10 Challenges Facing A Market Rebound

THE MARKET CANARY

Many traders say there is a real and visible disconnect between US financial markets and the economy. Interest rates are at historic lows, the housing sector is flourishing, and consumer spending (which accounts for two-thirds of the US economy) remains amazingly resilient. Until recently, markets ignored this positive news.

In October 2002, the markets finally responded with a rally. Does it mean the worst is over? Maybe, but don't bet on it. A number of factors need to be considered by anyone with a whim to put money into the US markets.

Michael Woolfolk, currency strategist at the Bank of New York, recently noted in a research paper that demand for US fixed-income assets declined sharply in August. This prompted renewed concerns that the US may not be attracting sufficient capital to fund its record current account deficit, which now exceeds 5% of gross domestic product.

In an October 31, 2002, report in The Wall Street Journal, Woolfolk said, "The flow of investment capital from foreigners into the US has become increasingly important in terms of US efforts to cover the current account deficit. With foreign direct investment, such as the purchase of hard assets like factories, having withered to almost nothing amidst a withering global economy, portfolio inflows have become a more important component of the global capital entering the US that helps to support the dollar."

Without approximately $2 billion invested by foreign investors per day, the economic recovery train risks derailment. But as of June 2002, foreign direct investment (FDI) was down more than 60% since 2000 to its lowest level since the early 1990s. Even more disturbing, merger and acquisition (M&A) investment in the US was down more than 80% for March­April 2002 over the same period last year.

In August 2002, net foreign investment into the US totaled $39.14 billion, down from a net foreign investment into the US of $67.32 billion in July.

According to the article, while net purchases of US agency and corporate bonds by non­US investors were up in August, total purchases of US Treasuries dropped 95% to $1.12 billion, down from July's $21.02 billion (three months before a 50­basis point drop in interest rates).

10-POINT INVESTMENT CHECKLIST

Technical investors believe that everything they need to know can found in the charts. But the charts give little indication of an economy on the mend. In September 2002, the markets retested and broke through September 2001 lows. And while a recent rally has taken markets higher, continued headway is proving challenging.

The indexes' response to current resistance levels will be imperative in demonstrating if the eagerly anticipated recovery is finally here. The underlying health and vitality of the US economy will have an even greater effect.

Those who fail to properly assess the true influence of certain factors risk watching their portfolio values slide. From least to greatest importance, here are 10 reasons why international investors should think twice about jumping on the US investment train:

10) US multinational tax treatment

The USA is one of only three nations in the world that taxes corporations (and citizens) based on citizenship, not residency (or domicile). If headquartered in the US, multinationals pay tax on all income earned. The Foreign Sales Corporation (FSC) rules were enacted in 1984 to offset the unfavorable tax treatment that US multinationals with operations overseas experienced in their home country.

In 2001, the World Trade Organization ruled the program an illegal subsidy, and there has been no viable replacement (the ephemeral Extraterritorial Income Exclusion Act didn't count). As a result, US companies pay higher taxes than companies based in nations with a territorial tax system. The effect of this is already being felt in the expatriation (also known as "inversion") of a number of US corporations to Bermuda (Stanley Tool and Ingersoll-Rand, for example), and explains why companies like Daimler-Chrysler are headquartered in Germany instead of the US.

There has been much ado in the US media about how these corporations are being unpatriotic, but the reasons those companies do so are rarely mentioned. The answer, of course, is that the dismantling of the FSC rules has put companies with global interests in an uncompetitive position should they remain headquartered in the US.

If Congress is working on FSC replacement legislation, it is a well-guarded secret. The result is a negative impact on profits for all US-based corporations. The only viable answer is a rewrite of the incredibly complicated and voluminous tax code or a reduction in corporate tax rates. If the government continues its current approach and adopts further punitive legislation, it does not bode well for US multinational profits or stock valuations.

9) Anti-inversion legislation

Rather than address the root of this problem, namely an unwieldy tax code, factions of the government have instead chosen to engage in politically motivated patriotism to introduce more labyrinthine legislation to deter moves offshore by US companies. One elected official went so far as referring to these companies as "Benedict Arnolds." This sends a message to foreign corporations and investors. In addition, greater legislative burdens dramatically increase the costs of doing business.

8) Soaring insurance costs

Since September 11, 2001, insurers have been jacking up rates from 30% to 100% while cutting coverage. Losses suffered in the terrorist attacks totaled more than $50 billion. The problem is so acute that a bill has been put before Congress to help insurance companies and those they insure. The bill is expected to limit the government's liability to $100 billion, which would then have to be supplied by taxpayers if it passes. But the move is essential to ease a severe shortage in available coverage by insurers.

Losses from terrorist attacks can be felt across all sectors, and a 50% or more increase in insurance premiums in everything from workers' compensation to aircraft insurance is having a significant effect on the costs of doing business, especially for US-based corporations.

Coverage costs for certain asset types are much higher. For example, terrorism and war-risk coverage for a ship valued at $500 million now costs about $500,000 a year, or 400% more than before the catastrophe. Further, New York City landlords are seeing costs for insuring their buildings soar by 500%.

Insurance costs are closely linked with soaring litigation claims (another challenge being addressed by the government). A large percentage of insurance claims result from lawsuits arising from catastrophic events. Both problems must be dealt with if the US economy is to enjoy long-term health and prosperity.

7) Costly financial regulation

The introduction of new antiterrorism and antioffshore laws such as the Qualified Intermediary Rules and the US Patriot Act are giving foreign investors serious pause in considering US investments. The level of due diligence and disclosure (forget any expectation of financial privacy) to which anyone wishing to invest or do business in the US must submit has moved up a number of notches thanks to these two pieces of legislation alone.

Where is the money going? The latest capital inflow figures identify the euro zone as one place taking over the role of investment safe haven. According to Reuters, the European Central Bank reported that combined net inflows of direct and portfolio investment such as purchases of shares and bonds soared to 19.3 billion euros in April as foreigners and euro-zone residents moved their funds into the region.

The April inflow was one of the highest in 2002, up a whopping 877% increase over March's inflow of 2.2 billion euros. This is not because the euro economies look any better than the US economy; they don't. Is this a temporary blip or a permanent trend, and how much is due to uncertainties over new, far-reaching, costly legislation and red tape?

6) Soaring litigation costs

There is no sign that the number of frivolous lawsuits and size of awards aimed at corporate America or anyone with money is abating. In times of economic weakness, this puts added pressure on corporate profits and leads to more bankruptcies. Has anyone estimated the cost of litigation on the US economy per annum? It's significant, and something that corporate America cannot afford.

A paper published in 2002 by the Council of Economic Advisers estimates that the US tort system soaks up 1.8% of Gross Domestic Product, or $180 billion a year. The kicker is that only 20% of the money goes to claimants for economic damages. In a number of mass tort cases, courts have begged Congress to intervene, but politicians have been reluctant to act. Reform would reduce payments to a constituency that recycles settlement money into political contributions: the trial lawyers, according to The Economist.

It is the responsibility of any investor looking to buy stock in a US company (or foreign company with a US nexus) to assess litigation risk. One major class-action suit can ruin a balance sheet, as companies enmeshed in asbestos claims have learned.

5) Regressive protectionism

There is a current disturbing regression back to protectionism in the US. What happened to the free-trade agreement signed with Canada and Mexico more than a decade ago?

Protectionism, as any first-year economics student will tell you, may silence antitrade, prounion rhetoric in the short term, but it will have a longer-term deleterious effect on the people it should be helping: the American people. The US economy will ultimately be the largest casualty. Lumber and steel prices are soaring and supplies of both are tenuous at best, which will threaten one of the strongest sectors of the US economy: housing.

4) Corporate governance/executive compensation issues

Given the current economic situation, investors distrust corporate heads' ability to execute their tasks effectively and report revenues and profits honestly. And investors also view many executive pay packages as fiscally irresponsible, to say the least. In attempting to address the issues, regulators and politicians risk throwing the baby out with the bathwater by enacting even more convoluted regulations and legislation.

Like any other marketplace, the motto of the stock market is caveat emptor. Those who know what to look for can compare the balance sheets to the stock chart when something is amiss. Case in point: the value of WorldCom stock dropped from $64.50 on June 21, 1999, to $0.83 the day before the scandal broke. Enough investors knew something was wrong to drive the stock into the basement months before the revelation hit the streets. The stock spent most of the time after June 1999 below its 200-day, 90-day, and 60-day moving averages, and broke lines of support all the way down. Anyone who rides a stock down more than 10­15% without exercising a stop-loss has only him- or herself to blame.

3) Stock valuations

During past great bull markets, the average stock valuation of the Standard & Poor's index companies topped out at 21 times earnings in both 1929 and 1965 (earnings that did not include stock option tax savings but, in fairness, paid lower taxes). At the bottom of the market in 1974, forward Nasdaq price/earnings ratio was 7, according to S&P Comstock. As of early June 2002, it was around 50. At the same time, the Standard & Poor's 500 sat at a P/E of 23.

Since June, valuations have stubbornly remained high. As of November 13, 2002, the Dow Jones Industrial Average (DJIA) showed a trailing P/E of 20.5. The broad-based S&P 500 showed a trailing P/E of 29 and forward-estimated P/E of 18, and the Nasdaq 100 Composite showed a trailing P/E of nil (negative earnings) and a forward P/E of 41. With the coming changes to eliminate earnings from tax savings due to option compensation writeoffs (treating of stock options as an expense), S&P 500 P/Es are expected to top 30. These are hardly post-recession valuations, no matter which way you slice it. Cutting price/earnings ratios of the major market indexes in half would still put them above average historic post-recession values.

2) US current account deficit

Current account is the broadest measure of international trade because it includes goods and services as well as income, charitable contributions, and foreign aid. The current-account deficit increased in first-quarter 2002 to a record $112.5 billion, up from $95.1 billion in the previous quarter. According to the US Commerce Department, the trade deficit for goods and services hit a new record high of $38.28 billion in August before inching down to $38.03 in September.

This is a trend that has been under way for some time. Exports rose 2.2% to $80.1 billion from March to April 2002. However, imports grew at more than twice that rate, to $116 billion, leading to a record trade deficit. While imports have since dropped thanks to the longshoremen's strike on the West Coast, the deficit remains high (see Figure 1).

Figure 1: US trade deficit growth since 1992.

This is both good and bad news. From a global economic standpoint, the current account deficit will continue to widen if the US is to lead the world out of recession. The downside is that this trend exerts a downward pressure on the US dollar, which has fallen 9% against the euro and 8% against the yen so far as I write this in December 2002. This in turn will further discourage foreign investment in the US. Who wants to see the value of their investment drop in currency terms?

Declining capital inflows result in a snowball effect. Once started, this trend is difficult to reverse, short of imposing exchange controls (which would speed up the investor rush for the exits and further discourage foreign direct investment in the US).

While giving the markets and the economy a temporary shot in the arm, the recent 50­basis point decline in interest rates by the Federal Reserve will further exacerbate the flow of money out of the country as foreign investors seek higher rates of returns in bonds and other interest-bearing securities elsewhere.

1) The terror threat reaction

Currently, the biggest market wildcard is the threat of terrorism, and it is playing heavily on investor sentiment. However, the US government's reaction (continuing to introduce legislation to counter terrorism) ends up punishing mainstream investors, corporations, and consumers.

A targeted attack on terror should be adopted, as opposed to a broad-based restriction on the economic engine of the US. There is a workable medium between protecting citizens and running the economy/foreign policy effectively, but it has yet to be reached.

Look for companies where this effect is minimized, or that will benefit from increased security and defense-spending directives such as the new Homeland Security program. However, a continued drop in the dollar will affect returns if they are US-based — unless their business is export-related.

DOLLARS AND SENSE

These points are not the end of the story. Among other factors, I did not mention the Iraqi situation. While the looming possibility of war creates uncertainty, it exerts an equal pressure on all markets.

How low will the dollar go, and what effect will the drop have? There is a direct link between the value of the greenback and US markets. In a June 2002 article from The Wall Street Journal, investment titan George Soros commented that after years of rising against other major currencies, "it seems that the trend in the dollar has been reversed." Trends in currency markets tend to last several years and involve major swings, he continued, so a drop of around a third in the dollar's value from recent levels "would not be unprecedented." The fall in the dollar has "some very negative implications" for the world economy, Soros concluded. If he is right and the almighty buck drops 30%, look out.

A continued drop in the dollar would mean that American consumers, who are currently driving the economy, would be discouraged from buying exports, thereby jeopardizing a sustained global recovery. The effect on those nations supplying export goods to the US would be substantial. Unfortunately, when the American economy gets the sniffles, the cold spreads around the world. But until the US economy starts showing signs of stabilization, global investors are looking at markets further afield in the euro zone, Canada, and some Asian markets, hoping to find more attractive earnings multiples.

For those who wish to keep their money on this side of the Atlantic and Pacific, it is not the time for a buy-and-hold strategy. It's nowhere near summer, but now may be as good a time as any to try out your shorts.

Matt Blackman is a trader, technical analyst, software and book reviewer, and a content provider for www.thechartmaster.com. He can be reached at matt@goldhaven.com.

SUGGESTED READING

Hagerty, James R. [2002]. "Soros Foresees Further Erosion In Value of US Dollar, Equities," The Wall Street Journal: June 28.

_____ and Christopher Oster [2002]. "These Days, 'Names' at Lloyd's Find Investing Can Be Costly, Contentious," The Wall Street Journal: July 12.

Lifton, Tyler [2002]. "Net Foreign Investment Into US Slows In August," The Wall Street Journal: October 31.

Oster, Christopher, and Dean Starkman [2002]. "Benefits To Economy Touted by Bush May Take Some Time, Industry Says," The Wall Street Journal: November 18.

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Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.