The dire predictions for stocks just three weeks ago were met head on by the sixth best October in market history. The major averages are back near their all-time highs. Bears are unfazed, citing weak breadth as a major reason for a reversal and further declines. Many are looking for the levels of late-August to be retested, but this seems unlikely as the rationale behind the selloff was based on questionable extrap-olation of international and domestic data. With the full participation of the financial media, the slowdown in China was spread across global economies and impending deflation would bring not only Emerging Markets, but also Developed Countries, to their knees. To us, it had characteristics of a “bear raid.” Changes in the marketplace brought about by ETF’s and an increased presence of Algorithmic Traders set the stage for sharp fluctuations in stock prices.
The growth of liquidity in passive ETF’s gives traders the ability to buy and sell (including short sales) major sectors without trading individual stocks. Other examples are; Emerging Market ETFs, Commodity ETF’s, and country ETF’s. One of the first sectors sellers gravitated to was Biotech. When drug pricing was questioned, the run on the Biotech and Health Service sectors forced many investors of individual ETF participating companies to sell, if for no other reason than the stocks continued to fall. This has happened to a lesser extent with MLP’s as oil prices declined. With media support, misguided research explaining that a China slowdown would dramatically reduce earnings for any tech business even marginally involved in Asia. For individual companies like Apple, it was a combination of a peaking in momentum for smartphone sales and its exposure to China, which would drive the stock price lower. Any company supplying Apple was also degraded. A Report by Goldman Sachs, listing US companies and their percentage of revenues from China, sent their stock prices down 30%-50%. Even after company CEO’s refuted these data, widely published by Forbes, USA Today and most national newspapers, there has been no retraction by the analyst or the media outlets.
We mention Apple because it was immediately following the release of their 3Q2015 earnings that, despite Conference Call assurance in July, momentum in smartphone sales was continuing and China was growing better-than-anticipated, the stock plunged. From its high of $132 prior to earnings, the stock sold down to the low $90’s. The point here is that somehow fundamentals were no longer a deciding factor for Apple and for many other tech stocks. Apple is a company with about $200 billion in cash and cash equivalents, or about $35 in value per share. While unknown sources convinced media that Apple was wholly dependent on smartphones and China and it was time to sell. To hell with the fact Apple is a cash machine and good fundamental analysts know the value of the company is the present value of future cash flow. Apple’s recently released 4Q2015 was more in line with the Conference Call and the stock rallied to about $120, where it is today. Apple’s December 2015 quarter guidance implies continued revenue growth in China and Emerging Markets. Also, 69% of Apple users have yet to upgrade to a larger screen. We did not sell any of our Apple in our managed accounts.
3Q 2015 Earnings
According to Thomson-Reuters, S&P 500 earnings, ex-Energy, are expected to grow 6.3% in 3Q2015. FactSet in its latest Earnings Insight shows that of the 340 S&P 500 companies reported, 76% have beaten the mean estimate and 47% have reported sales above the mean estimate. For companies with higher earnings than estimated, the aggregate beat is 5.9%. As would be expected, Energy and Materials are reporting the largest year-over-year decreases of all major sectors.
The Table shows that only Healthcare, Infotech, Consumer Staples and Consumer Discretionary are up since the beginning of the year, although all Sectors rose for the month of October. While difficult to draw a direct correlation of the impact of earnings on October ETF prices, the companies beating estimates rose 2.2% for the four day period around earnings, double the historic 1.1% rate. Healthcare and Infotech have been showing better-than-anticipated earnings and revenues on an individual company basis. Both sectors are leaders in the rally. According to Bespoke Investment Group, the Healthcare sector is up 6.3% since 10/23/15, while the S&P 500 is up only 1.5%. On an equal-weighted basis, the rise is 7.3% with only two stocks in the sector showing declines, Stryker (-2.7%) and CR Bard (-0.2%). For this sector, this is contradiction to the weak breadth mentioned earlier in the Report.
Money Flows into Stocks
One of the indicators that we follow is Mutual fund and ETF’s net purchasers and net sellers of Mutual fund shares. Mutual fund investors have been net sellers of US equity funds going back to January 2010. Only during 2013 and into 1Q2014 were there any consistent purchases. There have been net sales of US domestic equity fund shares in 75 of the latest 80 weeks and for the past 15 straight weeks. Thus far in 2015 the outflow is $114 billion against a total inflow of $46 billion for full-year 2014. International flows are small by comparison with net flows into foreign funds of $28 billion year-to-date, compared with $11 billion for all of 2014. These data continue to confirm the absence of the individual investor, outside of money managers and company sponsored pension plans. Both domestic and international fund flows were negative for the four weeks ending 10/21/15 and therefore Mutual funds were probably not a positive during the rally. The net flows into ETF’s are more volatile. Unfortunately, the data do not break out domestic and international, but do show a $9.5 billion net inflow into equity ETF’s for the four weeks ended 10/21/15. For the last two week period, that inflow was $7.2 billion. For the year to late-October the flow into equity ETF’s was $81 billion, compared to $60 billion for all of 2014. Inflows were positive for 65 of the past 89 weeks. ETF flows are more indicative of institutional purchases and sales and given the volatility they appear more trading oriented, with individual weeks reaching $20 billion in either direction.
The US Economy
Real GDP for 3Q2015 at a 1.5% increase was inline and cannot be expected to change anyone’s investment strategy. For the market, it was priced in and has no implication for Fed action. Housing, though the recent data are mixed, is more a supply/demand problem with insufficient inventory resulting in rising prices as potential purchasers back away. Although New Home Sales were down in September, prices are up 13% year-over-year. This week will see economic data for manufacturing and retail sales. These data are not market movers but Friday’s employment report may disappoint as there has been a rise in layoffs and many skilled jobs go unanswered. Short-term, after the great October, anything can happen. Biotech research and technology improving productivity will not go away. Companies on the leading edge of medical innovation will not be regulated out of the market. The recent earnings of Apple, Google, Amazon and Microsoft affirm our belief in large cap technology companies. As 2016 approaches, dollar comparisons will become more favorable. During the recent rally, companies with more than 50% in international revenue showed better relative performance. This indicates investors are already discounting better earnings in the coming year.
The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Markets remain vulnerable as investors and traders continue to assess China and Emerging Market economies, a stronger dollar, and mediocre earnings. Earnings should begin more favorable comparisons in 2016 and stocks, currently 16.7x estimated forward 12-month earnings are fairly valued. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.