CWS Market Review – January 10, 2014

“It amazes me how people are often more willing to act based on little or
no data than to use data that is a challenge to assemble.” – Robert J. Shiller

There’s a weird new feeling on Wall Street these days. For the first time in a long while, folks are actually optimistic about the economy. How about that? In fact, it’s now conventional wisdom that 2014 will be the best year for the economy since the recession.

Unfortunately, that’s a rather low bar to clear. Still, the signs keep coming in positive. This week, we learned that thanks to rising exports, the U.S. trade deficit fell to a four-year low. Another key indicator is that freight rail traffic is at an all-time high. The housing market is also doing well, and construction spending is the highest it’s been since March 2009.

The GDP report for the third quarter had the second-best growth rate in the last 30 quarters (again, low bar). Lately, firms up and down Wall Street have been revising their estimates for Q4 higher. Merrill Lynch now says they see Q4 GDP coming in at 3%, and they project real consumer spending to rise by 4%.

Of course, there are still lots of weak spots in the economy, and the jobs market is a major concern. I’m writing this to you early on Friday, and the big January jobs report comes out later today. The consensus on Wall Street is that the economy created 200,000 net new jobs last month. I won’t try to predict if that’s right or wrong but I’ll note that ADP’s report, that’s the private payroll firm, came in at 238,000 net new jobs. For us, the important thing is to see if the promising trend remains in place. More jobs mean more consumers and that means more profits. It’s just that simple.

Fourth-quarter earnings season has finally arrived. Over the next five weeks, 16 of our 20 Buy List stocks will report earnings. In this week’s CWS Market Review, I’ll highlight Wells Fargo ($WFC) which will be our first earnings report for this earnings season. I’ll also take a closer look at what the Fed has in store for us this year. Later on, I’ll discuss the terrible, horrible, no good, very bad day Bed Bath & Beyond ($BBBY) had on Thursday. The shares plunged 12.5% after they lowered their Q4 guidance (Spoiler alert: I still like BBBY). On the plus side, Ford Motor ($F) raised its quarterly dividend by 25%. But first, let’s look at what last year’s broad-based rally means for us.

History Says “Let Your Winners Run”

One interesting aspect about the market’s rally is how broad-based it’s been. Previous big rallies have often been uneven and skewed to certain sectors like tech or emerging markets. But last year, 460 of the S&P 500 stocks gained ground. That’s the most since at least 1990. We can also see the broad participation by looking at the equally-weighted version of the S&P 500 (the standard version is weighted by value). The equally-weighted S&P 500 jumped 34% last year and it’s up an amazing 248% from the March 2009 low (below is a chart of an equally weighted S&P 500 ETF).

A broad-based rally has historically been an omen for more good things to come. When more than 400 stocks in the S&P 500 rally, the market averages a 14% return the following year. Also, some folks are worried about rising valuations, but history is again on the side of the bulls. Since 1936, there have been 156 quarters in which the S&P 500’s P/E Ratio has expanded. The index climbed 108 times in the following quarter (or 69% of the time). In other words, letting your winners run has been a good strategy.

I should also note that firms are starting to invest their massive cash hordes. The companies in the S&P 500 are sitting on a total of $3.8 trillion. Between you and me, that’s a lot of money. This is what some folks are calling “the capex recovery,” and I think it’s for real. Don’t get me wrong. I love me some dividends, but companies are beginning to realize they need to invest in order to grow. Getting next to nothing for your cash may have been fine in 2009 or 2010, but that won’t cut it in 2014. Ford and Microsoft are two such companies that have ambitious business investment plans for this year. Now let’s look at what the Federal Reserve may have up its sleeve.

Will the Fed Alter the Evans Rule?

On Monday, Janet Yellen was confirmed as the next Chairman of the Federal Reserve. She’ll take over from Bernanke on February 1, but that may not be the only big change at the Fed. I think there’s a small but growing chance that the Fed may alter the “Evans Rule.”

Let me explain. A little over a year ago, the Federal Reserve introduced a new policy: The Fed said it wouldn’t raise short-term interest rates until the unemployment rate reached 6.5%. Ben Bernanke was careful to say that this was a threshold and not a trigger. He’s repeated that many times since.

The use of this specific economic metric has been referred to as the Evans Rule in honor of Chicago Fed President Charles Evans, who has advocating using such a strategy. One of the odd parts of monetary policy is that it’s much more effective if it’s seen as credible. A central bank can yammer all they want, but if no one believes them, the implementation of policy becomes that much harder. Credibility is the watchword for any modern central banker.

While the Fed is still seen as an opaque and secretive institution, Ben Bernanke has probably pulled back the curtain more than any other Fed chair. As such, the Bernanke Fed has also been careful in telegraphing their intentions to market participants. That’s also why last year’s Taper Tantrum was so bizarre.

I think the commitment to credibility is why the Evans Rule may not live much longer-or more specifically, the 6.5% threshold. The fact is that the unemployment rate has fallen a good deal, and there’s a good chance we could hit 6.5% by the middle of this year.

Yet there seems to be no demand for short-term interest rates to rise anytime soon. The one-year Treasury is still around 0.13%. At this point, most FOMC members don’t expect a Fed rate increase until 2015—and a good majority of them don’t expect much of an increase next year.

This week, we got the minutes from the Fed’s December meeting. This was the one where the Fed finally decided to taper their bond purchases. I thought it was interesting that the minutes indicated that some members felt the FOMC needed to lower the unemployment threshold. While this view wasn’t adopted by the committee, it’s clearly on their radar.

It could hurt the Fed’s credibility with the market if unemployment drops and the Fed does nothing month after month. I suppose that Bernanke’s threshold-not-trigger statement grants them some leeway, but I’m not sure how much. I expect to see more tapering in 2014, but I doubt we’ll see any interest rate increases. There’s just no inflation pressure-at least, not yet.

When the Fed adopted the Evans Rule in December 2012, it was a cost-free commitment. The rule told traders what to expect and when, and it helped remove a lot of worry from the markets. But now that promise is coming due.

Frankly, I rate altering the Evans Rule as an event with a low probability but one with a large potential impact. At some point this year, the Fed may alter the Evans Rule and lower the threshold to 6%. In my view, that would be very good for the market.

Bed Bath & Beyond Drops 12.5%

After the closing bell on Wednesday, Bed Bath & Beyond ($BBBY) released a disappointing earnings report. For the third quarter (Sep-Oct-Nov), the home furnishings company earned $1.12 per share. That was three cents below Wall Street’s forecast.

Previously, the company had said they expected Q3 to range between $1.11 and $1.16 per share. So technically, BBBY hit their own guidance, but the Street was expecting more (and so was I). Net sales rose 6% from last year’s third quarter. Comparable store sales, which is a key metric for retailers, rose by 1.3%. Honestly, that’s not that great. So far this year, BBBY has earned $3.20 per share for the first three quarters, and that’s a nice increase over the $2.89 per share from the same period last year.

But the bad news is that BBBY cut their Q4 guidance. I was afraid this might happen. The previous range was $1.70 – $1.77 per share. Now it’s $1.60 – $1.67 per share, so 10 cents at both ends. That lowers their full-year range from $4.88 – $5.01 per share to $4.79 – $4.86 per share. I had been expecting the company to clear $5 per share for the year. For some context, last year, BBBY earned $4.56 per share.

Yesterday was ugly. The stock got crushed for a 12.5% loss. I know this is painful and I apologize for the volatility, but traders aren’t always so rational. In fact, this kind of thing has happened to BBBY before. Eighteen months ago, BBBY got hammered for a one-day loss of 17%. What happened? They had actually beaten expectations but lowered their quarterly and full-year guidance.

The odd thing is that once those results were known, many months later, they really weren’t that far off from Wall Street’s original estimate. Before the June 2012 plunge, Wall Street had expected full-year earnings of $4.63 per share, and as I had mentioned before, they earned $4.56 per share last year. So the market panicked with a 17% drop in response to (what turned out to be) an earnings adjustment of less than 2%. Not surprisingly, the aftermath of the sell-off was a great buying opportunity. This is exactly why we like high-quality stocks.

Now let’s break down some of the numbers. For Q3, Bed Bath & Beyond’s EPS grew by 8.7% while their sales rose by 6%. Of that sales increase, 78% came from comp store sales and 2% came from new stores. BBBY’s gross margins fell a bit due to inventory acquisition costs, shoppers using more and larger coupons and a shift towards lower margin goods. Expenses for selling, general and administrative dropped a bit partially thanks to lower payroll costs.

There are also a few technical points. Bed Bath & Beyond doesn’t use three-month quarters; they use 13-week quarters. Since one year isn’t exactly 52 weeks, every so often, they have to use a 14-week quarter. Last year’s fourth quarter was a 14-weeker so the comparisons aren’t quite apples to apples. Also, the date range isn’t the same either (this is important because it covers the important holiday shopping season).

For Q4, BBBY sees comp store sales rising by 2% to 4%, instead of the earlier projection of 3.5% to 5.5%. Net sales are expected to fall by -3.9% to -5.7%. Again, that’s with one less week of sales. The company estimates that adjusting for the missing week, Q4 sales growth will range from -0.3% to +1.6%.

Bed Bath & Beyond didn’t have a lot to say about the coming fiscal year, but they did say they anticipate opening 30 stores next year. They also continue to have a very strong balance sheet. I expect more details in April when the Q4 report comes out.

Here’s my take: This is where our locked-and-sealed strategy comes to the test. Lots of investors would dump BBBY at the first sign of trouble, but I’m not doing that. This is a very well-run outfit that really had a fairly minor adjustment to their earnings outlook. The shares are going for a bit over 14 times this year’s earnings. Sure, the one-day plunge ain’t a lot of fun, but that’s how the stock market works. The long-run is still in our favor and I’m sticking with BBBY. To reflect the sell-off, I’m lowering the Buy Below to $77 per share.

Ford Raises Dividend By 25%

Not all the news was lousy this week. Ford Motor ($F) investors got some pleasant news when CEO Alan Mulally officially withdrew his name from consideration for the top job at Microsoft ($MSFT). From the beginning, I doubted he would jump ship. Mulally and his team have done a commendable job in turning around Ford, but the job is far from done. Their European operations still need a lot of work.

In the CWS Market Review from November 8, I wrote, “I also expect the company will raise their quarterly dividend in January. The current dividend is 10 cents per share, and I think it can rise to 12 or 13 cents per share.” This week, Ford raised their quarterly dividend by 25% to 12.5 cents per share. So it turns out, they chose the middle-point of my range.

Ford’s CFO, Bob Shanks, said, “This increase in the dividend provides our shareholders with a regular, growing dividend that we believe is sustainable over an economic or business cycle.” Things continue to move in Ford’s direction. Two years ago, Ford restored its dividend at five cents per share. Last year, they doubled it to ten cents, and now we’re at 12.5 cents. Going by Thursday’s close, the stock yields 3.16%. Ford remains a good buy up to $17 per share.

Wells Fargo Is a Buy up to $48 Per Share

The first Buy List stock to report this earnings season will be our favorite big bank, Wells Fargo ($WFC). Wells is due to report on Tuesday morning, January 14. Business at Wells has been going pretty well lately. The bank has beaten its earnings estimates for the last eight quarters in a row. For Q4, the current consensus on Wall Street is for earnings of 98 cents per share.

If Wells does earn 98 cents for Q4, that would give them $3.87 for all of 2013, which is quite good. That’s a strong improvement over the $3.37 per share they made in 2012. The easy earnings growth may be a bit harder to come by in 2014. On one hand, the improving economy means that more people are paying their bills on time. But the downside is that Wells’s mortgage business has slowed down. If you recall, WFC laid off 5,300 people in their mortgage division last year. That was painful but necessary. Wall Street currently expects Wells to earn $4.01 per share next year, which is probably a bit low. Even if that’s right, it gives the stock a forward P/E of just 11.5. That’s a good value.

Fortunately, the stock has continued to do well. On Thursday, WFC got as high as $46.20 per share which is another all-time high. Later this spring, I expect to see another dividend increase from Wells. Until the earnings report comes out, I want to keep a tight leash on our Buy Below price. Wells Fargo is a very good buy up to $48 per share.

That’s all for now. Next week will be the first full week of earnings season. We’ll also get some key economic reports. On Tuesday, we get retail sales. The Fed’s Beige Book is on Wednesday, and the CPI report comes out on Thursday. I’m also curious to see the Industrial Production report which is due 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

Posted by Eddy Elfenbein on January 10th, 2014 at 7:18 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.