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Tailwagging November 12, 2007 By Mat Johnson "People may bet on the hourly wiggles in the market, but it's the earnings that waggle the wiggles long term." — Peter Lynch Another week, another round of concerns from the financial sector. Stock analysts, the media and institutional investors are chanting in harmony about the "credit crunch." First off, there is no credit crunch. A "credit crunch" is defined by the inability of borrowers to obtain financing; which typically occurs during recessions, and coincide with very high interest rates. The underlying cause is widespread fear on the part of banks, bankruptcies and defaults. While it certainly is more difficult to obtain financing than before, current credit market dislocations highlight that it was far too easy to get credit before, which has resulted in a rise in defaults. Current credit conditions now reflect the prudent scrutiny of borrowers, and little more. With respect to businesses, they are generating their own financing through very high levels of cash flow, so they're largely not in the market for credit. In essence, many people are citing something that they believe to be true and concluding because the stock market is down that they are right. Convenient, but the case is not so simple. What is occurring is that the market has fallen susceptible to emotions, which are running high, and casting fundamentals by the wayside. This isn't to say that the market's prospects haven't dimmed as of late. While we remain sanguine about the market's prospects longer term, emotions, particularly those that stem from fear of loss, can result in a real impact to economic and business prospects: consumers can curtail spending, businesses can postpone investment and the worst case scenario is that the two feed off of one another and tip the economy into recession. We don't think the worst case scenario is likely, but judging by the market's behavior as of late, investors appear to be pricing an increased possibility of a recession occurring. A large part of our believing that a recession is not imminent owes to the fact that while financial market events have been significant enough to impair the economy to some extent, economic fundamentals remain firm. Thanks to globalization, more volatile employment is based abroad. This helps to immunize against fluctuations in employment here at home. Also owing to globalization is that growth abroad is translating to healthy levels of foreign demand. This was most notable in Friday's release of the trade balance, where the deficit has shrunk to the lowest level in nearly two and a half years thanks to a strengthening in exports. Given that nearly 45% of S&P 500 company earnings are derived from abroad, and that these are the country's largest employers, this too provides a key level of support to sustaining employment and income growth, as well as consumer confidence and spending. Just the Facts Third quarter GDP growth was recently reported to have risen by 3.9% (strongest growth in a year and a half). Since the report, additional economic reports have come out that suggest this figure will be adjusted higher. Additionally, business inventories continue at very low levels, while sales are growing twice as fast. This strong pace of sales relative to inventories should translate directly to business activity strength, meaning that as sales continue to rise, companies will need their employees to meet end-market demand, rather than rely upon inventories on hand. Obviously we are at a period with substantial uncertainty, particularly with respect to how steadfast consumer and business confidence holds up. With the bulk of earnings reports having passed (retailers are up this week), economic reports will provide the key source of information for investors to assess the risks and opportunities through year-end. This week we are looking at a robust economic calendar, with October Retail Sales being released on Wednesday, followed by the Consumer Price Index on Thursday. Friday will bring the release of Industrial Production. In essence, we will get a look at the key variables of: how well is consumer spending holding up; are consumer prices moderating enough to appease the Fed's inflation concerns, and are the low level of business inventories continuing to translate to business activity that sustains current employment. In total, these are the reports that will provide a firm context of the underlying business backdrop that companies are operating within. Given how the market appears to have placed a higher probability of the economy moving toward recession, merely seeing that economic recent trends have continued may renew the focus on the underlying fundamentals, and displace emotion as the driver of the market's direction.

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