Hazards ahead as a new quarter starts

Times Staff Writer

Crisis? What crisis?

All told, your 401(k) savings balance probably doesn’t look much worse for the wear and tear it has endured lately.

Stock markets worldwide continued to rebound last week from the recent plunge sparked by rising U.S. mortgage defaults and lender failures in the sub-prime loan market for people with checkered credit.

The blue-chip Standard & Poor’s 500 stock index jumped 3.5% for the week and now is just 1.6% below the six-year high it set Feb. 20.


Hedge fund firm Bridgewater Associates estimates that global stock markets and other high-risk assets on average have recovered 80% of the losses they suffered in the pullback that began Feb. 27.

The average U.S. equity mutual fund is up 3% for the year, according to Morningstar Inc.

If a surge in mortgage delinquencies in the sputtering housing market isn’t enough to upset investors for more than a few weeks, what would it take to give them a bigger jolt?

Here are three major risks that Wall Street is weighing as the second quarter approaches:


* U.S. consumer spending dives. Perhaps the surest ticket to a bear market in stocks would be for Americans to close their wallets -- either because they’re spent out or because they’re nervous about their finances or their job outlook.

This is so obvious that it might well be overlooked as a risk. Investors have no recent experience with a consumer-led recession. The last one was 17 years ago, in 1990. The 2001 recession, by contrast, was led by a plunge in business outlays.

Consumer spending accounts for more than two-thirds of U.S. gross domestic product. So if you put the consumer in a deep freeze, you almost certainly would do the same to the economy.

Since 2001 some analysts have repeatedly predicted a dramatic pullback in consumer spending. They’re still waiting.


But the housing sector’s woes unquestionably have raised the threat level to Americans’ shop-till-you-drop habits. What had been code yellow now looks more orange-ish.

For one thing, the end of easy mortgage money means that a large number of lower-income families now can’t get credit.

“When they can’t borrow as much they can’t spend as much,” said Susan Sterne, head of Economic Analysis Associates in Greenwich, Conn.

She expects real (after-inflation) consumer spending to rise a modest 1.9% this year, down from 3.2% in 2006 and 3.5% in 2005.


Analysts at brokerage Goldman, Sachs & Co. estimate that spending will rise 2% in both the second and third quarters, but they expect enough of a rebound in the fourth quarter to lift the full-year gain to 2.8%.

Economic optimists say the debt problems of lower-income families won’t be enough to trigger recession. The bottom 40% of income earners account for no more than 20% of total U.S. spending, said Steven Wieting, economist at Citigroup Global Markets in New York.

Meanwhile, for workers overall wages still are growing, and the unemployment rate is a relatively low 4.5%.

Still, if consumer spending data disappoint in the next few months, the stock market is unlikely to just kiss it off.


* Corporate earnings shrink. Wall Street is fully expecting a slowdown in profit growth this year with a weaker domestic economy. But an outright decline in earnings might be a shock investors couldn’t handle.

Bad news: The margin of safety is dwindling.

Total operating earnings of the Standard & Poor’s 500 companies are expected to rise a mere 4.3% this quarter from a year earlier, according to analyst estimates tracked by Thomson Financial. That would be less than half the pace of the fourth quarter and the slowest growth in nearly five years.

Any growth in 2007 would mean a new high for profit, because it would be building on the record results of recent years.


If earnings were to contract, however, that turn of events would add to fears that an economic recession loomed, or was already here -- a “hard landing” instead of the “soft landing” that has been Wall Street’s consensus expectation for 2007.

What keeps many investors in U.S. stocks is the belief that the market isn’t expensive based on key yardsticks. For example, the price-to-earnings ratio, or multiple, of the S&P; 500 index is about 17 based on 2006 earnings per share. That’s modestly above the market’s long-term average P/E.

But if earnings fell, the P/E would rise, and the market would become more costly (unless share prices slid as well).

Brett Gallagher, deputy chief investment officer at Julius Baer Investment Management in New York, said he didn’t believe a P/E of 17 was cheap, given the risks.


“I think slower growth, lower [profit] margins and lower multiples are more likely,” rather than less likely, in the near term, he said.

Yet even if a weaker U.S. economy is a drag on earnings, some companies may make up for it overseas. Athletic-wear giant Nike Inc. last week said its U.S. sales grew just 2% in the fiscal quarter ended Feb. 28. By contrast, the company’s Asia-Pacific sales jumped 11%; European sales surged 15%.

Nike’s stock closed at $109.05 on Friday, just under its all-time high reached earlier in the week. The price is up 10% this year.

Don’t underestimate the boost that economic strength in China, India, Eastern Europe and other regions can provide for U.S. companies, said Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis.


The global economic expansion, he said, includes “many more players, making it far stronger, more diverse and much more sustainable compared to any recovery in the past 50 years.”

* The dollar’s value tanks. The U.S. economy has been built on foreign money over the last two decades. Massive inflows of capital from overseas have been needed to cover the nation’s trade and budget deficits. Other countries’ saving underwrites our spending.

What would happen if foreigners lost their appetite for U.S. assets? Granted, that question has been asked so many times since 1990 that Wall Street is downright bored with it.

Which means that a dollar crisis would be exactly the kind of thing to catch most investors by surprise.


A fast slide in the buck could be a sign that the allure of U.S. investments is fading with foreigners.

The euro last week hit a two-year high against the dollar after Federal Reserve policymakers, who’ve been on hold with short-term interest rates since June, hinted that they were no longer leaning toward raising rates again.

This is where things get dicey. High U.S. rates, compared with the rest of the developed world, help support the dollar’s value. If the U.S. economy were to weaken enough that the Fed felt the need to cut rates, the result could be a steep plunge in the dollar -- which in turn could spark inflation by raising prices of the imports U.S. consumers crave.

If inflation rose, the Fed presumably would have to go back to tightening credit. Who wants to bet how financial markets would react to that?


“The perfect storm will come when the dollar goes,” said Paul Kasriel, chief economist at Northern Trust Co. in Chicago.

Then again, the dollar has been in a declining trend since 2002, yet the economy, and markets, have coped with it.

For now, there are enough foreigners willing to do their saving in dollars to keep them, and us, happy with the outcome: a continuing global economic expansion.

Predicting when that will change is a lot like predicting the Big One on the San Andreas fault: Someday, for sure. But maybe not tomorrow, or this year, or even this decade.