For those that are following along closely, you shouldn’t be surprised if the market corrects 5%-10% in the coming months. Let’s talk about this.
From a technical standpoint, it may not be too far of stretch to say that we’re likely going to test the bottom of the S&P 500 (SPY) uptrend, and that could feasibly mean a drop to the 200-day moving average (blue line above). My technical alerts are telling me that with respect to the S&P 500, we’ve just dipped below the 50-day moving average, an arbitrary simple rolling average but one that is no less self-fulfilling than value investing itself.
Don’t panic though. We’ve cut through the 50-day moving average many a time before during this multi-year uptrend, and frankly there’s not much different this time around than in previous episodes. That’s not to say, however, that with every new high we make we’re not becoming more vulnerable. From my perspective, broader equity valuations are at nosebleed levels, and we’re headed into a tightening credit market environment. Stocks eventually have to correct, right? In my opinion, yes.
Perhaps the fundamental shot across the bow was Honeywell’s (HON) announcement Friday that it would slash its sales outlook for 2015, to the range of $39-$39.6 billion from the range of $40.5-$41.1 billion. That’s a $1.5 billion revenue revision lower, and not all of the revision is a result of currency and divestitures. Upping the lower end of its earnings per share outlook did little to assuage the market’s concerns. During the first quarter, the company’s reported sales dropped 5%, and while organic performance was still in positive territory, cash flow from operations and free cash flow plummeted ~40% and ~50%, respectively. We don’t think it’s as simple as writing Honeywell’s lowered outlook off due to currency and asset sales. Weakness was prevalent across the board, and its core organic growth outlook for 2015 was cut to ~3% from ~5%. Fundamental strength may be fading in “old economy” names.
In what can probably be called a “dead cat bounce,” crude oil prices (USO) have come back a bit, and we must say, we’re pleased with the relatively conservative move to swap the Energy Select Sector SPDR (XLE) into the Dividend Growth portfolio. Two other conservative companies we hold in the Dividend Growth Newsletter include Kinder Morgan (KMI) and Energy Transfer Partners (ETP), midstream pipeline plays that are less levered to changes in the price of the black commodity. Kinder Morgan increased its quarterly cash dividend to $0.48 ($1.92 annualized) representing a 14% increase on a year-over-year basis. That’s just fantastic growth for a midstream entity as large as KMI. The company earned adjusted distributable cash flow of $0.58 per share during the quarter, revealing excess dividend coverage of $200+ million. CEO Rich Kinder noted that the company remains on track to meet its full-year dividend target of $2 per share, and dividend growth investors have to be pleased.
Newsletter portfolio holding Intel (INTC) also didn’t disappoint with its first-quarter results. The company had been in the news quite a bit as of late with reports that it has been interested in acquiring Altera (ALTR) and Broadcom (BRCM), but we think the biggest news, which perhaps has been bolstering the stock, is the realization that the executive team is a fantastic capital allocator. Weak PC sales have been the story for some time at Intel, but a lower capex budget and expectations for higher levels of profitability reveal that top brass is executing extremely well. We value Intel’s decision to slash 2015 capex by $1.3 billion at $10+ billion in incremental value, assuming the company is able to continue to find ways to save money. Shares rallied significantly on its quarterly report.
General Electric (GE) also released results for its first quarter. Performance wasn’t clean as the company continues to execute its strategic shift away from financials exposure, but we were generally pleased that the firm remains on track to generate as much as $1.20 per share in operating earnings from its industrial operations in 2015. The company’s record industrial backlog of $263 billion should solve any issues on the top line in coming periods, and we think its execution in the quarter was better than conglomerate peer Honeywell’s. At GE, industrial organic revenue advanced 3% in the quarter, while growth markets revenue increased by a pace double that mark. The firm’s gross margin and operating margin leapt 90 basis and 120 basis points, respectively, during the period. If we back out the $90 billion GE is expected to return to shareholders through 2018 (via dividends, buybacks and Synchrony), the company is trading at a below-market forward multiple of ~15 times. Honeywell is trading north of 17 times at the moment. We think a mispricing in GE’s shares still exists, especially for a firm that is expected to return so much cash to shareholders in coming years.
All in, we’ve seen a bit of a crack in the industrial economy’s armor with Honeywell’s performance, and if the Fed is still dedicated to beginning the credit tightening cycle this year, forward outlooks and equity prices could face pressure in coming months. As we outlined at the top of this piece, a 5%-10% correction from here to test the 200-day moving average wouldn’t be out of the question. What we do at the 200-day may dictate how the markets perform in the next several months beyond that. Stay tuned.