Semiconductors Get Slammed As Investors Scramble To Protect Profits

Volatility continues to increase in the stock market and many of the leaders are breaking down. In particular, semiconductors took a rather big hit when one of the bellwethers warned of weakening global demand. Nevertheless, despite the significant headwinds, I do not think this spells the end of the bull market. But the technical damage to the charts is severe, particularly to the small caps, which are in full-blown correction mode. The large caps must show leadership and rally immediately -- or it will put at risk the critical and widely-anticipated year-end rally.

In this weekly update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.

Market overview:

So far in October, the market already has seen five days with moves greater than 1%, which is as many such days as we saw in the prior five months combined. Jeff Macke observed in Yahoo! Finance that nearly one third of every trading day in the month of October since 1970 has seen 1% movements, up or down, including the infamous Black Monday of 1987. Heck, even the great Wall Street Crash of 1929 commenced in October.

No, weakness in October is not unusual, and this year in particular, because it has been so long since the broad market has pulled back in a meaningful way, I see it as a welcome cleansing that should validate some key support levels, wring out some excesses and overbought technical conditions, and establish a base from which to kick off the highly anticipated year-end rally.

Germany announced on Monday that factor orders fell -5.7%, which heightened fears among an already fearful investor community that Europe is worse off than thought. But then on Wednesday, the Dow Jones Industrial Average saw its best percentage gain of the year when the FOMC minutes expressed concern about the strong dollar and global economic weakness, which suggested that interest rate hikes are still a long ways off.

But then Thursday brought the worst daily point drop of the year, and the NASDAQ Composite endured its worst week since 2012. The NASDAQ started last week up +7.1% year-to-date, but fell -4.7% to finish the week up only +2.4% YTD, while the mighty NASDAQ 100 fell -4.2%, bringing its 2014 gain down to +7.4%. The Dow Industrials is back to breakeven for the year, and the S&P 500 is clinging to a +3.2% gain after losing -3.2% last week alone. For its part, the Russell 2000 small cap index is now in full-fledged correction mode, down -9.5% for the year and -13% from its July recovery peak.

So, what's really going on? Well, for all the flailing about and gnashing of teeth throughout the investment community, let’s keep in mind that the S&P 500 has not experienced a -10% pullback in over three years, while historically, such pullbacks tend to occur at least once every year, and -5% corrections typically occur three times a year.

I believe what we are enduring is a simple case of weak holders bailing out, of momentum riders locking in profits for fear of riding their positions back down to breakeven or losses. Nobody enjoys that, so these bearish events can become self-perpetuating. With visions of prior selloffs, no one wants to be the guy left holding the bag while others tell tales of getting out just in time.

Technology -- particularly the chip sector -- took a direct hit to the chin late last week. The Philadelphia Semiconductor Index fell -7% on Friday to a six-month low. This all resulted from a warning on Thursday afterhours by Microchip Technology (MCHP) that sales in the most recent quarter will fall shy of previous guidance and that an industry correction has commenced, largely due to weak demand in China. Juniper Networks (JNPR) also cut its third-quarter guidance citing lower-than-expected demand. MCHP is known as the proverbial canary in the coal mine because, unlike most chipmakers that report sales to distributors (many of whom may be building inventories), MCHP only reports revenue that has been sold from distributors to global customers. The bad news sent investors scrambling to protect profits in the strongest performers, including some of Sabrient’s favorites like Skyworks Solutions (SWKS), NXP Semiconductors (NXPI), Broadcom (BRCM), and RF Micro Devices (RFMD), all of which fell precipitously on Friday.

Is this it, then, i.e., the end of the bull market that has been driven by Fed liquidity, as the Fed pulls the last bit of its quant easing off the table? I still say no. I believe this economic recovery has legs on its own, and it only requires a gut check and some renewed investor confidence to rejuvenate the bullish conviction that has suddenly disappeared.

There are headwinds, to be sure. The Fed is widely expected to announce the official end to QE3 onOctober 29. Over the past five years since quant easing began, the correlation between growth in the Fed balance sheet and S&P 500 performance has been close to 1.0. Although some commentators are predicting that a new round of stimulus will be necessary sometime next year to support the economy, investors certainly aren’t counting on it now. With liquidity plateauing, corporate stock buybacks and IPOs that have been supportive of equities are expected to slow.

The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, spiked above 20 for the first time since early February and closed Friday at 21.24. The VIX hit a low of 10.32 back on July 3, so it has more than doubled in the three months since then. In my article last week, I noted that 50-day SMA was crossing up through the 200-day SMA, which is bullish for VIX but bearish for stocks. From a historical perspective, VIX often hits a peak in October. Nevertheless, it remains well below the 40 level that it reached in October 2011, and recall that at the height of the financial crisis in 2008, VIX spiked above 80. In fact, the 19-20 level is its five-year average.

Most of the world is struggling to get their economies on track. Global economic growth and inflation are both lower than anticipated for this stage of the recovery, given the broad focus among central banks on stimulus and liquidity, which means there is little hope for deleveraging anytime soon and the ratio of global debt to GDP continues to climb.

But overall, the bull case remains compelling for the next few years. The economic recovery continues to gain traction, with an expectation of +3% GDP growth. Mid-term election years are typically bullish, and the holiday season usually fosters bullish sentiment. Interest rates remain low, and the Fed stands ready to support the economy as needed. Remember, although the Fed is nearly done with injections of newly minted cash, maturing securities still will be reinvested rather than unwound. And corporate earnings reports are expected to be strong.

Q3 earnings season is now underway, and according to Capital IQ, S&P 500 companies are expected to post +7% earnings growth and +4% revenue growth, in aggregate. But even if Q3 earnings growth is indeed robust, all eyes will be on forward guidance and any words of caution or lack of visibility (like we heard from MCHP). After all, nearly half of S&P 500 earnings come from foreign markets. Moreover, weakness in commodities and many fixed income instruments appear to be sending out recessionary signals.

The 10-year U.S. Treasury bond yield closed Friday around 2.3%, which is once again down significantly from the prior week. It is the low for the year and its lowest close since June 2013 (which was the middle of its big spike upward). This should come as no surprise given the global flight to safety and the extremely low rates of comparable 10-year government bonds in Germany and Japan. Looking forward, there is little reason to expect a sudden spike or rapid march higher any time soon, helping provide equities with the fuel to outperform.

So, I still expect the stock market to get its act together and finish the year a good bit higher -- although I am not so confident anymore that it will be able to achieve new highs. The fundamental story for U.S. equities might be somewhat less attractive than it was a few months ago, but it is still better than the alternatives.

Nevertheless, it seems time to walk away from speculative bets and perhaps even from simple passive investing in broad indexes. Instead, the time is ripe for selective buying of high quality companies with market-dominant positions. Some of these top firms have been hit the hardest lately in the wave of fear-based profit-taking. But those with the strongest market position, solid cash flow, and lower debt levels will be back. Given the prevailing market conditions (elevated fear and volatility), investors must avoid the speculative stocks, especially those with high short interest -- rather than benefiting from short-covering, they have been the biggest underperformers during this bout of market weakness.

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The author has no positions in stocks or ETFs mentioned. The materials available from us are published solely for informational purposes. They are not to be construed as advice or ...

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