Monday, July 2, 2007

The Pros and Cons Going into the Third Quarter

Let's look at the pros and cons of the market as the third quarter begins.

Earnings Concerns

Second-quarter earnings growth is so far expected to fall further to 4.3%, even though rising energy prices seem poised to given another lift to earnings.

The expectations for first quarter earnings were low as well. Analysts and companies issued very conservative guidance because of the slowing economy. As a a result, many companies surprised to the upside, adding fuel to the bulls argument.

International Sales

But the market thus far remains confident that strong global growth, led by China and Asia, will continue to boost U.S. profits, even as the economy slows.

This was one of the main reasons for the surprising strength of some earnings reports. Companies with strong international exposure were the obvious beneficiaries of this trend. The rest of the world still looks like they will do well in the second half of the year, so this trend will probably continue.

Mergers and Acquisitions

This year's record pace of takeovers slowed by 49 percent in June, data compiled by Bloomberg show. Delaware Investments, the Hartford and City National Bank, which manage more than $500 billion, say the decline plus the decision by leveraged buyout firm Blackstone Group LP to sell shares to the public are signaling that the five-year bull market is nearing an end.

The drop-off may simply be seasonal; M&A firms obviously had a ton of deals in the pipe which they continually announced over the last few quarters. However, there may also be a problem developing with the financing of these deals. The Bear hedge fund problems may tighten the lending markets, preventing some of these deals from going through. There has been a fair amount of press over the last week about lenders tightening standards in a variety of ways.


Adding to existing concerns, the woes of the housing market and the resulting meltdown in the subprime-mortgage market have claimed new victims. Two hedge funds owned by Bears Stearns & Co. were brought close to collapse two weeks ago.

I debated this issued with Barry Ritholtz. There are plenty of reasons to be concerned, but I think what we'll see is a few funds having big problems, but a limited broader impact. I should add, this is a developing situation and as more facts come out that conclusion will either be supported or shot down.

There is also the possible impact on the economy as a whole. The housing market will go through another 12-18 months of mortgage rate resets. These will continually add downward pressure on the economy as a whole.