CWS Market Review – October 25, 2022

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The Important Nugget Buried in the Fed Minutes

The stock market is finally showing some backbone. On Tuesday, the S&P 500 rallied 1.63% to close at its highest level in five weeks. The index finished the day less than 0.25% away from its 50-day moving average (the blue line in the chart below).

For traders, the 50-day moving average is an important psychological barrier. If we move above it, that could give more confidence to the bulls. The S&P 500 has traded below its 50-DMA nonstop for nearly six weeks.

I say this cautiously because we know how these bear market rallies like to fool us, but I have to confess that I’m more optimistic for the market’s latest move. Let me explain why.

For one, it’s been a far more measured climb. The S&P 500 hasn’t jerked forward by huge advances in a few days like we’ve seen in previous false starts. But more importantly, there may be concrete reasons why the Federal Reserve may alter its rate-hiking policy soon.

I’m referring to a small two-sentence blip buried in the minutes of the Fed’s last meeting. In fact, I overlooked it in my first reading.

First, some background. The stock market’s most recent closing low came on October 12. That’s when the S&P 500 finished the day at 3,577.03. The next day was a raucous one. The S&P 500 plunged as low as 3,491.58 which brought the stock market all the way back to its pre-Covid high from more than 30 months ago.

During the trading day, the Federal Reserve released the minutes from its September meeting. The overall tone of the minutes was quite hawkish. The Fed members clearly believe that the Fed needs to keep raising rates.

That’s what dominated the headlines. However, the minutes also contained this brief section:

Several participants noted that, particularly in the current highly uncertain global economic and financial environment, it would be important to calibrate the pace of further policy tightening with the aim of mitigating the risk of significant adverse effects on the economic outlook. Participants observed that, as the stance of monetary policy tightened further, it would become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation.

I added the boldface. Why is this important? It means that some members inside the Fed recognize that there’s a limit to the Fed’s current policy. The yield curve is already inverted. Interest rates can only go so high. Perhaps we don’t know exactly what that level is, but the negative effects will soon become clear. To use the buzzword of this year, the Fed needs an offramp and some FOMC members are already discussing it.

I don’t think the Fed will alter course immediately, but it’s a real possibility within the next few months. We now have solid evidence that the Fed’s higher interest rates are causing harm to the economy.

I could be premature, but the stock market appears to have picked up the signal. After the minutes came out on October 13, the stock market staged a dramatic U-turn and closed higher by 2.6%. From low to close, the S&P 500 gained more than 5% that day.

The following day, October 14, was the day of the CPI report. Once again, the numbers were higher than expected, and the stock market dropped, but here’s what’s important: the low from the 12th held. The market didn’t make a new low. This tells me that the minutes were a turning point. Since then, the S&P 500 has rallied five times in seven days.

Let’s be clear that the Fed isn’t about to stop. The central bank will almost certainly raise short-term rates by 0.75% at its meeting next week. After that, the Fed meets again in mid-December. The futures market is evenly split on the odds of a 0.5% increase or another 0.75% increase.

After that, things may start to change. Except for one or two smaller rate increases, the Fed will probably hold tight for much of 2023. If the economic news is dire, then we may even see rate cuts before this time next year.

Let’s remember that the stock market peaked in January. The first Fed rate hike wasn’t until March. It’s natural for stocks to move before the news, even if the full details aren’t completely known. The initial move we’ve had over the last two weeks could be an omen for a friendlier Fed in 2023. This bear-market rally could finally be real.

Thursday’s Q3 GDP Report

While this week will be dominated by earnings news, on Thursday, the government will release its first estimate for Q3 GDP. This will be a noteworthy report because the first two quarters showed negative growth.

Two or more consecutive quarters of negative growth is often used as a shorthand for a recession. That’s not the technical definition used by most economists. Still, it’s an alarming thing to see two quarters in a row of falling real GDP. To be fair, the consumer side of the economy has seen some slow growth.

The consensus on Wall Street is that the U.S. economy will post growth of 2.3% for Q3 (that’s the annualized after-inflation number). I think there’s a good chance we’ll exceed that number, but that doesn’t mean the economy is in full health.

The weak spot is the housing market. Unfortunately, the housing market become the chief mechanism for Fed policy. I wish there were a better way to curb inflation without flattening the housing market. Mortgage demand is now at a 25-year low. Applications to refinance a home are down 86% from one year ago.

Update on Polaris

Before I get to this week’s stock, I wanted to pass along an update on Polaris (PII). I featured the stock for you in August.

Polaris is a cool company. They make snowmobiles and all sorts of off-road vehicles. I like Polaris because it’s a good example of a company with a wide “moat.” Not many firms can do what they do.

In April, Polaris bombed its Q1 report. The company earned $1.29 per share which was 49 cents below expectations. Sales were flat. This summer, Polaris rebounded with a good Q2 report. The company made $2.42 per share which beat the Street by 33 cents. Sales were up 8% to $2.063 billion.

This morning, Polaris reported another solid quarter. For Q3, the company made $3.25 per share. That’s up 65% over last year. Wall Street had been expecting $2.82 per share.

Polaris also increased its full-year guidance (of course, that’s only for one more quarter). The company now expects 2022 sales to rise by 15% to 16%. The previous guidance was 13% to 16%, and before that it was 12% to 15%.

Polaris also reiterated its full-year guidance of $10.10 to $10.30 per share. In the first three quarters of this year, Polaris made $6.98 per share so the guidance implies Q4 earnings of $3.12 to $3.32 per share.

That’s up 11% to 14% over last year. If those forecasts are accurate, that means Polaris is going for less than 10 times this year’s earnings. Not that long ago, Polaris would have gone for twice that valuation. One more thing: Polaris has increased its dividend every year for the last 27 years. The stock rallied 3.7% today, but it’s down significantly in the last few months.

Another stock I want to highlight is Middleby (MIDD). You may remember that we had Middleby on our Buy List in 2020 and 2021. It was our second-best performer last year with a gain of 52%. I decided against including it on this year’s Buy List, and I had pretty good timing. The shares are down more than 30% this year.

But Middleby is worth a look, especially at a discounted price. If you’re not familiar with Middleby, the company makes kitchen equipment for hotels and restaurants. Think big ovens and grills, and stuff with conveyer belts. The stock got demolished during the Covid panic in early 2020. Then it roared back and we did very well with Middleby.

So far this year, Middleby beat earnings for Q1 and Q2. For Q3, Wall Street expects $2.36 per share. For next year, Wall Street expects earnings of $10.29 per share. That means the stock is going for just over 13 times earnings. That’s not bad. The Q3 report will probably be out in early November.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

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Posted by on October 25th, 2022 at 6:21 pm


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.