Argentina’s Potential Default

*****Hmmm. The Dow Industrials got killed two days in a row. So much for my "up one day, down the next" theory. 

We are in the heart of earnings season, so it shouldn’t be a big surprise that buyers are patiently waiting on the sidelines. We’ll have seen the majority of third quarter corporate earnings by the end of the first week in November. 

I know it may seem like a horrible Halloween prank, but stocks may stay volatile for another 2 weeks. 

That’s probably the best hope for any kind of sustained rally. Once earnings are out of the way, at least analysts should have some idea of how earnings going forward will look. And then investors can price those expectations into stocks. 

*****Merck (NYSE:MRK) reported that it would be cutting 7,200 jobs. Chrysler announced layoffs and if GM (NYSE:GM) gets bought out, that will no doubt lead to more layoffs. Goldman Sachs (NYSE:GS) is cutting its workforce by 10%. 

Clearly these cuts are not good news. As I’ve discussed here in the Daily Profit, unemployment is the best barometer for recession. So long as people are losing jobs, the U.S. economy isn’t going to recover. That’s why the IMF has said the U.S. economy won’t grow until mid-2009. 

Now that doesn’t necessarily mean that the bear market for stocks will continue that long. Bottoms for prices tend to get put in while an economy is still in recession. And much right now depends on how long the credit crisis hampers business. 

The earnings results we’re seeing right now are for the third quarter, July through September. That’s before credit issues slowed the global economy to a virtual standstill. So investors are trying to price the current economic weakness into stocks based on earnings and forecasts. 

Obviously, that’s taking stock prices lower – to historic lows in some cases. If credit issues linger, then the risk to forward earnings rises. But if credit issues ease sooner than later, investors may decide there is upside to their earnings expectations. 

One thing’s for sure, investors are pricing in the worst-case scenario right now. 

*****It’s hard not to expect the worst when you see headlines like "US foreclosure filings up 71% in 3Q". The US economy’s troubles are rooted in the housing market. So news that foreclosure notices have nearly doubled in a year is not helpful. Analysts are still calling for another 10%-15% drop in home prices. 

However, it’s important to note that a foreclosure notice isn’t the same as an actual foreclosure. The notice means that the home-owner is in danger of foreclosure. I can guarantee that whoever holds that mortgage does not want to foreclose on the property. There’s too much foreclosed property already on the market. And falling prices and credit issues make it difficult to move. 

So there may be renegotiations of some of these problematic loans, especially given Paulson’s pledge to do "everything it takes" to get the economy back on track. 

Again, here’s a situation where investors are pricing bad news into stock valuations, but that bad news is still in worst-case scenario mode. There’s potential for good news on foreclosures somewhere down the line. 

*****Still, as if falling home prices, increased foreclosures, more layoffs and uncertainty about earnings weren’t enough, fears are rising that certain emerging economies will default on their debt obligations. 

Argentina just announced that it’s taking over pension funds, a pretty obvious admission that it needs the cash now and will worry about actually funding pensions later. Credit markets are assigning a 94% probability that Argentina will default. Of course, this is nothing new for Argentina. That country has constant money problems. 

But the problem’s going global, as Pakistan, Iceland, Belarus and the Ukraine are all seeking financial assistance. And you can’t just let a county be bought out the same way Bear Stearns and Merrill Lynch were. 

Anyone holding emerging market debt now has to pay even higher prices to insure that debt through credit-default swaps. You remember credit-default swaps – those are the derivative instruments that brought down our financial sector. It’s amazing to me that anyone would even sell these time-bombs anymore. 

*****Investor’s Business Daily has an article about how the credit problems are affecting natural gas companies. This is an issue we’ve discussed in regards to Chesapeake Energy (NYSE:CHK). 

Chesapeake and other natural gas drillers have seen their stock prices plummet as natural gas prices fall due to recession fears. Plus, problems in the credit markets have forced them to cut production, which impacts future earnings. 

Chesapeake was one of the first natural gas companies to announce as production cut as prices have fallen 40% since July. But of course, no sector is more prone to wild swings in pricing and production than the commodities sector. And natural gas is no exception. 

When times are good, companies leverage themselves to the hilt to raise production and cash in on rising prices. Of course, much like stock investors, they almost always go too far. Production inevitably outstrips demand. Prices then fall, companies cut back. And then the whole cycle starts anew. 

That’s why commodities are called cyclical. And when investing in cyclical industries, you make money buying at the bottom of the cycle (buy low) and taking your profits when everything looks rosy (sell high).