Are markets waking up to reality?

published 8 October 2007

This feature is part of our FREE daily Money Morning email. If you'd like to sign up, please click here: sign up for Money Morning.

Are the markets finally waking up to reality? For weeks, they've been galloping ahead on any signs that growth is slowing, reasoning that this will mean an interest rate cut. But in the last few days, investors seem to have twigged that slower growth means also worse earnings which is rather less bullish for equities.

As MoneyWeek regular James Ferguson often points out in his Model Investor email, a growth slowdown can ultimately be good for high-quality blue-chip stocks. When the slowdown kicks in, all firms take an earnings hit, but high-quality ones will be least affected. Once interest rates are cut, the earnings that these firms retain start to look more attractive relative to bond yields and their shares rise. (For more on James' service see: Model Investor

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

The problem is that you need to get over the hump' first past the red ink and all the bad headlines that come from the downgrades. The market is already starting to wobble as investors realise that the double-digit earnings growth they're pencilling in for next year could prove as ephemeral as a lottery win pencilled in for Saturday.

But the true outlook may be even worse than the one they're pricing in...

Last week, I suggested the Dow would hold up better than the S&P and the FTSE as we head into the slowdown. I still think that's true, despite the inevitable uncertainty the Dow is showing as it approaches its previous highs. But I'm not sure that the distinction is that important.

The numbers are getting gloomier by the day. The US NAHB homebuilders index is in freefall; historically this index has been a very good leading indicator of GDP. Other indicators such as disposable income, consumer durable goods expenditure and consumer confidence are also heading lower.

Collectively, the runes point to much-slower-than-consensus GDP growth; probably slow enough to cause a profits recession rather than simply weaker profits growth. The only thing that might turn this around is a big increase in business spending, but there's little sign of that so far.

The indicators are less ominous in the UK and Europe, although some of the forward-looking ones are turning down. But watching these seems as irrelevant as checking a weathervane when there's a hurricane warning on the radio; if the US has problems, there's no way we can escape some of the fallout.

So markets are likely to have a severe hump to get over in terms of profits and the interest rate outlook isn't clear on the other side either. Many are confidently predicting the Fed will cut rates early next year, but inflationary pressures may be harder to shake than expected. Meanwhile, the Bank of England seems certain to hike again and the European Central Bank remains firmly hawkish.

The newsflow is also getting gloomier. With Hewlett-Packard, we have one of the bluest of blue-chip stocks in trouble for spying on its executives. Hedge funds are evaporating. Merger plans are becoming incomprehensible Is Renault-Nissan buying GM? Is it buying Ford? Are Ford and GM buying each other? And who really believes that any of those ideas make sense?

Private-equity deals get stranger by the day one consortium is planning a leveraged buy-out of a chipmaker with erratic cashflows where they'll have to put in around half the equity. Targets must be getting very hard to find. Best of all, my Bloomberg screen announces that "Cablevision Awarded Stock Options to Dead Executive, Then Backdated Them". I thought tax dodges like that only occurred in Douglas Adams' novels. We must be well into the silly season of the investment cycle.

Less flippantly, this downturn looks like it could get very nasty. Even countries such as India and Japan, which have a decent chance of decoupling from the US slowdown, could initially see their markets clobbered in sympathy. Real bears hibernate through tough times. More and more, I'd like to do the same.

Turning to the stock markets...

The FTSE 100 closed 74 points lower, at 5,822, on Friday, just above session lows. The falls were prompted by losses on Wall Street and a weak mining sector; miners BHP Billiton, Anglo American and Xstrata were among the day's worst performers. Support services provider Brambles Industries and building materials group Hanson were the only blue-chips to make gains. For a full market report, see: London market close

Losses on Wall Street also hit sentiment across the Channel, with the Frankfurt DAX-30 ending the day 78 points lower at 5,883 and the Paris CAC-40 66 points lower at 5,141.

Across the Atlantic, investors continued to express their concern over a US economic slowdown prompted by Thursday's negative housing data. The Dow Jones Industrial Average closed 25 points lower, at 11,508. The S&P 500 was 3 points lower, at 1,314. And the Nasdaq fell 18 points to 2,218.

In Asia, the Nikkei finished flat at 15,633 today, with investors turning to defensive stocks such as food and transport.

Crude oil retreated over the weekend, last trading at $60.59, whilst Brent spot was at $58.87 a barrel.

The price of spot gold fell by over $2 overnight, last trading at $586.20 this morning.

And in London, building supplies giant Wolseley reported a 12% surge in full-year profits today, mainly due to increased demand from the US. However, shares fell by as much as 5.3% this morning following the announcement that the company will sell 59.5m new shares in order to cut debt and fund acquisitions.

And our two recommended articles for today...

Will the Bank of England raise rates again?

- Charles Stanley's Jeremy Batstone looks at the latest inflation data, consumer attitudes and, of course, the MPC minutes to suggest what might happen to interest rates next. For his predictions - and why he thinks the Bank's got it wrong on inflation - read: Will the Bank of England raise rates again?

Why China is heading for environmental catastrophe

- The rapid growth of China and other developing nations is having a disastrous impact on the environment. That's because the agricultural practices used to feed ever-growing and increasingly wealthy populations are simply unsustainable. To find out what the implications for government and trade will be, see: Why China is heading for environmental catastrophe