Market Keeps an Eye on California; but Earnings, Fed Still Paramount

With the potential bankruptcy of two California utilities -- PG&E (PCG Quote) and Edison International (EIX Quote) -- looming, those stocks have been unsurprisingly destroyed by the stock market. There's growing fear that the utility crisis in that state could somehow engulf other states and possibly cause a greater reaction within the stock market.

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But analysts believe the larger market will weather this storm with a minimal amount of pain, as it has for the last few weeks. If there is going to be a recession, this situation isn't going to be what tips the scales. Companies with a stake in this issue will continue to hurt but overall, other factors, such as earnings and the Federal Reserve , will dominate trading in the broader market.

Strategists are concentrating on the utilities, banks and other financial institutions as places that are -- and will continue to be -- most affected by this crisis. The utilities have been tarred and feathered of late. This is due in part to the crisis in California, but also to the improvement in the broader market and investors having regained their confidence in buying technology shares. With that renewed optimism often comes dissolution in defensive sectors such as utilities.

Since the beginning of the year, the Dow Jones Utility Average has shed 17% of its value, after hitting a new all-time high at the end of 2000. The California situation largely has been responsible, but stocks with a peripheral relationship to the situation have been slammed as well. These include generators who sell power to California, like Duke Energy (DUK Quote), and it has extended to unrelated utilities, such as Virginia-based Dominion Energy(D Quote). Analysts expect these stocks and others to rebound in coming months, although the market's resurgent fascination with growth stocks makes a rally in these names an uphill battle.

Look Out Below! Wanna see some ugly charts? Look at the two major players in the California power crisis

Source: BigCharts

"A lot of the more deregulated utilities, like Duke Energy, have fallen from their highs in sympathy with the problems the two utilities in California face," said John Eade, director of research at Argus Research. "At the same time, there are companies like TXU (TXU Quote) selling excess power to California, and I think the outlook is probably a little bit better for those companies, although those shares are also off their highs."

Duke is down 18% since Jan. 1, Dominion has dropped 13% and TXU is off nearly 19%.

Spreading Misery

Large banks that have engaged in a significant amount of lending to these companies, as well as companies that have exposure to these utilities, either through providing insurance or handling underwriting for the companies' bonds, may also see some weakness, as Bank of America (BAC Quote) did earlier this month. Bank of America's stock was hit earlier this month due to concerns about the company's loan exposure to Southern California Edison, a subsidiary of Edison International, and to PG&E. Other major banks have participated in lending to those companies.

"It harkens back to when the telecom infrastructure buildout was slowing, and the high-yield stuff was blowing up," said Art Hogan, chief market analyst at Jefferies, referring to the problems confronted by telecommunications companies last year. "You saw the financials getting banged up but you never really knew how much each of them was holding."

Generally, exposure to a particular company or even a couple of companies is generally not enough to completely derail a bank's balance sheet, as they diversify their portfolios and maintain reserve accounts to guard against situations like this. The true danger stems from the persistently high prices consumers are now paying for natural gas and other types of fuel; it dampens consumer spending to a point where retailers, automakers and other cyclical companies do not see a significant rebound in activity in the second half of 2001.

This is an issue not confined to California. Regardless of how California's situation is resolved, consumers are likely to pay higher utility bills, and that saps their ability both to spend on other discretionary purchases and to invest in the stock market.