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By Jason Stipp | 10-28-2011 10:40 AM

Five Scary Stories From the Market

The news on GDP, Europe, Avon, and Netflix should keep investors on the edge of their seats, says Morningstar markets editor Jeremy Glaser.

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to a very scary Friday Five. Halloween is right around the corner, and unfortunately there is no shortage of scary stories in the market today.

Here with me to offer the details on five of them is Morningstar markets editor, Jeremy Glaser.

Jeremy, I'm frightened to be with you today.

Jeremy Glaser: Thanks, Jason.

Stipp: So what do you have for the Friday Five this week?

Glaser: We're going to take a look at the European debt deal, at GDP, at Avon, Netflix, and finally 3M.

Stipp: So on Thursday, we got a confirmation that some agreement had been made about a plan from the European Summit, and the market actually really liked this. Stocks were up on Thursday. So why is this scary?

Glaser: It's scary because the deal is far from finished, and I think the markets are reactivating like this is a done deal and maybe the debt crisis, if not completely over, is on its way. I think there are still so many open questions about how this deal is actually going to be implemented that investors might need to still exercise a little bit of caution. They agreed to write down the value of privately held Greek sovereign debt by 50%, but that's a voluntary program, and we don't know yet how many of the banks are actually going to take them up on this and exactly what the bond reworking is going to look like. I think we'll have to see if that actually happens.

They talked about recapitalizing banks and expanding the EFSF, the European Financial Stability Facility, by either using leverage or bringing in new capital. But there was no discussion of where that money is going to come from, other than it won't be from the European Central Bank, which should be one of the most obvious places for that money to actually come out of.

So until a lot of those questions are answered, I think that ... we're going to need to exercise some caution until we really see if they can deliver on it.

Stipp: So certainly still some cliffhangers there.

We got GDP data on Thursday, Jeremy. 2.5% is not a bad number; it was better than we saw earlier in the year. So is there any reason to be scared here?

Glaser: That particular number was not terrifying in any way. But when we see that the real GDP is now above our pre-recession peaks, but that employment still looks terrible and that consumers still are very uneasy, and there is a lot of a very poor consumer confidence, it just shows that this recession is in a lot of ways very different, and it begs a lot of questions: Is this employment problem really permanent? Do we have this long-term structural unemployment that's going to create a group of people who may never be able to get jobs again? I think there are a lot of troubling implications for the economy and for growth, looking in the medium and long-term.

So I think that even though the economy is kind of back in that slow-growth mode, we really need to see some good numbers on the employment front and some better things on housing as well, which will help with employment, before I think I will be a little bit less scared about it.

Stipp: A household name reported some pretty frightening results during this earnings season. Who was it, and why is this story so scary?

Glaser: I don't think there is going to be a lot of people dressing up as the Avon Lady this Halloween, after their third-quarter results. Our analyst Erin Lash described them as "dismal," as Avon really struggled a lot across a lot of different geographies. In the United States, sales were down pretty substantially. Even in emerging markets, which was an area where Avon was hoping to see a lot of growth and a lot of investors had hoped for growth, such as in Brazil, they just aren't doing that well.

Brazil is a place they've been for a long, long time, and have made it work, but they are just not seeing the kind of growth they were seeing before. They are seeing orders fall, and I think the idea that they didn't have to build stores, that they could go out and recruit local networks of people to then sell the products directly and get rid of that overhead, it seemed like a great idea, but they just haven't been able to execute. And I think that until they're able to actually make that happen, people are going to be pretty terrified of that stock.

Stipp: 800,000 was a frightening number for a one-time highflier media company. What's the story behind that and why is that potentially scary for that firm?

Glaser: Netflix had probably one of the scariest roller coaster rides of any stock in recent memory. They just shot to the moon when people were excited about the prospects for the company, and have been tumbling back down to earth over the last three months. Issues with a price increase, with an aborted idea of creating a new DVD business called Qwikster that didn't go over so big, and just people leaving the service in droves--that 800,000 that you mentioned--leaving the service, have just made Netflix look very vulnerable.

And I think that people are finally seeing that the company didn't have a sustainable competitive advantage in the streaming business, that there were great economies of scale when they were actually sending out these physical discs to people--you need the distribution centers, you need the relationships that they had built. But when it comes to streaming, it's easier for anyone to do, and the media companies are going to drive a really hard bargain and are going to make you pay a ton of money for the right to do that. So we don't think they're going to be able to have great earnings power. They're not going to have great margins. The idea of expanding overseas, our analyst, Michael Corty, who covers Netflix thinks that's not going to work out that well for them, either.

They just don't have a lot going for them now. It's not that the whole stock is going to collapse, or the company is about to collapse. I think that there is a market there, but it's just much, much smaller than I think lot investors had thought over the last few months.

Stipp: Also in earnings news, Jeremy, an industrial bellwether had some frightful data to report on its earnings. What's the story there and how bad was it?

Glaser: 3M's earnings weren't great. But the thing that was probably most disconcerting about their earnings were the comments that people are really cutting back on orders in the fourth quarter, and it's not because so much that they're seeing a huge decrease in demand, but they're worried about a big decrease in demand. And a lot of this probably has to do with all the fretting over Europe, the fretting over maybe slowing growth in some emerging economies, and people are just getting really cautious again, and that could be the start of a cycle that kind of starts another recession. A lot of these things tend to be self-fulfilling prophecies.

So if 3M is really not an outlier here, and a lot of companies are just pulling back and saying "hey, we're not going to have as much inventory; we're really scared; we're getting really skittish," that's only a bad sign, and we could see that cycle through the entire economy, and we could see the slow growth that we talked about earlier go even slower

Stipp: Well, Jeremy, now that you've sufficiently terrified me this week, I hope you'll have some better news to report in the future. But thanks for joining me today.

Glaser: You're welcome Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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