CWS Market Review – September 9, 2011

As ugly as trading has been since mid-summer, the stock market is finally showing some strength lately. I was particularly impressed by Wednesday’s huge rally and by the fact that we didn’t give it all back on Thursday. Up till now, every rally has been met with an equal or greater sell-off.

Over the past month, the S&P 500 has made three major bottoms and each time, we failed to go lower. While that’s certainly no proof that a new up phase is at hand, it may indicate that the worst is past us. Bear in mind that the S&P 500 hasn’t made a new closing low in one month.

In this issue, I want to take a step back and address some issues impacting the broader economy and how they affect the financial markets. Don’t worry. I’ll steer away from any “econospeak,” and I’ll try to make it very easy to understand. First, the good news is that corporate profits have rebounded fairly well since the worst days of the financial crisis three years ago.

Analysts on Wall Street still have pretty optimistic earnings forecasts for the rest of this year and into next year as well. For Q3, analysts see earnings for the S&P 500 coming in at $24.95. For Q4, they see profits of $26.23. That translates to profit growth of 15.72% and 19.61% respectively. In other words, earnings aren’t merely expected to grow but the rate of growth is expected to increase as well. I should caution you that these forecasts aren’t terribly reliable beyond a few months. The other good news is that corporate balance sheets are, as a whole, pretty strong.

The big question, however, is “Why is the economy still doing so poorly, especially on the jobs front?” The answer is that it all comes down to housing. I’m making a huge generalization here, but economic recoveries in this country have often been fueled by the housing sector.

Think of it this way: A developer’s decision to build a new 123-unit housing development or a brand-new 214-unit high-rise glass condo has a major ripple effect on the local economy. Except for a large government project, few things are as economically powerful as a new real estate construction project. You’re getting a big injection of money concentrated in one area all at once. Just think of how the cash flows through the local economy: the local contractors and sub-contractors get work. Those folks, in turn, spend their new cash at local stores and restaurants. What happens is that it starts a virtuous cycle.

It doesn’t end there. The other aspect that feeds off housing is the financial sector. Most Americans have far more invested in their homes than in the stock market. New homeowners take out mortgages, then savers get their interest and the banks get their profits. Once again, the virtuous cycle feeds upon itself and everyone is happy.

Yet this time, the housing sector is a bust because during the housing bubble, we built too many homes. Way too many homes! The Wall Street Journal recently reported, “Sales of newly built homes, which peaked at 1.3 million units in 2005, were running at an annual rate of just 298,000 units in July and are on pace to post the lowest count this year since record keeping began in 1963.”

Obviously, those excess homes won’t get tossed into the garbage, so no one is willing to plunk down the cash to get a new development going. That oversupply of homes is weighing on the housing market like a ton of bricks. And not just the housing market; it also weighs on all those areas that rely on the housing market. Home prices are depressed and many Americans are underwater with their mortgages or barely in the black.

The issue of bad mortgages has put enormous huge strain on banks as well. For example, we recently saw the financial world turn sharply against Bank of America ($BAC). This is an odd perception/reality dynamic because BAC is clearly far from being a sound institution, but it’s very hard to answer the question, “Do they need more capital?” (Bloomberg: Moynihan Tries to Keep Bank of America Intact as Mortgage Loans Fall Apart.) The bank said no, but investors said yes. Take a wild guess who won.

Now we have this strange disconnect in financial markets which I’ve labeled the “Fear Trade.” This is when bonds, gold and volatility are up but stocks are down. Since corporate profits have been decent, P/E Ratios are especially depressed. As I mentioned in last week’s CWS Market Review, a Double Dip recession is far from certain. This week, in fact, we had better-than-expected news for the ISM Services index. We also learned that the trade deficit hit a three-month low. The trade deficit report was so good that Goldman Sachs has said there’s a sizable upside risk to their 1% GDP forecast for Q3.

Strategists on Wall Street currently estimate that the S&P 500 will close this year at 1,353 which is a 14% run from here. One month ago, the consensus was that we’d finished the year at 1,401. So despite the market’s lousy mood, Wall Street really hasn’t pared back its estimates very much.

Now I want to focus on two upcoming earnings reports. On Tuesday, September 20th, Oracle ($ORCL) will report its fiscal first-quarter earnings. I was shocked by how low ORCL’s share price was recently. For a few days, it dipped below $25, but Oracle’s business continues to be very strong. The company told us to expect Q1 earnings between 45 cents and 48 cents per share. Oh, please! That’s obviously too low. The consensus on Wall Street is for 47 cents per share. I’m expecting at least 51 cents per share.

Oracle is a remarkably profitable company, plus they’re sitting on nearly $30 billion in cash. By the way, don’t believe any rumors that Oracle is going to buy Hewlett-Packard ($HPQ). That’s just crazy. My take is that Oracle is a very good buy below $30 per share.

The other earnings report will come from Bed Bath & Beyond, ($BBBY) on the following day. Three months ago, the company gave us an outstanding earnings report, plus they raised their full-year forecast which shows you that good companies can prosper during rough times. For the upcoming earnings report, BBBY told us to expect earnings to range between 77 and 82 cents per share. My numbers say that 82 cents is about right.

For this fiscal year (ending in May), BBBY should earn about $3.70 per share. I want to caution you that the stock has already done pretty well (it’s our second-best performer this year), so it’s not a screaming bargain right now. I’m going to hold my buy price on BBBY at $58 per share.

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

– Eddy

Posted by on September 9th, 2011 at 8:54 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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