Investors Waiting to See Clarity on the US Economy

By: Roger_Conrad

Greetings from the Orlando Money Show 2008, America's leading bazaar of investment opinion and products. There are many ways to make money in the markets, just as there are many ways to lose it. Not everyone is going to be interested in everything at the show. But there are few better places for individual investors to see this much at the same time.

From a professional's perspective, I find investment conferences most valuable for what they tell me about investor concerns, particularly those who read my advisories. And with so much happening in the market over the past several months, they were myriad.

At the top of the list was the US economy. As I've written in Utility & Income, the main problem now is we still don't have any visibility of where the bottom is. No one knows how bad things may get, which makes the market vulnerable to selling anytime something unexpected occurs.

This week, the biggest number in Wall Street's eyes was a survey of purchasing managers in the service industry. The unexpectedly bad number ignited fears that the heretofore steady conditions in the service sector—which now accounts for roughly 80 percent of the US economy—were starting to deteriorate rapidly. That triggered one of the worst single-day selloffs in some time, with damage extending to all sectors as well as markets around the world.

As has been the pattern of late, the selling ended quickly. And in fact, much of the market recovered sharply the next day. But the action is another stark reminder that, until there's some clarity on the economy, there will be near zero tolerance for risk in the marketplace, and even very solid companies will be at risk to tumbling.

In my view, the most important thing to know about the US economy is that the Federal Reserve is on the case. The central bank slashed the federal funds rate by 1.25 percentage points over a nine-day period last month. And despite some inflation concerns from a few of its governors, it's certain to move aggressively again if the economy and markets really weaken.

The closest parallel to the current situation is the deep credit crunch of the early 1990s. Then, the problem in the financial system was the savings and loans, which were in the middle of a massive bailout. The economy was stuck in the doldrums, and the most frequently heard comment was the Fed was “pushing on a string” with its efforts to fire things up by slashing interest rates.

This brings the total to 37 Canadian Trusts from my portfolio that have increased distributions since 2006.

This is a sure-fire indication that these trusts are thriving and will continue to hand investors fat profits.

Eventually, the Fed's efforts were rewarded as growth revived. But until investors were able to see the bottom for the economy, the markets were at risk to selloffs depending on the news flow.

Given how complex and interconnected the world economy and investment markets are currently, it's even more difficult now to declare a bottom. It's still unknown, for example, just how much a US recession would impact economies of developing nations such as China, which in turn would affect prices of commodities across the board, with potentially dire consequences for producers.

Another big question is just how vulnerable is the global financial system to a blowup of bond insurers. A series of credit ratings cuts for insurers such as MBIA, for example, would almost surely lead to massive downgrades in “insured” bonds, which are widely held.

It's very unlikely big banks, the Fed and others will allow a failure of bond insurers, given the consequences. But again, until we have some clarity on how a bailout/shoring up of the system would work, we won't really have visibility on the overall economy, and the stock market will be at risk.

The good news overall is the Fed's moves make recovery certain. The bad news is the timing will remain a matter of speculation, and there's still a considerable risk of more selling in the markets before the picture inevitably brightens.

When it comes to individual companies, the key question for investors is what kind of exposure they have to a slowing US economy. Specifically, the question is what kind of impact slower growth will have on earnings—and dividends, in the case of higher-yielding investments.

A big part of that is how exposed they are to credit conditions. Can they live within their means until money gets a little easier? Or will they be forced to issue equity at a big discount to underlying value, and/or borrow at what may wind up being the equivalent of loan shark rates?

The only way companies—whether they're utilities, banks, Canadian trusts or industrial corporations—can answer these questions is with their numbers. That means earnings results, and the more current the data, the better.

Absent reasonably up-to-date numbers, companies' securities—anything from common stocks, bonds or preferred shares—are vulnerable to perceived risks. And with investor tolerance for recession risk near zero, market response to perceived risks can be extremely deadly.

One of the best examples is in the communications sector over the past month. Traditionally, phone service has been considered recession resistant as an essential service.

With deregulation and the rise of broadband and wireless, however, investor concerns have risen that the industry may be more economically sensitive than in the past. As a result, telecoms today are trading as though they'll be as battered by US economic weakness as any other industry.

We saw this play out in graphic relief with the market's response to AT&T earnings last month. A comment from the CEO on possible exposure to a slowdown was taken as a full-scale earnings warning, and telecoms plunged across the board.

When AT&T did announce, it posted blockbuster results that belied any hint of vulnerability. That stopped its fall but, to date, has done little to revive the stock.

AT&T's “earnings warning” had an even greater impact on rural telecoms, which are perceived as more vulnerable because of a lack of exposure to wireless communications. Unfortunately, these companies tend to report earnings well after the big telecoms. As a result, although AT&T has been able to clarify for investors its economic exposure, there's been an effective knowledge vacuum in the marketplace regarding how rural telecoms are doing.

A vacuum means uncertainty, and investors hate uncertainty. Consequently, rural telecoms have remained weak and prone to selling off on any news that the economy may be slowing more than expected.

The good news: We finally have our first earnings report from a rural telecom—WINDSTREAM CORP—and the results are quite encouraging. In results announced today, the company topped earnings expectations as new broadband connections once again outweighed the loss of basic copper connections. The company has added 28 percent more broadband customers over the past year and continues to increase penetration rates for the service, as well as for its pay television operations.

In short, it was an improvement on third quarter results, just as management had indicated last month. More important, it's clear confirmation that the company's strategy of upselling new services and adding new basic customers with low-cost acquisitions is still working well, despite worries about the economy.

As I've pointed out, the game with rural telecoms isn't earnings or even revenue growth. Rather, it's about generating cash flow to cut debt, buy back stock and pay big distributions.

Windstream's payout ratio in the fourth quarter was only 71 percent, excellent backing for its 9 percent-plus distribution. Clearly, investors have priced in too much recession risk, and the shares' recovery today is a partial reversal of that.

As for the rest of the rural telecom sector, we're in a zero-risk-tolerance investing environment that's fearful of recession. As a result, it's unlikely the companies will get much credit for being recession resistant until they can prove it on a one-by-one basis.

That means we'll have to wait for earnings to come out before there's a recovery in the likes of CITIZENS COMMUNICATIONS and others. But the Windstream results make it pretty certain that we'll see that recovery.

The telecom example is a clear sign that there are strong bargains to be had in this environment—but only if investors are willing to look a little beyond the headlines and have the fortitude to buck the herd's tendency to panic. Remember, damage done to stocks on the basis of perceived risk—in this case, recession worries—is quickly repaired but only if the business behind that stock is still healthy.

Get to know your stocks. There's no better antidote for the current market.

By Roger Conrad
KCI Communications

Copyright © 2008 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

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