| SATURDAY, NOVEMBER 12, 2011

More Sound and Fury, Market Barely Budges

By MICHAEL SANTOLI

For all of the year's market gyrations, the S&P has barely budged in 2011. Stockholm Syndrome for stocks?

Is the stock market suffering from Stockholm Syndrome?

Think about it: U.S. stocks for months have been held captive by every mock-sincere handshake and thumb-biting hostile gesture offered during the unending European financial debate, and the market has begun to move in empathetic identification with the mood of these captors.

Witness Wednesday's 3% slump, on some fresh complication in the European debt negotiation that spiked Italian government bond rates. Or Friday's 2% pop on a perceived outbreak of sanity (or self-preservation) by the Italian Senate.

Figuring the stock market's true intentions means discerning its hidden motivation, like a method actor attempting to plumb a difficult role. But lately, it has been futile to venture beyond the obvious to decipher the main market drivers.

Strategists at Deutsche Bank note that this year the price/earnings ratio on American stocks has closely tracked the Euribor-OIS spread, an arcane-sounding but now widely watched gauge of bank-funding stress on the Continent.

Jason Trennert, proprietor of market-analysis firm Strategas Group, says the manic-depressive day-to-day action shows that "the magnitude of the world's macroeconomic concerns has led the global financial markets to arc between the poles of utter financial disaster and some silver-bullet solution that could diminish the concerns about sovereign solvency, albeit only temporarily."

It's hard to argue against this point, but perhaps what's most significant is the fact that through all the buffeting of seemingly intractable, almost existential threats to the West's financial fortunes, the stock market has attempted to find an equilibrium somewhere around where it started the year. In the absence of new and nasty headlines or evidence of acute market stress, the default mode of stocks—at least for now—is to hang firm or to climb a bit.

And so maybe it's fitting that the Standard & Poor's 500 Index has again traversed the flat line for the year (defined as the 1257 mark where it ended 2010) four out of the five trading days last week. It finished Friday up 0.85% on the week—and a mere 0.5% higher year to date.

The Dow Jones Industrial Average, finished the week up 1.4% at 12154, 5% higher than it started the year.

This is what happens when the opposing currents of macroeconomic and structural fiscal threats and corporate financial vigor meet, when loose Federal Reserve policy collides with the tightening effects of risk-averse and regulation-strapped banks. It makes for a lot of day-to-day movement, mostly in one direction on a given day, but little progress—little progress even over the vast stretch of 13 years, when the S&P 500 first tickled its current quote.

The crux of the bull-bear debate today, then, is whether the market's perseverance is best compared, in boxing terms, to a resolute fighter with an iron jaw or a punch-drunk tomato can without enough sense to go down. This can be a fine and imprecise distinction, and the first condition can morph into the second with one blow too many. But when a market refuses so many perfectly good excuses to collapse for good, its resilience probably deserves the benefit of the doubt.

As put on Friday by veteran market strategist Vince Farrell of Ticonderoga Securities:
"The market seems to handle whatever [is] thrown its way. The Greeks tried to take the system down, but it looks like, as the Spartans of old, they are being carried back on their shields. The Italians are hoping the full [Mario] Monti will pull a bunch of technocrats together and muddle through. U.S. economic news, on balance, continues to improve. Inflation came off the bubble in China and some are guessing the government will ease [interest rates] a bit by the end of the year.

"The stock market ran up to the 200-day moving average, got terrified, passed out and plummeted. Then it came to and rallied back. What was that all about? I guess it's just the Internet warp-speed electronic version of what used to be a several-week process of correction and backing and filling. But we have been saying the trading range would be alive and well and would take a slight upward tilt. Despite sickening swings and volatility, it has done that."

It's both tempting and logical to project that this trench warfare—hopeful buying before the requisite weekend summit meetings, followed by mid-week selling upon witnessing another outbreak of clay-foot-in-mouth disease among Euro officials—will keep stocks trapped around the flat line through year's end.

History hints, however, that stock markets abhor stasis in a given year. In the 115-year history of the Dow Jones Industrial Average, it has finished a calendar year up or down less than 5% just 23 times—half as often as it has gained or lost more than 20%. So maybe the final seven weeks of the year will liberate the index from the range that has held it captive for months?

GO SHOPPING AT THE FIRE SALES. That's the tack some shrewd investment pros advocate in today's colicky capital markets, as they seek to buy the solid assets—bonds, loans and such—of distressed or otherwise cash-hungry institutions.

For individual investors, KKR Financial Holdings (ticker: KFN) appears an attractive opportunity in this vein. An affiliate of the famous buyout firm, KKR Financial is essentially an $8 billion, publicly traded fund that buys high-yield bonds and corporate loans, as well as some real-estate and energy interests, and distributes a sizable portion of its income as dividends. The company is technically a limited-liability partnership rather than a REIT or a "business-development company," as some similar vehicles are structured.

CEO Bill Sonneborn has been vocal about its ability to exploit the urgency of motivated asset sellers "to accrete value to our shareholders much higher than [our] mid-teens hurdle rate," as he put it on a Nov. 3 conference call. By some estimates, more than $1 trillion in asset dispositions by European banks could hit the market in the next couple of years in the banks' hunt for unencumbered dollars.

Buyers of KFN shares, at the current $8.48, are getting the fund at a discount to its $9.14-a-share book value. And, based on its latest 18-cent-per-share quarterly distribution, its annualized yield is 8.5%.

Sonneborn arrived at KKR Holdings in 2008, after having run the funds business at Trust Co. of the West. He is among the managers of the firm who know their way around the credit markets. Among the largest shareholders is Leon Cooperman of Omega Advisors, who on the Nov. 3 earnings call said, "I only have seven" questions, one of which was about how management might "get the stock to fair value."

Assuming the market keeps presenting KKR Financial with assets on sale and the payouts persist near current levels, getting the stock toward fair value should follow.

IN TODAY'S MARKET, WHERE FABULOUSLY profitable companies such as Google (GOOG) and Apple (AAPL) fetch price/earnings ratios below the historical market average, what would you hope to pay for a dollar of earnings derived from selling crushed rock, concrete block and asphalt?

In the case of Vulcan Materials (VMC), there currently are no earnings, but a lofty valuation nonetheless. The company's enterprise value (stock market value plus net debt) is more than 18 times its projected 2011 cash flow (earnings before interest, taxes, depreciation and amortization). Vulcan, whose shares finished the week at $30.51, is forecast to operate in the red this year and next, continuing a string of post-housing-bubble years when the company essentially hasn't made any money.

It isn't entirely clear what equity investors see in Vulcan, a $3.7 billion market cap, debt-heavy, once-acquisitive gravel peddler from the Southeast, whose credit rating recently was cut further into junk territory by Moody's. Presumably they have noted that Vulcan's operating results are at a trough, and expect that within a couple of years the company could re-attain the kind of profitability levels—$4.71 per share at its 2006 peak—that once made the stock a highflier. But that isn't clear, and it could take quite a few years.

A couple of years back, Barron's cast a skeptical eye on Vulcan and its peer Martin Marietta Materials (MMC) ("Warning: Rough Road Ahead," Jan. 19, 2009), when Vulcan shares were nearly double their current level. Lately there have been bouts of enthusiasm over Congressional gestures toward reauthorizing a highway-construction bill and other hypothetical infrastructure initiatives, which would certainly help. But the pending highway bill merely would maintain the recent spending pace.

It is likely that Vulcan has seen the worst of the fundamental operating environment in construction. But the key question is whether demand can improve dramatically and quickly enough both to allow Vulcan to service its debt load of $2.8 billion and deliver the sort of ramp in bottom-line results that its valuation would seem to demand.

In the meantime, management is in a liquidity-preservation mode. The dividend was all but eliminated, dropped from $1 a share annually to four cents. Executives on a conference call cited the uncertainty coming from Europe's sovereign-debt opera for the shift, though there are other signs that credit markets need to be appeased. Vulcan is now replacing a $1.5 billion revolving bank line that doesn't expire for another year with a $500 million asset-backed line, led by a new bank.

Some investors might take comfort in the fact that the shares trade right at book value. But more than $3 billion of the company's $3.8 billion in book value is in the form of goodwill from past acquisitions and other intangible assets.

Some bearishly positioned fund managers argue that a write-down for goodwill impairment could be on the way. Unless this were a huge adjustment—one that took debt to total capital from the current 43% to above 65%, the maximum allowed under its bank agreement—this would be a mere non-cash bookkeeping entry.

Still, it would serve as a reminder that there is far less value within Vulcan than what it paid to buy other companies while it was riding the housing boom, and it would remove whatever perceived book-value support undergirds the stock.

Vulcan fetched north of $120 a share in May 2007. For now it is apt to stay stuck in the rubble.

Rally Resumed

Strong earnings from Disney, improving consumer sentiment and signs of stability in Europe sparked a stock rally that lifted the Dow to its sixth gain in seven weeks.