Roll With This Sea Change

 | Jan 27, 2014 | 6:00 AM EST  | Comments
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You get deep in the weeds of this market, and you can really figure out what's going wrong and why.

There's a profound set of cross-currents playing havoc with stocks and, more important, a huge wave of confusion and pessimism is engulfing all of us right now.

Let's start with the real, proximate cause of this difficult period: the last employment number. As part of Get Rich Carefully, I spent a huge amount of time analyzing the precipitants of sea changes in the market. It's amazing how very few there are. We tend to think that individual stocks can control all, and they can on an hourly basis, but not much more profoundly than that. The market has a terrible memory.

We tend to think that Federal Reserve pronouncements can play a huge role, but even those diminish as they are met with other Fed data points and speeches. Also, the Fed is so well-covered these days that everything's pretty transparent and discounted.

We know that the federal government's infighting can truly trigger difficulties for the market because it saps confidence.

But the only real predictor -- the only real forward-looking, non-coincidental piece of data -- is the nonfarm payroll report, and the stench of that last number hangs over our markets for many, many weeks after. In fact, the nonfarm payroll number has set the tone ever since the beginning of the Great Recession.

It's amazingly controlling in its implications.

As I have studied the number, the reason it's so important has become glaring. It's because this number is so outsized that it actually impacts more than just Wall Streeters and investors. It impacts consumers and businesspeople, particularly small-businesspeople. A very weak number, like the one we had last, signals the possibility of a recession, and that's what's been in the air ever since that number came out.

That brings us to premise No. 1. The employment number has called into question the durability of the nascent recovery. It has called into question the strength of all of the following sectors:

  • Autos. Autos had been the bedrock of this recovery, and then we heard AutoNation (AN) CEO Michael Jackson say that inventories are backed up. That made us suddenly wary of a group of stocks that had been definitive market leaders. Take a look at GM (GM) and Ford (F) after that announcement. Horrendous. Parts makers aren't immune, either.
  • Home construction. I liked the tenor of the home-related stocks coming into the year. But they have ceased to be strong because of a profound belief that the consumer is spent and not optimistic about the future. (I have not been a fan of the homebuilders for some time, yet for some reason I am constantly being criticized on Twitter as being their champion. But they have acted well with the decline in U.S. Treasury interest rates.)
  • Commercial construction. We are hearing mixed tidings here: Some banks and companies saying things are getting better, but the Architectural Billing Index has turned down. This is the most important group for the next leg up in the economy, and it suddenly seems tepid.

Now, let's deal with the most glaring breakdown after the employment number: retail. First, now that we're surveying the landscape after the holidays, we're finding that only Costco (COST), Macy's (M) and Starbucks (SBUX) delivered consistent 5%-plus U.S. same-store sales.

Most retailers reported horrendous comps. This is a crucial group coming off a crucial quarter, the only one that really matters, and it has been a tremendous tone-setter prey to confirming the employment weakness.

We've got some crosscurrents here that are playing real havoc with the group and with the faithful behind it.

First, going into the holiday, there was a presumption that the only things really selling well were hard goods. We came to accept a belief that it wasn't that the consumer was on the ropes. It was that he or she was buying hardware, and not software. But the shocking numbers from Gamestop (GME) and Best Buy (BBY) ended that presumption.

Once we saw those figures, we quickly switched theses and causes to:

  • A shortened period between Thanksgiving and New Year's
  • Miserable weather throughout the country
  • Woes in the wake of the government shutdown

But then we got the huge comeuppance from Howard Schultz, CEO of Starbucks, that these cyclical and one-off concerns were not behind the weakness. We are having a seismic, secular sea change that has to do with a permanent decline of mall traffic and a migration to online shopping. Starbucks can't be Amazon'd (AMZN), but it now looks like everyone else can be, with the exception of Macy's and Costco.

Macy's has the most advanced Web business of all apparel companies, which explains much, and Costco has the lowest prices because of its club status.

So now, coming into the year, we "lost" autos, home-related, commercial construction and retail. That's a huge chunk of what worked in 2013.

Based on these inputs, the big-portfolio managers rapidly switched directions and headed to tech, financial stocks and industrials.

That headlong shift met new facts on the ground these last two weeks, culminating into the big decline of the last few days.

First, the industrials are heavily skewed toward worldwide growth. Worldwide growth includes China. Every single industrial company has reported decent order and revenue growth, including the much-maligned General Electric (GE), which has been the most visible disappointer. Yet, despite that, the now-well-publicized problems of the Chinese banking system -- they were problematic but not well-publicized until a particular bank's woes became obvious -- trumps the narrative of worldwide growth. A European comeback is minimized by the Chinese financial system.

Lost in the shuffle here is that American industrial strength -- as represented broadly by the surge in the transport stocks, based on real data about multiple-merchandise strength from the rails -- is still unequivocally on course. But my earlier discussion about autos, housing and the consumer points to those going off course shortly, or at least that's the perception.

Without China, the industrial thesis that had suddenly come to the fore seems naked and weak, especially after the run the group has had.

The financials? They were real good going into the quarter, and their reports have been real good as well: They're coming out with low loan losses, waning federal investigations -- although those never really go away -- and a return to net interest margin growth. But the sudden worries about China have caused a flight to quality that has driven U.S. interest rates down to levels that could return the banks to net-interest-margin weakness. So, the group now gets called into question.

Tech's the lone standout, and European tech is gaining strength, as we heard from Avnet (AVT). This company has 100,000 clients and many in Europe, so it knows best. That news, again, is being ignored because of the amorphous beast that is China.

Now, on top of all of these woes come the twin blindsides of Argentina and Turkey, and a new leg of decline in the emerging markets that many had thought had stabilized after the summer rate surge.

Now, at this point, emotions have run rampant that these aren't just canaries in the coal mine but that the coal miners are dropping like flies. There's absolutely no recognition whatsoever that these two proximate national causes of the emerging-market declines are just total ne'er-do-wells

Turkey's gone from being a secular growth state to one in transition to a backward state that embraces religion over growth, a fact that few want to admit or talk about. Argentina's going the way of Venezuela because of a very bad government. The fact that their currencies had held up at all going into these longer-term transitions simply shows the blind faith people have in growth in any darned nation that is perceived to be backward that can go forward. It's total joke thinking, but it has a lot of sway among the non-stick-following cognoscenti that we always have to put up with.

So now we have a world where most managers are out of position. It's a moment when consumer spending might be stalled, with the Fed unable to help, and with fledgling theses getting rocked as rates come down quickly.

The fact that these inputs are producing market-wide panic simply has to do with the S&P 500's initial grip on all stocks. We are in the throes of that moment. Making things worse is that we haven't seen a pullback for ages. This has produced too much euphoria, and too many new investors who have never been bloodied. People don't know where to turn. They are just fleeing en masse.

Now, as I have written endlessly for more than 30 years, there is a real pattern to all of these selloffs.

You get the initial shockwave. Everything gets crushed. Then you take a look at what the bonds are saying and doing and you take your cue from them. Right now the bonds are saying we should go back to the bond-market-equivalent stocks that had gotten so out of favor. They are saying that you need to select special situations, either where companies are self-helping with breakups, huge buybacks and mergers or where activists are playing a role. The bonds are saying we could be in for a recession, and that we should therefore invest accordingly.

I don't think we are going into a recession, I think that's way too extreme. Bond flight to quality can be a powerful and often misleading course after a few weeks of upside pressure, and then you revert to more normal investing based on earnings and expectations.

Still, the bottom line for the moment is that the panic is not going to produce long-term positive results. You simply have to wait until big-money repositions and then take advantage of the wreckage of that repositioning, betting that the international woes are fleeting and that the U.S. strength is simply in pause mode. You'd be betting that the pent-up demand from the Great Recession can still drive things, and that some of the consumer weakness is, indeed, one-off and not all cyclical or secular.

That's where I come out right now. You need to examine the share pullbacks of companies that have reported excellent numbers, and start investing in the expected whoosh down. You have to have conviction that the market is in reset mode and nothing else. You have to accept that the stocks that were working, coming in, are now going to give back this year's performance if they haven't done so already, and that they will now roll back the fourth-quarter's gains.

Most important, you have to accept that stocks are simply rotating in a business-as-usual fashion, something we haven't seen in such a long period of time that it seems downright alien. It is quite unfortunate that anyone who is calm in the face of the selloff gets blasted for being too complacent or even a Pollyanna. But if you do not have an issue in close reading, you can see that I am not saying, "Damn the torpedoes, full speed ahead." I am saying, "Damn some of those torpedoes, they are hitting home -- but others are duds that allow us to advance, yet with different stocks than we would have expected just a few short weeks ago."

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