It’s incredible, really, that some investors are surprised that the Dow Jones Industrial Average, NYSE, and S&P 500 are in the red for the year, spooked apparently by weak corporate earnings.
How can this be a surprise? Is it fair to say that 2013 was an irrational momentum play? Has that logic finally caught up to investors? Once again, I enter as evidence 2013’s fourth-quarter earnings—which should not have caught anyone off guard.
The ball got rolling in late 2012, when 78% of S&P 500 companies issued negative earnings-per-share (EPS) guidance for the first quarter of 2013. The negative earnings momentum continued into the second quarter, when 81% of companies on the S&P 500 lowered their earnings guidance.
Against the backdrop of rising key stock indices, a record 83% of all S&P 500 companies waved the white flag, revising their third-quarter earnings guidance.
Still, the S&P 500 climbed higher. And in a desperate bid to help investors avoid the economic iceberg and take profits, a record 88% of reporting S&P 500 companies issued negative fourth-quarter earnings guidance. (Source: “Record high number and percentage of S&P 500 companies issuing negative EPS guidance for Q4,” FactSet, January 2, 2014.)
And here we are in the midst of fourth-quarter earnings season and investors are sending the key stock indices into the red, disappointed, it would seem, with what they were warned was coming.
As we enter the last week of January, the S&P 500 is down 2.5% so far this year. At this same time last year, the S&P 500 was up roughly 2.2%. The Dow Jones Industrial Average is down 3.5% in the first four weeks of 2014; during the same period in 2013, the Dow Jones Industrial Average was up 5.2%. And what about the NYSE? It’s down 2.3% so far this year; by this point last year, the NYSE was up an even three percent.
Now granted, all of the major indices are topping all-time highs and a breather is in order. But a breather on the heels of bad earnings could turn into more than just a short-term dip.
What do you look for in undervalued stocks with less downside risk and great upside potential? Avoid excessive debt loads and those firms that have a bad track record of generating positive free cash flow—meaning, look for undervalued, financially solid companies that generate more cash than they need to keep their business running.
On top of that, look for brands with a low forward price-to-earnings (P/E) ratio and companies that have seen their share prices drop sharply over the last few years.
Cooper Tire & Rubber Company (NYSE/CTB), Shiloh Industries, Inc. (NASDAQ/SHLO), and Zumiez Inc. (NASDAQ/ZUMZ) may be good places to start for some investors.
While it may seem obvious, we all need a reminder sometimes: Investors need to protect themselves against any correction in an overvalued market by finding undervalued companies with great upside. Buying undervalued stocks in an overvalued market can provide downside protection. It also offers the potential for solid gains, as investors turn their attention to fundamentals and earnings.
This article Have These Stocks Already Been Through a Correction? was originally published at Daily Gains Letter