October 10, 2024

Fundamentally: Credit Downgrades Can Be Poor Predictors — Fundamentally

THOUGH Wall Street is worried that the European debt crisis will worsen, the stock market barely budged when Standard Poor’s downgraded the credit ratings of several euro zone nations — in the process stripping France, Austria and the euro zone’s primary rescue fund of their AAA standing.

In fact, the Morgan Stanley Capital International Europe index and the Standard Poor’s 500 index of domestic stocks both rose in the days immediately after the news.

Surprised? Don’t be. Historically, credit downgrades have been a lousy predictor of stock market performance.

When Moody’s downgraded Japan in November 1998, for example, Japanese shares surged by more than 26 percent in the subsequent 12 months. When Canada lost its AAA credit rating in 1992, its equities gained 30 percent in the next year. And since the United States was taken down a notch by S. P. last August, the S. P. 500 has gained more than 9 percent.

This is not to say credit downgrades are a buy signal. It’s just that analysts at the major rating agencies are reacting to the same news and information that the rest of the market has already seen. So downgrades are really a lagging indicator, says Jeffrey Kleintop, chief market strategist at LPL Financial.

“With little move in the stock or bond market on the news of the downgrades, it is clear that markets had already made the credit adjustments and are now recognizing improvement” in the region, he says.

MARKET watchers note that while the rating agencies’ views carry weight, they merely represent one opinion among many on Wall Street. “I don’t see why their voices should be louder than the rest of the voices in the wilderness,” says James W. Paulsen, chief investment strategist at Wells Capital Management.

Indeed, when S. P. downgraded United States’ credit rating last year to AA+ from AAA, conventional wisdom said the move should make investors wary of Treasury debt, which in turn would push up the yield on 10-year Treasuries. Yet since the downgrade was announced on Aug. 5, the yield on 10-year Treasuries has actually fallen to 2.03 percent from 2.56 percent, a sign that global investors still view United States government debt as a haven.

Mr. Paulsen likens downgrades to interest rate moves by the Federal Reserve. “By the time the Fed officially raises rates, the market will have fully discounted it,” he says.

So instead of taking cues from the rating agencies, how should investors try to gauge the European crisis?

Mr. Paulsen says he prefers to rely on market indicators to judge whether angst over Europe is growing or shrinking. Among them are the performance of cyclical sectors of the economy versus defensive ones, and the so-called junk spread — the difference in yields between risky high-yield bonds and safe Treasuries. Both indicators speak to the level of fear in the market.

Since last summer, the consumer discretionary sector (companies that make things households want, not need) has returned more than 13 percent, versus 8 percent for the more conservative consumer-staples sector. At the same time, the junk spread has narrowed modestly, which speaks to a growing sense in the market that even if Europe slips into recession, its effect on the domestic recovery will be modest.

Robert C. Doll, chief equity strategist at the investment manager BlackRock, says the simplest thing that investors can do is pay attention to European bond yields, especially those for debt issued by troubled nations like Italy.

On the day S. P. downgraded Italy by two notches, to BBB+ from A, 10-year Italian bonds were paying 6.64 percent. Today, it’s 6. 34 percent.

Simon Hallett, chief investment officer at the asset management firm Harding Loevner, says the real issue “is about the health of companies in the region, not the health of the countries.”

And, on that count, the consensus among market analysts is reasonably positive. Despite growing fears that several countries in that region are in or near a recession, companies in the S. P. 350 Europe index are still expected to enjoy earnings growth of nearly 10 percent this year, says Christine Short, senior manager at S. P. Capital IQ .

Not only is that up from the 1 percent overall earnings growth that European companies had last year, it compares favorably with the 8 percent profit growth projected for domestic companies.

Of course, those are just estimates. And they’re likely to change as the year progresses, so it’s good to pay attention to them. They may be more important than those tarnished credit ratings.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Article source: http://feeds.nytimes.com/click.phdo?i=60941bb2b87179e3812fad01c939af08

Fundamentally: Companies Are Spending on Dividends if Not Jobs

“People keep repeating it as if it were a mantra: ‘Companies refuse to hire; companies refuse to spend,’ ” says James W. Paulsen, chief investment strategist at Wells Capital Management.

But this criticism isn’t quite right, Mr. Paulsen says.

It’s certainly true that most businesses haven’t been willing to expand payrolls significantly in the last two years, says Richard Weiss, head of asset allocation strategies at American Century Investments. “But there’s cash being used in less visible ways,” he adds.

To be sure, this type of spending — from dividend increases to corporate acquisitions — may not be enough to pull the economy out of its rough patch. But at least “it indicates that companies are more confident in the economic recovery” than some might think, says Brian G. Belski, chief investment strategist at Oppenheimer Company.

In June, manufacturing and trade sales rose more than 12 percent from June 2010, according to the most recent Census Bureau data. Stripping out petroleum products, whose value was recently inflated by high oil prices, this is still the highest level for business sales in more than five years.

And some companies aren’t just continuing to pay dividends despite the sluggish economy — they are increasing them. (Monsanto and General Mills are just two examples.) This is something that investors didn’t see in the 2008 downturn.

So far this year, there have been 241 dividend increases or initiations among Standard Poor’s 500 companies, versus only three dividend cuts, according to Howard Silverblatt, S. P.’s senior index analyst.

Collectively, those moves have increased payments to shareholders by nearly $29 billion, he says. That’s more than double the amount of dividend increases that S. P. 500 companies delivered in the first eight months of last year and is a reversal from the $41 billion in dividend cuts made from January to August 2009.

“The bottom line is that dividends are doing extremely well,” Mr. Silverblatt says.

Investors with dividend-paying stocks have also fared relatively well. While most types of equities are down this year on recession fears, dividend-paying stocks have held up far better than average. PowerShares Dividend Achievers, an exchange-traded fund that invests in stocks that have bolstered their annual payouts for at least 10 consecutive years, has lost 3.7 percent year to date, versus a 9.5 percent loss for the S. P. 500.

Strategists say companies seem comfortable returning profits to shareholders because of stronger-than-expected earnings and all the cash on their balance sheets. S. P. 500 companies are sitting on $1.13 trillion in cash and short-term investments — two-thirds more than they had heading into the recession in 2007, according to Capital IQ.

In a slow-growth economy, this cash also gives companies the flexibility to increase revenue and profit growth through mergers and acquisitions, says Richard Peterson, a director at S. P.’s valuation and risk strategies unit. He notes that domestic companies are on track to post their first year of $1 trillion or more in deal activity since 2006.

What’s more, the third quarter is on track to be the busiest period for mergers and acquisitions since the spring of 2007, Mr. Peterson says. About halfway in, some $194 billion in M. A. deals have been announced, versus $269.8 billion in the full second quarter.

“Despite what’s transpired in the markets in the past several weeks,” he says, “there are very few signs of a pause in activity.” Just last week, Google announced a planned $12.5 billion acquisition of the mobile phone maker Motorola Mobility.

Mr. Peterson says the trend is likely to continue, not only because of companies’ cash on hand, but also because investment-grade corporations can still borrow cheaply in the bond market, thanks to strong demand for high-quality bonds.

Duncan W. Richardson, chief equity investment officer at Eaton Vance , says that “this is very different than 2008,” as companies are in much better shape today.

As for job creation, Mr. Richardson says it always tends to come in the later stages of an economic expansion. But he says that “if investors wait on the sidelines for the job situation to pick up dramatically, they’ll probably be jumping in too late” to make any money.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Article source: http://feeds.nytimes.com/click.phdo?i=408b9067b941582d127d4c03cabbcb3a