CWS Market Review – June 8, 2012

I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over. – Warren Buffett

In the CWS Market Review from February 17th, I explained why the monthly jobs report has become so important to the stock market. The first Friday of each month has become a Super Bowl-like event for Wall Street.

The reason has to do with simple economics. Corporate profit margins have gone about as far as they can go. Companies have done a commendable job increasing their bottom lines, but it’s mostly been done by cutting costs. For many businesses, the main cost is labor. The problem with cutting costs and raising your profit margin is that it’s a finite solution. You can’t do it forever and at some point, you gotta grow the top line. It’s as simple as that and in a low-inflation environment, raising prices is out of the question. That leaves us with getting more customers in the door, and that means more jobs.

The poor jobs market has taken its toll on stocks, but in this week’s issue of CWS Market Review, I’ll show you what’s been driving the market recently. I’ll also explain why the stock market wants inflation to go up, or more specifically, why it wants inflation expectations to go up. All investors need to understand this fact.

I’ll also highlight some of our Buy List stocks that have turned sharply recently. Even in a tough environment like this one, high-quality stocks can prosper. Fiserv ($FISV), for example, is back above $68 and it’s within striking distance of a new 52-week high; and quiet, unassuming Sysco ($SYY) is up to its highest close in over a month. But first, let’s talk about the market’s sudden about-face this week.

After a Tough Battle, the Bulls Hold the Line

Last Friday’s dismal, awful, no-good jobs report rattled Wall Street. Sixty-nine thousand jobs was less than half of what economists were expecting, and the numbers were revised downward for the previous months. The slump in the market brought the S&P 500 as low as 1,266 on Monday. The index also dropped below its 200-day moving average for the first time in five months. Bloomberg said the market was going for 12.9 times earnings which was its lowest valuation since November.

But here’s the key: the index never closed below the magic line of 1,277.14. Not once. Why’s that number so important? Because it marks an exact 10% correction from the April 2nd high of 1,419.04. I know it sounds bizarre, but trust me, technicians watch these battles closely and there was a war this week for the market’s soul. Last Friday, the S&P 500 closed at 1,278.04, and on Monday it closed at 1,278.18. In other words, the bulls had held the line.

Once the bulls finally made a stand, the game quickly changed. Technicians call what happened a “doji pattern,” meaning the opening and closing were at nearly the same price. Dojis can often mark important turning points. The market rose modestly on Tuesday and then surged 2.3% on Wednesday for its best one-day rally of the year. Even Facebook ($FB) went up. The S&P 500 broke above its 200-DMA, and the Dow finally closed out back-to-back gains which it hadn’t done since late April. Remarkably, that was one of the longest droughts without consecutive ups in the last 100 years.

The market was also buoyed by some positive economic news which was a welcome relief from a stunning run of dismal economic reports. On Tuesday, the ISM Services Index came in at 53.7 which was 1.7 above expectations. Then on Wednesday, a Federal Reserve report was surprisingly positive on the economy. On Thursday, the Labor Department reported that initial unemployment claims fell to 377,000.

The market was also relieved that China cut interest rates for the first time since 2008. Perhaps the best news came when Spain held a bond auction that went fairly well. The country’s budget minister had publicly warned Europe that a bailout was inevitable since the bond market had effectively shut them out. That’s why this recent bond auction was good news. Bear in mind that half of U.S. GDP growth was due to exports.

What Does Wall Street Want? Inflation!

Last Friday, the yield on the 10-year Treasury bond closed at a ridiculously low yield of 1.47%. The yield has come up some since then as the stock market has turned, but the fate of the bond and stock markets are closely tied.

The low-yield for bonds tells us how scared investors are and that they’re willing to pay nearly any price for safety. Ultimately, however, the low yields are good for stocks since they lower borrowing costs and make cash flows from equities more attractive.

What’s fascinating is that the stock market has been strongly correlated with the 10-year inflation premium found in the bond market. That’s the difference between the yield on the 10-year Treasury and the yield on the 10-year TIPs. Check out this chart below which shows the S&P 500 (red line) and the difference between the 10-year inflation premium (blue line). For the last several months, these lines have been acting like waltzing partners.

Roughly speaking, every 0.1% increase in inflation expectations adds about 50 points to the S&P 500. (Note: This is a short-term correlation, not a long-term rule.) This relationship makes sense for several reasons. One is that higher inflation would shake money out of the bond market, and that will undoubtedly find its way towards stocks. Remember also that we’re not talking about inflation specifically but about expectations of inflation. Only part of the bond rally is due to lower inflation expectations.

Also, a stronger economy would boost stock prices and the ensuing greater demand would put upward pressure on prices. Banks are currently sitting on tons of cash and if they think inflation will tick up, that will spur them to ramp up lending. With that, businesses will see greater incentives to borrow and expand—and hopefully hire employees. This would create a positive reinforcing cycle.

In his Congressional testimony this week, Ben Bernanke specifically referred to the inflation expectations metric we’re using, except he used the five-year rate. Bernanke said that he expects inflation to stay around 2%. Obviously, the Fed is constrained by its dual mandate to provide maximum employment and low inflation. But right now, rising prices are not a problem. In fact, consumers are benefitting from falling (but still elevated) prices at the pump. Oil is in the midst of its longest losing streak in 13 years.

I think if inflation expectations were allowed to drift higher, it would be accompanied by a decent stock rally. Inflation expectations probably wouldn’t need to rise very high—perhaps to 2.7% (which is where they were in mid-2006) would do the trick. I don’t expect this tight stock-inflation relationship to last. But for the next several months, the future of the market and the course of inflation expectations are joined at the hip. Any market rally is dependent on higher inflation expectations.

Ford Continues to Be One of the Best Buys Around

Now let’s turn to some of the stocks on our Buy List. Ford Motor ($F) had some more good news this week. I continue to believe this is one the cheapest stocks around. The company took advantage of its increased debt rating by raising $1.5 billion from the bond market. This was Ford’s first investment-grade offering in seven years. The offering of five-year bonds was popular enough to get a coupon of 3%.

Ford also said that it’s working to iintroduce indigenous, or China-only, brands to China. The company is also working on building up its own brands in that country. I think this is an exciting move. Ford’s stock dipped below $10 per share earlier this week which I think is an unbelievable value. The automaker will most likely earn about $1.50 per share this year. The shares were at $19 early last year and the company’s outlook has improved by any objective measure. Ford Motor continues to be an excellent buy.

A few weeks ago, I highlighted Sysco ($SYY) as a good stock to own during turbulent markets. SYY just broke above its 200-day moving average and closed at its highest level since May 2nd. I was particularly impressed to see that Sysco was able to auction off $300 million in three-year bonds with a coupon of 0.55%. The company also sold $400 million worth of 10-year bonds with a coupon of 2.6%. That’s the seventh-lowest coupon for a bond of that maturity.

What’s interesting to note is that Sysco’s stock currently yields 3.77% which is more than the company’s cost of debt. Theoretically, Sysco could borrow money to buy its own stock for a quick arbitrage profit. (BTW, I hope they don’t!) This shows you the big disconnect between the stock and bond markets.

Reuters summed it well: “Although Sysco’s business is not the most glamorous, delivering food is viewed by investors as an essential business that generates guaranteed cash flow in good and bad economic times.” Sysco remains a good buy up to $30.

That’s all for now. Next week, Wall Street is nervously eyeing the Greek election scheduled for Sunday, June 17th. The last election produced a stalemate as no one could get a governing coalition together. Not next week but the week after, we’ll get earnings reports from Bed Bath & Beyond ($BBBY) and Oracle ($ORCL). I’m also expecting another dividend increase from Medtronic ($MDT). 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 June 8th, 2012 at 6:58 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.