The Dreaded Return of the Triple Whammy

This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

The New York Sun

In the week ended July 19, eager investors paid little heed to an escalating Middle East crisis, a rash of disappointing earnings news, and a slowing economy, snapping up an estimated $5.2 billion worth of equity mutual funds after unloading $900 million worth the week before.

Could be they switched directions way too soon, a recently issued commentary from Merrill Lynch’s well-regarded North American economist, David Rosenberg, suggests.Why so? He cites another, lesser-known market danger that has ominous implications: in brief, the return of the triple whammy.

The triple whammy — declining equity prices, rising energy prices, and a higher Fed funds rate — is a combination that has negative liquidity implications and foreshadows bum economic tidings.

A rare occurrence, the triple whammy suggests to Mr. Rosenberg that next year will be a bummer on the economic and earnings fronts, which is invariably a forerunner to falling stock prices. That’s the warning Mr. Rosenberg just fired off to the firm’s institutional clients.

The liquidity risks, he says, center on the following:

• The falloff in stock prices compresses the earnings yield and raises the equity cost of capital, not to mention the negative impact on household net worth (households own more than $10 trillion worth of equities).

• The run-up in oil siphons off consumer discretionary spending and raises the cost of doing business, being a tax on growth and a crimp on margins.

• In addition, a higher Fed funds rate, which raises the cost of borrowing, pushes up the debt service bill on more than $2 trillion of household debt and $3 trillion of short-term corporate liabilities.

Interestingly, the triple whammy, prior to this year, has occurred in only seven other years in the past five decades. For the first years after these unhappy events, growth either decelerated or was negative on six of the seven occasions.That’s a pretty impressive and disturbing 80% track record.

On average, Mr. Rosenberg says, in the year after the triple whammy, real GDP growth was trimmed by 220 basis points, which would mean a downshifting from 3.5% this year to around 1.5%- 2% next year, which is well below general expectations.

Given his outlook, the Merrill economist views as a stretch Wall Street’s consensus forecast of 11% per-share earnings growth next year. “Margins are already at a cycle high and every leading indicator at our disposal is pointing to much slower sales growth in the year ahead,” Mr. Rosenberg says.

Not only does he rate the consensus 11% estimate as highly optimistic, if not downright unrealistic, he also thinks an outright decline in next year’s earnings cannot be ruled out. If he’s right on that score, of course, such a happening would assuredly clobber the stock market.

How does Mr. Rosenberg come up with such a possible scenario? Two reasons. One, profit margins are already at peak levels. The other: GDP growth is almost 100% certain to slow in the coming year under the weight of the lagged effect of the longest and most tenacious Fed tightening cycle on record (17 straight rate hikes since June 2004). He also tacks on another influential factor — the peak in housing activity (which occurred in January). Economic growth, he points out, has always slowed after housing starts hit their cyclical highs.

Actually, the Merrill economist expects paltry S&P 500 operating earnings growth next year of just 3% to 4%. One factor that’s likely to lead to slightly positive 2007 profit growth is said to be the hoards of cash sitting on corporate balance sheets. As such, Mr. Rosenberg sees continuing record stock buybacks, which he figures will boost the year’s per-share earnings growth by 2% to 3%.

Given his mediocre-earnings outlook, he expects analysts to cut their estimates. Rated most vulnerable to the analyst’s knife are said to be the consumers discretionary, technology, and industrial sectors.

But his clear bottom line: Don’t forget about the triple whammy!

The New York Sun

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