What about the China effect?

Commentary: Nation's influence on U.S. earnings may feed the bull

By Zachary Karabell

NEW YORK (MarketWatch) -- October memories may be inspiring for baseball, but more often than not, they're haunting for Wall Street.

Black Mondays, Terrible Tuesdays, Wicked Wednesdays -- you get the drift. Over the past decades, October has given birth to some of the worst moments in stock market history. With the markets having been on their recent run -- a run that few expected so soon or to last so long -- there is a sense of trepidation in the proverbial air.

Without question, some of the surge in equities has had the distinct feel of momentum over fundamentals. Yes, the U.S. economy has stabilized but no, it hasn't started expanding.

While GDP figures may show growth for the third quarter, most of that will be the result of government spending and/or inventory restocking on the part of companies, and not due to any substantial resumption of dynamic activity in the United States.

In fact, many, many companies have shown surprising profitability because of their ability to trim costs and cut labor. Take Starbucks Corp. /quotes/comstock/15*!sbux/quotes/nls/sbux (SBUX 20.05, -0.60, -2.91%) , which has been ruthless -- effectively ruthless, but still -- in eliminating stores in order to bolster crumbling margins.

And though stocks have been on a bull run for months, it's almost impossible to assess whether this market is cheap or expensive, largely because neither corporate executives nor Wall Street analysts know what to expect from earnings in the next year.

The past 12 months have been so anomalous that any assessment of what the coming months hold is largely guesswork -- though a repeat of what took place between the fall of 2008 and the spring of 2009 seems unlikely. For markets that trade on forward expectations, the lack of clarity is unsettling to say the least.

The momentum up has been undeniable, but as any trader will tell you, momentum can turn quickly, and mercilessly. If this is indeed a momentum market, then we have every reason to be nervous.

China feeding world economy

This has been evident in industrial names, ranging from Honeywell International Inc. /quotes/comstock/13*!hon/quotes/nls/hon (HON 36.76, -0.39, -1.05%) to Caterpillar Inc. /quotes/comstock/13*!cat/quotes/nls/cat (CAT 50.03, -1.30, -2.53%) , for base metal companies that supply the inputs such as Freeport-McMoran Copper & Gold Inc. /quotes/comstock/13*!fcx/quotes/nls/fcx (FCX 66.81, -1.80, -2.62%) and Vale SA /quotes/comstock/13*!vale/quotes/nls/vale (VALE 22.81, -0.32, -1.38%) , and for high-tech companies such as Intel Corp. /quotes/comstock/15*!intc/quotes/nls/intc (INTC 19.37, -0.20, -1.02%) and Cisco Systems Inc. /quotes/comstock/15*!csco/quotes/nls/csco (CSCO 23.22, -0.32, -1.36%)

The same is true for consumer companies operating in China and service Chinese consumers, including such American stalwarts such as Yum Brands Inc. /quotes/comstock/13*!yum/quotes/nls/yum (YUM 33.17, -0.59, -1.75%) , the owner of Kentucky Fried Chicken, as well as Avon Products Inc. /quotes/comstock/13*!avp/quotes/nls/avp (AVP 33.22, -0.74, -2.18%) , and Nike Inc. /quotes/comstock/13*!nke/quotes/nls/nke (NKE 63.94, -0.76, -1.18%)

Kentucky Fried Chicken, in particular, has long seen its most robust growth coming from China, with less than 10% of its franchises on the mainland accounting for more than a quarter of the company's earnings. That trend has been even more notable in the past year, as business in the developed world has tumbled.

Too many investors, however, continue to view the China growth story as a growth story happening in China. They then look for Chinese companies in which to invest. Given how well some of those have done in the past six months, it's hard to call that a mistake. Just look at the performance of the FXI iShares FTSE/Xinhua China 25 /quotes/comstock/13*!fxi/quotes/nls/fxi (FXI 40.25, -0.67, -1.64%) , the largest China-focused exchange traded fund.

Only part of equation

On the other end are tech giants ranging from Intel to Microsoft Corp. /quotes/comstock/15*!msft/quotes/nls/msft (MSFT 25.03, -0.69, -2.68%) , industrials companies galore, material and oil companies, many of which generate 60% or 70% of their business overseas.

China has been emerging as a powerful component of the global system over the past decade. But this year, it has become the axis of global growth this year -- even though it is still much smaller an economy than either the European Union or the United States.

China demand acts as a catalyst and a source of cash flow for companies worldwide, and that factors intimately into the earnings picture of many businesses that are otherwise thought of as American. That includes companies like Avon and Caterpillar, Archer Daniels Midland Co. /quotes/comstock/13*!adm/quotes/nls/adm (ADM 28.70, -0.52, -1.78%) and Dell Inc. /quotes/comstock/15*!dell/quotes/nls/dell (DELL 15.20, -0.06, -0.39%) Others on that long and growing list are mainstays Procter & Gamble /quotes/comstock/13*!pg/quotes/nls/pg (PG 56.99, -0.93, -1.60%) , IBM Corp. /quotes/comstock/13*!ibm/quotes/nls/ibm (IBM 118.85, -0.76, -0.64%) , McDonald's Corp. /quotes/comstock/13*!mcd/quotes/nls/mcd (MCD 56.67, -0.40, -0.70%) and Coca-Cola Co. /quotes/comstock/13*!ko/quotes/nls/ko (KO 53.16, -0.54, -1.01%)

U.S. economy can lag

Is October correction inevitable?

Commentary: Not if you study patterns of crash years

By Ethan Anderson

GRAND RAPIDS, Mich. (MarketWatch) -- Most investors seem braced for a big correction, but in my experience the majority is usually wrong.

In order to predict the future, one must consider the past and research similar market cycles to come up with a probable forecast for the future. After studying comparable periods to the one we are experiencing today, investors will realize that an October correction is not likely.

Consider the following:

We have not yet recovered fully from 2008. The market rebound after the crash of 1987 did not see a correction of 10% until 1990, which is more than two years later. Moreover, that correction was after "only" a 35% drop from top to bottom. At present, we are only six months removed from a 55% drop in the market.

October may be a negative month, but it's usually more in the range of 3% to 5%. The Octobers of 2008 and 1987 were the two biggest October sell-offs of the last 30 years, but each was preceded by a negative September. This year, September was positive.

During past October sell-offs, the month didn't represent the first wave of the attack. May and June often paved the way. October then stepped up to wipe out the survivors who believed the worst was over. Again, we did not see major selloffs in May or in June. In fact, this past June marked the fourth consecutive month of gains.

If we do sink lower in October, the catalyst can easily be the lack of top-line growth in earnings reports. However, if top-line growth is present, it can be another factor driving the market up in October.

To play devil's advocate, I must point out that six months after the market bottomed in 1987, the market was 21% higher. After the 2002 bottom, it was 24% higher. Today, we are 58% higher than we were in March. This is a significant jump.

To prepare investments for October, consider diversifying with a prudent amount of truly non-correlated asset classes like Treasury Inflation-Protected Securities (TIPS), commodities such as precious metals, managed futures and inverse funds.

If you have already pulled significant assets out of the market and are sitting on the sidelines, get back in but not all at once. Dollar-cost-average back into a diversified portfolio in order to avoid buying in on the worst day of the year, and consider tactical asset allocation programs for a small percentage of your portfolio.

On the fixed income side, TIPS is a good way to get some income and inflation protection. The Fidelity Floating Rate Bond Fund /quotes/comstock/10r!ffrhx (FFRHX 9.33, -0.02, -0.21%) still looks attractive. Blackrock Global Allocation /quotes/comstock/10r!mdlox (MDLOX 17.55, +0.02, +0.11%) is a wonderful fund with multiple asset classes.

For equities, Tom Soviero and some of the rest of the folks over at Fidelity Leveraged Company Stock Fund /quotes/comstock/10r!flvix (FLVIX 26.77, -0.10, -0.37%) are some of the best in the business, as is the team running the Kinetics Paradigm Fund. /quotes/comstock/10r!wwnpx (WWNPX 19.76, -0.06, -0.30%)

In conclusion, it is inevitable that a correction will occur in the market at some point, but research shows that an October correction is unlikely. A 3% to 5% pullback is conceivable for October, but do not prepare investments for a major selloff. You will regret it.

Ethan Anderson is a senior portfolio manager with Rehmann , one of the largest accounting, financial services and consulting firms in the Midwest. Anderson sits on Rehmann Financial's Investment Research Committee and has been recognized as a "5 star" portfolio manager by Morningstar Inc.

No reason to be spooked by October this year

Commentary: But markets should be wary of Iran

By Robert Maltbie

LOS ANGELES (MarketWatch) -- While some might get spooked by an often-volatile October, signs are that the markets are in strong shape.

Just the facts: My indicators are as bullish as they have been since March 2003, preceding a 26% upside surge in equity averages that year. Four out of five of our market indicators are bullish and one is neutral.

Let's start with the bear case:

The market is fully valued at 17 times earnings and it is too late to get in the market. But price-to-earnings is a backward-looking measure. If we use projected forward estimates, a different picture emerges. If we value the S&P 500 using 2010 estimates, which call for a 20% or greater increase in earnings, we find a more reasonable price-to-earnings ratio of 14, far below 19 where the market topped in 2007

As for our neutral indicators, they are "sentiment" indicators showing that volatility and possibly fear have greatly diminished. This is evidenced by the CBOE volatility index /quotes/comstock/20m!i:vix (VIX 26.71, +1.10, +4.30%) which has retreated to 23 from a high of more than 80 a year ago when we were in free fall. Offsetting this is a bullish AAII pundit survey showing investment advisors are bearish, perhaps bracing for "seasonal harshness," by 39% bulls to 45% bears.

Our remaining indicators are all currently solidly bullish -- technical indicators, monetary data, liquidity measures and valuations. Our Ouiji board swigglies and charts show positive, lead by a strong breadth and upside volume that is recently supported by expanding new 52-week high-to-low ratio.

A final anchor of positive support is that the Dow, the S&P and Nasdaq all have broken decisively above 200-day moving averages and held their ground. These are characteristics of a market with healthy internals, good days are better and exceed bad days and more stocks are starting to participate.

Monetary Indicators: This is our most powerful market force, also called "Don't fight the Fed." Money stock is expanding at near 8% annual rate. The real rate is higher considered against the backdrop of a deflating economy which is what we have had for nearly two years now.

The yield curve is also very steep and positive in its slope. This is a powerful 1-2 punch for the market, the fed is pumping money into the markets and economy and rates are staying low. These two factors have been important catalysts of every major bull market since 1920.

Liquidity or the directionality of money flows is another bullish sign that is just getting started. After freezing up with the cataclysmic events hitting markets over the last year, corporate M&A is rebounding, stock buybacks are returning, and money is starting to flow back into equity funds, including exchange-traded and hedge funds.

Big-time mergers by Walt Disney Co. /quotes/comstock/13*!dis/quotes/nls/dis (DIS 27.10, -0.36, -1.31%) , Abbott Labs /quotes/comstock/13*!abt/quotes/nls/abt (ABT 49.59, +0.12, +0.24%) and Dell Inc. /quotes/comstock/15*!dell/quotes/nls/dell (DELL 15.16, -0.10, -0.66%) are starting up again, as these and buybacks have pulsed to nearly $50 billion in September. Meanwhile, money markets have experienced a $54 billion outflow lately.

These add up to more than $100 billion in possible additional demand for equities. Offsets of insider selling and IPO issuance although increasing, are still at non-threatening or neutral levels.

Last but not least, we must not forget valuations. This is also bullish both on absolute and relative levels. While we are at the onset of a new recovery in earnings, more stable indicators such as market capitalization-to-GDP and price-to-sales provide evidence of reasonably cheap valuations.

The market is at a 20% discount to GDP and relative parity to sales. In 2000, the market traded at 1.8 times GDP and the price-to-sales ratio was 2.3. It seems we've worked off a lot of excess over the last 10 years.

Our relative valuation measures are positive lead by an earnings yield to quality corporate bond yield ratio of 1.2, a spread last see in 1982. Stockowners are getting paid or reinvesting back in the company more than high-grade bond owners, and stockowners should see this earnings stream significantly grow over the course of he next two years or so.

Also, cash dividends on the S&P at a 2.1% tax-favored yield far exceed treasury yields out to 10 years. Cap this off with the fact that the Leading Economic Indicators index is now at 104 following four successive monthly increases.

With easy earnings comparisons and no inflation on the near term horizon we expect the Dow Industrials to break 10,000 in October -- barring geopolitical events.