You can't afford to ignore the credit market

Pete Arnold of the Egan-Jones credit-rating agency, and the rest of Wall Street have a saying: "Credit precedes common." In other words, changes in a company's credit quality can predict what will happen to a company's share price.

Mr. Arnold's phrase is not an entirely new idea, but it is a particularly timely idea. In the current investment climate, no prudent investor can afford to ignore what's happening to a company's balance sheet. A company's financial position will often weaken first. Then, the market will crush the stock. Therefore, if you keep a close eye on the financial health of your investments, you have an early warning system about danger for the stock price.

Credit has become a more important investment influence than at any time since 1998, when the Asian crisis hit. In the summer of 2007, the subprime crisis finally unsheathed its sword. A number of subprime investors suffered mortal wounds, leading to massive losses. Since then, the crisis has only widened and deepened, spilling over into other areas of the economy. It looks certain to toss the U.S. economy into recession, if we aren't there already.

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With these thoughts in mind, I put in a call to Egan-Jones last weekend. Mr. Arnold called me back and we chatted as snow flurries swirled just outside the window of my study, dancing around the old dogwood tree. Arnold emphasized the imperative of analyzing company-specific credit trends, not only to avoid risk, but also to recognize opportunities that the equity market may be missing.

So credit analysis can sometimes provide a treasure map, instead of warning buoy, you might say. What are the credit markets telling us today? Where are the risks and where are the opportunities?

With Egan-Jones as our guide, let's take a look at today's unstable stock markets and see what signals the credit markets are sending our way. We'll look first at the sunny side of the omelet

The credit markets are still in lockdown mode. Before August 2007, money was easy. If you wanted to finance a leveraged buyout, people would throw money at you. Not any longer. Now, finding that easy money is like getting a drink during Prohibition. It will cost you.

As such, the list of improving industries is really short. It's basically energy and energy service companies. But especially, Egan-Jones reports, the domestic producers. They are unaffected by geopolitical troubles and have more natural gas exposure. Egan-Jones views the latter as a positive given the wide swings and uncertainty in oil prices.

In the energy service sector, credit quality is strong across the board, Egan-Jones notes. The risk here is that companies might squander their credit on expensive acquisitions. Overall, though, the financial strength in the energy sector is improving. If credit precedes common, then you'd expect the stock prices of the group to stay strong, or at least to weather the turbulence better than the rest.

Outside of the oil patch, however, most industries rate neutral, such as the pharmaceutical, retail, chemical, and auto part industries. These neutrally-ranked industries have a swirl of good and bad things going on. Investors will have to pick carefully to be among the "good" names.

One example of the dispersion of results from the auto supplier sector: BorgWarner (NYSE:BWA) had great results recently, pushing its stock to all-time highs. ArvinMeritor (NYSE:ARM), on the other hand, swung from a profit to a loss. Its stock hovers near 10-year lows.

Let's look at the declining industries

Many of these you'd expect. Insurance is a bad one right now. The mortgage crisis has hit most insurers with losses in their investment portfolios. Many of them now face a wave of mortgage-related claims and writedowns. Egan-Jones is very bearish on insurers.

The banks aren't any better off. As the recent wave of mega-billion dollar writedowns illustrates, most of the large U.S. banks possess a very thin shield of capital to protect them against insolvency. Leverage is the biggest part of the problem. Many financial intuitions use titanic amounts of leverage. Consider that Fannie Mae (NYSE:FNM) has only $40 billion of equity supporting $840 billion in assets and another $640 billion off balance sheet, hidden in the folds of the footnotes. This whole sector is a disaster.

Egan-Jones also warns against broker and finance companies. Companies such as Morgan Stanley (NYSE:MS) and Bear Stearns (NYSE:BSC) reported their first quarterly losses in company history. Many of these companies will need capital infusions, probably from Asian sovereign wealth funds or from deep-pocketed Arab funds. Auto manufacturing, homebuilders and cable television/media companies round out the declining industries.

Interesting note on the homebuilders: In 2007, write-downs overwhelmed profits for the industry as land values fell. Egan-Jones points out the specific case of Lennar Corp. (NYSE:LEN), which sold a property portfolio for 40% less than the value of the property on Lennar's balance sheet. The company had to book a $475 million loss as a result. Bad stuff still brews in the land of homebuilders.

I should add that there are good reasons to pay attention to Egan-Jones. For one thing, unlike competitors Moody's and Standard & Poor's, Egan-Jones does not receive money from the companies it rates. Egan-Jones is simply a subscription service, like my investment letter, Capital & Crisis. Therefore, it is truly independent.

Not surprisingly, independence is an extremely valuable attribute in the world of credit analysis. A recent study relates: "Credit ratings from Egan-Jones more accurately reflect information in the marketplace and are frequently up to 237 days ahead of actions taken by Moody's and S&P."

In short, if you buy the notion that "credit precedes common," you'll want to hang onto your energy stocks and tread carefully in the mortgage-lending, insurance and brokerage sectors.

The message from Egan-Jones is quite clear: If you invest in the stock market, you cannot afford to ignore the credit market.

By Chris Mayer for Whiskey and Gunpowder

Whiskey & Gunpowder is a free, twice-per-week, e-mail service for more from the team, go to https://www.whiskeyandgunpowder.com