CWS Market Review – September 1, 2017

“The race is not always to the swift, nor the battle to the strong, but that’s how the smart money bets.” – Damon Runyon

Like many of you, I’ve been distraught by the scenes of destruction caused by Hurricane Harvey in Texas. It always feels a bit improper to discuss the financial impact of such terrible events, yet it’s an important subject. For these areas to rebuild, they need investment, and that’s what we talk about around here.

Fortunately, the financial disruption from Harvey, while serious, appears to be contained at this point. That’s a relief, especially considering the sheer amount of rain brought on by the storm. The stock market has been calm, as it was before the hurricane. The Nasdaq Composite (see below) just closed at an all-time high, and the S&P 500 Total Return has now closed higher for the tenth month in a row.

Houston is, of course, a crucial city for the energy industry. Right now, one-fifth of the nation’s refinery capacity has been shut down. At the moment, 3.6 million barrels per day are offline. That costs money. According to GasBuddy, the retail price for gasoline is up 11 cents per gallon in the past week. There simply isn’t enough fuel to fill the pipelines to supply other areas of the country. Gasoline futures just touched a two-year high.

In this week’s issue, I’ll discuss what it all means for us and our portfolios. We’ll also look at interest rates. Remember all those forecasts from the Fed for higher and higher interest rates? Well, that seems to be off the table. Later on, I’ll examine how some of our Buy List stocks are reacting. But first, let’s take a broader look at where we are now.

The Disruptions from Harvey Won’t Last Long

On Thursday, the Nasdaq Composite closed at an all-time high, and the S&P 500 is less than 0.4% from its all-time high close. So despite the terrible destruction from Harvey, investors continue to be optimistic. The S&P 500 hasn’t posted a weekly decline of more than 2% in nearly a year.

This week, unlike in weeks past, we don’t have any earnings reports to discuss, or upcoming earnings to preview. Earnings season is past us. The summer is over, and we’re coming up on what’s historically been the rough time of the year for the stock market.

I tend not to place a great deal of faith in these kinds of trends, but I’ll note that September 6th has historically been a peak for the market. From September 6th to October 29th, the Dow has lost an average of 2.3%. Of course, that’s the average for 120 years, so we can’t say too much about any one particular year.

When looking at the impact of an event such as Harvey, it’s important to remember how dynamic markets are. For example, if people can’t get oil from Houston, then foreign suppliers rush in to fill the void. In the near term, I expect to see gasoline prices rise, which normally happens at this time of year anyway.

We’ll also see a drop in employment and a rise in consumer prices, but I expect both will be short-lived. This also happened during other recent natural disasters. While the cost of Harvey is in the tens of billions, overall U.S. GDP is close to $20 trillion, so we need to maintain our perspective. I assume that many planned new car purchases have been delayed, but we’ll see a rise in car buying soon. I would also expect that in the post-Harvey environment, lawmakers are much less inclined to see a government shutdown. At least, I hope they are.

So far, insurance stocks are holding up fairly well. On our Buy List, shares of AFLAC (AFL) have broken out to a new all-time high. I’ll have more on AFL later. One of the more surprising reactions to Harvey is the surge in shares of Continental Building Products (CBPX). Of course, since the company specializes in gypsum wallboard, the rally makes sense, but I certainly didn’t see the uptick coming.

One month ago, CBPX reported a three-cent earnings miss; still, the shares jumped after the earnings report. I suspect traders were expecting even worse news. The problem is that product costs have been rising, but Continental hasn’t been able to pass that along to their customers. That may soon change.

This has been a very good week for Continental. On Monday, shares of CBPX rose 3.6%, followed by a 0.4% gain on Tuesday and a jump of 7% on Wednesday (see above). It’s now in the black for us this year. Three weeks ago, I dropped my Buy Below from $26 to $23 per share. I probably moved to soon, but I want to hold off raising it for now. The recent rally is due to expectations of more business, and I’d prefer to see proof. This is a good example of the effects of a natural disaster that you might not expect.

You Can Forget About That Parade of Rate Hikes

On Wednesday, the government updated its report on Q2 GDP growth. The initial report in July said the economy grew in real, annualized terms by 2.6%. This week, that was raised to 3.0%. That’s the best quarter for the economy for the past nine quarters.

From the 60s until the last recession, the U.S. economy tended to grow in real terms by about 3%. Since then, the economy has grown in slower terms, around 2%. While the last GDP was encouraging, I doubt it’s the beginning of a growth resurgence. The Atlanta Fed has a model that tries to predict the GDP numbers. For Q3, the model currently says 3.3%. That would be very good.

Later today, the government will release the employment report for August. The numbers recently have been pretty solid. Unemployment is currently at 4.3%, which is tied for a 16-year low. The economy has added an average of 200,000 jobs every month for the last seven years.

For our purposes, what’s been most interesting has been the lack of inflation. Traditional economics (don’t laugh) suggests that prices should rise as we get close to full employment. If anything, inflation has been going down as more people are working. The Fed likes to watch the PCE price index. That rose by just 1.4% in July.

Last December, the Fed said it sees raising interest rates three times in 2017, 2018 and 2019. I wrote, “Not to put too fine a point on it, but that’s nuts.” It looks like I was right. While the Fed has already raised rates twice this year, a third hike doesn’t look to be happening. In fact, the futures market doesn’t see another hike coming until June 2018.

What’s been interesting is the behavior of the bond market. Long-term yields have been trending lower while short-term yields have been climbing higher. The three-year note is the dividing line. Anything longer than that means yields are going down. Shorter than that, they’ve been rising (see colorful chart below). This means that the yield curve is getting flatter. Traditionally, a flat yield curve is a warning sign for the stock market and the economy. While the yield curve is indeed getting flatter, we’re still a long way from the danger zone.

The 10-year inflation-protected bond still yields you a measly 0.4%. A few years ago, I ran some numbers and said that the stock market does well until TIPs yield 2.4%. That shows you how much room we have. Of course, five years ago, 10-year TIPs were yielding -0.90%.

I also wanted to touch on another interesting phenomenon: divergence between energy stocks and materials stocks. These two sectors tend to be decently correlated, but the connection is far from perfect. This year, however, they’re moving in different directions. This represents a major trend of 2017: metal prices are going higher, while energy prices, oil and natural gas, are going down. There’s no rule that extraction industries need to run parallel, but they generally have.

Copper, for example, is now at a three-year high. Gold and silver have been coming to life recently as well. This may suggest that the global economy is getting back on its feet despite a sluggish energy patch. This may also explain the weak dollar this year. In fact, the Dow is actually down this year, if it were priced in euros. Overall, I think the financial markets are in a healthy state, and hopefully, the Houston area will be back as strong as ever. Now let’s look at some news from our Buy List.

Buy List Updates

On Thursday, shares of Microsoft (MSFT) closed at another all-time high. The stock is now a 20% winner for us this year. We added MSFT to our Buy List in 2014. It was almost exactly four years ago when Steve Ballmer announced his retirement. Shares of MSFT jumped 7.3% on the news. Just as a rule of thumb, if the company you lead gains $20 billion in market value on the news that you’ll be out the door, then the relationship probably wasn’t meant to be. Since the day of Ballmer’s announcement, shares of MSFT have gained more than 150%.

Last earnings season, which was their fiscal Q4, Microsoft had another solid report. They beat Wall Street’s consensus by four cents per share. The software giant also gave upbeat guidance for the current quarter. The company said it expects Intelligent Cloud revenue to rise by between 8% and 11%. They also see Productivity and Business Processes revenue rising by 21% to 24%.

I also expect to see a dividend increase fairly soon. In the past, the company has announced dividend increases toward the middle of September. They’ve been pretty generous as well. Over the last seven years, Microsoft has tripled its dividend. The company now pays out a quarterly dividend of 39 cents per share. Going by Thursday’s close, that works out to a yield of 2.1%. My guess is that Microsoft will soon bump up its dividend to 42 cents per share. Microsoft is a buy up to $76 per share.

AFLAC (AFL) is one of two stocks left that have been on our Buy List all 12 years. The other is Fiserv. Shares of the duck stock have come to life in the past few weeks. Keeping with the animal theme, AFLAC is one of the stocks that acts like a rabbit. It will sit and sit and sit and then suddenly start hopping like mad.

Seven months ago, AFLAC bombed its Q4 2016 earnings report. They missed by 17 cents per share. The stock dropped 4% that day. In the CWS Market Review from February 3rd, I wrote, “Let me be clear: I’m not at all worried about AFLAC. This is a very well-run firm, and the stock is going for just over 10 times this year’s earnings estimate.” The shares are up 23% since then. This week, I’m going to raise my Buy Below on AFLAC to $86 per share.

That’s all for now. The August jobs report will be coming out later this morning. We may see a fresh 16-year low in the unemployment rate. The stock market will be closed on Monday for Labor Day. Next week, we’ll get the factory orders report on Tuesday. The important Beige Book comes out on Wednesday. Then on Thursday, we’ll get a look at the productivity report. 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 September 1st, 2017 at 7:08 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.