Stocks closed lower yesterday although well off their morning lows, following a sharp selloff in Europe triggered by apparent problems with a large Portuguese bank. There were a lot of additional reasons given for yesterday’s decline, including some brokerage downgrades of market forecasts, weak economic data from Europe, hints in the Fed’s FOMC minutes that it might begin to raise interest rates before we all die, and some good old profit taking. The latter is probably the primary root cause of yesterday’s weakness.
As I noted on Wednesday, stocks often have a skittish time into the beginning of earnings season. Alcoa is always the first to report. Its report Tuesday evening was surprisingly strong and its shares have acted well all week. Today, Wells Fargo is the first of the major banks to report. It is also the easiest to understand as it looks more like a community bank on steroids than a complex integrated combination of domestic/international or commercial bank/investment bank. Thus, what we are going to learn from Wells is the true state of commercial and real estate lending. They aren’t likely to be pretty. Net interest margin spreads are going to be depressed and mortgage volumes are likely to be down. While Wells is very well run and the stock might react well if the company beats low expectations, the overall market isn’t likely to be thrilled to learn that the banking industry is in the doldrums, something it probably already knows.
As for the Portuguese bank, a lot of its problems are self-inflicted. We don’t expect this is a harbinger of a repeat of the 2010-2011 banking crisis in Europe, largely because the ECB has become so accommodative. But it can serve as a reminder that the European banks have not done nearly as much as the U.S. banks have to clean up their balance sheets, improve quality and reduce leverage. I don’t expect another banking crisis any time soon, but in the next serious bout of economic weakness, European banks will be much more exposed to problems than their American counterparts.
As for Europe as a whole, data from France and Italy serve as a reminder that much of Europe isn’t growing, at least not at any meaningful rate. Europe remains a flawed economic region generally tied together by one common currency but consisting of a mix of nations that are economically efficient, like Germany and its northern neighbors, and those that are still essentially not very competitive on the world stage. In the older pre-euro days, currency values could adjust to even things out but with countries like Germany, France, Spain, Italy and Portugal all using the euro and, therefore, on a level playing field, watching Germany and France compete is akin to watching Germany and Brazil play soccer. In economic terms, what Germany gains, the southern tier of Europe gives away. As a result, data this week serves as a reminder than Europe as a whole may be headed for a Japan-like economy for the next many years moving back and forth across the zero growth line. It isn’t a pretty picture. That’s the bad news. It shouldn’t come as any surprise, meaning such a forecast is largely already baked in. That’s sort of the good news.
The weakest part of the market yesterday was the small cap sector, particularly the speculative elements that were so strong earlier in the year. I am a broken record on the subject, but will reiterate once again that I believe except for the most nimble traders, this is a part of the market to avoid. Avarice has made this segment of the market utterly overvalued. Even a 50% correction would return many of these names to fair value. That doesn’t mean all rapidly growing companies are overvalued. In particular, many of the large biotech companies are relatively inexpensive. But there are many that will simply never, and I rarely use the term never, see their early 2014 highs again.
With that said, investors can properly ask themselves, “Where are the values in this market?” and my answer is that there aren’t many extraordinary values at the moment. Stocks are up about 7% so far this year (including dividends). Annualizing that would suggest an annualized return of 14%, the third straight year of double digit gains. It is hard to find bargains after a run like that. But with that said, it is still easy to find stocks paying at least 2.5% in dividends, dividends that grow significantly every year. That competes very well against bonds paying 2.5% over the next decade, or cash that pays nothing. It is hard to come to a conclusion that stocks are headed for a major correction as bond yields fall further and cash returns nothing. What is most likely is that stocks will churn a bit over the next several months returning something less than the 14% annualized they have returned so far this year. That doesn’t mean it is time to sell stocks, but it does mean one should review portfolio holdings and weed out names that have gone up too far, too fast, or those who have been fundamental disappointments. A little extra cash might be useful to capture some bargains amid stocks that sell off sharply and unnecessarily if they simply miss earnings by a penny or two simply for temporary reasons.
Futures suggest some rebound this morning.
Today Giorgio Armani is 80.
James M. Meyer, CFA 610-260-2220
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