The Guest Blog

Farrell: Barbarians at the Gate, Pt 2


This wouldn't be the first time something went over my head. But I saw a report that step-up bonds are becoming more popular. A step-up bond is one where the interest rate is increased if the bond issuer is downgraded. OK, but if you're downgraded isn't it because your finances have worsened and paying interest becomes more of a problem? If you're downgraded and have to pay more, isn't that then a reason for being downgraded again? And then you would have to pay more in interest and get downgraded again, etc.

You think this is ridiculous, but read "Barbarians at the Gate."One of the classic business books. When RJ Reynolds was bought out for a zillion dollars in 1988, the bankers dreamed up PIK bonds. Payment-in-Kind. You got more bonds instead of cash interest payments. And if the bonds didn't trade at par, then the interest rate would be adjusted upwards until they did. Problem was, the higher the interest payment (payable not in cash but in additional bonds) the more certain everyone became the bonds couldn't be good, as who could afford such lofty interest payments. In effect, you couldn't get the bond interest high enough for the bonds to trade at par. Hello step-up bonds. Raise the interest rate when the company is in financial trouble such that the credit rating is downgraded? Someone help me out here. How is this idiocy different from the other idiocy?

Other than an always welcome dose of insanity from Wall Street, the news on Monday was pretty good. The pending home sales index (homes under contract but not yet closed) rose 8.2%. That's actually hard to square with the terrible weather we had, so it's a bit all the more impressive. This is the best gain since October, 2001, and the second best ever. We should get a fall-off as the tax credit expires, but we should also see this small surge upwards in anticipation of the expiration. The Institute of Supply Management non-manufacturing index turned in a stellar number of 55.4 from 50 last month (50 is the line between expansion and contraction). This is the highest reading since May, 2006. New orders increased to 62 from 55, order backlogs to 55.5 from 46. Even employment went up to 49.8. That is still below the expansion threshold, but awfully close.

The underlying fundamentals are trying to get better.

The ISM manufacturing index released on Friday was wonderful, but keep in mind it represents about 13% of the economy. We needed a similar breakout in the non-manufacturing index, which is where all the jobs are. The above number may well be the beginning of that breakout.

Housing is key to the recovery, and, despite Case-Shiller being positive for the eighth month in a row, it seems we have risk ahead of us. As mentioned, the tax credit is due to expire, the Fed is no longer buying MBS paper, and the "shadow inventory" is a subject of great confusion. Inventories of existing homes are at 8.6 months, which would be about 3.5 million homes. The range of estimates on the "shadow" range from 1 to 5 million homes. It looks at best that home prices are bottoming, but the risk of another price dip is possible. I am not predicting it, just worried about it.

Consensus earnings estimates for this year for the S&P 500 are about $78. With the index around 1180, the P/E is 15 times. The first quarter GDP will be reasonably good if for no other reason than inventories will be built. Estimates for next year are clustered around $85, and a good GDP report will reaffirm that number. The market is trading at a bit less than 14 times that estimate. Since 1929, when inflation has been less than 2% (headline CPI inflation), the P/E multiple has averaged 18 times. In fact, 18.4 times. The unusual debt levels we have today make a discount to that seem fair, but the market still seems reasonably priced.

I took a look at the S&P 100 and saw that 44 of those companies raised their dividend in the last 12 months. Raising a dividend during that turbulent time is a statement worth noting. Those 44 companies, arguably the best and most diverse, are trading at 14 times consensus estimates for 2010. With reasonable stock prices and low interest rates, it's hard to be bearish.

The ultimate key to the economic picture is job growth.

Last week's jobs report was generally very good. The downturn in average hourly earnings (-0.1%) was offset and then some by the upturn in average hours worked. In fact, if average hour worked did not go up there would have been 300,000 more jobs created (thanks to Brian Wesbury of FT Advisors for that). In a recovery, productivity gains show themselves first. We have had three quarters of very strong productivity growth. Temporary jobs follow, then full-time jobs, then wage gains. We are on track for that pattern. GDP growth will not track prior recoveries because of the debt burden. But GDP growth should be good enough to support stock prices.

Having said all that, most moves off bear market lows see 10% corrections sometime in the first 14 months post the bottom. We haven't had that, so caution is warranted near term. I am as sick of saying that as you are of hearing it.

Vincent Farrell, Jr. is chief investment officer at Soleil Securities Group and a regular contributor to CNBC.