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I Think It's Too Early to Be Buying on this 'Dip'
10/08/2014 6:00 pm EST
MoneyShow's Jim Jubak feels it's too early to start 'buying on the dip' because there's still too much risk and not enough reward at these prices and in this environment.
Why am I not buying anything right now on this 'dip'?
On Tuesday, October 7, the Standard & Poor's 500 stock index closed at 1935, a level not seen since August. As of that close, the index was now down 4.2% from the September intraday all time high at 2019.26. That's almost half way to a real 10% correction.
The small-cap Russell 2000 was actually in a correction. Small-cap stocks were down as of the October 7 close 11% from their March record high.
So why not back up the truck or at least nibble?
There's still too much risk and not enough reward at these prices and in this environment.
I think the market breaks down into three major parts right now-small-caps, the S&P big-caps, and commodity stocks. Each part offers its own mix of risk and reward, but, in each case, I think we're still looking at more risk than reward at the moment.
Start with small-caps.
Small-caps have three problems. First, they're seen as relatively riskier than the big-cap stocks of the S&P 500. A day like Monday, October 6, when small-cap technology stock GT Advanced Technologies (GTAT) unexpectedly declared bankruptcy over problems with its biggest customer, Apple (AAPL) and lost more than 90% of its value in a day just confirmed that risky reputation for many investors. (Apple is a member of my Jubak's Picks portfolio.)
Second, the sector-and especially, its growth/momentum stocks had a great run-but now the price momentum, at least, has stalled. When that happens, momentum investors sell. And everybody with a big gain in these stocks looks to take profits.
And that has left a gap without support for many of these stocks. Do you think that the momentum folks who drove Hi-Crush Partners (HCLP) from $29.35 a unit on November 7 to a high of $69.15 on August 29 know anything about the business beyond that it sells sand used in natural gas fracking? So, when the momentum comes off-and the stock gives back 37% of gains in falling to $43.35 on Tuesday-there are very few investors to pick up the slack. Growth investors will step up at some point. When? That will require a body of investors who understand that the company may mine sand for injection for fracking in oil and natural gas wells, but that what the company sells is its ability to service those wells with sand through a system of rail lines and storage silos. It also requires investors who see that with the slump in natural gas and oil prices, producers have more, and not less, reason to frack, so they can service their debt. My best estimate is it will take until after the November 6 earnings report to demonstrate that revenue hasn't fallen off a cliff, as the recent plunge in the share price would suggest. I think it is unlikely that revenue won't show some impact of the slump in natural gas, and oil prices, and demand. The Wall Street projections for revenue growth of 134% in 2014 from 2013 are likely to come down. But not as much, I think at this point, as the market now expects.
The amount of sand pumped into an individual well in an effort to increase the flow of oil and gas has been on an upward trend as energy producers try to cut costs by getting more out of each well. I'd expect to see that new well drilling is indeed down, but that sand use per well continues to climb because lower energy prices put pressure on producers to pump more even at lower prices to meet their debt payments. At some point, dividend investors will step up, once the company has demonstrated it has the cash flow to back up a dividend running at an annual rate of 5.3%. This kind of transition from momentum to growth can take a while-all transitions in investor base do: look how long it took Microsoft (MSFT) to go from a growth stock to being a value/dividend play. Fortunately, Hi-Crush Partners does pay that 5.3% dividend while this transition goes on, which is why the stock is a member of my Jubak's Dividend portfolio. I'll have a deeper look at Hi-Crush Partners tomorrow.
Third, small-cap stocks are, to a large degree, captive to the trend in the big-cap S&P 500. It's going to be very hard for small-caps to rally while the S&P 500 is under downward pressure. From this perspective, what I'm waiting for is either some kind of reversal in the S&P 500 trend or for small-caps to fall to a bargain versus the big-caps. The forward price-to-earnings ratio for the Russell 2000, as estimated by Birinyi Associates on October 3, was 18.06. That's still higher, but not extravagantly so, than the forward PE for the S&P 500 at 16.35. (Of course, there is the little issue of whether investors can trust these forward earnings projections. We'll know more about that after we're seen third quarter earnings.)
All three of the view points on small-cap stocks argue for waiting until we're at least halfway or more through earnings season.
As I've argued recently, I think what we're seeing with the big-cap stocks of the S&P 500 is a real test of buy on the dip. The strength of belief in that strategy-buttressed by its repeated success since you have to go back to April-October 2011 to find a drop of 10% or worse-has truncated most drops at 4% to 5%. We're at that level now but there's a discernable lack of enthusiasm for buying into this dip ahead of earnings season.
The big worry isn't so much over this quarter's results-but about what companies will say in their guidance about the fourth quarter. Economic growth looks like it will be close to nil in the EuroZone, and Japan, and even for US companies with their historic underweighting of overseas sales, that slowdown is worrying. Add in the uncertainty from slower growth in emerging markets and you can see why buying big-cap stocks after a 4% drop isn't a no brainer.
Want a preview of what investors are worried about in third quarter earnings reports? Take a look at YUM! Brands (YUM) report yesterday, October 7. The company missed earnings projections by a penny and missed revenue estimates as well ($3.35 billion versus a projected $3.42 billion) on a 3.2% year-to-year drop in revenue. In China same store sales fell 14% and margin fell by 4.6 percentage points. Same store sales in the company's KFC Division grew by 3%; for Pizza Hut, same store sales declined to 1%; and for Taco Bell, same store sales rose 3%.
Worse, the company said it couldn't forecast the recovery in Chinese sales or how long it would take to recover from yet another safety scandal at a supplier. That uncertainty led the company to cut its estimate for 2014 earnings growth to 6% to 10% from a previous projection of at least 20% growth.
Now most companies reporting third quarter earnings won't have a supplier scandal that drove away customers to report, but the drop in sales in China was by no means YUM's only growth problem.
And the end result-a big drop in guidance for the remainder of 2014 is exactly what Wall Street is worried that it might hear from a significant sample of S&P 500 companies over the next month. Today, October 8, Alcoa (AA) had dropped 2.13% as of 2:00 PM New York time in advance of its earnings announcement after the close.
Talk about nervous.
The worry weighing on the big-caps, which tend to have more overseas sales than small companies do, is that no one knows how the stronger dollar and the slow economies of Europe, Japan, and much of the developing world will affect, not so much earnings for the quarter that ended in September, but guidance for the fourth quarter and into 2015. That's where any nasty surprises are likely to turn up and, at this poin,t no one is sure if the nasty surprises will be enough to push the S&P 500 down through major resistance at 1900. If the index does fall through that level, we are suddenly looking at the possibility of a real, honest to goodness 10% correction.
That's not the end of the world. Bull markets see corrections all the time or, at least, they used to. But a 10% correction would be a shock for a market that has become accustomed to seeing a rally whenever stocks fall 4%.
And then, third, there's the commodity sector, which looks set up for a decline of more than 10% and one that lasts for a while, too. That's probably not enough, by itself, to send the S&P lower, but it sure won't help. (Between them, the energy and materials sector make up about 13% of the S&P 500.)
No matter what commodity you look at, the story is distressingly the same: Abundant supply (with more scheduled to come on line) and slack demand, because of slow growth in Europe and Japan and slower growth in China, add up to falling prices. And with no signs that anybody is willing to cut plans to increase supply or to curtail production, the decline in commodity prices isn't over.
For example, with another drop today, Brent crude oil (the European benchmark price) fell to near $90 a barrel intraday. That puts Brent crude down 21% from its June 19 high of $115.06 a barrel. Brent has climbed from that intraday low but it is still very close to the 20% drop that marks the official start of a bear market. (The US benchmark West Texas Intermediate touched $86.83 intraday, the lowest price since April 2013.)
The demand/supply picture doesn't look likely to improve in the short-run. Forecasts are calling for a warmer than normal winter in the United States-which will cut heating demand for natural gas. The Saudis have apparently decided not to cut production in response to global oversupply. Speculation on the reasons for this decision is running wild-maybe it's a way to punish the Russian economy as part of a deal with the United States, or maybe it's an attempt by the Saudis to slow the US shale boom, or maybe the Saudis, who are lowering prices for the Asian market, just want to defend market share or maybe it's an attempt to strike back at producers such as Libya and Iran in order to restore discipline to OPEC.
Absent a pick up in demand from China or unexpectedly cold weather (and given news stories about China's leasing of tankers to store oil, it's not clear how much of an increase in demand would be required in order to move global oil prices,) the trend for oil and natural gas is still in a downward.
It's hard to see a different picture for other major global commodities. Copper is suffering from the slowdown in demand from China. Iron ore is seeing slow demand from China as well as a huge increase in production capacity from the big three of Vale (VALE), BHP Billiton (BHP), and Rio Tinto (RIO) that is designed to create new efficiencies of scale that will cut production costs by another $5 to $10 a metric ton for these producers, which already have the lowest costs per metric ton in the world. (Vale is a member of my Jubak's Picks portfolio.) A side effect of that, of course, will be further downward pressure on iron ore prices. Gold has seen a recent bounce on financial market turmoil and slight weakness in the dollar but no one that I've been able to locate thinks the bounce will continue absent any signs of global inflation. (For more on gold see my sector Monday post scheduled for October 13.)
Some of the stocks in energy and other commodity industries look cheap right now but my read is that they're likely to get still cheaper before we see a bottom on expectations for a turn in the supply/demand picture.
Here, as in the rest of the market, looking at risk and reward, I'll continue to wait before buying anything.