CWS Market Review – June 5, 2015
Posted by Eddy Elfenbein on June 5th, 2015 at 7:08 am

“I can assure you that any specific projections I write down will
turn out to be wrong, perhaps markedly so.” – Janet Yellen

Thanks for the tip, Janet, but frankly, we were already pretty skeptical of the Fed’s forecasting abilities. To be fair, the Fed’s lackluster track record precedes Yellen’s tenure. But the track record is clear: the Federal Reserve has consistently been overly optimistic on the U.S. economy.

Lately, the Fed has sounded far more aggressive on the need to raise interest rates, while the markets are much more doubtful. When in doubt, I side with the markets over economists. Last year, Janet Yellen implied that rate hikes would happen by the middle of 2015. Well, we’re nearly there, and short rates are still flat as a pancake. It looks like the Fed may not move until the fall. Some folks, like Christine Lagarde at the IMF, think the Fed should wait until next year.

Wall Street is slowly beginning to realize that higher rates are on the way, though they may tarry. In response to the expectation for higher rates, there’s been a pronounced rotation developing just below the surface. This is very important, and I want all investors to understand what’s happening. In this week’s CWS Market Review, we’ll take a closer look at this rotation and how it impacts our portfolios. I’ll also take an early look at Q2 earnings, plus I have some updates on our Buy List stocks. But first, let’s examine the internal shift spreading across the canyons of lower Manhattan.

The Elfenbein Theory of the Stock Market

On my blog two weeks ago, I unveiled the “Elfenbein Theory Which Explains the Entire Stock Market.” I expect my Nobel Prize shortly. Until then, you can read the full post here.

The quick version is that there’s a general pattern to sector rotations in the stock market. These patterns tend to mirror the movement of interest rates, both long-term and short-term. Here’s the matrix I used:

As the stock market has accepted that interest rates will rise, this has caused a shift within the market. It’s interesting that this shift is happening while the overall market has been rather placid. It goes to show that just looking at the major market indexes only tells you part of the story.

What’s happening is that stocks with high-dividend yields have generally lagged the market, while sectors closely tied to the economic cycle have done well. You can see this most clearly by looking at the relative performance of areas like REITs and Utility stocks.

When interest rates move up, investors naturally shun the safety of dividends in hopes of finding more growth elsewhere. Check out this intra-day chart of the Dow Utility Average (in black) along with the Dow Transportation Average (in gold). The two lines have nearly become mirror images!

The important point isn’t that Transports have done well while Utes haven’t. It’s that the Trannies have done well specifically when Utes haven’t. That, my friends, is the key.

What it means is that investors are leaving dividends behind and moving towards cyclical areas. By cyclicals, I mean sectors like Transportation (trucking has been especially strong). This would also include the Tech sector, which has done pretty well this year. The best performer this year on our Buy List is Cognizant Technology Solutions (CTSH), with a 22.4% gain.

There’s an important but subtle distinction about this rotation. The market’s strength has mostly been in areas we call the “early cyclicals.” That’s shorthand for “everything but commodities,” and that’s why the Energy and Material areas are still rather weak. ExxonMobil (XOM) is hovering just above its 52-week low.

An important area to watch is the Consumer Discretionaries. These are large-ticket items, so they tend to be cyclical. But these items are often financed by consumers, so the sector has some correlation with financial stocks. I urge investors not to be overly mechanistic when thinking about the market because a lot of lines get blurred.

When we look at the short end of the yield curve, sure enough, we see some hints that the market is pricing in a rate increase. One price I like to watch is the spread between the six-month and one-year Treasury yields. This is a good clue as to what the six-month yield will be six months from now. From 2012 through 2014, there was a barely a difference between the six-month and one-year yields. Most of the time, the spread was about four or five basis points (or 0.04% to 0.05%). That’s basically nothing, and a few times, there was no spread at all.

This year has been a different story. The spread between six-month and one-year Treasuries recently hit 20 basis points, or 0.2%. That may not sound like much, but it’s the widest spread in more than five years. In short, the bond market is saying, “We’re not asking for much for the next six months, but after that, you’d better start paying up.”

The futures market now thinks there’s a 60% probability the Fed will raise rates by December. That pretty much comports with the yield spread I just mentioned. Interestingly, the Fed meets again on June 16-17. Don’t expect a rate hike then, but I’m sure the committee members will be focused on one soon. But that discussion hinges on the economy.

It’s clear that the broader economy once again faced a slowdown this winter. This was the third time in the last five years that Q1 GDP growth was negative. The more recent data, however, have been more optimistic.

This week, we learned that the ISM Manufacturing Index expanded for the first time this year. The Employment and Non-Manufacturing Indexes both showed expansions, but at a lower rate than last month. The trade deficit for April declined to $40.9 billion. That was $3 billion less than economists were expecting. Also, the Fed’s “Beige Book” was broadly positive.

I’m writing to you on Friday morning ahead of the big May jobs report. On Wednesday, ADP, the payroll firm, said that 201,000 private-sector jobs were created last month. For Friday’s report, the consensus on Wall Street is for a gain of 220,000 net new jobs. According to the last report, 223,000 new jobs were created in April. The unemployment rate ticked down to 5.4%, which was the lowest in six years.

By the way, can you imagine how people would have reacted in, say, 2012 to the news that unemployment would be at 5.4% and the Fed still wouldn’t have raised rates? How the world has changed. Naturally, the unemployment rate is somewhat distorted by the fall in the workforce participation rate. Some of that is demographics, but not all. Sadly, there are a lot of able-bodied people who have dropped out of the work pool entirely.

Sorry, But the Earnings Recession Isn’t Over

Second-quarter earnings season is still a few weeks away, but let’s look at where we stand. Q1 earnings were pretty bad, a 5.5% drop from last year’s Q1. The only good part is that analysts had been expecting even worse. This came after a 5.4% earnings drop for Q4.

Wall Street currently expects earnings for the S&P 500 of $28.57. That’s the index-adjusted figure (each point in the S&P 500 is about $8.85 billion). That represents a 2.6% drop from last year’s Q2. When all the numbers are in, I think there’s a good chance that Q2 earnings will only be down slightly from last year. Unfortunately, this would be the third quarter in a row of falling earnings.

After that, Wall Street expects earnings to rise by 1.3% for Q3. Then earnings start to rip higher. Wall Street expects double-digit growth for Q4 and all of 2016. That, of course, is a long way off but it suggests that once the near-term issues of the strong dollar and weakness in Europe pass, the earnings outlook is bright.

Now for some Buy List stocks that look especially attractive at the moment. While Wabco (WAB) is technically a transport, it does well when rails do well. The stock has been a great performer for us this year. I also like Signature Bank (SBNY). This is another one that doesn’t make a lot of noise, but it’s very good. Among the tech stocks, I still like Qualcomm (QCOM). It’s especially good if you see it below $69 per share.

Updates on our Buy List Stocks

Ross Stores (ROST) is due to split 2-for-1 next Friday, June 11. This week, I’m lowering my Buy Below to $104 per share. The Buy Below will split along with the stock, so the after the split, Ross will be a buy up to $52 per share. This is a very good stock.

This week, I want to make some minor adjustments to our Buy Below prices. I’m lowering Oracle’s (ORCL) Buy Below to $46 per share. I’m also lowering Bed Bath & Beyond (BBBY) to $75 per share. There’s nothing wrong with either stock. I simply don’t want investors chasing after them. Both stocks are due to report earnings later this month. They’re our only two Buy List stocks on the February/May/August/November reporting cycle.

I also want to raise my Buy Below price on Fiserv (FISV) to $82 per share. Fiserv tends to be pretty quiet, so I forget how good it is. I also want to raise the Buy Below on eBay (EBAY) to $65 per share. The shares have done very well since the last earnings report.

That’s all for now. Next week looks to be a slow week, but there will be a few key economic reports. On Tuesday, the Department of Commerce will report on wholesale inventories. On Wednesday, the Treasury Department will update us on the budget. The numbers here have been improving. Then on Thursday, the Census Bureau will report on retail sales for May. 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

Morning News: June 5, 2015
Posted by Eddy Elfenbein on June 5th, 2015 at 5:05 am

Tsipras Should Hold Greek Referendum on Euro, Pissarides Says

IMF Urges Fed to Delay Short-Term Rate Hike Until First Half of 2016

Fed Deflects Outside Aid to Investigate Data Leaks

Cash Shells Need Foresight To Beat The Cycle

What to Expect From the Jobs Report

Apple Is the New Pimco, and Tim Cook Is the New King of Bonds

Shell CEO Discusses $2 Billion Debt Payment With Iran Oil Minister

Vodafone in Talks to Exchange Assets With Liberty Global

Yahoo to Shut Down Maps, Some Other Services

Pepsi Plans to Introduce Healthier Craft Sodas Like Agave Vanilla Cream

Baidu Leads $11.5M Investment In Startup That Provides WiFi For China’s Commuters

Amazon, Google Race to Get Your DNA Into The Cloud

U.S. Tax Informant Dodged Prison, Now Seeks $22 Million Reward

Credit Writedowns: Trends and Prospects For Private-Sector Deleveraging in Advanced Economies

Howard Lindzon: It’s a Lost decade…NO…It’s a Bubble ….Welcome to my World.

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Bio-Reference Labs Being Bought for $52.78
Posted by Eddy Elfenbein on June 4th, 2015 at 1:13 pm

This morning, Bio-Reference Laboratories (BRLI) said that it’s being bought out by Opko Health (OPK) for 2.75 shares each. That comes to $52.58 per BRLI share.

This is an interesting buy because BRLI had long been a controversial stock. The numbers said it was cheap, but that’s probably out of fear that something very bad was about to happen.

Here’s what I wrote two years ago:

I have to confess that I have very incomplete knowledge of this story, but there’s something very unusual going on with Bio-Reference Labs (BRLI). On the surface, it seems like a very well-run lab testing outfit. Earnings have grown impressively for several years.

Last month, however, some short-selling websites came out publicly against BRLI with claims of phony billing practices. The stock dropped from around $26.14 to $24.20 on very heavy volume. The allegations stem from a former employee who claims she was fired after she exposed the wrongful practices. For their part, BRLI strongly deny the allegations and claim she’s a disgruntled former employee.

The shares have rallied back and BRLI is now above $28 per share. But by most conventional measures, the stock ought to be higher. Clearly, the allegations are hanging over the stock and it has an unusually large short position against it. Of course, this can backfire and create a “short squeeze” as those who bet against BRLI are forced to cover which sends the price even higher.

This isn’t the first time BRLI has been hurt by Internet bears. In September 2011, one website said the company often promoted specialty tests that were not cost effective. The next earnings report comes out on June 5th.

I think these situations are fascinating because you really can’t split the difference. One side is telling the truth and another side is not. How exactly does “tail risk” impact the stock? It’s hard to say but let’s say the market believes there’s a 20% chance the allegations are true and the result is a $15 drop in shares price. That would mean if the company is right, the stock gains $3, and if they’re wrong, it drops $15. (Bear in mind, I’m making these numbers up.)

The point is the market has to find a middle ground when there isn’t one. As a result, you get an odd share price. I should add that this is another reason why investors should like dividend-paying stocks. Companies can fudge all sorts of numbers, but if they’re going to send you a dividend check, you can be sure it’s real.

A few months later I named Bio-Reference as one of the stocks I was considering for the 2014 Buy List. Ultimately, I passed. As always, I want to be as certain as I can. If not, I’ll pass.

It’s interesting to note that BRLI is trading about 14% below the buyout ratio. There are still doubts.

Avon Drops to 20-Year Low
Posted by Eddy Elfenbein on June 4th, 2015 at 11:40 am

Shares of Avon Products (AVP) dropped to a 20-year low this morning.

That’s sad to see. Avon was one of the great Nifty 50 stocks of the 60s and early 70s. But earnings have plunged and the stock has followed.

The data I used for this chart goes back to 1972, but I have a chart book showing how well the stock did during the 1960s. Avon was a fantastic performer for 10 years.

Morning News: June 4, 2015
Posted by Eddy Elfenbein on June 4th, 2015 at 7:10 am

Greek Groundhog Day Continues With Talks Failing to Break Impasse

European Central Bank President Hints at Concession for Greece

US Steelmakers Demand That Americans Become Poorer With Anti-Dumping Tariffs

New York Finalizes Bitcoin Trading Rules

Alibaba Unit to Raise $1.6 Billion in Share Sale For Media-Related Acquisitions

Bill Ackman’s Next Dealmaking Bet: Pershing Square Invests $350 Million In Nomad Foods

Walmart Adjusts the Thermostat to Warm Worker Relations

Joy Global’s Profit Plunges as Miners Cut Spending

Food-Industry Cutbacks Create Problems for Kraft Castoffs

6 Things That Twitter Investor Chris Sacca Thinks Will Fix Twitter

Disney Lays Off 250 Employees, Replaces Them With Indian H1-B Workers

Dish and T-Mobile US in Merger Talks

Apple Takes On a Market Full of Streaming Services

Joshua Brown: If The Greek Stock Market, Bond Market and GDP Disappeared

Jeff Carter: Electric Cars Aren’t Green; But Subsidies are Greening Someone’s Pocket

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Optimistic Beige Book
Posted by Eddy Elfenbein on June 3rd, 2015 at 2:20 pm

The Fed’s “Beige Book” report is one of those wonky things put out by the Fed that’s actually fairly interesting. The one that came out today had mostly good things to say about the economy.

The informal survey of anecdotal business contacts’ views is conducted by each of the central bank’s 12 regional districts, and paints a fairly rosy picture of the outlook. The latest beige book report finds “overall economic activity expanded during the reporting period from early April to late May.”

Growth was characterized as “moderate” in the Chicago, Richmond, Minneapolis and San Francisco districts; “modest” in New York, Philadelphia and St. Louis regions; mixed in the Boston district; “slight” in Cleveland and Kansas City; holding steady in Atlanta; and slowing “slightly” in Dallas. The latter could be associated with falling business spending in the energy sector.

In a hopeful sign for the housing market, the Fed reported “residential and commercial real estate activity and construction improved since the last report.”

Overall loan demand increased, the report said, particularly in the New York district.

Quiet Rotation Today
Posted by Eddy Elfenbein on June 3rd, 2015 at 1:02 pm

The big jobs report comes out Friday but we got a sneak preview this morning. ADP said that the economy created 201,000 private sector jobs last month. For Friday’s report, the consensus on Wall Street is for 220,000 net new jobs.

Also, the Department of Commerce reported that the trade deficit fell to $40.9 billion in April. That was less than consensus. Bill McBride notes that exports are 14% higher than their pre-recession peak, while imports are right at their pre-recession peak.

This is an interesting day in the markets and it’s a continuation of what I discussed before; interest rate-sensitive stocks are lagging. This is a classic Quadrant I day. Industrial cyclicals are up, especially transports. The top-performing sector so far today is trucking.

What’s interesting is that the broader market is up modestly so it’s masking the dramatic rotation that’s happening under the surface.

Morning News: June 3, 2015
Posted by Eddy Elfenbein on June 3rd, 2015 at 7:07 am

OECD Gives Global Economy ‘B Minus’ As Cuts Forecast

OECD Calls US Dip A Blip But Chops World Growth Forecast

Greece in Last-Ditch EU Talks To Break Debt Deadlock

The Secret Money Behind Vladimir Putin’s War Machine

How OPEC Hurt Big Oil

US Congress Pushed China Into Launching AIIB, Says Bernanke

Korean E-commerce Leader Coupang To Raise $1 Billion From SoftBank At $5 Billion Valuation

Amazon Debuts Free Shipping on Small Goods, No Minimum Order

In Bid to Cut Costs, J.P. Morgan Cuts Voicemail For Some Employees

Fitbit IPO Could Top $500 Million When it Makes NYSE Debut

Perrigo Plays European Defense

Huffington Post In Limbo At Verizon

Deutsche Bank Partners With Microsoft, HCL, IBM in Tech Lab Launch

Cullen Roche: Does A “Liquidity Trap” Ever End?

Jeff Miller: How To Think About Risk

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6-Month/1-Year Spread Rises
Posted by Eddy Elfenbein on June 2nd, 2015 at 6:27 pm

The spread between the six-month and one-year Treasury yields recently hit 0.20% for the first time in more than five years. That’s up from four basis points in November.

This is yet another sign that the market thinks higher rates are coming soon.

The one-year Treasury closed today at 0.26% while the six-month bill stood at 0.07%. That implies that the six-month bill will yield 0.45% six months from now.

Auto Sales Reach 10-Year High
Posted by Eddy Elfenbein on June 2nd, 2015 at 3:37 pm

U.S. auto sales were very strong last month:

The U.S. auto industry remained on track for the best sales year in almost a decade as consumers bought cars and trucks at the fastest monthly pace since early 2006.

Sales of pickup trucks and SUVs in May again led the way, which bodes well for profit margins of the major automakers. Consumers are shying away from cars and snapping up trucks and sport utility vehicles as the national average price of gasoline, at $2.75 a gallon, is nearly a dollar less than at this time last year.

As has been the case since the 2008-2009 recession, the auto industry’s recovery continues to outpace that of the overall economy, which is on course to grow 0.8 percent in the second quarter, according to Federal Reserve forecasts.

Consumers are finding it easier to obtain auto loans – another factor in boosting sales, analysts have said. Experian reported the average length of U.S. loans for new and used vehicles in the first quarter hit record highs, and nearly 30 percent of new-vehicle loans have payback periods longer than six years.

This probably represents a rebound from the cold winter. Sales at Ford (F) dropped by 1.3% (Wall Street had been expecting a bigger drop), and the F-Series trucks fell by 10%. Demand is still high for the F-150 as Ford is ramping up production.