Stocks and corporate bonds have been resilient in the face of bad news.
But analysts think they know which of these two components of a diversified portfolio is more vulnerable.
Using topographical metaphors, stock investors are looking across a valley, and corporate bond investors are peering over a cliff.
In the last few days, investors seemed undisturbed by historic losses by Merrill Lynch, deteriorating house prices, record high oil prices and a record low dollar. For the second straight day Thursday, stocks rebounded from steep morning losses.
A major reason for the optimism is the upbeat outlook by analysts toward profit growth in the current quarter and 2008.
Analysts surveyed by Reuters Estimates expect flat profits for Standard & Poor’s 500 companies for the third quarter, which ended Sept. 30. But they forecast a swift return to double-digit profit growth. For 2008, analysts see S&P profits climbing 13.7 percent, more than double the growth rate for 2007 and back on par with the robust gains of the last five years.
“If you’re going to sell [stocks] on earnings, I don’t think that’s a good bet,” said Ashwani Kaul, senior market analyst for Reuters Estimates.
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The rosy scenario appears to be based on expectation that the losses and profit declines currently being disclosed by financial firms for the third quarter represent the worst of this sector’s performance.
“I think we bottomed out in the third quarter,” Kaul said. “The financial picture is not going to get worse.”
What’s more, technology profits are picking up the slack from weak banks and brokerage firms.
“We’re seeing ridiculous growth numbers coming out of technology,” Kaul said. “We can’t be in a recession if people are buying technology products.”
The strength of the corporate bond market also reflects the long-running record of profit growth.
“We are seeing record low default rates in the U.S.,” said Diane Vazza, head of global fixed-income research at S&P.
With just 12 corporate bond defaults this year, there’s a good chance 2007 will end with a default rate lower than the S&P forecast of 1.4 percent of corporate bond issues. The long-term default rate for U.S. corporate bonds is 4.5 percent.
But despite the outlook for improved corporate earnings, the corporate bond market might be living on borrowed time.
“Trouble is brewing,” said Vazza.
For one thing, for the first time ever more than half of all U.S. corporate debt securities are rated speculative grade, which makes them ineligible for some institutional investors that are required to buy only investment-grade bonds.
It takes about three years for speculative bonds to enter a period of default risk. Some of the most speculative paper was issued this year, before the junk-bond market froze in late summer.
An S&P indicator called the distressed debt ratio, which measures the level of the lowest-priced junk bonds as a percentage of all junk bonds, declined in recent years, along with the junk bond default rate. This summer, the ratio turned higher.
“We came off a period of high liquidity,” Vazza said. “We’re seeing risks build.” Looking out beyond the next 12 months, “we’re saying defaults could be more pronounced and severe,” she said.
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