CWS Market Review – February 17, 2012

Despite repeated death notices, the most-hated stock market rally in history continues to march on. On Thursday, the S&P 500 closed at 1,358.05 which is its highest level since May 2nd. The index is already up 8% this year and we’re only halfway through the first quarter. The S&P 500 has almost exactly doubled from its March 9, 2009 low close—and we’re just a small push away from a new post-crash high.

In this issue of CWS Market Review, I want to take a step back and discuss what’s in store for the market going forward. The Q4 earnings season has passed and we rallied despite unimpressive results. That most likely won’t happen again. The problem for investors is that much of the easy gains have already been made. This, of course, is the unfortunate benefit of panicked investors having sent the stock market to generational lows. In 17 months (from October 2007 to March 2009), the S&P 500 shed 57%.

The good news is that the end of the world didn’t come. At least not for the non-Greece part of the world. Much of the three-year rally has been investors realizing that the worst has passed and that Earth is still here. Now, however, the lack of bad news is no longer enough; we’ll need to see actual growth. Companies can’t rely on current consumers to spend more money. Those folks are tapped out. Instead, we need more consumers.

One outcome of this new market focus is that investors will start paying much more attention to the jobs market. We already saw that on Thursday with the market rallying on the news of the lowest jobless claims in nearly four years. The equation is quite simple: More profits will have to come from more revenue, and that needs to come from more consumers, and that means more jobs. Lots more jobs.

Job Growth Is Desperately Needed for Profit Growth

The January jobs report was pretty good: a net gain of 243,000 jobs. The difficult task before us is that, going by that rate, it will take several years for the economy to get back to anything resembling normal. Over the last two years, 3.1 million jobs have been created. That’s pretty good, but we need to put it into larger context. In the two years prior to that, 8.7 million jobs were lost. Plus, we’re not even counting the natural growth of the population. This shows that the big obstacle for companies is a dearth of shoppers: folks who could be out there buying stuff but can’t because they have no income.

Think of it this way: When a recession hits, companies go into survival mode (I’m generalizing). This means they stop hiring, and they stop making new stuff. Next, they dump their current inventory for any price they can get. They don’t care about the price; just get some bucks in the door. This means that profit margins drop to the floor.

This is the key point I want to get across: It’s profit margins that are really a killer for investors. This is why a 5% drop in GDP can lead to a market drop of 50% or more. Stock prices don’t follow the economy; they follow profits which are just one facet of the economy. One of the early signs of a company running into trouble is lower profit margins. Conversely, rising margins are almost always a sign of a company’s strength. Higher margins tell us that a company has pricing power in the market; this is a fancy way of saying that people really want what they’re selling.

As the economy slowly woke up from the Great Recession, it was easy for companies to increase margins. That’s not hard to do when companies cut back on a major part of their overhead: compensation. As a result, profits soared while jobs didn’t improve that much.

For the economy as a whole, profit margins have risen about as far as they can go. It’s possible that margins can go still higher, but we play it safe around here so it’s more prudent for us to assume that profit margins will revert to their long-term mean. Floyd Norris recently wrote in the New York Times: “In the eight decades before the recent recession, there was never a period when as much as 9 percent of American gross domestic product went to companies in the form of after-tax profits. Now the figure is over 10 percent.” Think of “profits as a percent of GDP” as a national profit margin.

As a whole, I think overall profit growth will be pretty meager this year. The S&P 500 will probably earn somewhere between $100 and $105 which is a modest increase over the $97 for 2011. Of course that’s just an estimate, but I doubt we’ll see a major plunge. In fact, I think the odds of a big downturn in profits in 2012 are about as low as we can reasonably expect. As long as interest rates are still low, this environment is very favorable to equities.

DirecTV Tops Estimates By Ten Cents Per Share

The only recent Buy List earnings report was from DirecTV ($DTV) on Thursday morning. The company crushed estimates. For the fourth quarter, DirecTV earned $1.02 per share which was ten cents ahead of Wall Street’s consensus.

DirecTV continues to do very, very well. One problem for them, and it’s not major, is that the cost of getting new subscribers is getting higher. We always want to view a company as being like a machine: Dollar bills go in and dollar bills come out. That, in essence, is what it’s all about.

Before, it was very inexpensive for DTV to get those dollar bills to roll in. All they had to tell people is that cable is terrible, and that was enough. Now it’s getting harder. Infrastructure costs are rising and those costs will have to be eaten or passed along. Again, this is not a major problem for DirecTV but it is something on their radar.

DirecTV is raking in profits. For Q4, earnings-per-share rose by 38%. That’s outstanding. On the company’s earnings call, they said, “We expect to grow earnings per share to well over $4 this year, on pace to achieve our EPS target of at least $5 in 2013.”

The stock closed Thursday at $45.38 per share, which means it’s going for about 11 times this year’s earnings, and nine times 2013’s estimate. That’s a good bargain. It’s no wonder some value investors have taken notice. I rate DirecTV an excellent buy up to $48 per share.

Earnings Due Next Week from Medtronic

The only Buy List earnings report coming up is from Medtronic ($MDT). The medical supply company is due to report before the opening bell on Tuesday, February 21st. Medtronic has had a surprisingly good run since its last earnings report. Wall Street currently expects quarterly earnings of 84 cents per share which is probably a penny or two too low. Medtronic has previously told us to expect earnings for this fiscal year (ending in April) of $3.43 to $3.50 per share.

The stock closed Thursday at $39.58, so that’s a decent valuation based on the earnings estimate. In December, I raised my buy price to $40 per share. I want to keep it there until I see what Medtronic has to say about their guidance. I think it’s very likely that they will narrow their profit range with this earnings report. Medtronic remains a good buy below $40 per share.

Before I go, I want to highlight some other stocks from our Buy List. CA Technologies ($CA) just hit a fresh 52-week high. The stock is up 34.7% for the year. Quiet little Harris Corp. ($HRS) is at a six-month high. The company just reported earnings above Wall Street’s consensus for the 14th quarter in a row. Jos. A. Bank Clothiers ($JOSB) has woken up from its slumber and has now rallied for seven of the last eight trading days. Finally, Oracle ($ORCL) looks like it’s ready for a breakout above $30 per share.

That’s all for now. Be sure to keep checking the blog for daily updates. The stock market will be closed on Monday in honor of President’s Day. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by on February 17th, 2012 at 9:41 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.