Why is it taking so long for the stock market to recover from the popping of the bubble?
Look, the bubble popped in either January 2000 -- when the
Dow Jones Industrial Average
hit its high of 11,723 -- or in March 2000 -- when the
Nasdaq Composite Index
topped out at 5,048. And here we are on Oct. 2, with the bear still firmly in control of the market, despite yesterday's rally.
If U.S.-style capitalism is good at creative destruction, why haven't all the layoffs and bankruptcies and interest-rate cuts cleaned house by now and launched a new recovery?
Good question. After all, the bear market of 2000-02 (and counting) has already lasted longer than the bear of 1973-74.
I certainly don't have a definitive answer, but I do have an explanation that makes sense of where we are, what we've been through and where we're going. It's based on the idea of creative destruction -- the necessary down cycle that corrects the excess of the up cycle in capitalist economies. And to that framework, it applies the common sense principle that the pain of the down cycle is proportional to the excesses of the up cycle. In other words, the worse the bubble was, the longer it will take to correct it.
Every day that passes makes it clearer that the bubble of 2000 was one mean monster. First, it wasn't limited to just one industry such as networking or communications, or even to a single large sector of the economy such as technology companies. The bubble excesses have sucked down even such traditional strongholds of safety and conservatism as utilities.
Second, the nature of contemporary balance sheets leveraged the damage of that bubble. The same tools that enabled companies to raise more money more efficiently and more cheaply than ever before also created an often-unpredictable web of interlocked liabilities that's proving extremely difficult to unravel.
Prime Example: Duke Energy
Want to see what I mean? Let's take a look at how the bubble sucked in a conservative utility company like
and why it's taking so long for Duke to fix the damage.
On Sept. 20, Duke warned that earnings for 2002 would fall 16% short of projections. That would put 2002 earnings a good 20% below those for 2001. And don't look for 2003 earnings to make up for the problem, either, Duke said. Earnings for that year will be flat with the lower numbers now projected for 2002. That's another 20% drop from Wall Street expectations for 2003. Not surprisingly, the stock, already falling because of pressure on the utility sector in general, fell 15% in the days after the announcement.
Duke's problems are a direct result of the excesses of the capital markets during the bubble period, in both obvious and not-so-obvious ways.
Duke's entry into the energy-trading business falls into the obvious category. The financial markets were throwing money at
in 2000 because that company was the leader in energy trading. At the stock's high in 2000, Enron had a market capitalization of $73 billion. Trading energy, rather than actually producing power, seemed to represent the future of the utility industry.
Like other traditional utilities --
American Electric Power
comes to mind -- Duke moved to become a trader, too. And when the energy-trading bubble collapsed, billions of dollars in market capitalization were destroyed. Duke and other traditional utilities are still paying the price for those excesses as
Securities and Exchange Commission
investigations hang over the stock price.
Hot Trends Gone Cold
But it was the not-so-obvious excesses that led to Duke's most recent announcement. The other hot trend in the utility business in 2000 was merchant power generation. Traditionally, utilities have built power plants to provide energy to customers in a geographically defined service area. The company might have sold excess power from time to time, but it didn't build plants with the goal of generating excess power to sell outside its service area.
Merchant power generators, on the other hand, intend to do just that. They would use massive economies of scale to generate surplus power at low prices and then sell that power to regions that were experiencing higher power costs. The business went hand-in-hand with energy trading. And with the capital markets ready to put up the cash to build plants, companies such as Duke,
went on a building spree.
The availability of all that capital, however, created a glut of new power plants that drove down the price of wholesale electricity (and incidentally lowered the volatility of energy prices, making energy-trading operations less profitable as well).
Unwinding this overbuilding of power plants takes time. Certainly, utilities can cancel plans to build even more plants; in its latest announcement, Duke deferred three new plants. That will cut capital spending to $6.2 billion in 2002, and the company plans to reduce capital spending further to just $3.5 billion in 2003.
But it isn't as easy to "destroy" inefficient or unneeded assets; after all, those assets are power plants, not stock brokers or engineers who can be fired. The utility industry's inability to quickly reduce the oversupply of power plants is likely to keep energy prices low well into 2003 (or whatever year you think the economic turnaround will arrive).
By itself, the difficulty in removing excess power production explains why Duke and other utility companies aren't ready to rebound now. And to the question of why the market remains bearish and the economy remains slow, that difficulty serves as a partial answer from a traditionally conservative sector.
Balance Sheet Imbalance
But it's only the first part of the story. As tough as it is to fix the physical side of Duke's balance sheet, those problems are pretty much in the stock price now. The potential problems that are likely to keep the downward pressure on the stock for the next year don't involve physical assets at all. No, the challenge now facing Duke -- and so many other conservative and aggressive companies -- is in the financial engineering built into those balance sheets during the bubble.
On Sept. 25, Duke announced it would sell $1 billion in stock to reduce the debt created by its acquisition of Westcoast Energy. Because the price of Duke shares has fallen so much, this offering will dilute the holdings of current shareholders more than anticipated at the time of the Westcoast deal. So a good deal at a good price -- which I believe the Westcoast Energy acquisition was -- winds up hurting the share price.
In addition, because of falling wholesale energy prices, Duke looks like it will generate just $3.8 billion in operating cash flow in 2003. With the capital budget still at $3.6 billion even after the recent cuts, Duke doesn't have enough cash flow to finance that capital spending and to make its $1 billion annual dividend payment. Duke will either have to slash capital spending further or raise that $1 billion for dividends in the capital markets, or some combination of the two.
Duke has the financial strength to raise that cash, and the dividend doesn't look to be in danger, but it will take most of 2003 for the company to work its way out of this cash bind. By 2004, it's likely that Duke's cash flow will be large enough to fund both a reduced capital spending budget and the dividend internally.
Months of Hard Work Ahead
So no big deal, right? By 2004, the problem will be in the rearview mirror, right? Probably, but in the meantime, the balance sheet squeeze at Duke will drag out the needed consolidation in the merchant energy business. Duke is one of the healthiest players in the sector and is the logical buyer of assets from troubled companies. Those kinds of deals would help Duke in the long run and help the recovery of the industry as well. Anything that hinders Duke's ability to act aggressively as a buyer, however, will delay the consolidation and make it tougher for the industry to put its troubles behind it.
Now if Duke, which is a relatively healthy company with a strong balance sheet, still hasn't put its problems behind it, you can imagine why it's taking so long to correct the sprawling excesses of the bubble of 2000.
Rather than leading its sector out of the slump in the near future, Duke faces more months of hard work in order to fix its own problems. Sectors in which the leaders are much weaker than Duke face even more delays and a much longer time to recovery.
Those delays are likely to be longest in sectors in which the degree of financial engineering far exceeds that at Duke.
But you can use the delays and your estimates of how long it will take to correct the excess in any specific sector to create a schedule for the arrival of that correction and eventual recovery. In the case of Duke, 2003 looks likely to be devoted to fixing the balance sheet and conserving cash. The cash crunch, though, should be over by 2004, and Duke then would have the financial muscle to buy already completed power plants from weaker utilities.
On that schedule, I'd expect Duke shares to start to stabilize and show some strength in the second half of 2003. The utility sector as a whole would see a still later recovery -- maybe in the second half of 2004.
That may seem like a long time to wait, but the utility industry is likely to recover more quickly than most. That's because the financial problems facing it are straightforward, at least by comparison with some of the balance sheet deals still unwinding in other sectors.
At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.