We’ve been heeding our own words of caution for the past several weeks now, as we’ve trimmed some of the cyclical exposure in both the Best Ideas portfolio and Dividend Growth portfolio. We also added protection to both portfolios several percentage points ago in the form of put option contracts on the S&P 500. These instruments aren’t for everybody, and the put options can still expire worthless if we don’t take profits.
The above chart of the SPDR S&P 500 (SPY) shows the ongoing market correction, and we expect to continue to provide daily market commentary in the event that things get considerably worse. Our high-level prognostication is that the broader equity markets will be lower than they are today within the next 6-18 months, if not tomorrow or next week or next month. It’s very well likely, however, that we may have a strong finish to the week, with up days on both Thursday and Friday. The broader markers do not go down every single consecutive day in a correction.
Yesterday, the International Monetary Fund (IMF) shaved its forecast for the pace of global economic expansion in 2014 and 2015 due in part to legacies from the recent credit crisis and increased downside risks to expansion, including both financial and geopolitical. The report titled ‘Legacies, Clouds, Uncertainties’ (pdf) has reminded the markets of the many downside risks still present, and we think it is worth highlighting a few of them below (from the Foreword):
The downside risks are clear.
First, the long period of low interest rates has led to some search for yield, and financial markets may be too complacent about the future. These risks should not be overplayed, but policymakers clearly must be on the lookout. Macroprudential tools are the right instruments to mitigate these risks; whether they are up to the task, however, is an open question.
Second, geopolitical risks have become more relevant. So far, the effects of the Ukraine crisis have not spread beyond the affected countries and their immediate neighbors. And the turmoil in the Middle East has not had much effect on the level or volatility of energy prices. But clearly, this could change in the future, with major implications for the world economy.
Third, there is a risk that the recovery in the euro area could stall, that demand could weaken further, and that low inflation could turn into deflation. This is not our baseline, because we believe euro area fundamentals are slowly improving. But should such a scenario play out, it would be the major issue confronting the world economy.
The IMF’s cautious stance continues to be compounded by ongoing weakness in the energy markets, led by the declining price of crude oil (USO). Brent crude, for example, has fallen to its lowest level since June 2012, and this has hurt the energy sector (XLE) greatly. Falling energy prices may positively impact those with crude-derivatives as a key cost input, but the energy sector is a large component of the broader return of the equity markets, and our view is that weakness in energy equities will not be offset by the incremental profit generation of those using crude-derivatives as an input. Many end users of the black commodity may even have crude hedged at certain above-market prices, limiting the benefit of falling oil prices to their own profit expansion. Said differently, we view falling crude oil prices as a net-negative proposition for the equity markets.
Those that know us well understand that we’re not big fans of the long-term investment prospects of the primary beneficiary of declining oil prices, the airline group. Though we won’t address the industry’s poor structural characteristics in this note, part of the reason airlines aren’t reacting positively has been due to Ebola concerns. In fact, the first Ebola-related death in America was announced this morning, and we think fear of the fatal disease spreading to more cities in the United States will change the direction of demand for travel and related industries (hotels and cruise line operators). Spirit’s (SAVE) announcement that, in the third quarter, it has experienced reduced load factors and generally weak margins isn’t helping the matter either. We don’t include any airline or hotel or cruise line operator in the portfolios, and we have no urgent need to do so.
At the moment, we think the equity markets appear to be under-estimating the risks of an Ebola outbreak in the US. For example, if there is another Ebola report in another large city in the US, we wouldn’t be surprised to see the equity markets see another large down day. According to the European Commission (via CNN), there have already been eight confirmed cases of Ebola in European countries. Experimental drugs are not working to fight the disease, as evidenced by the recent sad death in Dallas, and fear is a huge driver behind market price changes (the other being greed). In a global economy, can the Ebola virus truly be contained? We’re not so sure.
In other news, JC Penney (JCP) and Sears (SHLD) remain in dire straits. JC Penney disappointed investors at its recent analyst day with news that September sales disappointed, though most investors may still be happy that the company has at least prolonged a bankruptcy filing. We don’t think JC Penney will survive the next recession, especially as online purchases from other sources proliferate. As it relates to Sears, vendors and insurers appear to be growing more and more concerned about its survival, which also is not guaranteed. Vendor concern is generally a sign that the noose around the company’s neck is tightening, as vendors generally don’t want to be involved in customer bankruptcy proceedings. Though speculators may like to trade around these two firms, we see little reason to own either JC Penney or Sears. The latter could even be considered a put-option candidate, as prospects are meager.
All-in, the markets ended up today firmly in the green thanks to the midday release of the Federal Open Market Committee minutes. The Fed cut their growth outlook and expressed concerns about the stronger dollar, but traders took this to mean that interest rates would remain low for longer-than-expected. For traders, sometimes bad news is good news.
We’re staying cautious in light of the many risks out there.
Airlines – Major: AAL, ALK, DAL, JBLU, LUV, SAVE, UAL
Hotels: CHH, H, HLT, HMIN, HOT, IHG, MAR, OEH, WYN
Related: CCL, RCL