October Surprise

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Includes: FAST, VDSI
by: Income Surfer

Two-thirds of the way through October, and the global equity markets have barely been riled. I'm sure next quarter we'll hear about a few obscure hedge funds that went broke this quarter because the rise in global interest rates caught them wrong-footed with highly leveraged bets, but on the whole, market participants seem calm. No, I should say complacent. After all, there are numerous events that are likely to disrupt these calm markets in the coming months. The US has a presidential election to start with, which could be called amusing entertainment if… one of those two wasn't likely to be the next US president. Then you have various geopolitical events in the Middle East and Southeast Asia. Then you have rising bond yields around the globe, a slowing Chinese economy, and deflating housing bubbles in New York, Miami, and much of Canada. I have been very surprised by one thing this October however… the fact that third quarter earnings are coming in okay so far.

Now let's not get carried away. For one thing, we are still less than 25% of the way through earnings season. For another, the retailers will report in a few weeks… and their results are almost certainly going to be dismal. After six quarters of negative revenue growth, and four quarters of negative earnings growth, both revenue and earnings growth may just turn out to be flat…or maybe slightly up for the third quarter. Oh, the days when companies were able to grow both their top and bottom line numbers. That sounds to 1997, doesn't it?! Part of the reason I am expecting flattish results is because the results from the oil/gas sector should have improved in the third quarter… especially against the backdrop of very easy 2015 comparisons. Many companies in the S&P 500 have easy year-over-year comparisons at this point, plus the top and bottom line expectations have been dismal. Still, the results so far don't look nearly as bad as some have forecast.

The results from some sectors, most notably the industrial and manufacturing group, suggest that they continued to struggle in the third quarter… on the back of strengthening US dollar and a reduction of CapEx spending. Additionally, companies that do business with the European banks have been talking about how tough the business environment is. As luck would have it, two of our holdings, Fastenal (NASDAQ:FAST) and Vasco Data Security (NASDAQ:VDSI), have released (or prereleased in the case of Vasco) disappointing results in the last week. This is a tough point in the business cycle for Fastenal, and their growth rate has clearly been slowing as they have grown larger over the past decade. Vasco's situation can best be summed up by a comment an investor friend of mine (Sabeel) said yesterday, "…everyone who does business with the European banks is poisoned right now." Yes, it's true. I want to see how Vasco's products are doing in North America and Asia when they release results next week, however, because I can't imagine that data/transaction security is something that any modern company can scrimp on for long.

The other development I currently see in equity market is that bond yields have climbed in recent weeks (especially in England, German, and the US), while many traditional dividend stocks have sold off. It is not completely clear to me whether the decline in stock price of many of the consumer staples and telecom companies have significantly underperformed the broad S&P 500. Investors who are bullish on the US equity market will tell you that the selloff is the result of a rotation out of defensive names and into cyclical companies… and that the change is a good sign for both the markets and economy. I am skeptical personally. These "bond proxies" are selling off at the same time that the yield on traditional bonds has been climbing, making me suspect that the change in interest rates is playing a major role. It could also be that investors have started to recognize that margins have peaked out in these sectors, and that earnings/revenue growth has been nonexistent, but I am fairly certain the yield-starved nature of the market was behind the run-up of these stocks in the first place.

Where markets go from here is anyone's guess. Personally, I think most global markets will trade sideways until the next recession comes along. There has been a recession following every two-term US president, going back to 1910. Plus this expansion, anemic as it has been, is much longer than most. I expected the recession would have arrived in 2015, but apparently not. No matter, Mrs. IS and I will keep doing what we are doing… and following our game plan… and remain confident that it will all turn out alright. As individual investors, we have time on our side, and I intend to use it. Additionally, there is an inordinate amount of cash on the sidelines. This cash isn't just controlled by individual investors, but also institutions and investment companies. The presence of this cash, and the desire by central banks to print new liquidity, will likely mitigate the next downturn in global stock markets. Even if the Federal Reserve does raise interest rates, and I really doubt they will do so more than once, the central banks of the EU… China… and Japan are continuing to increase liquidity. That capital is flowing around the world. That doesn't mean that the central banks have eliminated the business cycle, or the boom/bust rhythm of the equity markets, but it does mean that they will continue to try to prop up asset prices as long as they can. While demographics in the developed world, and productivity improvements in the emerging economies, are putting deflationary pressures, the global economy… central bankers are determined to create inflation. For these reasons, I am only particularly bullish on three assets right now. Precious metals… and cash… and land. The next six months should be interesting.

Disclosure: We are long the companies mentioned in this post. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. Please do your own research and consult a professional before making any investment decisions.