Market Mayhem

Worries over emerging markets continue, but North America looks poised for a recovery

The stock market has been in quite a funk these last few weeks.

Expectations of a reduction in stimulus from the Federal Reserve, weak economic data in the U.S., slowing Chinese growth, problems with specific developing countries - all of these factors have triggered a massive wave of selling in emerging markets earlier this year.

Since April of 2013, the currencies of Brazil, South Africa, Indonesia and Turkey have declined by more than 15 per cent. The MSCI Emerging Market Index has trailed the S&P 500 by more than 23 per cent.

A dismal January U.S. employment report added to concerns that momentum in the world's biggest economy may be slowing. Non-farm payrolls rose by 113,000 in January - an improvement on December's numbers, but much less than expected.

The only bright light in the report was the jobless rate, which slipped from 6.7 per cent to 6.6 per cent. In spite of the gloomy employment report, global market equities have managed to rally over the last few weeks.

Emerging Global Markets: The Eye of the Storm

But the problems in the emerging markets are widespread. The Argentinean peso has been devalued. Strong growth in Brazil has waned, and the Turkish lira has plummeted. In South Africa, an ailing economy is mired in miners' unrest; in China, meanwhile, growth is endangering commodity exporters who have ridden the cyclical boom.

The common denominator for much of this malaise is the removal of stimulus by the Fed - a move that will boost U.S. yields and attract investment flows from abroad.

As things turned sour, India's central bank was the first to boost rates in an attempt to stem the flow of investment dollars out of the country. Next to react was Turkey, followed swiftly by South Africa.

One by one, central banks of fragile emerging markets raised their benchmark interest rates as capital outflows from emerging market debt and equities reached $9.1 billion.

Already, the chaos in emerging markets has wiped $1.7 trillion off of global stocks, hurting investors and forcing a re-examination of these markets, which appear to be wobbling badly as they endanger global growth.

The start of 2014 has been challenging for stock investors as risk assets of all types posted negative returns to kick off the year. The Morgan Stanley Capital Index (MSCI) AC World index stumbled 4.1 per cent in January, experiencing the worst monthly performance since June 2013.

Bonds, gold, and the U.S. dollar outperformed as the storm washing over the emerging market currencies sparked a flight-to-quality, with defensive assets showing strong market leadership - the first time they have done so since late 2012.

For some, the problems with emerging markets are reminiscent of the 1997/1998 Asian Crisis that began with a slide in the Thai baht, but quickly managed to spread to the entire region, driving global markets into a prolonged tailspin.

While there are many similarities between the 1997/1998 problems and those of today, there are also a number of important differences. In 1997, countries at the heart of the trouble mostly had fixed exchange rates and little-to-no foreign currency reserves, coasting on a credit boom that fuelled bad loans and papered over the lack of meaningful reforms.

Today, the current troubles in the emerging markets are remarkably uneven. In India, slowing growth is laying bare government economic reforms yet to be implemented.

All bull markets have periods of stock price weakness along the way

In Argentina, economists are fretting that a decade of economic mismanagement and a hastily devalued currency may precipitate a recession. And in South Africa, falling commodity prices have slammed mining companies leading to violent protests.

Reasons for optimism

With worries about the health of emerging markets spilling over into developed markets, the S&P 500 slumped more than five per cent from its record high, with the skeptics out in full force declaring a doomsday scenario for Western markets.

But despite the volatility in markets, I (for one) remain optimistic about the prospects for the S&P 500 this year.

In January, the S&P 500 Utilities sub-sector rallied 2.9 per cent and Health Care was up 0.9 per cent. Consumer Staples lost 5.3 per cent and Telecoms were down 4.2 per cent. The worst performing sub-sectors were Energy, down 6.3 per cent, and Consumer Discretionary, which dropped 6.0 per cent in January.

The yield curve, an important predictor of U.S. recessions, remains steep and has actually steepened in recent months.

If the yield curve had narrowed appreciably or become inverted, it might have been a worrisome sign: a significant change to the yield curve such as this has proceeded every U.S. recession in the post-war period.

As well, investor euphoria remains in the dog house, with high-beta stocks struggling to get a bid. It's the low-beta stocks that remain expensive, suggesting a flight to safety rather than momentum traders trying to ride a bullish wave.

Europe is providing a level of bullishness that we haven't seen in some time. The January Purchasing Managers Index (PMI) recently touched a three-year high.

Technically, markets may also be getting some support with more than 60 per cent of S&P 500 stocks trading below their 200-day moving averages in early February.

The fundamentals look a little better for U.S. stocks as well, with the Institute for Supply Management (ISM) New Orders index signalling an attractive risk-reward opportunity.

Although the recent uncertainty in the market is unsettling, it is expected. The market is in transition from a macro-driven "risk on/risk off" framework to one in which individual stock fundamentals are paramount.

Expect volatility during this transition period, but bear market stock hunters should be cautious. All bull markets have periods of stock price weakness along the way. In fact, since 1980, market pullbacks of five per cent or more are quite common, while pullbacks of ten per cent or more are extremely rare. In general, a pullback of ten or more percent that is sustained for some time is generally a precursor for bear markets and/or recessions.

What I Recommend

Two-thirds of U.S. stocks have reported their earnings, and the fourth quarter is shaping up to be the strongest in two years.

Consensus earnings are for 7.6 per cent growth in S&P 500 companies this year, but if companies continue besting consensus estimates, earnings growth for the year could top 8.8 per cent. Share buybacks should add another 110 basis points, which would result in total 2014 earnings per share growth for the S&P 500 of 9.9 per cent.

During this past quarter, the Materials and Financial sectors have shown the strongest earnings growth, while Health Care and Technology have shown the highest revenue growth.

Given the breakout performance of the Financials lately, I am buying more alternative asset managers.

One name I really like is Och-Ziff Capital Management Group (NYSE-OZM, $15.27). The company, founded in 1994 by Dan Och in partnership with Ziff Brothers Investments, is one of the largest alternative asset managers.

Och-Ziff Capital Management aims to achieve positive, risk-adjusted returns throughout market cycles, with a focus on risk management and capital preservation. The company has a 19-year track record of low-volatility absolute returns using relatively little leverage. As markets continue to recover, I expect Och-Ziff to gain share given its brand, outperformance, and scale.

Its overseas footprint is strong and acts as a differentiating factor in diversifying its investment strategies and attracting assets. As a partnership, it distributes over 80 per cent of its economic earnings, resulting in an above-average yield.

* My advice: I have a buy recommendation on the stock and a 12-month price target of $19.00 per share.

Best Buy Co., Inc. (NYSE-BBY, $24.84) is the number one specialty retailer of consumer electronics in the United States.

The stock sold off very hard after it reported its December quarter, where same store sales showed a modest decline. The company is undergoing a restructuring and has executed the first stages quite well, taking out costs faster than expected while carefully managing the spending needed to deliver the turnaround.

The shares are cheap, trading at just 13.2 times forward earnings. I see several opportunities for upside to be executed through margin and competitive initiatives.

* My advice: I have a buy recommendation on the stock and a 12-month price target of $29.50 per share.

SNC-Lavalin Group Inc. (TSX-SNC, $46.98) is a manufacturing stock that has plenty of upside if it can execute on its strategic plan.

SNC-Lavalin, active in the engineering, construction, and manufacturing sectors, is recovering from a bribery scandal. Company margins are improving, the firm seems to be executing well against its strategic plan, it trades at a big discount to its EPC peers and the company's backlog is beginning to grow.

* My advice: I have a buy recommendation on the stock and a 12-month price target of $54.00 per share.

The Bottom Line

With sentiment shaky, it's possible that we could see further weakness in the weeks ahead. I do not expect North American equities to underperform for very long, however.

Unless the macroeconomic picture in the U.S. rapidly deteriorates, the current pullback should prove to be an opportunity to add to stocks on both sides of the border.

I am standing ready to deploy my cash again in the Financials, Technology, Industrials/Autos, Base Metals and Chemicals sectors when the dust clears from the recent market mayhem.

- John Stephenson, CFA From The MoneyLetter, Feb 23, 2014