The equity markets have been under significant pressure the past few weeks, and we think there is further downside to come. Our view is that the equity markets will be lower than today’s levels within the next 6-18 months, if not tomorrow or next week or next month. We’ve taken profits on cyclicals, and we’ve already closed out the put option hedges in both portfolios for a substantial gain (the latest transaction alert email can be accessed here).
Europe appears to be in a giant mess again. The region hadn’t been strong by any stretch of the imagination, but we recently picked up material weakness during Ford’s (F) recent analyst day, which in part prompted us to take a very cautious stance on cyclical exposure. We think it is probable that Europe may be entering a recession…again, if it ever really recovered from one.
In remarks delivered at the Brookings Institution in Washington, European Central Bank President Mario Draghi highlighted the grim realities of what the European continent is facing. The statements cannot be ignored, as the vast majority of S&P 500 companies generate material profits from the region. Here are just a few highlights (source):
As I was preparing these comments, I happened to re-read John Maynard Keynes’ open letter to President Franklin D. Roosevelt, published in the New York Times in December 1933. In it, Keynes tells President Roosevelt that the administration is engaged simultaneously in recovery and reform, and identifies a tension between the two. He worries especially about the risk that over-hasty reform impedes recovery.
There are some parallels here for Europe: we are also engaged in reform and recovery. But in fact we face the opposite concern to that expressed by Keynes. “Without reform, there can be no recovery.”
In saying this I am of course well aware of the argument that reform is better achieved in good times. I do not however find this argument particularly compelling.
First, all too often has reform been postponed in bad times on that basis, and then forgotten in good times.
Second, I am uncertain there will be very good times ahead if we do not reform now. This is because the problems we face in Europe are not just cyclical, but structural. Potential growth is too low to lift our economies out of high unemployment. It is also too low to allow us to overcome quickly the debt burden left over from this crisis and the period that preceded it. Thus, while stabilisation policies that raise output towards potential are necessary, they are not enough. We need to urgently raise that potential. And that means reform.
The third reason I am sceptical that reform should wait for better times is the results we have achieved already. Europe has in fact been in a reform process for several years, as many parts of our economy were broken during the crisis and needed to be repaired. We have taken many successful initiatives during what were, by any standards, bad times. And in several countries the first fruits of that endeavour are now becoming visible.
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I have today provided you with a description of the many ongoing reform and policy steps that, in combination, will lift the European economy out of what has already been too long a crisis.
The issue is not really whether policies to support demand should precede or follow policies to support supply. Reform and recovery are not to be weighed against each other. The whole range of policies I have described aims simultaneously at raising output towards its potential and at raising that potential.
This combination of policies is complex, but it is not complicated. Each of the steps involved is well understood. The issue now is not diagnosis, it is delivery. It is commitment. And it is timing.
I recently said of monetary policy that, at the current juncture, the risks of doing too little exceed the risks of doing too much. If we want a stronger and more inclusive recovery, the same applies to doing too little reform.
The reality is that economic and policy reform in Europe faces a great many obstacles, confounded by varying motivations and interests from all across the continent. We don’t think that reform can be achieved in the manner at which Draghi hopes, and therefore, we extend our views that perhaps a recovery in Europe is one based on false optimism. Europe appears headed for another recession, and we don’t think the US markets are immune to its troubles.
As pessimism about Europe’s economic health continues to send shockwaves through the global financial markets, semiconductor firms (SMH, SOXX) were blindsided by a warning from $8-billion market cap firm Microchip Technology (MCHP) today. The chip maker for a wide variety of embedded control applications said that third-quarter revenue would come in below expectations. Management teams miss internal targets all the time, but that’s not what is significant in this case. What caught our eye is CEO Steve Sanghi’s statements regarding unusual weakness in China and concerns about an oncoming semiconductor “industry correction:”
We were disappointed with the level of business activity in the September quarter. The September quarter is usually a back-end weighted quarter because of a traditional weak August due to holidays in various parts of the world. The month of September is usually a strong month for our revenue after the summer holiday period. This time, the September sales did not materialize to our expectations. The revenue miss was led by China where the September quarter is traditionally the strongest. This time, sales in China, excluding ISSC, are expected to be down sequentially.
Microchip often sees the turn of the industry ahead of others in the semiconductor industry. First, in contrast to many others in the industry, we report sales from distribution on a sell-through basis worldwide. We built a significant amount of inventory in the distribution channel in the September quarter. If, like many others in the industry, we recognized sales on a sell-in basis to our distributors, our sales would have been significantly higher for the September quarter. Second, Microchip does business with over 80,000 customers worldwide, most of whom are small and nimble and are able to adjust their demand in real time. We believe that another industry correction has begun and that this correction will be seen more broadly across the industry in the near future.
Though it seems like there are published concerns about the economic health of China (FXI) almost on a daily basis (and we don’t think investors should read too much into Microchip’s warning), the economic health of the country is getting noticeably worse, in our view. Here’s what we wrote about China more recently:
There are growing concerns about slowing growth in China. Not only is there a crackdown on corruption that could come to bite luxury—Richemont (CFRUY), Tiffany (TIF)–and gaming entities—Las Vegas Sands (LVS), Wynn Resorts (WYNN)–but the most important barometer of strength in the country continues to wane: Iron ore prices have fallen to a five-year low this month. Rio Tinto (RIO) and BHP (BHP) have not ignored this, and have scaled back capital spending significantly. This, of course, has implications on the construction firms from Caterpillar (CAT) to Joy Global (JOY) and others. On the retail front, Yum! Brands (YUM) and McDonalds (MCD) continue to face challenges with food scandals in China, and KFC, the greatest restaurant growth story in the region, just can’t seem to get things back on track, which could hurt unit growth. The country’s industrial performance is down, too, and reversed some pretty hefty double-digit expansion in July. China’s GDP growth rate should remain robust—greater than 7%–but in the game of expectations, even a 7% mark could be considered disappointing. Pimco thinks 6.5% is the new norm. The IMF says 6.5%-7% is about right. I’m not sure that the global markets are resilient enough to handle a meltdown of China real estate, especially at current valuations.
Chip stocks weren’t the only ones taking a hit as a result of a warning today. Juniper (JNPR) sent the telecom equipment group in a downward spiral as a result of its own third-quarter warning, released after the market closed yesterday: “Revenue for the third quarter of 2014 is now expected to be in the range of $1,110 million to $1,120 million, below the Company’s previous guidance of $1,150 million to $1,200 million, primarily due to lower-than-anticipated demand from service providers, particularly in the U.S.” This isn’t “new” news, as telecom equipment suppliers have been facing some pressure from reduced wireline capex, but Juniper’s revised top-line guidance wasn’t really encouraging either.
Though chip and telecom stocks are under significant pressure today, we’re still not opposed to holding Intel (INTC) in the newsletter portfolios. The company has been a fantastic performer as of late, and its 2.7% yield is quite enticing. That said, we wouldn’t be looking to add to the position in such a market, until the firm’s yield approached 3%-4%. This would imply a price quite lower than today’s levels but still in-line with the low end of the fair value range of $26 per share. It’s probable that Intel could be a stand out in the chip industry given its recent progress, and we’d wait for the company’s quarterly report before drawing any definitive conclusions about the position in shares.
In what has been a consistent punishment, the energy sector continues to feel the pain from lower oil prices (USO). Brent crude has now reached the lowest levels in four years. Long-time readers of Valuentum know that we don’t like the business structure of MLPs, and many upstream MLPs are feeling the hit from declining prices of the black liquid. We’re reiterating our opinion that, while falling energy prices may positively impact those with crude-derivatives as a key cost input, the energy sector is a large component of the broader return of the equity markets and weakness in energy equities will not be offset by the incremental profit generation of those using crude-derivatives as an input. We continue to view falling crude oil prices as a net-negative proposition for the equity markets.
All told, Warren Buffett’s age-old saying still applies: “Be fearful when others are greedy, and greedy when others are fearful.” With market pundits continuing to say “buy every market dip,” our view is that the markets remain greedy, which makes us perhaps not fearful, but certainly cautious.
Look for the daily market commentary under the article series, The Correction, to continue all next week.
‘The Correction’ Series, previous articles
Oct 9, 2014
The Correction: The Markets Took a Turn for the Worse Thursday
Strong reports from Alcoa and Pepsi could not buoy the markets. We might get another big leg down soon. Pay attention.
Oct 8, 2014
The Correction: The IMF, Oil, Department Stores, and the Fed
The Fed bailed out the markets today. Sometimes, bad news is good news for traders.
Oct 7, 2014
The Correction: The Markets Are Not Panicking
Let’s talk a bit about old tech and a couple disappointing pre-announcements. Third-quarter earnings season may not be bright.
Oct 6, 2014
The Correction: Markets Continue to Breathe Sigh of Relief Monday
The market shrugs off GT Advanced bankruptcy.
Oct 3, 2014
The Correction: Protection Makes Sense
Nobody ever was hurt taking profits, to my knowledge.
Oct 2, 2014
The Correction: Markets Ease Thursday
Warren Buffett does his magic to calm the markets. But you have to answer the age-old saying: at present, are we greedy, or are we fearful?
Communications Equipment – Networking: ARUN, CSCO, FNSR, JNPR, NOK, RVBD
Semiconductor Equipment: AMAT, CREE, KLAC, LRCX, MKSI, SNPS, TER, UMC
Semiconductors – Specialized: ALTR, CRUS, LLTC, LSI, NVDA, MCHP, XLNX