Valuentum Exclusive Analysis for the Discerning Investor

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The equity markets were in free-fall again Thursday, with the SPDR S&P 500 ETF (SPY) dropping considerably during the session. If you recall, yesterday brought a huge rally in the S&P 500—in fact, it was one of the biggest rallies of the year—thanks in part to “bad news” from the Fed being interpreted as good news, with the market thinking that interest rates might remain low for a longer-than-expected period of time.

As we might have imagined, the optimism didn’t last long, and today, the S&P 500 is giving all of those gains back. We’ve mentioned quite a few times in the article series titled, ‘The Correction,’ that we’ve taken profits on cyclicals and have added put-option protection to the Best Ideas portfolio and Dividend Growth portfolio. Though the put options are in-the-money (the SPY is trading below the strike price), they can still expire worthless if we do not take profits. We continue to expect to provide daily market commentary should things get considerably worse in the markets, a growing probability.

The earnings news today actually hasn’t been bad.

Alcoa (AA) kicked off earnings season with a strong report. The company’s third-quarter release showed it beating expectations on the top and bottom lines. We were particularly impressed with the company’s adjusted net income of $0.31 per share, and the biggest positive came from its Engineered Products and Solutions (EPS) segment, the downstream business, which delivered the highest after-tax operating income in the company’s history. Alcoa reaffirmed its expectations for global aluminum demand to grow at a 7% pace in 2014, which was roughly in-line with top-line growth achieved in the quarter (8%). The firm is executing at a high-level, and its focus on growing its multi-material value-add operations is progressing well. However, commodity pricing will continue to be volatile, and we have no interest in owning Alcoa heading into oncoming weakness across the cyclical space. Our fair value estimate of Alcoa is unchanged following the relatively robust third-quarter performance.

Pepsi’s (PEP) third-quarter results, released today, also revealed strength. Organic revenue advanced 3.1% in the quarter thanks to emerging market strength, which drove core earnings per share 10% higher, to $1.36. The company’s core constant currency earnings per share increased 11% during the period. Gross margin performance was also solid in the quarter, and management increased its full-year 2014 core constant currency earnings per share growth target, to 9% (was 8%). Despite the positive revision, CEO Indra Nooyi stated that macroeconomic activity remains challenging, emerging markets remain volatile, and developed markets remain sluggish. We think the pressure by Nelson Peltz to split up the company will wane, and we still don’t think the break-up is good idea.

Carl Icahn (IEP) is helping one of the largest positions in both the Best Ideas portfolio and Dividend growth portfolio, Apple (AAPL). The activist investor and self-proclaimed “buddy” with Apple management posted an open letter to the iPhone-maker. Icahn has called on Apple to accelerate its pace of share buybacks and outlined a case in which Apple’s shares could be worth over $200 on the basis of fiscal year 2016 and fiscal year 2017 earnings. The high end of our estimated fair value range for Apple is $136 per share, so we’re not quite as bullish as Mr. Icahn (our point fair value estimate is $115). However, we still expect material upside to Apple’s shares, and we continue to hold them in both newsletter portfolios (this is saying something). Apple offered strong relative pricing outperformance today.

On the negative side, the energy sector (XLE) continues to get shellacked.

China (FXI), announced today, that is has levied tariffs of 3%-6% on imports of coal (starting October 15) to support its own domestic mines. This is punishing much of the coal industry (KOL). We’ve stated our negative position on coal firms many a time in the past, punctuated by our joint outlook for the railroad and coal industries here (July 1, 2013). We’re reiterating our opinion that we’re staying far away from the US coal mining industry, especially the most leveraged names. If pressure on US coal weren’t enough, oil prices (USO) continue their slide, with elevated supplies and weak global economic growth the main drivers. Brent crude has fallen below $90 for the first time in two years.

The equity markets still appear greedy, with significant strong moves to the upside following any dip. This tells me--and perhaps in the words of Warren Buffett--that it’s likely time to be fearful, which has translated into a more conservative stance for us (in trimming cyclicals and adding downside protection). Further, equity-market reversals/corrections happen after significant churn near recently-achieved highs/lows, and this week has been among the most volatile with its ups and downs, and we’re only a few percentage points from all-time highs in the S&P 500.

We’re reiterating our cautious view on the broader equity markets and continue to believe that we’re headed lower, at least in the near term. The correction continues. Please expect the daily market commentary to continue. 

Industrial Minerals: ACI, ANR, ARLP, BTU, CCJ, CLD, CNX, HCLP, MCP, NRP