    thanks, but pretty sure it can always get worse.
    Reply | Link to Comment
  •  
    Nov 24 03:47 AM
    Alan, welcome to our group. i have looked at what i have written in the last 6 months, and it is mostly negative economically. this bothers me as my style is to look for ways to make every bad situation good. things cannot be as bad as i see them. i keep looking for a piece of data that is positive, that would provide a road map out of this maelstrom. maybe i will see one tomorrow - i can only hope.
    Reply | Link to Comment
  •  
    Nov 24 04:15 AM
    Just thought I would point out that your book value for Apple is incorrect. How can their "tangible book value" be 3.6 when Apple currently trades at only 3.007 times its cash position. Apple has 24.5 billion in cash, and no debt. Unless their real estate holdings have negative value, then your book value is understated. Apple is probably trading closer to 2.2 times its book value right now.
    Reply | Link to Comment
  •  
    Nov 24 04:18 AM
    Adding to my comment above, I could understand how this can be overlooked. Sites such as yahoo finance sometimes incorrectly state their variables. This can be result of lag time in updating the variables. Apple was trading at about 3.5 times their book value when they were trading closer to $110.00.
    Reply | Link to Comment
  •  
    Nov 24 06:50 AM
    Andy, you are correct about the cash being $24.5 billion, but the book value (or common equity) is actually less: $21 billion. How? Equity is Assets less Liabilities. Total assets for AAPL are $39.6 billion (cash plus inventory, receivables, etc.). Total liabilities are $18.5 billion roughly ($14 billion short-term, which includes payables and $4+ billion long-term). With a market capitalization of $73 billion, the ratio is 3.5.

    Reply | Link to Comment
  •  
    Nov 24 09:37 AM
    U WISH U STUPD SHORT
    Reply | Link to Comment
  •  
    Nov 24 09:55 AM
    Nice to see you're paying attention, Andy.
    I just wanted to point out that it appears is too late for the aapl short trend: we have seen dozens of articles advising shorting aapl in the last two weeks, which meant that that directional trend would likeley see a reverse based on the popularization of the strategy.
    Today we the the opposite trend being rechristened by the usual suspects:
    biz.yahoo.com/ap/08112...
    It looks to me like aaple is going to settlle at a higher price range, around 90, until January. Unless ofcourse this is not the end of the beginning.
    Reply | Link to Comment
  •  
    Nov 24 10:42 AM
    RE: "I included a column called "leverage", which is Assets divided by Equity. The higher that ratio, the more obligations or liabilities the company has."

    =====================
    Your concept of "leverage" is distorted. Apple has $25 BILLION in cash and $ZERO debt. How can it, in fact, be "leveraged"?
    Reply | Link to Comment
  •  
    Nov 24 11:17 AM
    I have learned that "cash" isn't always "cash", as sometimes it is spoken for. In the case of software companies, they book sales with large up-front cash before they are actually able to book the revenue (deferred revenue). Honestly, I am not sure why AAPL has so many liabilities - they aren't listed on my balance sheet in the normal detail. The FACT is that while they have a ton of cash, they also have a ton of liabilities. If you are an AAPL investor, you should be aware, so why don't you explain?

    AAPL is on the list solely because it has a high market cap. If you notice, the leverage is among the lowest of all the companies. You will also note that AAPL has a relatively low P/TB. Instead of thinking that I am picking on AAPL, which I assume you do, you should take comfort in its relatively better position. Leverage in general ranges from a mathematical low of 1.0 to sometimes astronomical levels (though negative equity can lead to negative numbers). So, to answer your point, AAPL does have low leverage, but it does have significant liabilities nonetheless.
    Reply | Link to Comment
  •  
    Nov 24 12:42 PM
    thanks for weighing in, Mr. Zaky. overall this is a good article, if grim. added to the list, we'll see major insurance companies, already shored up by the fed through medicare, saying it will need help to cover the rising cost of taking care of old people, since they're previous models didn't have us all living so long.
    consumers will give up a lot of things...places to eat will feel it pretty hard...but we're hooked on technology, especially our cellphones and smartphones, partly because they help us feel that we're not so alone and, especially in tough time, that's a comfort. i think Apple will do well over the holidays. i mentor zoo volunteer teens and they ALL want iPhones or the Touch for the holidays. not one is pining for Android or, dare i mention it, Zune. it's the App store and cheap entertainment, once you buy the iPhone and contract.
    then once they get the gift, they'll be in the Apple store in January. the King of Prussia store is still doing a booming business, even in a constantly slow mall. February is a long way away, except we'll have a change in the white house by then. Hopefully, it'll help.
    Reply | Link to Comment
  •  
    Nov 24 02:45 PM
    Are you blind? I disclosed at the end longs only and said in the article that I am long. I remain long in my heart and my ass just not my brain. I was hopeful that maybe someone would have a stronger criticism than yours.

    The market is extremely oversold, like never before. My contribution wasn't a suggestion to go and sell today but rather that we should open our mind that "the" bottom may just lie further off in the future and lower than we might ordinarily expect.




    On Nov 24 09:37 AM DonSuper wrote:

    > U WISH U STUPD SHORT
    Reply | Link to Comment
  •  
    Nov 24 03:57 PM
    Nothing like reading an overly pessimistic forecast, then watch the market jump 400+ points. You would not qualify to be my investment advisor.
    Reply | Link to Comment
  •  
    Nov 24 04:14 PM
    I am long and I didn't say that the next move is down the drain, just that I can more clearly see a rationale for this move continuing for some time. I am not an investment advisor, but you wouldn't qualify to be my client if I were due to your irrational expectations about the necessity or ability to predict the very short-term.
    Reply | Link to Comment
  •  
    Nov 25 01:49 AM
    Alan,

    Nice piece.. well stated.

    This financial decline is very likely to persist for substantially longer than many realize yet. Many equities with less than strong balance sheets may decline precipitously from here even. As we languish in this long slow period, consumer spending will dry up for most discretionary items. That hits AAPL in the solar plexus.
    Reply | Link to Comment
  •  
    Nov 25 05:20 PM
    You said, "Why buy a stock, when you can buy debt at such a steep discount?" Could you please explain specifically what debt one can buy at a steep discount .... do you mean that one could be shorting the stock instead of buying it?
    Reply | Link to Comment
  •  
    Nov 25 05:40 PM
    NWC, I offer the example of GM bonds trading at 14 cents on the dollar. While it is extreme, corporate bonds in general have been pounded. When a bond's price falls, it becomes more equity-like. At 100 (par value), a bond-holder to maturity already knows the most that they can make (the interest payments plus the return of principal). Hypothetically, if a bond investor buys a new issue that goes belly up the next day, he could be out 100% of his investment. The most he would have ever made is the interest. That is a pretty bad risk/reward scenario (though the odds would typically be very low that the investor would lose everything and so quickly, though there is that risk).

    When the bond price tanks, the risk/reward ratio changes - the holder now has upside (like the equity investor). Since technically the bond holder has additional downside protection in the event that there is a bankruptcy (equity investor wiped out before bond investor loses a penny of principal or interest), you can probably appreciate that scenarios exist, especially in distressed situations, where the bond becomes superior to stocks. In the case of GM, why would you buy equity at any price if you could buy debt trading at 14 cents on the dollar? While GM stock could "double" or "triple" in a "good" scenario, the bond would probably do even better. The answer is complex, but I believe that it has to do with how one values an option (being long GM is a way out of the money option, but volatility is high and expiration is way out there) and the potential for the reorganization to not wipe out equity holders if it happens. As corporate bonds have become cheaper, stocks have discounted this phenomenon. As long as pressure remains on corporate bonds, there should be pressure on stocks as well.

    So, I am not sure I am answering your question exactly as you expect, but yes, sometimes it makes sense to buy deep discounted debt and hedge it by shorting the stock. In a broader sense
    Reply | Link to Comment
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