It's hard to think further ahead than the
June 27 meeting -- but let's try.
Now it's September. The Fed has stopped raising interest rates -- perhaps after a June hike of 25 basis points, perhaps sooner. The economy is showing definite signs of slowing, so that it looks like the central bankers may be able to stay out of the game for a while. And the stock market in general has rallied as investors bid a not-so-fond farewell to worries about Fed inflation policy.
What stocks do you
want to own?
Think about it. Any market move that follows the Federal Reserve's departure from the battlefield isn't likely to float all ships. If the economy is indeed slowing to something like the 3% to 3.5% rate of growth that would put the Fed on the sidelines, it certainly will be good news for the stock market as a whole. But a decline from the recent, 5%-plus growth to something like 3% won't fall evenly across the economy. Some specific companies and sectors will feel the slowdown much more than others.
Economy Is Throttling Back
We've already seen some initial signs of this.
announced sluggish auto sales;
reported lower-than-expected growth; and
cited sagging appliance sales.
The market as a whole interpreted these stories favorably -- as signs that the economy was slowing and that the Fed would soon stop raising interest rates. The
Nasdaq Composite Index
rallied 19% from May 23 to June 6 in response. But General Motors fell 8%, Costco Wholesale fell 19% and Circuit City tumbled 34%.
The classic way to prepare for a slowdown in growth is to avoid those sectors that suffer the most and that suffer first when the brakes are put on. You don't want to get caught in those stocks when investors start to worry whether earnings are going to fall short of projections.
I think that advice still stands -- but I'd take it a step further. Thanks to very low inflation and intense competition among sellers, the recent period of extraordinary growth has been extraordinarily unprofitable for many companies. Many inefficient and even some efficient companies have found themselves caught between rising costs for inputs, such as energy and labor, and stable or even falling prices in the market for their output.
I think that trend is likely to get worse during any slowdown in economic growth. So I'd add this warning to the classic advice: Especially avoid the stocks of companies that are likely to get caught in what I'd call "the Big Squeeze" between falling growth and rising costs.
Makers of Big-Ticket Items Get Hit
What sectors are likely to feel the slowdown first?
The pattern so far looks absolutely classic. First to get hit are the makers of big-ticket items, for which most customers require substantial financing. The Fed's interest-rate increases have made financing these purchases more expensive, effectively raising the prices that consumers have to pay. So on June 1, U.S. automakers reported sluggish sales growth.
GM announced that total adjusted sales fell by almost 6% in May from the same month in 1999.
did better in absolute terms, with sales climbing 1.4% in May. But it did worse in comparison with recent sales growth. In April, for example, sales had shown a 12% year-to-year jump. On June 6, Circuit City reported that while sales for the three-month period that ended on May 31 were up 14% from the same period of 1999, sales growth in May came in at just 6%. The culprit? Extremely sluggish sales of major appliances such as refrigerators and washers. Rounding out the picture, new home sales fell in April by almost 6%.
Next to feel the crunch, if the slowdown follows the classic pattern, would be companies that make and sell consumer nondurables, such as clothing and cosmetics. This comes at a time when many retailers are already hard-pressed. For example,
, a middle-market department store chain, just reported quarterly earnings of 48 cents a share -- well below the 63 cents a share reported in the same period last year and below the 59 cents a share expected by Wall Street analysts. Unit sales of goods were below plan in the quarter, and the company had to discount aggressively to clear inventory. No wonder the stock trades near its 52-week low.
Analysts rushed to cut their estimates after Dillard's reported, but the stock didn't take much punishment. After all, it was already trading at a meager 10 times trailing 12-month earnings per share, and it's been stuck between 14 and 15 a share since the end of April.
Retailers Are Vulnerable
That doesn't mean, however, that there isn't damage to be done in the retail sector. As investors have fled retailers with sagging performance, they've jumped into a handful of stocks that have recently shown the ability to grow despite the troubles at competitors.
, for example, has been taking market share from
has the buzz with its formula of low prices and style, and the company is planning an aggressive rollout into new regional markets. And
pushed same-store sales up 29% in May.
But Kohl's now trades at 70 times trailing 12-month earnings, Target at 23 times, and Talbots at 24 times. So far, it doesn't look like the Fed's interest-rate hikes have significantly cut into employment, hours worked or wages, and in May, consumer confidence rebounded to a level near the historic high. As long as these numbers stay here, consumers likely will keep buying, and that will limit the effect on the top and bottom lines at these best-of-class retailers.
Still, already I see signs that investors are worrying about the possible effect of a slowdown on these stocks. An analyst downgraded Target on June 7, for example, to buy from strong buy on evidence that showed that June, all of a week old, had started off with sales running below plan.
It's not just high price-to-earnings stocks, however, which are at risk.
trades at a modest 16 times trailing 12-month earnings per share (once you add back in acquisition-related charges). But the grocery-store chain is stretching to make Wall Street estimates. Albertson's managed to match the 53 cents a share analysts expected when it reported on June 5, even though growth in same-store sales fell well short of company goals. But Albertson's found significant savings by buying more efficiently, reducing working capital and cutting net interest payments to make up the gap. If sales slow down along with the general economy, management is going to have to reach even deeper into its bag of cost savings to produce those extra pennies per share.
Caught in the Big Squeeze
I'm afraid Albertson's current dilemma is a precursor of the fix that many companies will find themselves in if the economy slows significantly. The costs of doing business aren't likely to come down significantly in that environment. Interest rates are likely to stabilize in the absence of Federal Reserve action -- but certainly, the central bankers aren't about to risk reheating the economy by reducing rates any time soon.
Energy costs are headed up over the short term, according to most forecasts, and will remain stubbornly high in 2001 before returning to a more normal range of $19 to $20 a barrel for oil in 2002. And facing relentless global competition, companies aren't likely to feel they can reduce their capital spending plans without risking their futures.
On the revenue side, with inflation at the consumer level already extremely low, most companies have only modest power at best to raise prices.
The components of this Big Squeeze -- falling sales growth as a result of a slowing economy, rising costs and a lack of pricing power -- aren't limited to retail or durable-goods companies. In fact, I think an investor can find them in pretty much any sector that he or she examines.
Procter & Gamble
shows all the signs for a potential Big Squeeze. In its last quarter, the company met analyst projections but showed lower-than-expected growth of 6% in sales (vs. projections of 8%) and of 4% in volume (vs. projections of 6%). On June 8, the company announced it won't match the consensus analyst estimate of 64 cents a share for this quarter -- even with major contributions from a decline in the corporate tax rate to 32%, from lower bonus payments, and from a Web-based order management program designed to cut costs. Instead, said the company, earnings will be flat, with the 55 cents a share recorded in the same quarter of 1999. And this is before any slowdown has really had a chance to bite.
Or how about
? Last quarter, revenue declined by 5%. But the company managed to beat earnings-per-share estimates thanks to one-time capital gains from the sale of an investment in
and from a 6% reduction in operating costs that included such items as reduced pension contributions.
In general, I'd propose this test to avoid the Big Squeeze. Look for companies with better-than-expected revenue growth -- in both dollars and units -- over the last few quarters. Look for companies that are producing better-than-expected earnings numbers without the aid of one-time capital gains, changes in tax rates or unsustainable cost savings in operations. And finally, check management's discussion of the business in the most recent quarterly reports filed with the
Securities and Exchange Commission
to see what kind of cost increases the company is seeing in the goods and labor it consumes.
Those checks won't catch every potential bomb before it goes off -- but they should improve the quality of your portfolio in time for any problems that a slowing economy might bring in the last quarter of 2000.
Jim Jubak is senior markets editor for MSN MoneyCentral. At the time of publication, he owned or controlled shares in the following equities mentioned in this column: Icos and Texas Instruments. Holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He welcomes your feedback at
Rowland's Watch Portfolio