CWS Market Review – February 25, 2011

In last week’s e-letter, I said I was concerned that the stock market’s rally looked overextended. Unfortunately, I was spot on. On Tuesday, Wall Street gave us our biggest one-day sell-off in six months-and that was just the beginning. The market continued to fall on Wednesday and Thursday. The $VIX, which is the Volatility Index, spiked to its highest level since November.

What’s also troubling is that oil has soared due to the political unrest in the Middle East. If you’re a Middle Eastern tyrant, your job security ain’t looking too hot right about now. The problem with higher gasoline prices is that it almost acts like a regressive tax on American consumers. The major difference is that those funds generally leave the country instead of heading towards the U.S. Treasury.

I continue to believe that stock returns won’t be very impressive this spring. A flattish market is the safest assumption. For the entire year, I continue to like the market a lot. Profits have been very strong and the rout in the bond market has cooled off. The yield on the 10-year Treasury is back below 3.5% which isn’t much competition to a market that just completed its fastest double since the Depression. I think it’s very possible that the S&P 500 can break 1,500 before the year is over. Make no mistake; that’s a very aggressive forecast. On top of that, our stocks are ahead of the market for the year so far, and I expect that lead to grow. We already have five double-digit winners on the Buy List.

Today I want to revisit an issue I discussed before: the relative downturn of cyclical stocks. I thought we had already seen the peak in cyclicals a few weeks ago, but it turned out to be a head-fake as cyclicals gave us one last surge. Since February 11th, cyclicals have been trailing the market and they’ve faced a lot of pain this week. Since last Thursday, the Morgan Stanley Cyclical Index ($CYC) is down over 6.2%. That’s equivalent to 750 points on the Dow which is about three times what the Dow has actually lost.

You may be curious as to why I pay so much attention to the relative performance of cyclical stocks. The reason is it tells us a lot of what the market is thinking. Also, cyclical peaks and valleys tend to be very pronounced. Once a trend is established, it’s often quite strong and will last for a few years. If you want an example, the Dow would have to be around 24,000 today if it had kept pace with the CYC since March 2009.

Many of the stocks on the Buy List are counter-cyclicals (also known as “defensive stocks”). These are stocks from sectors like healthcare, utilities and consumer staples. The common characteristic is that defensive stocks don’t see their businesses suffer much during an economic downturn. Consumers don’t cut back as much on their food or medical costs (or cigarettes-thank you, RAI). I think it’s very likely that these sectors are due for a long stretch of outperformance.

The other fact to keep in mind is that cyclical stocks tend to outperform the market when the market itself is rising. This is sort of a double-whammy effect and that’s exactly what we’ve seen over the past two years. Conversely, cyclicals tend to underperform during falling markets, though this is more of a generality than an iron rule. That’s why I think defensive stocks will prosper this year even though the market will also do well, but you certainly shouldn’t expect the S&P 500 to double again over the next two years.

Now let’s look at some individual stocks. One of our healthcare stocks, Medtronic ($MDT), reported earnings this week. In last week’s issue of CWS Market Review, I said to expect earnings of 86 cents per share which was two cents more than Wall Street’s consensus. Once again, I was spot on.

My take is that Medtronic is a very good buy, but I should warn you that the company is currently working its way through a rough patch. Stocks that turn out to be good buys are often seen as damaged goods on Wall Street. That’s why their share price is low and that’s how Medtronic looks today. The company lowered its full-year guidance twice last year. No doubt, that’s spooked a lot of folks. Still, the company is making a good profit and the lowered guidance isn’t as bad as it may appear.

With the earnings report, Medtronic narrowed its full-year guidance to a range between $3.38 and $3.40 per share. Since MDT’s fiscal year ends in April, that’s equivalent to a Q4 forecast of 91 to 93 cents per share. (My take: That’s probably a wee bit too low.)

Let’s bust out some math: In August MDT lowered its 2011 EPS guidance to a range of $3.40 to $3.48 from $3.45 to $3.55. Then in November, it was brought down to $3.38 to $3.44; and now it’s $3.38 to $3.40. This means that MDT will probably wind up missing the low end of the original forecast by a few pennies, yet the stock has badly lagged the market. Medtronic is a strong buy below $40 per share.

Outside of Medtronic, some other Buy List stocks that look good right now include Moog ($MOG-A), Stryker (SYK) and Oracle ($ORCL). Oracle is due to report earnings in about a month and I think we’ll see some very strong numbers. I also want to note that shares of Ford ($F) continue to plunge lower. Ford is a risky stock but it’s one the few cyclicals I like.

Next week will be a fairly quiet time for earnings news, although Leucadia ($LUK) may report. The big news event will occur next Friday when the Labor Department releases the jobs report for February. Almost all of the jobs reports have been terrible, so it will be interesting to see if there’s a break in that trend.

I’m also keeping a close eye on the market’s 50-day moving average. This is one of those simple rules that has a pretty good track record. As long as the S&P 500 trades above its average close for the previous 50 days, the market tends to do well. When it breaks below the 50-DMA, the index does much worse. It’s that simple, but the 50-DMA has a much better track record than folks who are paid much more than it have. Despite the recent sell-off, we’re still holding just above the 50-DMA. This could change very soon.

That’s all for now. Be sure to keep visiting the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

Best – Eddy

Posted by on February 25th, 2011 at 7:47 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.