Long Awaited Market Rout Is What Long-Term Value Investors Need

by: Tarek El Sherbini

Summary

The sell-off in US and European capital markets over the past two days can pave the way for valuable investment opportunities to start appearing in the period ahead.

This earnings season will be one of the most important in a long time and will determine market direction.

If the market weakness is prolonged, the Fed is likely to slow down its rate rise campaign.

While emerging market equities have been in a downward direction for much of the year, in tandem with their currencies, Western equity markets have held up - until August. Since the end of August, barely 5-6 weeks ago, Western markets starting moving suspiciously. The US markets, which have been the strongest performing for the past few years, have been very hesitant in their directions - reaching new records on few occasions in the past few weeks, but with clear reluctance and with pockets of weakness clearly appearing in different sectors - notably technology, telecoms, utilities and fast moving consumer goods. The FTSE 100, on the other hand, reached a 6-month low in the past few days and is still in a downward direction.

Various obvious factors were meant to upset the otherwise upward trend in markets. Tremors always precede an earthquake. The rising US interest rates is one of them, the trade war another, but also pockets of high valuations in some sectors - mainly technology and fast moving consumer goods - and overreached market growth. The current equity bull market in the US is one of the longest, if not the longest, in history.

On the 10th and 11th of October, the S&P 500 lost 4.35%, the Dow lost 5.3% and the NASDAQ lost 5.25% - the largest 2-day drop since the Brexit vote more than 2 years ago. All 11 sectors in the S&P 500 closed lower, putting the index on track for its third straight week of losses for the first time since June 2016. The FTSE 100 lost 3.25% on those two days and the FTSEurofirst 300 lost 3.6%.

Why did markets sell off now specifically? The reason cited is that treasury yields have been rising suspiciously for the past week or so, raising concern about higher cost of funding for companies, especially the ones with high debts to roll over. I do not agree with this explanation, as the sectors that are most leveraged in the US - telecoms and utilities - faced the lowest declines on the 19th of October. The other reason cited was the reflection of higher interest rates in valuation calculations. This could be a reason, but not a full one, and definitely not a cause for an abrupt selloff like the one we saw - not all investors in the world adjust their valuations of all stocks on the same day. Third, profit taking; investors sensed the reluctance in the markets because of all the fundamental reasons I mentioned above, and they took this as a selling opportunity - before others sell first. No one likes to be left standing when the music stops in a musical chairs game.

So, what lies ahead? The sharp falls in US markets on the 10th and 11th of October was probably a correction, whether this will be the start of a protracted correction will be clearer in the weeks ahead. Key will be the outcome of this earnings results season for the financial quarter of June-September. This will probably be one of the most important earnings seasons in quite a long time, as investors will be anxious to see if earnings remain strong in the US, and if the trade war, emerging markets' weaknesses, and other factors have started to weaken earnings.

The most important earnings results to look for will be those of technology stocks - mainly the FANGs (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Alphabet/Google (NASDAQ:GOOG) (NASDAQ:GOOGL)), in addition to Apple (NASDAQ:AAPL). This handful of stocks have been driving the growth of US markets over the past year, due to being the largest, the most profitable and the fastest growing group of companies in the US stock markets. All US companies will be releasing quarterly earnings between now and early November. If earnings are strong, this will create relief that fundamentals have not changed. Stocks, especially technology stocks, are then expected to continue growing, albeit in a more reasonable fashion rather than in turbo speed - which will be positive for investors. Driving too fast above the speed limit can result in bad accidents.

The other non-fundamental question will be about US interest rates and interest rate guidance. The next meeting of the FOMC committee of the Federal Reserve will be on 7-8 November. How financial markets perform between then and that meeting, in addition to usual economic figures, will have a significant role in how the Fed maintains or changes its policy of fast raising of interest rates. No Chairman of the Federal Reserve would want to be blamed for a stock market crash or for causing a recession, especially when that Chairman has been in the job for less than 10 months.

Investors should follow very closely the market developments and should be prepared to re-enter the market once they see stabilisation in market levels. When re-entering, they should be phasing their purchases in the coming period, with wider time spread between purchases to ensure best stock acquisition prices are achieved in potentially volatile market conditions in the period ahead.

Disclosure: I am/we are long FB, GOOGL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.