By David Nelson, CFA
Last week the Bulls fumbled the ball and Bears seized the opportunity to put some points on the board. It’s too early for end zone dances but I see a lot of high fives on their side of the field, while the rest of us brush off the dirt and get back into the game.
The S&P and Dow start this week off 3.14% and 4.21% respectively for the month, making it the biggest pull back since early last fall. Even secular bulls like me understand corrections happen, so the following is a guide for those looking beyond the current turmoil.
On CNBC early last week, I mentioned the 50 day moving average often acts like a magnet. I went on to suggest the S&P just might surprise everyone and trade sideways while the averages caught up. It didn’t take much time to prove that theory wrong. By the end of the week the SPX sliced right through the 50 day closing at 1790.
Emerging Market Trigger
Last week’s carnage started in China with a weak PMI confirming a contraction. That triggered a wave of selling spreading across Asia and the emerging markets, eventually arriving on our shores. The taper and even the prospect of the Fed unwinding its quantitative easing programs have hit emerging markets particularly hard. I agree the Fed exit is certainly part of the problem but there is an even larger issue weighing on developing markets.
It’s Not Just About the Taper (2 Year Chart EEM – iShares MSCI Emerg Mkt Indx)
I think investors are finally waking up to fact that many emerging market countries are simply not shareholder friendly. Accounting issues in China or a government in Brazil that seems to use corporate profitability as an ATM doesn’t give portfolio managers like me a lot of confidence. Just last week Securities & Exchange Commission Administrative Law Judge, Cameron Elliot ruled the Chines units of the Big Four Accounting firms should be suspended from auditing U.S. – listed companies for six months. When investors hear the words accounting issues, they head for the exits and that’s just what they did.
If that wasn’t enough to shake your confidence on China, we find out over the weekend that a crash crunch may be emerging with reports that a Citibank local website posted a notice saying fund transfers could be delayed. CNBC reports that Citigroup spokesperson Richard Tesvich said “This is part of our regular maintenance every year during the Chines New Year period.” I wasn’t aware of the story when questioned by Al Jazeera host David Schuster about the Chinese New Year on Friday night’s broadcast. I laughed it off. Well I’m not laughing now.
Earlier last week there was a large liquidity injection by the People’s Bank of China (PBOC) in anticipation of the Lunar New Year holiday. This Citibank website posting may have sparked concern that it wasn’t enough.
The lesson here is that despite the negative effects for emerging markets due to a Fed taper there are other factors taking place throwing both their currency and stock markets into turmoil.
We saw a currency crisis during 97-98 and the selloff was quick and painful. The snap back rally was just as fast.
Just Like Your iPhone Your Portfolio Deserves an Upgrade
I can’t tell you whether this is the start of a 5% correction or something more sinister but I can tell you what I’m doing about it. Just like your iPhone every so often your portfolio needs an upgrade. We are in the middle of earnings season and just like others there are winners and losers. When the tide goes out all the boats in the harbor go down so a correction can be an opportunity to get into high quality stocks at discounted prices.
We all have stocks in our portfolio that are on a hit list. Either they are breaking down technically or the quarter just reported missed and even worse the guidance going forward wasn’t encouraging. Swap out of these names and use the cash to buy shares in companies that have reported great quarters but have pulled back with the rest of the market.
I’m Not Picking on IBM
I know it looks like I keep picking on IBM but it’s a text book example of a company that has lost its way. Value investors often point to IBM’s low PE and the fact that Warren Buffet is one of the biggest shareholders. IBM has had sub-par revenue growth for a long time yet has been able to grow earnings steadily with the help of cost cutting. The last 6 quarters reveals this strategy has run its course and management needs to address a broken business model.
When I talk to a manager or a division head within the company, I’m told that every quarter senior management comes to them to cut costs even further. They go on to say they have nothing left to cut and are now hitting bone. If IBM is really looking toward the future they should shed themselves of non-core businesses and buy growth, even if it means a hit to their PE. I know value investors say the stock hasn’t gone anywhere since 2011 so it is due for a catch up. I need to see some sort of catalyst or an indication management is really addressing the problems before I get involved. Until then, I see it as just another value trap.
Airlines
Use the funds and move into a company that reported great earnings but is now getting hit with the rest of the market. Anyone that flies can tell you the airlines have made every aspect of their business a profit center. Want to check your bag, sure. $25 please. Want to take another, no problem. Cough up another $35. Food and extra leg room also add to your cost. Some are even considering charging you to go to the in-flight lavatory. Dublin based Ryanair is working with Boeing to develop a coin operated door for their bathroom in the sky. The point is, the industry has turned the corner and understands what they have to do to grow profits.
Another Entry Point For Delta (DAL)
Delta (DAL) had a superb quarter and is off about 6% after gapping up on the strong report. Over the last year (DAL) has given investors several entry points all around the 50 day moving average. A high beta name like (DAL) could easily pull in and touch the 50 day. With above average revenue growth and a PE of 11x calendar 2014 earnings, I would put this name on your shopping list.
You don’t have to choose the stocks I mention but I encourage you to go through the process. Re-examine your positions and ask yourself is there something better I can replace it with. When the dust settles I think you’ll find that the cream rises to the top.
This Week
All eyes will be on the Fed Wednesday as Ben Bernanke presides over his last Federal Reserve meeting as Chairman. Prior to last week, many including myself believed the Fed would clip another $10 Billion off the QE program and stay on schedule. Given the damage in the emerging markets it’s quite possible they may take a pass this month.
Rallies could be met with selling until the NYSE Bullish Percent Index moves back to the upside. Complete confidence won’t be restored until the S&P takes out previous highs.
Funds managed by David Nelson currently own Delta (DAL).
