CWS Market Review – February 10, 2012

After defying my prediction for several weeks, long-term interest rates are beginning to creep higher. This is by far the most important event on Wall Street right now, and every investor needs to understand how higher bond yields will impact their investments.

In this issue of CWS Market Review, I’ll explain what’s happening and why. I’ll also show you areas that will benefit the most from a turn in the bond market. Later on, I’ll cover some of the recent earnings reports from our Buy List. The good news is that our strategy continues to do well. (Didya catch Wright Express? It just hit a new 52-week high on Thursday.)

Before I get to that, let’s take a closer look at what has the bond market so spooked. On Thursday, the yield on the 30-year Treasury bond closed at 3.20%. That’s the highest yield in 15 weeks. Of course, that’s still very low, but the important point is that investors are migrating out of sure-thing assets in search of more excitement.

Who can blame them? It’s not so much that bond yields are rising; it’s that the era of ultra-low yields is gradually passing. There are two reasons why long-term interest rates had been so low. One was due to aggressive buying by our friend at the Federal Reserve. The idea was that by gobbling up tons of bonds, Benny and his buds could push down yields and give the housing a market a boost. In turn, that would help lift the entire economy out of its doldrums. A reawakened housing sector has typically been the catalyst for an economic recovery.

So, did it work? Put it this way: The latest numbers show that housing prices are back to 2003 levels, which is a roundabout way of saying “No, it didn’t work.”

The other reason why bond yields were so low is that investors from around the world fled European markets and parked their money in safe U.S. Treasuries. The yield on 30-year Treasury Inflation Securities currently runs about 0.74%. That’s roughly one-third the yield you would have gotten one year ago.

Now that Greece has reached an austerity deal in exchange for more bailout cash, some of the pressure has been taken off the quest for safety. I noticed that the one-year Treasury just hit its highest yield in six months. Don’t be too concerned; it’s still only at 0.15%.

What the Change of Sentiment Means for Investors

Our concern is the change of sentiment. The effect this has on the stock market is that investors are revisiting the areas they punished last year while backing away from the areas that did so well for them in 2011. What’s fascinating is that how poorly a stock did in 2011 is almost perfectly correlated with how well it’s doing this year. Look at Bank of America ($BAC) which went from being one of the worst performers last year to one of the best this year.

It doesn’t end there. Earlier this week, I posted a chart showing the performance of the ten different S&P 500 sectors for last year and this year. It’s almost a perfect mirror image. Last year, for example, investors rushed to dividend stocks in their desire for safety. This greatly helped our dividend-rich tobacco stock, Reynolds American ($RAI).

But this year, Reynolds hasn’t done much of anything. Personally, I don’t blame Reynolds. The company is doing just fine and I still like it (the earnings report and guidance were quite good). The difference is the market’s sentiment. Unfortunately, the market’s mood is impossible to predict. That’s why our strategy here is to stick with high-quality companies. If you’re patient, the market will eventually reward the deserving.

Who’s Been Winning from the New Market

Some of the market’s strength represents a new-found optimism for the economy. That’s why I said that cyclical stocks were about to take center stage. That’s exactly what happened. On Thursday, the Morgan Stanley Cyclical Index (^CYC) closed at 1,015.65 which is the highest level since July 28th. That’s an impressive 37.7% run since October 3rd. Again, it’s more accurate to say that this move is walking back the dramatic selloff rather than being a rally.

This is also why tech stocks and financial stocks have been leading the market. The Tech Sector has rallied for ten days in a row and for 17 of the last 18. This explains why the Nasdaq recently touched an 11-year high even though the S&P 500 is still shy of its high from July. Most people know that the Nasdaq is heavily weighted with tech stocks, but it also carries an outsized portion of financial stocks. Five months ago, I said the Financial Sector ETF ($XLF) would be a good “speculative buy” if it fell under $12. It did. In fact, the XLF actually dipped under $11 at one point. On Thursday, it closed at $14.71.

The lesson is that the market is rewarding more risk taking. That will help Buy List stocks such as Moog ($MOG-A), Ford Motor ($F), JPMorgan Chase ($JPM) and Hudson City ($HCBK). I also expect that gold will pick up as well.

Another interesting aspect of this market is that as risk-taking gets rewarded, the market itself has become dramatically less volatile. The difference between the S&P 500’s daily high and low this year has averaged only 1%. That’s down from over 3.3% in August.

The reason for the decreased volatility is that over the summer, two theses competed for the market’s soul: more safety versus more risk. The safety side won and that’s why yields got so low. As the daily tug-of-war has faded from the trading pits, the market’s frenetic swings have calmed down. Except for some occasional bumps, I expect the placid market to continue for several more weeks.

Strong Earnings Lift Wright Express to an All-Time High

Now let’s take a look at a few recent earnings reports from our Buy List:

In last week’s CWS Market Review, I said to look for a strong earnings report from Wright Express ($WXS). The company had embarrassed Wall Street analysts for the past few quarters and they did it again. Wright earned 98 cents per share which was six cents above Wall Street’s forecast.

I was also pleased with Wright’s guidance. For Q1, the company said it expects earnings between 87 and 93 cents per share and revenue between $134 and $139 million. For the year, Wright expects earnings to range between $4.10 and $4.30 per share on revenue between $590 million and $610 million. It’s too early for me to get a feel for whether or not these projections are too conservative.

The stock initially dropped after the earnings report but regained its composure and rallied to an all-time high. Wright is up 13.2% on the year for us. The stock is a very strong buy up to $65.

On Wednesday, Reynolds American ($RAI) reported Q4 earnings of 72 cents per share. That was four cents better than Wall Street’s consensus. More importantly, Reynolds offered earnings guidance for this year of $2.91 to $3.01 per share. I think the company has enough room to raise the quarterly dividend from 56 cents per share to 59 or 60 cents per share. Don’t expect the kind of capital gains surge we saw last year to repeat itself. Still, Reynolds is an excellent stock for conservative investors.

Sysco ($SYY) was our dud of the week. The food supplier reported Q1 adjusted earnings of 46 cents per share. Wall Street didn’t like that at all. The shares dropped 3.6% on Monday plus another 1.44% on Tuesday. I have to admit that I’m frustrated with Sysco. This is exactly the kind of defensive stock that won’t be richly rewarded over the coming weeks. The best part is the generous 3.66% yield. I’m keeping my buy price at $30 per share.

The final earnings report for this quarter will come on Thursday, February 16th when DirecTV ($DTV) reports its fourth-quarter earnings. One year ago, DTV earned 74 cents per share. Wall Street expects that to increase to 91 cents per share this time around. I particularly want to hear what the company has to say about their outlook for 2012.

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 February 10th, 2012 at 5:37 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.