CWS Market Review – September 23, 2011

One day after the Federal Reserve announced “Operation Twist,” the stock market got absolutely slammed. The Dow was dinged for 391 points on Thursday and this comes on top of a 283-point haircut we took on Wednesday, most of which came after the Fed’s announcement.

In the last two days, the S&P 500 has shed 6%. The index closed Thursday’s trading session at 1,129.56 which is the lowest close in a month. We even hit an intra-day low of 1,114.22 which was below the recent closing low of August 8th (1,119.46). However, we haven’t pierced the intra-day low of 1,101.54 from August 9th. At least, not yet. The $VIX, also known as the Fear Index, shot up more than 10% on Thursday to close at 41.35 which is a one-month high.

So what’s going on?

In this issue of CWS Market Review, I’ll give you the low-down on the Fed’s plans and why the market reacted so negatively. Plus, I’ll update you on two very good earnings reports from our Buy List standouts, Oracle ($ORCL) and Bed Bath & Beyond ($BBBY). More importantly, I’ll highlight some outstanding high-yielding stocks that will help us weather the storm.

First, let’s take a closer look at Bernanke’s new plan to get the economy off the mat. At 2:23 pm on Wednesday, the Federal Reserve released its policy statement from this week’s meeting. In it, the Fed said it’s going to replace $400 billion of short-term debt in its portfolio with long-term Treasury debt.

The idea is to push long-term interest rates down with the hope of spurring more borrowing. Ideally, this will also help get the housing market going again. As I explained in the CWS Market Review from two weeks ago, economic recoveries are often led by the housing sector. The problem this time around is that housing is still flat on its back.

Bernanke & Co essentially downgraded the entire U.S. economy. The Fed aims to sell roughly three-fourths of the amount of short-term debt it holds. Investors concluded that if the Fed is going into long-term bonds, well…they might as well ride that wave. So they dumped stocks and crowded into Treasuries. By “crowded,” I mean a massive buying panic.

On Thursday, the yield on the 30-year Treasury plunged to 2.78%. That’s a drop of roughly 50 basis points from Wednesday afternoon. To put that in context, the Long-Term Bond ETF ($TLT) jumped from $114 to $123 in the same time period. (Remember that these are bonds. They’re supposed to be boring and stable.)

As dramatic as the 30-year bond’s drop was, the 10-year plunged to its lowest yield ever. On Thursday, the yield hit 1.72%. That’s a drop of 150 basis points since July 1st. We’re through the looking glass here, people.

I should point out that this recent action is slightly different from the fear trade that I’ve talked about before. The difference is that gold fell on Wednesday and it got hit hard yesterday which is a reflection that real short-term interest rates may rise from the Blutarsky levels they’re at right now. I doubt they’ll go very high, but the Fed is by far the largest player in the T-bill market.

As you might expect, the major losers on Thursday were the cyclical stocks. The Morgan Stanley Cyclical Index (^CYC) dropped 5.22% on Thursday to close at 762.10. Two months ago, the index was at 1,071.84. Both the Energy Sector ETF ($XLE) and Materials Sector ETF ($XLB) lost more than 5.6% on Thursday while defensive areas like Consumer Staples ($XLP) and Healthcare ($XLV) lost “only” 1.90% and 2.02% respectively. (That’s exactly why we call them defensive.)

The folks at Bespoke Investment Group point out that more than half of the stocks in the S&P 500 now yield more than the 10-year Treasury bond.

Some analysts on Wall Street are saying that Operation Twist is a really covert bailout of the big banks. I’m not cynical enough to say that’s the Fed intent, but it will certainly help the banks offload their holdings on Treasury bonds. But I’m doubtful that Operation Twist will spur more mortgage lending or even get people to refinance. Mortgage rates are already at 60-year lows. I don’t see how a few more basis points will help out troubled homeowners.

To be perfectly frank, I think this whole episode shows how limited the Fed’s powers really are. (At the Fed’s website, they included an FAQ on Operation Twist). David Kelly of JPMorgan Funds said, “Ben Bernanke is at least trying to do the right thing. He just doesn’t know what the right thing is.” Ouch!

Still, some of the big banks like Goldman Sachs ($GS) and Morgan Stanley ($MS) plunged to multi-year lows. Bank of America ($BAC) closed at $6.06 on Thursday; Warren Buffett’s warrants have a strike price of $7.14. Our Buy List mega-bank, JPMorgan Chase ($JPM), fell below $30 per share and it now yields 3.42%. JPM is still, by far, the healthiest of the major banks.

I honestly don’t see how Operation Twist will boost the economy, but I’m still not in the Double Dip camp. I think the most likely scenario is that the economy will bounce along at a 1% to 2% growth rate: not enough to get the labor market going but not slow enough to be an official recession.

As rough as this week was for the stock market, I’m happy to say that we had two very good earnings report from our Buy List. After the close on Tuesday, Oracle ($ORCL) reported earnings of 48 cents per share which was two cents better than Wall Street’s forecast.

I was actually expecting even more from Oracle. My mistake was that I didn’t foresee how weak their hardware business would be. Despite my over-optimism, the market reacted positively to the earnings report. On Wednesday, the shares got as high as $30.96. (Bear in mind that they were under $25 just one month ago.) The stock only broke down once the rest of the market did.

Oracle continues to be a very profitable company. Over the past 12 months, Oracle’s cash flow is up 46%. Wall Street was mostly upbeat on the earnings report. For their fiscal second-quarter, which ends in November, Oracle forecasts earnings of 56 – 58 cents per share. That’s a surprisingly narrow range. The Q2 from last year came in at 51 cents per share and that was a very strong quarter; Oracle cautioned investors that the comparisons are much tougher. I continue to rate Oracle a strong buy up to $30 per share.

While I was overly-optimistic on Oracle, I wasn’t optimistic enough on Bed Bath & Beyond ($BBBY). On Wednesday, the company reported fantastic second-quarter earnings of 93 cents per share. That was nine cents more than Wall Street was expecting.

This comes on top of a blow-out earnings report last quarter. BBBY also raised their full-year guidance for the second time this year. Originally, the company told us to expect earnings to grow by 10% – 15% for this year. Then after the big earnings report in June, they raised that forecast to 15% – 20%. Now they’ve bumped that up to 22% – 25%. That translates to full-year earnings of $3.74 – $3.84 per share. In business, good news often leads to good news. Businesses aren’t like ball players who have an “off night” or a “hot hand.” If there’s something good going on, it will tend to last.

At one point on Thursday, BBBY was one of only two stocks in the S&P 500 to be higher for the day. Thanks to Bed Bath & Beyond’s strong earnings and higher guidance, I’m raising my buy price to $60 per share. This is a very solid company.

Some other stocks on my Buy List that look particularly attractive right now (thanks to their high yields) include Abbott Labs ($ABT, yields 3.79%), AFLAC ($AFL, yields 3.75%), Johnson & Johnson ($JNJ, yields 3.68%), Reynolds American ($RAI, yields 5.85%), Sysco ($SYY, yields 4.00%) and Nicholas Financial ($NICK, yields 4.13%).

That’s all for now. Be sure to keep checking the blog for daily updates. Next week is the final week of the third quarter. We’ll also get another revision to the second-quarter GDP report. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on September 23rd, 2011 at 8:33 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.

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