CWS Market Review – October 19, 2012

“There’s no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or worse, to buy more of it when the fundamentals are deteriorating.” – Peter Lynch

Hold on, folks. We’re about to enter the high tide of earnings season. So far, the Q3 earnings reports have been pretty decent. Not great, but decent—although there have been some notable exceptions such as Google ($GOOG), which lost a cool $60 yesterday.

I’m happy to see that our Buy List continues to do very well. AFLAC ($AFL) and Fiserv ($FISV) just hit new 52-week highs. Hudson City Bancorp ($HCBK) is up over 50% for us in three months. And just as I expected, JPMorgan Chase ($JPM) handily beat Wall Street’s forecast last week. The shares finally broke $43 and are at a new post-Whale high. The bank is clearly doing well, so I’m raising my Buy-Below price on JPM to $45.

I was also pleased to see Johnson & Johnson ($JNJ) beat its earnings estimate and guide higher for the rest of the year. Few things please me more than the old “beat and guide higher” chorus. On Thursday, the stock got oh so close—just two pennies away—from breaking its all-time high set four years ago. I’m going to raise my Buy-Below on JNJ as well. The stock is a strong buy up to $76 per share.

The only dud this week was Stryker ($SYK), and honestly, that wasn’t by much. The phony bone company missed estimates by a penny per share and gave mediocre guidance. The company blamed their troubles on—stop me if you’ve heard this one before—weakness in Europe and the medical device excise tax. Still, the stock rallied after its earnings report. Stryker remains a solid buy up to $57.

In this week’s CWS Market Review, we’ll break down earnings season. Next week, five of our Buy List stocks report, so it’s going to be busy. The good news is that investors are gradually migrating towards riskier assets. On Thursday, the S&P 500 closed less than 0.6% from its highest close since 2007. Still, I think we have a few hurdles to overcome before a sustained rally occurs.

Deconstructing Third-Quarter Earnings

According to the latest numbers, 104 companies in the S&P 500 have reported earnings so far. Of that, 75 have topped Wall Street’s estimate, 26 have fallen short and three have reported inline. That’s a pretty good “beat rate.”

The financial media have gotten in the habit of saying that this earnings season will be the first earnings decline after 12 straight quarters of growth. They may be jumping the gun. I still think earnings have an outside chance of showing a very slight increase over last year’s Q3. On top of that, analysts expect earnings growth to ramp up to 13% for Q4. Analysts have largely stopped lowering guidance over the past few weeks. As of now, Wall Street expects the S&P 500 to earn $114.83 next year. That means the index is going for 12.7 times next year’s earnings estimate, which is very reasonable.

Once again, we’re witnessing a similar theme: a housing recovery is lifting consumers. This week, we learned that housing starts rose to their highest level in four years. Housing starts are up 82% from their recession low. The Commerce Department reported that retail sales for September rose more than had been expected, and the number for August was revised higher to show the strongest growth since 2010.

This probably hints that the holiday season will be a good one for retailers, which is something we haven’t seen in quite some time. I think it’s interesting to note that toymakers Hasbro ($HAS) and Mattel ($MAT) have both rallied strongly since the summer. Someone’s expecting Santa to be extra-generous this year. A strong holiday season should also bode well for Bed Bath & Beyond ($BBBY).

The market was also buoyed by a strong industrial production report. This is welcome news because the last IP report was a dud. I’ve also been impressed by the strength of financials stocks. Since June 4th, the Financial Sector ETF ($XLF) is up more than 22%.

Beware the Dreaded Triple Top!!

We don’t want to get ahead of ourselves. While the economy is showing some emerging signs of strength, we still have a long way to go. The problem is that investors have crammed themselves into risk-averse assets like U.S. Treasuries.

There’s also the issue of stretched profit margins. Companies have done a good job of growing their profits by cutting overhead. In other words, cutting jobs. While the earnings beat rate has been pretty good this earnings season, the revenue beat rate is only running at 42%. That’s 20% below the long-term average. What this tells us is that companies still aren’t seeing impressive top-line growth. You can’t cut your way to prosperity indefinitely. At some point, companies need to see more bodies come through the front door.

I’m also concerned that the market is heading into a perfect example of a Triple Top. For the uninitiated, a Triple Top is a chart pattern when a stock or index hits three eerily similar peaks very close together, but can’t break though. (See the chart below.) It’s like a fullback trying to bust over the goal line on a second and third effort.

A Triple Top grabs traders’ attention because it’s often, though not always, a bearish sign. It’s as if the bulls tried and tried, but finally surrendered to the bears. Again, I caution you not to take these chart patterns too seriously, but the unfortunate fact is that many traders swear by them—and as we learned last May, it’s hard to argue facts and logic with an angry mob that’s out for blood (or worse, short-term profits).

The first sign that the chart followers were in charge came last week, when the S&P 500 came within a hair’s breath of touching its 50-DMA moving average. The index actually fell below it during the day on Friday, but closed just above it. Once the line held, that was a clear signal. The stock market proceeded to rally on Monday, Tuesday and Wednesday, which built the final “up” stage of a Triple Top.

If we can’t make a new high soon, then the next level of support is the 50-day moving average, which is currently at 1,432.87. If the S&P 500 drops below that, then I’m afraid we may be in for another leg down. As always, the key for us is to focus on high-quality stocks at good prices. Once the election passes, I think the environment will be much better for us.

A Look at Next Week’s Earnings Reports

Now let’s look at some of our upcoming Buy List earnings reports. Not everyone has announced when they’ll report, but it appears as if we’re going to have five earnings reports next week.

On Monday, CR Bard ($BCR) will lead off the parade when it reports Q3 earnings. Wall Street wasn’t pleased with Bard’s number from three months ago, and it punished the shares in the near term. But Bard is a high-quality stock, and it soon recovered. For Q3, the company told us to expect earnings to range between $1.60 and $1.64 per share. I suspect that they might be low-balling us a little bit, which I can understand after the last earnings report.

The good news is that Bard stuck by its full-year guidance of 3% to 4% EPS growth, which translates to $6.59 to $6.66 per share. The company also raised its dividend in June to 20 cents per share. I’m looking for a good earnings report from Bard, but what I really want to see is a higher guidance for Q4 (meaning $1.75 to $1.80 per share). CR Bard remains a very good buy up to $112 per share.

On Tuesday, AFLAC ($AFL) and Reynolds American ($RAI) are due to report. I’m happy to see that AFLAC has quietly rallied. The stock reached a new 52-week high on Thursday. In July, AFLAC told us to expect Q3 earnings to range between $1.64 and $1.69 per share. That seems slightly high but it’s very possible for them to hit assuming a favorable yen/dollar exchange rate.

In July, the company narrowed its full-year guidance to $6.45 to $6.52 per share. That’s a lot of money for a stock at $50. As I’ve said before, I think the market unwisely treats AFLAC as if it’s a proxy on the health of Europe. That’s a big mistake. The company has shed almost all of the bum assets in Europe.

The key fact many investors are overlooking is that AFLAC has said that earnings growth should accelerate next year. In fact, I think AFLAC could earn as much as $7 per share in 2013. On Tuesday, I also expect the company to raise its dividend, as it has for every year since 1983. AFLAC remains a strong buy anytime the shares are below $50. Don’t chase this one.

I’m not so concerned about the earnings report from Reynolds American. The Street expects 79 cents per share. The important point is their full-year trend. Reynolds has said they see 2012 EPS ranging between $2.91 and $3.01. The company is right on track to hit that. I’ll also be curious to hear any guidance for 2013. RAI currently yields 5.52%. Reynolds is a good buy up to $45.

On Wednesday, CA Technologies ($CA) and Hudson City Bancorp ($HCBK) are due to report. In July, CA lowered the upper-end of their full-year guidance. The company now expects full-year earnings of $2.45 to $2.50. The shares currently yield just over 4%. Look for a good earnings report. CA is a good buy below $30.

Hudson City has been our all-star recently. The little bank is up more than 50% in the last three months! The latest surge was thanks to a blow-out earnings report from merger partner M&T Bank ($MTB). Net income rose by 60% as the bank netted $2.24 per share for the third quarter. That was 38 cents more than the Street’s consensus. Going by M&T’s closing price on Thursday, the buyout ratio values Hudson City at $8.81 per share. HCBK remains a strong buy up to $9.

That’s all for now. Next week is another big week for earnings. Also, the Fed meets on Tuesday and Wednesday, and we’ll also get our first look at the third-quarter GDP report on Friday. 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

P.S. Today is the 25th anniversary of the Crash of 1987. On October 19, 1987, the Dow lost 508 points or 22.6%. That’s still the largest one-day percentage loss in history. I should add that since then, the Dow has gained 679.2%.

Posted by on October 19th, 2012 at 7:09 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.