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Emerging market fears grip market

Buy when everyone is selling and hold when everyone else is buying. This is not merely a catchy slogan. It is the very essence of successful investments. – J. Paul Getty, Anglo-American industrialist who founded Getty Oil Company, named by Fortune magazine as the richest living American in 1957

Not since May 2012 has the Dow Jones Industrial Average posted a worse month as it lost 5.3% in January on renewed concerns over China’s growth and its effects on other emerging markets. This is certainly not the way to begin a new year, especially when economic growth in the U.S. seems to be gaining momentum. The government reported that fourth quarter GDP was 3.2%, which follows 4.1% growth in the third quarter. One has to go all the way back to 2003 to find two consecutive quarters of stronger economic growth. But the good news was overshadowed by worries over what effect the tapering by the Fed might have on foreign capital flows. As expected, in Ben Bernanke’s last meeting as Fed chairman, the decision was made to reduce the monthly bond-buying program by another $10 billion. In doing so, the Fed gave a vote of confidence to the U.S. economy and its ability to eventually stand on its own two feet. But suppressing interest rates here forced investors to go overseas to find more attractive yields and that process is now being reversed as the stimulus is being lifted. Along with improving GDP growth, economic reports in general have been better than expected and fourth quarter earnings reports have also been mostly positive. In fact, over 70% of the earnings reports so far have beaten analyst estimates. While these reports were fairly upbeat last week, notable exceptions such as Apple, and Boeing seemed to weigh on the market. One month does not make a year and although the stock market is off to a rocky start, patience should be rewarded as the economy and fundamentals continue to improve.

Last Week

New home sales for December fell more than expected but lean inventories and price increases suggested that there is sufficient strength in the housing market to support the economy. Frigid weather across much of the country might have been partly responsible for the 7% drop. In another surprise, durable goods orders for December fell 4.3%, worse than most economists had forecasted. While jobless claims also rose to 348,000, the longer-term trend is still favorable and indicates continued improvement in the labor market.

The fourth quarter GDP report showed that consumer spending was strong, business investment in equipment and software was better than expected and exports improved sharply. The only weakness in the report was housing as builders became cautious as home prices rose and mortgage rates increased. But the severe cold weather might have explained part of the slowdown.

For the week, the Dow Jones Industrial Average fell 1.1% to close at 15,698 while the S&P 500 Index shed 0.4% to close at 1,782. The Nasdaq Composite Index declined 0.6% to close at 4,103.

This Week

The most important economic report to be released this week will come on Friday when the Labor Department announces the employment report. The forecast calls for the unemployment rate to remain at 6.7% with a total of 170,000 new jobs created. Although the brutal winter weather might have some effect on the numbers, the estimate for non-farm payrolls is an increase of almost 100,000 jobs over the December number of only 74,000. Like durables goods orders last week, factory orders for December are also expected to decline while the January ISM manufacturing index may slip slightly.

Last week marked the peak of the earnings season but a number of companies are scheduled to report this week and investors will be watching closely. Among the more prominent ones on the list are Yum! Brands, Sysco, Emerson Electric, International Paper, Merck, Walt Disney, Philip Morris and Automatic Data Processing.

Portfolio Strategy

Emerging markets were a drag on portfolios last year as the MSCI Emerging Markets Index was down about 2% and their weakness has intensified recently as investors fear that slowing growth in China may be contagious. While countries such as Mexico and South Korea have relatively strong economies, those that are struggling are faced with weak currencies, high current account deficits and, in many cases, political uncertainty. In most portfolios, the emphasis has been on developed market international funds, where the allocation has been larger and the performance has been excellent due to improving economies in Europe and a resurgent Japan. While there may be further pain in emerging markets, most portfolios have only a small percentage of their assets allocated to this asset class. With the recent weakness in these stocks, valuations are attractive as the MSCI Emerging Markets Index trades at only ten times earnings, less than that of developed markets. Longer-term, we think that emerging markets offer the potential for above-average earnings growth and capital appreciation.

While the Dow Jones Industrial Average was down over 5% in January, the broad market as measured by the S&P 500 is only down 3.5% from its all-time high. Most portfolios are very well-diversified in terms of individual equities through the use of funds as well as the various asset classes, such as large caps, mid-caps, small caps, international equities, commodities and REITs. Fixed income investments have acted like shock absorbers and have provided a cushion by maintaining their value in the midst of this stock market sell-off. Municipal bonds have been particularly strong in January while REITs or real estate securities were up about 3% last month and offer a 4% yield.