The awful news out of Japan just seems to keep getting worse. There are now four reactors that are in trouble and significant (although outside the gates of the plant, not immediately dangerous) levels of radiation have been released into the atmosphere. That has severely strained the country’s electrical system (along with other damaged generating and transmission facilities), and there have been rolling blackouts across the country.
Most of the factories in the country have been shut down, either due to direct damage or to save electricity. Clearly that is going to be a massive hit to the economy, and first quarter growth there is going to be negative. By how much is really anybody’s guess at this point. The amount of direct damage is probably on the order of $200 billion, but that is still only a rough guess.
A Hit to Insurance Companies
Japanese insurance companies — and re-insurance firms worldwide — are going to take a big hit. While premiums will probably increase in response, it will take a long time to make up those losses. Given Berkshire Hathaway’s (BRK.B) exposure to the catastrophic insurance market, my guess is that Warren Buffet wishes he had held off on his offer for Lubrizol (LZ), although over the long term I think that deal will probably work out OK.
In the very short term, the insurance companies there are going to have to sell off assets to pay the claims. Those claims are going to have to be paid in yen, which is one reason that the yen has rallied on the news. With the economy slowing dramatically, there is less overall demand for resources. A steel mill that has been shut down for lack of electricity — and steel mills use a LOT of electricity — is not going to be using as much iron ore.
On the other hand, one has to assume that all those cars you saw floating away when watching the Tsunami devastation over the weekend are going to be replaced, and the buildings rebuilt. So after a short-term decline in demand, the net effect on demand for commodities should increase, not fall.
Nuclear Power Plant Future
The nuclear power at Daiichi will need to be replaced, and that means more demand for coal, oil or natural gas. That is effectively a permanent shift. Those four reactors are gone for good. Cooling them with seawater is a last ditch effort to prevent a repeat of Chernobyl. Doing so means that they will never be used again to produce power (seawater is very corrosive).
Fortunately, these four reactors all had containment vessels, unlike Chernobyl. So far this looks more like Three Mile Island than it does Chernobyl, but the story is not over yet. A Three Mile Island outcome is at this point the best-case scenario, and keep in mind that it has never produced another watt of power after its accident. I suspect that given current pricing, and overall environmental concerns, that natural gas will be the primary replacement for the lost generating capacity in Japan.
The renaissance for nuclear power has been aborted. Many had hoped that the combination of new and safer reactor designs, along with the need to reduce greenhouse gases and higher fossil fuel prices, would make nukes economically viable again. Whether they really are is a matter for debate, since they require massive loan guarantees to be built, along with liability caps.
Since nuclear power is a very high fixed cost/low variable cost endeavor, the economics of it are largely a question of how long it takes to build them, and how much it costs for the safety measures that surround the actual reactors (including things like the containment vessels). Here in the U.S., even if we don’t officially reverse course on building more of them, it will not be any easier getting them sited and built in the wake of the Japanese tragedy. That will tend to raise the cost of them and make them un-economical to use.
The U.S. currently has 104 nuclear power plants, and all of them were in operation before 1978 (Three Mile Island). Environmental opposition to building more of them had been softening, in a “lesser of two evils” way, since nukes do not produce greenhouse gases.
China and India will most likely continue building them — their thirst for electricity is nearly insatiable. However, I would expect that it will be a very long time before any more of them are built in Japan, Europe or the U.S. Many of the existing plants are probably close to the end of their useful lives, and thus we will probably see a net reduction in the amount of electric power we get from nukes over the next decade.
So if nukes are effectively off the table as an answer, and greenhouse emissions are still a concern (they are) then the demand will probably have to be taken up by solar and wind. That is why the solar stocks such as First Solar (FSLR) Solarfun (SOLF) and J.A Solar (JASO) have been one of the few groups that have rallied on the news out of Japan.
The immediate impact of the disaster is deflationary. The Bank of Japan has reacted by instituting its own version of QE2, and is buying about $180 billion of securities. Given that the Japanese economy is about one third the size of the U.S. economy, that means it is almost equivalent to the $600 billion Fed program, although the Japanese one is likely to be carried out much faster.
I think that this event insures that the full U.S. QE2 program will be carried out. The probability of QE3 has increased, but is still below 50%. A few weeks ago, the discussion was more about ending the program early than about extending it. The loose monetary policy on both sides of the Pacific will help support asset prices.
The U.S. Market, Going Forward
The U.S. market has had a remarkable run over the last several months, rising in nearly a straight line from under 1,100 on the S&P 500 in early September to over 1,340 in mid-February. It was probably due for a pullback in any case.
The upward move was not froth, but based on real economic fundamentals. The U.S. economy is showing very real signs of a real recovery, one big enough to bring unemployment down. Earnings, the mother’s milk of the stock market, are simply doing great. The total net income for the S&P 500 was 45.1% higher in 2010 than it was in 2009. Fourth quarter total net income was 30.7% higher than the fourth quarter of 2009. At the start of earnings season, growth of less than 20% was expected.
While the comparisons get tougher as we move forward, strong earnings growth is expected to continue. Earnings are expected to grow 14.6% for all of 2011 and to rise 13.4% in 2012. That means that the total net income for the S&P 500 is expected to almost double between 2009 and 2012 — growing from $5.45.3 billion in 2009 to $1.028 trillion expected for 2012.
Analysts have raised more than three estimates for S&P 500 firms over the last month for every two that they have cut. That means that the actual earnings will probably be higher than the current estimates. In “per share” terms, the S&P is expected to earn $95.58 in 2011 and $108.38 in 2012. Based on mid-day prices, that puts the P/E for the S&P 500 at 13.3x 2011 and just 11.8x 2012 earnings. That is extremely attractive relative to a ten-year T-note, which has a yield of less than 3.30%.
Where Will It Go from Here?
I can’t say that today will be the bottom of the market. There is simply too much uncertainty about what comes next. The likely worldwide economic effect should be a slowing at first, but then in the second and third quarters an acceleration in growth as the rebuilding gets underway.
I do not think that this will push the U.S. back into recession. And if that is the case, then the earnings projections we have now are likely to hold if not increase further. And if that is true, then the valuations in the market are sliding, and this would be a good time to accumulate stocks. In particular, I would look at some of the natural resource stocks — including energy — that have sold off hard in response to the tragedy. Some names to consider would be Vale (VALE), Cliffs Natural Resources (CLF) Petrobras (PBR) and Range Resources (RRC).
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