The Dow Jones Industrial Average is down 1.6% today. It has seen an amazing triple-digit move in 10 out of the last 14 days. The volatility has also picked up, and the index is now up 46% from the lows seen on Sept. 18th. September and October are always a challenging time for the markets, usually because of seasonality and the lack of company-specific data during the quiet period ahead of third-quarter earnings. Keep in mind that we are just 4.42% off all-time highs, so some perspective is in order here.
The decline feels a lot worse than it actually is, since several sectors and stocks are down much more than that, mainly in the energy and industrial complex. That is tied to the strength in the U.S. dollar, which has rallied over 8% since May. This would have some effects on companies' earnings and guidance. The continued negative data points out of Europe also contributed to the negative sentiment.
Europe is flirting with a recession, if they aren't already in one. The German data has turned south pretty quickly. It is the likely catalyst for today's declines and the volatility over the last few weeks. Germany missed on Industrial Production, Factory Orders, and Business Confidence. Last night's export decline of 5.8% was the lowest in five years, so reality is certainly hitting home that Europe is likely headed towards a recession, given that Germany is the largest country in the Eurozone.
The European Central Bank has monetary plans in place, but what is really needed is a full-on QE-like program, which the Germans are resisting. No solution is likely in the near term. Until we get some sort of news on this front, the problems in Europe will likely continue. Not surprisingly, Alcoa (AA) and PepsiCo (PEP) cited the weakness in Europe as a concern, on their third-quarter earnings calls.
This is what we have been concerned about over the last few weeks: the dollar impact to earnings and European weakness. It is one of the main reasons we sold out of many industrials and energy companies such as Boeing (BA:NYSE), 3M (MMM:NYSE), Stanley Black & Decker (SWK), General Electric (GE), Anadarko (APC), Marathon (MPC), and Occidental (OXY).
In hindsight, we should have sold out of both sectors entirely. We didn't, because the ones we held onto had already seen big downward moves, and we believed the yields would protect them. It hasn't mattered ¿ investors are now rotating and liquidating out of these two sectors in a hurry, and they are buying more into more defensive positions with yield.
We've been rotating as well, by adding to more U.S./domestic stories, or stories whose profits are primarily driven by the U.S. We believe this will be the type of stories to focus on for the remainder of the year. The big question is whether the slowdown in Europe affects our economic recovery.
In its minutes yesterday, the Fed basically told us that interest rates will remain low for a long time, possibly longer than we initially expected, which was the second quarter in 2015. This is a positive for the economy. Low rates, lower oil prices, better jobs, and strong U.S. corporate balance sheets are all positive offsets to the issues in Europe.
This favorable view is one of the reasons we have been buying the weakness, albeit slowly. Also, earnings should be decent. The consensus of estimates is 4.9% third-quarter earnings (down from 5.5% two weeks ago, likely FX related) and 4.1% third-quarter revenues. Valuations are getting more attractive. At the very least, investor expectations are now lower.
We will listen to what companies have to say about the macro issues. Yesterday's call from Alcoa was pretty encouraging, with respect to strong aerospace demand, U.S. truck (orders grew 57% year-over-year), and auto. Construction remained strong in the third quarter, and the CEO reiterated its growth targets in this end market (highlighting strength in non-residential construction), as well as in packaging. PepsiCo saw solid U.S. demand, benign pricing pressure and better margins, clearly executing in a challenging environment.
These are the things we are looking for: select end-market growth/momentum, self-help/restructuring stories, and solid execution. Some of our recent buys have been McDonald's (MCD), Panera (PNRA), and AbbVie (ABBV), all with company-specific options for improved results.
We've also begun to buy some of the cyclicals that have been overdone: Lear (LEA), Royal Dutch Shell (RDS.A), and United Technologies (UTX). These names also have restructuring and/or special situations to drive in better earnings over time.
We'll remain patient, and we'll continue to look for wide-scale entry points into the selloff. Valuations and expectations are now a lot better from a risk/reward basis, and the U.S. looks like the best bet for now.