What's Next for Wall Street?

Poor Wall Street: No one’s job is safe as the financial sector continues to go through its most dramatic upheaval since the Great Depression. Meanwhile, the US Congress—hardly a popular institution itself—is heaping scorn on the institution’s alleged “fatcats,” as it debates measures to stanch the global financial panic. Even the Republican candidate for Vice President has put the Street on her enemies list, railing about “corruption” and “predatory practices” throughout last night’s debate.

Running against Wall Street, of course, is hardly a new theme in politics. It’s somewhat ironic that Republicans are leading the charge this time around. But given their slipping poll numbers, it’s not surprising their campaign is trying to tie Democrats to Wall Street, even if it means throwing a president from their own party under the bus in the process.

At this juncture, the most important thing to Wall Street and the financial markets, however, is getting the much maligned $700 billion “rescue package” through Congress. The US Senate did its part earlier this week, passing a bill that also included such goodies as extended tax credits for renewable energy.

The US House was always the tougher nut to crack. But enough members in both parties have finally yielded to President Bush’s pleas to pass a highly controversial $700 billion “rescue package.” That will enable Treasury Secretary Hank Paulson to put his plan into action, to restore liquidity and pricing to the now-moribund market for mortgages and mortgage-backed securities.

The question now: What happens next? Will global stock markets now be off to the races, abruptly reversing the devastating slide of the third quarter? Will Paulson now be able to stabilize the mortgage market and restore security to the US financial system? Will the US economy now bottom and return to growth? Or will things continue to slide once the market gets its near-term relief?

I suspect the answers will probably come somewhere in between. Ironically, the so-called “bailout” is likely to be the least of our worries going forward. In fact, there’s definite precedent for the US government actually turning a profit on its investment here when all is said and done. That was the outcome of the 1994 bailout of Mexico, which at the time was perhaps even less popular than the Paulson plan is now. And more than a few heavy hitters look for that to happen this time around, including the legendary billionaire Warren Buffett.

Even if it succeeds in unfreezing the credit markets, however, the Paulson plan won’t solve all the ills of the market or the global economy. This week, we got a very disturbing piece of news on the latter, a record drop in the Institute for Supply Management (ISM) Manufacturers’ Index to a recessionary 43.5 percent for September.

The Index is now at its lowest level since October 2001—following the slowdown in the wake of the Sept. 11 attacks on Washington and New York—and was far below forecast levels of 50.1 percent. It’s another clear sign that US economic activity is slowing in the face of an extremely tight credit market. In addition, non-farm payrolls shrank far more than expected, and initial claims for unemployment insurance surged within an eyelash of 500,000--sure signs that the labor market is also weakening.

The upshot: Even if the credit markets do unfreeze, the economy is likely to sink further. Eliminating the uncertainty of a collapsing financial system will no doubt be of immense benefit to restoring overall market confidence. But the underlying stress tests on individual companies are certain to ratchet up in the coming months. And that almost certainly means more will succumb, adding to their stock market losses.

Ultimately, companies that do weather the stress tests will recover their losses of past months, as buyers return to this now panic-stricken market. And they’ll continue to pay us our dividends as we wait on their share prices to bounce back. That’s only going to happen if they continue to post solid numbers, with the next day of reckoning coming later this month and in early November with the release of third quarter results.

Earlier this week, I again highlighted the importance of a disciplined strategy of sticking only with companies that continue to measure up on the numbers. That means having the emotional detachment to cut loose the companies and mutual funds that falter in the stress tests, regardless of the losses sustained so far.

To the extent that I’ve followed that as an iron clad rule, I’ve succeeded in avoiding real blowups, even as conditions have worsened. Unfortunately, to the extent I’ve given holdings a pass--falling back on the idea that things would get better--I’ve been burned, just as I was during the Great Utility Bear Market of 2001-02.

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A good example of the latter was my decision to stick with Flaherty & Crumrine Preferred Income Fund (NYSE: PFD) earlier this year, after the closed-end fund trimmed its distribution by a penny in the wake of higher financing costs for its use of leverage. The main reason I gave the fund a pass was the quality of its holdings, basically a very diversified portfolio of preferred stocks issued by utilities and banks. The banks, I reckoned, continued to give me exposure to the financial services industry, though in a low risk way, while the utilities provided ballast.

As it turned out, the fund’s utilities have done their part, while the financials--though weakened--have by and large kept paying their distributions. The financing troubles from the fund’s leverage, however, have continued to worsen. The result is this week it “suspended” distributions, including one already declared for September.

Sticking around through the first distribution cut, consequently, subjected me and my readers to another more painful cut--and ultimately considerably greater losses. I’ve since recommended selling the fund on the grounds that it pays no dividend and that the pressures on it are likely to worsen. But I obviously could have saved a lot of pain by simply acting at the first sign of trouble, rather than simply holding and hoping for things to get better.

My troubles with Flaherty & Crumrine, of course, are no different from those experienced by of millions of other investors in this market. My firm resolution is not to repeat them going forward. That will mean unloading anything I recommend that shows definite signs of weakness.

Along with high tech, the utility sector was at the epicenter of the last bear market on Wall Street in 2000-02. After a strong performance in 2000, the industry began to show signs of weakness in early 2001, with the collapse of the California power market. The erosion continued throughout the year, as power prices declined in the wake of the recession and cracks began to appear in the then-burgeoning power trading business.

The shocking collapse of Enron in late 2001 intensified the pressures, as credit raters began systematically downgrading companies across the board--including those with little or no exposure to energy trading. And the meltdown climaxed in late 2002, with two dozen companies either in bankruptcy or perilously close to it and the entire sector facing a flood of state and federal investigations into their business practices.

As I’ve pointed out over the past couple weeks, the resurrection of the utility industry over the past six years is a very hopeful example for the now-battered financial services sector. Many feared an outright government takeover of companies as the recovery got underway. But little by little, management cut risky assets and slashed debt, while refocusing on core utility operations and repairing relations with regulators.

Today’s utility industry is considerably more regulated than in the late 1990s. Several states have pulled plans to open their monopolies to competition and others, such as Virginia, have actually rolled back deregulation, restoring incumbent utility Dominion Resources to its old integrated monopoly under a very favorable rate regime.

The demise of Constellation Energy in the wake of the credit crisis will almost surely accelerate this trend toward increased oversight and getting back to basics. Even before it occurred, for example, Great Plains Energy had dumped its Strategic Energy unit. The state of Michigan, meanwhile, continues to push ahead with its own re-regulation legislation, which will essentially restore the monopoly franchises of leading utilities CMS Energy and DTE Energy.

The utility industry is no longer a great business, where fortunes can be made overnight. But it’s definitely back to being a good one, where risks are defined, balance sheets are transparent and solid performance is rewarded with a fair return.

In my view, that’s what lies in store for the financial services industry. I’m not one who envisions a government takeover. Contrary to some pundits’ statements, there’s just not the appetite for it any more than there was to nationalize the utility industry earlier in the decade.

On the other hand, the Wild West days of recent years are gone forever. So is the “great” business that enriched players up and down the food chain. But what will emerge will be infinitely more stable and reliable, both for investors and borrowers who depend on access to credit. That is what’s attracted Warren Buffett to the sector now, just as he’s made a big move on utilities since the 2001-02 meltdown.

Utility stocks, of course, have hardly been immune from the ongoing financial crisis and accompanying market meltdown, as the Dow Jones Utility Average is now down some 20 percent this year. The damage, however, has been far from evenly spread.

More highly regulated companies such as Southern Company have largely held their own. Meanwhile, companies involved in wholesale generation such as Exelon and FPL Group have taken some hard hits.

As I’ve pointed out in past months, the stock market damage is far out of proportion to what we’ve seen in the actual earnings numbers. Both Exelon and FPL showed some pressures in the second quarter but generally reported robust overall numbers. Both have tempered their full-year projections a bit but have maintained the same general guidance they set out earlier in the year. That’s hardly the picture of an industry where the business fundamentals are coming unglued.

The key question, of course, is whether or not recent events in the financial system and the intensified slide in the economy have changed matters. We won’t really have the answers here until we can get third and fourth quarter numbers. At this juncture, however, things still look to be on solid ground overall.

How the utilities are being affected by the financial crisis is, not surprisingly, very much a hot topic in the news and analysis services covering the industry. Rudden’s Energy Strategies Report did a brief roundup in a report this week.

The basic conclusions were that, even as credit markets have frozen globally, high-quality utility companies have still been able to sell debt. Risk premiums paid to US Treasuries have been unusually high but still lower than those paid by companies in other less recession-resistant industries.

There’s also been no real sign to date that utilities are pulling back on capital expenditures, though that may happen if expectations for economic growth subside. Many of the projects are very long-term in nature and enjoy regulatory support, meaning they’re likely to continue.

Rudden cited anecdotal evidence that executives were drawing lessons of caution from the Constellation case, pulling back their exposure to the marketing and trading business. Rate spreads have gone up for this business, which should temper profits for companies with these operations. But as I pointed out a couple weeks ago, that affects only a very small group of companies in any significant way, a stark contrast with 2001-02.

The crisis also appears to be inducing utility executives to redouble their efforts to strengthen their balance sheets. That also means a further retrenchment to regulated utility operations. As for regulators, economic slowdowns generally mean less appetite for large rate increases. Here, too, many utilities are catching a break, as they’re now able to lock in lower fuel costs than earlier in the year.

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These are generally automatically passed through in rates. Cutting them will bring a lot more tolerance for rate increases tied to capital spending needs, which are expected to reach $1.5 trillion over the next 20 years. And unlike fuel cost boosts, CAPEX goes into the permanent rate base and earnings.

We’ve already seen some slowing of customer growth in formerly hot markets such as southern Florida and Nevada--and that’s hit the shares of utilities that operate there. Sierra Pacific Resources has been among the worst performing utilities this year. The key for these companies, however, is regulatory support. Sierra’s second quarter earnings were up 25 percent, as it continued to execute on long-term capital spending plans enacted with the cooperation of regulators. As long as that support is forthcoming, it will continue to weather this storm.

Again, my view is we have to continually subject our companies to close scrutiny at earnings season. And if the numbers show any of my recommendations are weakening appreciably in the face of these stress tests--including utilities like Sierra--I’ll advise taking the loss, no matter what it is.

At this point, utilities still appear to be living up to their reputation as recession resistant. The old adage that the light bill is the last thing cut, it seems, is still holding. So is its corollary that, even in a tight market for credit, utilities can still borrow money at decent rates.

There may still be stock market losses ahead. Thus far, however, utilities are proving themselves to be a sector apart. And that should add up to a mighty recovery once the financials begin to follow the road to recovery they’ve laid out since late 2002.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.

Join me and my colleagues Neil George and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.