Thursday, July 26, 2007

Rising Corporate Rates

"The U.S. economy in turn will not benefit from this tidal shift and increasing cost of financing. The Fed tightens credit by raising short-term rates but rarely, if ever, have they raised yields by 150 basis points in a month and a half’s time as has occurred in the high yield market."

This is a quote from Bill Gross in his August Investment Outlook. Of the many articles written lately, it is the best yet. It makes the point very clear that sub-prime problems are not over and its effects in other credit markets is going to carry on for some time. The free money times are gone, and this will effect many of the leverage buyouts and stock buybacks that have helped fuel the latest equity rally.

In a resent earnings release IBM announced that is was borrowing $11.5 billion to repurchase its own shares. It is estimated that this buyback will account for the 2-3% increase in their earnings guidance. Fewer shares with same earnings equate to greater earnings per share. Its a great system when rates are artificially low, but is that really how you want a company to grow earnings?

So far this year, companies have announced over $415 billion in stock repurchases. Some might be a wise use of cash; some energy companies come to mind. Yet borrowing money to buy back stock is not a sustainable way to increase shareholder value. Eventually its going to get to the point where the company is going to have to grow earnings organically. With all the investment in buying back shares instead of research and development, where will this organic growth come from? Since the rates companies can borrow money has increased 150 basis points over the past 45 days, buy backs will not be so easily financed. In essence the Federal Reserve didn't need to raise rates to take away the punch bowl at the party, but they are to blame for this sub-prime mess we are experiencing. Taking rates to 1% was too much grain alcohol in the punch for too long. There will be hangovers.

Below is a chart of the S&P 500. It shows that things have reached an oversold area, but things could stay oversold for a long time. One short term trend line has been broken, and 1500.43 looks like the next support level based on the opening range system used in a previous post. Once below 1500, 1476.76 should be the next area to look for support.

Below is a chart of the S&P 500 compared to a basket of multinational companies. These stocks are still leading and could continue to keep the major index averages from getting hit too badly. It is the group to watch for weakness.

This group of companies benefit from the lower dollar, as it makes their goods and services cheaper over seas. Below are two charts of the U.S. Dollar Index, one short term and the other longer term. It can be seen the steady downtrend the dollar has had. It is a position which has many people playing the short side of this trade. It could be set up for a nice short cover rally, before rolling over and going lower..again.

Australian Dollar vs U.S.Dollar.

U.S.Dollar vs Swiss Franc

New Zealand Dollar vs U.S.Dollar

Euro vs U.S.Dollar

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