Selling on Friday…
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The correction we’ve been monitoring certainly picked up some steam on Friday. The rioting in Egypt gave investors an easy excuse to drive stocks sharply lower. And there should be no surprise that tech stocks and the Nasdaq bore the brunt of the selling.

Tech stocks were strong momentum trades in the last couple of months of 2010 and the first weeks of 2011. Then earnings seasons started. I can’t say that earnings expectations were too high – many of the top tech stocks, like Apple (Nasdaq:AAPL), IBM (NYSE:IBM), Intel (Nasdaq:INTC) and Qualcomm (Nasdaq:QCOM) beat expectations and offered solid guidance going forward.

Even the second tier of tech stocks like F5 Networks (Nasdaq:FFIV), VMWare (NYSE:VMW) and (NYSE:CRM) reported decent numbers. But many of these stocks sold off after earnings. In fact, some of the declines were significant, like that of F5 Networks.

But all in all, we haven’t seen the kind of seriously weak earnings that would justify a complete revaluation of the Nasdaq. Rather, it seems to me, earnings have been almost a pre-ordained profit-taking catalyst, regardless of quality.

It would seem logical that the selling would be much worse if earnings were missing, or even coming in just in-line. But the majority of tech earnings have been good.

*****Of course, bank earnings haven’t been so hot, especially from Citi (NYSE:C) and Bank of America (NYSE:BAC). And Ford (NYSE:F) laid an egg last week, too.

So the question remains: does this correction have legs, or is it just a needed respite from the buying frenzy that started in late August? In other words, are stocks being revalued? Or is this just some profit-taking?

*****The Wall Street Journal shows the trailing 12-month P/E for the Nasdaq based on reported earnings is 12.7. The forward number based on earnings estimates is 16.

For the S&P 500, the current P/E is 18 and the forward number is 13.5.

Neither of these numbers suggests that stocks are overvalued. While we could easily argue that stocks may even be undervalued based on P/E ratios, we are probable safest saying stocks are fairly valued.

And unless we can make the case that there’s a reason that earnings will stagnate or decline, the fundamental case for a more serious correction is not terribly compelling.

*****Now that approximately 50% of the S&P 500 has reported 4Q earnings, The Wall Street Journal is out with some early stats. 4Q 2010 earnings are up 32% over 4Q 2009. Overall, year over year profit growth for all of 2010 was 51%, the third largest since 1998.

It will take a bit longer to get a feel for what earnings growth in 2011 will look like. But I haven’t seen any major warnings for this year yet.

*****So getting back to the correction issue, it could well be that we will see weakness in certain sectors, but not the overall stock market. First and foremost, I’m questioning the growth that we will see in the financial sector this year. And the reason has more to do with regulations than the strength of the economy.

Simply restricting the banks’ trading and fees will hamper profitability, even while the economy at large continues to grow. We also may see the same in earnings from manufacturing stocks as commodity prices remain strong.

*****In the final analysis, inflation may well be the strongest catalyst for stock prices in the year ahead. We’ve seen more countries discuss inflation as a catalyst for higher interest rates. And while I don’t believe that inflation will be exported to the U.S. from India, or China, or Brazil, there is certainly potential for inflation to become a concern here in the U.S. due to our own imbalances.

And I’ll say now, if inflation picks up to the point that it appears the Fed will have to act, that’s when a correction will get serious.

As always, we will have our eyes open…

Posted 02-01-2011 6:50 PM by Ian Wyatt
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