Weak growth in China sinks stocks

When stocks are attractive, you buy them. Sure, they can go lower. I’ve bought stocks at $12 that went to $2 but then, they later go to $30. You just don’t know when you can find the bottom. – Peter Lynch, American businessman and stock investor, research consultant at Fidelity Investments and former manager of the Fidelity Magellan Fund

In its worst week since the middle of 2012, the stock market declined about 3% on fears of an economic slowdown in China and other emerging markets and the effect it might have both in the U.S and other developed countries. The selling began on Thursday after China reported that its purchasing managers report showed an unexpected contraction in January. Although the amount of the decrease was small, it spooked the markets, especially after an earlier report had shown that China’s GDP growth had also slowed modestly. Perhaps the market was just looking for an excuse to lock in profits after the meteoric rise in prices last year that saw the S&P 500 Index post a total return in excess of 30%. There were only a few economic reports released last week on which to trade the market and the earnings season so far has been a mixed bag. Earnings were expected to rise about 7% in the fourth quarter and the results to this point have been mostly in line with that estimate. With only one week left in the month of January, some traders fear that negative monthly equity returns might set the tone for the whole year. While that thinking might be premature, it is important to remember that what happens economically and politically in other parts of the world can have a significant effect on both our economy and markets as well.

Last Week

Both existing home sales for December as well as the leading economic indicators took a back seat last week to economic data that came out of China. While the Chinese government reported that GDP growth was 7.7% last year, the number was well below what investors have come to expect from that country, namely double-digit gross domestic product growth. Even though China’s purchasing managers report fell from 50.5 to 49.6, a decline of less than one point, it nevertheless signaled that its economy is shrinking. Other emerging markets fell on this news as they are important suppliers of raw materials and other goods to China. 

The December jobs report was very weak but it should not deter the Federal Reserve from tapering its $75 billion-a-month bond purchase program designed to stimulate the U.S. economy. While last week’s events may give the Fed some second thoughts, most market observers believe that another reduction will take place as scheduled.

For the week, the Dow Jones Industrial Average lost 3.5% to close at 15,879 while the S&P 500 Index dropped 2.6% to close at 1,790. The Nasdaq Composite Index declined 1.7% to close at 4,128.

This Week

Unlike last week, there is no shortage of economic data this week to gauge the strength of the economy. December new home sales should be healthy and durable goods orders for December are expected to increase by 1.7%. The government is also expected to release its first estimate of fourth quarter GDP growth and the consensus calls for an increase of about 3.3%, less than the third quarter but still fairly strong. The Chicago purchasing managers index (PMI) could be less that the previous month but still indicate strong growth. Finally, the University of Michigan consumer sentiment index will likely show confidence in the economy rising modestly.

This week will mark the peak of the fourth quarter earnings season as about one fourth of the companies in the S&P 500 Index are on tap to release their reports. Among the notables include Apple, Yahoo, Qualcomm and Google in the technology sector, Pfizer, Amgen and Eli Lilly in the health care sector, Boeing, Caterpillar and 3M in the capital goods sector, Exxon Mobil, Chevron and ConocoPhillips in the energy sector and Dow Chemical and Du Pont in the materials sector.

Portfolio Strategy

While corporate earnings have been trending mostly in line with Wall Street consensus estimates, revenue growth has actually surprised on the upside for a larger number of companies. This was a concern for the markets at the beginning of earnings season and will definitely be put to the test this week as earnings announcements peak. Apple Computer, a technology bellwether, will lead the charge on Monday and is expected to report stronger than expected earnings. With the focus by investors squarely on earnings and domestic economic data, a good report by Apple could set the tone for the week and help the stock market regain some footing. Although the S&P 500 Index is trading below its 50-day moving average after last week’s sell-off, this downward trend could be reversed with favorable data on the economy and positive corporate earnings reports. The Federal Reserve Open Market Committee will also meet this week to assess the state of the economy and interest rates. Though it is widely expected that the Fed will taper another $10 billion from its stimulus program on the strength of the U.S. economy, debt-ceiling concerns in late February or the concerns over global economic growth could lead to a pause in the tapering process. The slowdown in China certainly has raised some eyebrows and will cause investors to reevaluate growth prospects in all of the emerging markets. While the magnitude of the sell-off in the stock market on Friday was unsettling in absolute terms, it has to be put in proper perspective. Even with the slide in stock prices last week, the S&P 500 Index is only off about 3% from its all-time highs.