July 23, 2015 / 5:13 AM / 2 years ago

Investors rethink stock valuations as China, growth weigh on prospects

NEW YORK (Reuters) - Apple Inc’s (AAPL.O) disappointing earnings matter to more than just the investors who hold its shares.

Traders work on the floor of the New York Stock Exchange shortly after the opening bell in New York, July 21, 2015. REUTERS/Lucas Jackson

With the iPhone maker among just a handful of companies accounting for more than half of the U.S. stock market’s gains this year, some fund managers and analysts are concerned that the long bull market, which has pushed the S&P 500 index .SPX up almost 50 percent in less than three years, is starting to wane.

They worry, among other things, that the stock market crash in China will cut into global growth; that a stronger dollar will erode into overseas profits for U.S. companies; and that companies are trading at rich valuations after four years in which the S&P 500 hasn’t experienced a 10 percent decline - known as a correction on Wall Street.

Now, with lackluster earnings results in tech companies, one of the market’s few bright spots this year, investors are concerned that a decline in shares of Apple, Microsoft Corp (MSFT.O), and IBM Corp (IBM.N) might foretell a wider pullback.

“The market is flashing a yellow light right now,” said Bob Doll, a senior portfolio manager at Nuveen Asset Management.

NARROWING MARKET

The S&P 500 is currently less than a percentage point away from an all-time closing record. But market internals - indicators professionals look at to determine the health of the market - look weak.

Fewer stocks are leading the rally while more are hitting their lowest prices in a year, Thomson Reuters data show. For the year through July 17, just five companies – Apple, Amazon.com Inc, Google Inc, Walt Disney Co, and Facebook Inc – accounted for 61 percent of the year to date gain in the S&P 500, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

    The spread between daily gainers and losers on the New York Stock Exchange on a 50-day average rolling basis has favored decliners since June 9, and earlier this month became more skewed in favor of those falling than at any time since mid-2012.

    Back then, amid fears of a global slowdown and a crisis among Spanish banks, the S&P 500 went through a 9.9 percent decline over two months. The recent pullback on the S&P, however, has been less than 4 percent.

    A look at stocks hitting yearly highs and lows similarly offers little comfort. There are more NYSE stocks hitting 52-week lows than highs on a 50-day moving average than since December 2011 after worries about the euro zone’s deepening debt crisis brought the S&P 500 down 9.8 percent between October and November.

The declines, though close to 10 percent, do not fit the traditional definition of a correction. The red flags that go up when the market hits that number sometimes ignite herd selling.

The weakening internals look to some to be similar to late 1999 and 2007, both periods that preceded bear markets, when index averages motored higher even though fewer stocks were being carried along with the rest of the market.

   

The widening gap between top-performing stocks and the rest of the market comes at a time when earnings in the S&P 500 are expected to fall 1.9 percent compared to the same quarter last year. Verizon Communications Inc (VZ.N), for instance, lowered its full-year revenue target on Tuesday, while United Technologies Corp (UTX.N) cut its 2015 profit forecast for the third time this year due in part to dimming views on new equipment sales in China.

    As the bull market’s gains narrow to fewer companies, fund managers are piling into the shares of those that are able to show growth. About 71 percent of actively managed large-cap funds currently hold Apple, for instance, making it one of the most widely-held stocks on Wall Street.

At the same time, rich valuations are making it harder to add new companies to his portfolio, said Lamar Villere, one of the co-managers of the $745 million Villere Balanced fund. The fund has added just two new companies this year, compared to a typical six in a given year, he said.

“In a market like this where things are fully valued, we are watching for some temporary thing to happen to spook other investors and give us an opportunity to buy,” he said.

Buying market pullbacks has been a winning - and crowded - strategy, with the largest decline so far this year a near 5 percent slip in January.

“This ‘buying the dip’ mentality has been so successful in the last several years, I wonder if we’ve got to wash that out,” said Jim Paulsen, who helps manage about $350 billion as chief investment officer at Wells Capital Management in Minneapolis.

“Maybe we go down 5 to 7 percent, people buy the dip and then it goes down another 5 percent and washes that out finally. I wouldn’t be surprised if we get a 10-to-15 percent correction.”

To be sure, there are still pockets of the U.S. stock market that look attractive. Connor Browne, one of the $1 billion Thornburg Value fund, said that his fund has been trimming its position in high-flying stocks such as Netflix Inc (NFLX.O) and moving more money into small and mid-cap companies that are less exposed to currency fluctuations or China.

The Russell 2000, which is made up primarily of smaller companies, is up 4.5 percent for the year, compared with the 2.7 percent gain among the large companies in the S&P 500.

Brian Jacobsen, chief portfolio strategist for Wells Fargo funds, said that high valuations, rather than a slowing domestic economy or signs of a bubble, are pinning in further gains in the U.S. market. The S&P 500 now trades at a trailing price to earnings ratio of 19.5, according to Thomson Reuters data, at the high end of its historical average.

Jacobsen now favors European stocks, which are cheaper and have better growth prospects in the year ahead, he said. Yet until he sees new orders for durable goods declining materially or credit spreads start to tighten, he’s content to keep his holdings in U.S. stocks without moving to cash.

“Unless the market takes a big jump here without any increase in earnings or revenue, then I‘m leaving my money on the table,” he said.

Reporting by David Randall. Editing by David Gaffen and John Pickering

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