CWS Market Review – February 22, 2013

“Lost in a gloom of uninspired research.” – William Wordsworth

As soon as I started joking about the stock market’s slumber party, we should have known something was up. In last week’s CWS Market Review, I said that trading had become dead boring; intra-day volatility had fallen to a 26-year low. Sure enough, the bears woke up from their hibernation this week and feasted on freshly grilled bull.

On Wednesday, the S&P 500 dropped 19 points—its biggest drop this year. The selling continued on Thursday, when the index lost another 9.53 points and briefly dropped below the crucial 1,500 barrier. In just two days, the S&P 500 shed more than $250 billion.

No, the Fed’s Bond Buying Isn’t about to End

So what went wrong? As is often the case, we can turn our eyes towards the Federal Reserve. On Wednesday, the central bank released the minutes from their late-January meeting. You think the jargon-packed minutes of a meeting of economists can’t evoke excitement? Well, welcome to Planet Wall Street, my friend.

What happened is that several members of the policy committee said the Fed should alter the size of its bond purchases in response to the economy. In other words, some of Bernanke’s posse are talking about pulling back on all the bond buying they’ve been doing.

It’s not exactly a state secret that Wall Street loves Quantitative Easing. In the Street’s eyes, the more the better, and that’s certainly been a major factor in causing the S&P 500 to double in less than four years. So once there was any hint that it might come to an end, the bears rushed in to take charge.

Here’s what we know. Fact one: The Fed is buying tons of bonds to prop the economy. Fact two: To borrow from LTC Kilgore, someday this policy is going to end. What we don’t know is when. All the Fed has said is that there should be “substantial” improvement in the labor market. While there’s been some improvement in the labor market, in my opinion, we’re still a long, long, loooong way from calling it substantial. As far as 0% interest rates go, the Fed has said that it’s pledged to that as long as unemployment is above 6.5% and inflation is below 2.5%. That’s at least a year away. Probably more.

What the minutes told us is that there are some voices within the Fed talking about a QE Exit Strategy. This really shouldn’t be a surprise. Instead of a sudden halt, they’re considering scaling back some of the purchases. Let me make something clear, something which has been overlooked: There was nothing in the Fed minutes about ending QE.

Here’s my take. The Fed minutes weren’t a reason to sell. Instead, they were a reason for people who had already been looking for a reason to sell to sell. Given that the S&P 500 has climbed for seven weeks in a row, I certainly understand that there are folks looking to clear out some positions.

Here’s the odd part: The Fed minutes were basically a dumb reason to make some smart moves. There’s no reason to fear that the Fed is going to pull the rug out from under the economy. But there is a good reason for investors to expect a modest pullback, which I’ve talked about for a few weeks. Earnings expectations are probably too high. I’ve also been disturbed by the fact that the low-quality stocks are leading the rally. This isn’t so troubling for us, since we concentrate on high-quality names, but our Buy List has lagged the broader market this month. That tends to happen when the market gets ahead of itself.

There’s really nothing in the Fed’s minutes that anyone should find surprising, at least anyone who’s been paying attention. As far as inflation goes, that’s not a worry at all. This week’s CPI report was very tame. In fact, there’s some emerging evidence that spiraling healthcare costs might finally be coming under control. Of course, the irony of the Fed minutes is that they’re talking about reining in QE because the economy is doing well (or at least better).

The key to watch is employment. That’s part of the Fed’s dual mandate, and the part that Congress is most interested in. The unemployment rate is currently at 7.9%, and that’s not counting the folks who have stopped looking for work. I’d say that the jobless rate would have to fall to 7% before they entertained the idea of cutting back on Quantitative Easing. Not ending it, mind you, but just trimming its sails. For now, the Fed is on the side of higher stock prices.

What Would Reduced QE Mean for Investors?

Let’s look ahead and talk about what will happen when the Fed finally takes away the punchbowl. The biggest impact would be in the gold market, and we got a preview of that this week. A drop in gold makes sense because we’re talking about higher real interest rates. The higher interest rates go above inflation, the worse it is for gold.

Interest rates have been close to or below inflation for years, and that’s been great for gold. However, the yellow metal hasn’t made a new high in nearly 18 months. Gold is down more than $200 an ounce since October, and it recently fell for five days in a row, including a $40 plunge on Wednesday. Like I said, it’s going to be a while before the Fed starts raising interest rates, but once it does, it won’t be pretty for gold.

Reduced QE would also be a big negative for cyclical stocks. The Morgan Stanley Cyclical Index (CYC) did much worse than the rest of the market on Wednesday. The CYC has now trailed the market for four days in a row. The Homebuilder ETF (XHB), a classic cyclical sector, dropped more than 4.4% on Wednesday. On our Buy List, cyclicals like Ford (F) got smacked around. Shares of Ford are now down to $12.39, which, I should add, is an excellent deal. Ford currently yields 3.2%, which is roughly 3.2% more than Bernanke.

Another victim of the Fed’s minutes was obviously low volatility. On Tuesday, the Volatility Index (VIX) reached a six-year intra-day low. From Tuesday’s close to Thursday’s close, the VIX jumped more than 23%. Not bad for two days’ work. Of course, this is an increase from very, very low to very low. Interestingly, the folks in the futures pits aren’t convinced that volatility is on its way back. I think they’re right. QE will be around for a while, and so will low volatility.

Medtronic Is a Buy up to $48 per Share

We only had one Buy List earnings report this week, and that came from Medtronic (MDT). I’ve been impressed by how well the medical-device maker has been doing for us lately. At one point, MDT was up more than 15% on the year. In January, we got good news from Medtronic when the company raised the low end of their full-year guidance by four cents per share. They now see earnings coming in between $3.66 and $3.70 per share. (Note that MDT’s fiscal year ends in April.)

On Tuesday, Medtronic reported that they earned 93 cents per share for their third quarter, which was two cents more than Wall Street’s consensus. That’s a nice increase from the 84 cents per share they earned one year ago. Sales rose by 2.8% to $4.03 billion, which was a teeny bit below consensus.

Despite the good earnings news, the shares lost ground on Tuesday and Wednesday. The two-day loss came to 5%, which I found rather surprising. Apparently, the market didn’t like Medtronic’s weak sales in Europe. The company generates about one-fourth of their total sales from the Old World. Medtronic also experienced a sales decline in their spinal-products business (ick!) and their defibrillators and pacemakers unit.

There was also good news as Medtronic said that the 2.3% excise tax that’s part of President Obama’s healthcare reform will cost the company $25 million this year, which is half the original projection. I’ll be curious to hear what guidance Medtronic gives for next year. The Street expects $3.86 per share, which I suspect is too conservative. Medtronic remains a very good buy below $48. The company has increased its dividend every year since 1977.

Nicholas Financial’s Quarterly Dividend

I want to add a quick note on Nicholas Financial (NICK)´s dividend. Perhaps I misunderstood, but I thought NICK’s big $2 dividend late last year was in lieu of all cash dividends for this year. Apparently, that’s not the case. The company just announced another 12-cent quarter dividend. The dividend will be paid on March 29th to shareholders of record as of March 22nd. Going by Thursday’s close, NICK yields 3.62%.

Before I go, I want to highlight a few stocks on our Buy List that are currently exceptionally good values. Microsoft (MSFT) had a good Q4 report, and the yield is up to 3.35%. As I mentioned before, shares of Ford (F) have slid back to $12.39. That’s a good price. Remember, Ford doubled their dividend a few weeks ago. Plus, the company just announced that it’s expanding its engine output in the United States. I discussed Bed Bath & Beyond (BBBY) in last week’s issue. BBBY has fallen into the bargain bin; below $58 is a very good price. Last month, I told you not to worry about Moog’s (MOG-A) lower guidance. The stock came within a penny of making a new 52-week high this week. Moog looks very good here.

That’s all for now. Next week, the government will revise its Q4 GDP report. It’s very likely that the trade data will cause them to revise the original -0.1% to a positive number. It could be as high as 1%. Then on Friday, we’ll get the ISM report for February. The report for January was surprisingly good. Let’s hope the trend continues. 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 February 22nd, 2013 at 6:47 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.