Japan Triggers Global Sell-Off

3/21/2011


Even before the earthquake and tsunami in Japan, U.S. stocks had been under pressure because of spreading turmoil in the Middle East, sharply higher oil prices, and doubts regarding the sustainability of the global economic recovery. Now investors must also cope with a sharp drop in activity for the world’s third-largest economy and the resulting stress on global supply lines — along with the incalculable threat of a full-scale nuclear disaster.

Not surprisingly, some investors are coping by cutting exposure to risky assets. Japan’s Nikkei 225 Stock Average has dropped more than 11% since the disaster struck, while the MSCI EAFE Index of developed-country markets in Europe, Australia, and the Far East has slumped more than 5%. In the U.S., the major averages are down more than 3%.

Asia is the lynchpin of the global growth story, and Japanese trade and investment are highly important to Asia. China had already shown signs of slowing, reflecting reduced growth in exports. And while rebuilding efforts will spur activity in the region, many are worried about impact of the needed borrowing on Japan’s massive debt load.

Meanwhile, turmoil in the Middle East continues to boil, with Saudi Arabian forces entering neighboring Bahrain and Libyan strongman Muammar el-Qaddafi escalating attacks on rebel forces. Europe continues to struggle with sovereign debt loads, and worries about U.S. debt burdens are likely to result in government spending cutbacks in coming years.

Against all that, what hope do the bulls have? Perhaps not much in the short term, as even a pullback below 11,000 on the Dow Industrials would not be surprising considering the market’s advance since August. But it’s worth remembering that the most important drivers of U.S. stock prices — corporate earnings, interest rates, and inflation — remain favorable.

Also, the S&P 500 Index trades at 13 times expected 2011 earnings, well below the 20-year average of 19 and the five-year average of 15. The typical U.S. stock is more expensive than the capitalization-weighted S&P 500 Index, but we are still finding modestly valued stocks of quality companies with attractive profit-growth prospects.

Conclusion

Near-term trading will hinge on developments in Japan, and a pullback near 11,000 on the Dow Industrials would not be surprising. Still, with the primary trend in the bullish camp and quality stocks available at reasonable valuations, an opportunistic stance seems appropriate. As a partial hedge, our buy lists hold 12% to 15% in a short-term bond fund. For new buying, attractive picks include Advance Auto Parts ($65; AAP) and new recommendation Corning ($21; GLW).


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