Debt-Spat Aftermath Whacks Stocks

By KOPIN TAN AND VITO J. RACANELLI | MORE ARTICLES BY AUTHOR

The debt-ceiling deal is done, but the investor jitters it sparked are not―and Europe's own debt woes aren't helping.

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Vital Signs

Washington's debilitating squabble over the nation's debt ceiling may have ended, but the damage done to investor confidence helped drive stocks down more than 10% from their recent April peak, and to a conventional definition of a correction. The kicker: Late Friday Standard & Poor's downgraded the U.S. credit rating to double-A plus from the triple-A rating it had for 70 years.

Capitol Hill and the White House had some help in undermining confidence from Europe, where bond yields in Italy and Spain climbed to decade highs as investors fled the government debt of those countries for the perceived safe harbors of gold, Swiss francs, and the Canadian and Australian dollars.

Stateside, lawmakers clinched a last-minute deal to raise our $14.3 trillion debt ceiling so Uncle Sam can keep borrowing enough to pay his bills and avoid a default. But while the $2.4 trillion in spending cuts proposed by Congress are heavily back-end-loaded―most won't kick in until after 2017―that noisy show of government belt-tightening is unnerving a market still heavily reliant on government benevolence.

It didn't help that economic momentum seems to be slowing. Last week's ISM nonmanufacturing survey showed the service sector, which drives three-quarters of our economy, decelerating in July. Particularly alarming was the decline in export orders to a reading of 49 in July from 57 in June, which reinforced fears that the global economy is stalling as China tightens credit and Europe cuts spending.

Then on Friday, there was some good news. U.S. nonfarm payrolls data showed a gain of 117,000 jobs, better than expected, while the unemployment rate dipped to 9.1% last month from 9.2% in June, the Labor Department reported.

Still, the specter of slowing global growth drove investors toward Treasuries, despite the threat of a credit-rating downgrade sometime during the next few months. The yield on 10-year U.S. notes last week fell below 2.5% at one point Thursday, and is down sharply from 3.74% as recently as February. The Standard & Poor's 500 dividend yield, at 2.13%, is the closest it's been to the Treasury rate in quite a while.

The Dow Jones Industrial Average ended last week down almost 700 points, or 5.8%, to 11,444.61. The S&P 500 had its third loss in four weeks and fell 93 points, or 7.2%, to 1199.38. It marked the worst weekly loss in almost three years for the benchmark, which has pulled back 12% from its late-April peak. The Nasdaq Composite Index fell 8% to 2532.

At one point last week, the Dow had fallen for eight straight days before its rout was interrupted, briefly and barely, by a shallow 0.3% rebound Wednesday. Stocks are oversold and due for at least a technical bounce. But the selling momentum―last week's trading volume was among this year's heaviest―also means rallies might draw more sellers.

Ironically, the masses railing against government spending also can't seem to wean themselves off it, and hopes quickly emerged that the closer the S&P 500 falls toward 1100, the more likely our central bank is to rescue the market with a third round of quantitative easing, or QE3.

Don Rissmiller, Strategas Research Partners' chief economist, examined the four segments that could lead our flailing economic cycle. Households propelled our economy for decades, but without appreciating real estate or easy credit their swagger is now limited. "Businesses can certainly drive the business cycle, but it seems hard to ask a profit-maximizing corporation to leverage up just as the cycle is slowing down," he writes. Foreign demand might goose U.S. growth, but exports alone can't carry us unless the U.S. dollar falls significantly lower. That leaves the government, which he thinks can make "the biggest difference."

Last week, Strategas raised the odds of a recession in 2012 to 35% from 20%, and in 2013 to 60% from 50%. Rissmiller argues we need "pro-growth fiscal policy," and "not just the removal of anti-growth issues" like the debt ceiling. Forceful government support dragged our economy out of recession in 2009, but growth slowed to 1.3% last quarter, jobs are still scarce, and the government is running out of tricks. And as the debt-ceiling fiasco reminded us, relying on our government can be an uncomfortable proposition.

DEFENSIVE SECTORS LIKE UTILITIES and consumer staples have held up better during this correction. Yet the top performer so far this tumultuous quarter remains a staunchly cyclical group. Don't look now, but technology stocks are down 4.7% this quarter―far better than losses pushing about 15% for industrials and 9% for the overall market.

Tech is the Meryl Streep of sectors, a consummate chameleon that telegraphs different things to different people, equally adept at conveying both pulse-quickening growth and staid stability.

Consider the evidence: About the only good thing from last week's lousy service-sector report was an unexpected jump in business activity in July, and tech companies benefit if corporations keep spending to boost productivity. Second-quarter profits in the tech sector expanded 23% from a year earlier―the third-best growth rate among 10 sectors, and behind just materials and energy (both of which are heavily dependent on volatile commodity prices). Best of all, tech's profitability exceeds Wall Street's expectations. Today, analysts expect tech profits to grow 17.6% this year―far better than the 9.5% rate they had penciled in when 2011 began. In contrast, the pace of 2011 profit growth for the overall market was nudged up only slightly, to 15.3% from 13.4% over the past seven months.

Yet such brisk growth doesn't come with far greater risks. Big-tech companies have stellar balance sheets and the biggest cash balances outside the financial sector. Usually they pay no dividend, or smaller dividends than slow-growing consumer-staple companies, and that only increases pressure on management to return value to shareholders soon or keep delivering outsize growth. Yet the Nasdaq 100, which represents the 100 largest nonfinancial tech stocks, trades at just 13.6 times projected profits―just half the index's historical median of 25.3 times over the past decade, and a big discount to, say, the 19.3 multiple for small stocks.

So which tech stocks are attractive? Ned Davis Research screened for the 10 biggest earners among S&P 500 tech companies, as well as the biggest cash holders.

The usual suspects that made both lists include Apple (AAPL), Google (GOOG), International Business Machines (IBM), Microsoft (MSFT), Oracle (ORCL), Hewlett-Packard (HPQ), Cisco Systems (CSCO) and Qualcomm (QCOM).

LIKE THE REST OF THE MARKET, residential real-estate investment trusts have pulled back since late July as investors scrambled to take profits. But unlike the rest of the market, they're still up nearly 14% this year.

Residential REITs aren't cheap, trading at nearly 24 times projected profits, the priciest since the housing bust. But these well-owned stocks should continue to increase their profits, says Jay Leupp, president of Grubb & Ellis Alesco Global Advisors, which invests in real-estate stocks around the globe. U.S. home ownership peaked at 69% in 2004 but has shriveled to 66.4% this year, and renewed concerns about job security will only swell the ranks of renters. The tight supply of rental apartment buildings should continue to support rent growth. And the kind of rising interest rates that might lure investors away from REITs aren't likely to materialize soon.

In some key coastal markets like New York and San Francisco, prices of apartment properties have risen faster than incomes, which pressures rental yields. But the demand for apartment buildings is spreading into middle America.

Some residential REITs Leupp likes include Essex Property Trust (ESS), Apartment Investment & Management (AIV), Associated Estates Realty (AEC) and Camden Property Trust (CPT). Some of these manage properties, for example, in the Southeast and in other mid-tier markets, where Leupp sees demand driving rent growth, and where job creation may pick up. He also likes operators of self-storage facilities, including Public Storage (PSA), which runs more than 2,100 locations in the U.S. and Europe, has little debt and pays a 3.3% yield; and U-Store-It Trust (YSI), which pays a 2.7% yield.

BEST BUY (BBY) SEEMS TO HAVE a lot to recommend it. The consumer-electronics purveyor has pulled back more than 40% since November. Shares slumping at 25.50 are valued at just 7.7 times projected 2011 profit―a discount to the 8.1 average for electronic retailers, and a staggering half-off its own median of 15.6 times over the past decade. It has little debt, nearly $6 a share in cash, strong cash flow and a leading position in its market. It even pays a sweet 2.4% yield.

Still, Best Buy could have a hard time living up to its name. The company scorched short-sellers in June when it announced a huge $5 billion buyback that sent shares to nearly 33, but it has already given back those gains, and then some.

Now what for a retailer in one of the world's most ruthless businesses? Like many peers, Best Buy has lost market share to online retailers like Amazon.com (AMZN). Growth in same-store sales hasn't been materially positive since 2007, noted Fitch Ratings when it downgraded Best Buy in June.

Given the competitive threat, a buyback of that size―roughly 40% of shares outstanding―suggests a lack of management imagination. Buying back shares can be a creative low-tax way of returning cash to shareholders, albeit exiting shareholders, and Best Buy has done big buybacks before, as in 2007. But online retailing has accelerated since. And buybacks, no matter how large, won't return Best Buy to real growth, although they will inflate earnings per share. The buyback probably puts a floor under Best Buy's shares for a while, but management is signaling implicitly that either it's out of ideas or out of growth. And that ersatz boost to per-share earnings will wear off.

Couldn't a billion or two have gone to improving its Website, or revamping its brick-and-mortar stores, or hiring more salespeople? How about a bigger increase to its regular dividend―raised 7% in June―or even a one-time special dividend, even if that's taxable? Heck, even buying Amazon shares might have been a better idea.

Best Buy replied that over the past seven fiscal years ended January, it invested nearly $13 billion through a combination of capital investments, repurchases and dividends. "We continue to see both dividends and share repurchases as an efficient and prudent way to return excess cash to our investors," the company said in an e-mailed response.

Best Buy can afford a buyback and remain nicely profitable, but it won't be able to buy off its problems forever. Online competition is still taking market share, and management needs to rethink its business if Best Buy doesn't want to end up as Amazon's showroom. 

River of Red

The Dow slumped about 6% last week to a low for the year, and is down more than 10% from its 2011 high. Only Kraft Foods rose, by 1.43%.