CWS Market Review – September 14, 2012
Posted by Eddy Elfenbein on September 14th, 2012 at 8:23 am

Last week, it was thank you, Mario. This week, it’s thank you, Ben!

The stock market surged to its highest close in four years on Thursday when it was reported that that the Federal Reserve is embarking on another round of quantitative easing. The last time the S&P 500 was this high was on the final day of trading in 2007. The market had a great day on Thursday, and several of our Buy List stocks like Medtronic ($MDT), DirecTV ($DTV), Hudson City ($HCBK) and Harris Corp. ($HCBK) all broke out to new 52-week highs.

I’m also pleased to announce that—after many of you requested it—I’ve added a “Buy Below” column to our Buy List page. I think you’ll like it a lot. Now you’ll be able to know exactly what I think is a good entry point for all the stocks on our Buy List. It’s important for investors to stay disciplined and never chase after stocks. My Buy Below prices will help you do exactly that.

In this week’s CWS Market Review, I’ll explain what the Fed news means, and I’ll try to keep it jargon free. I’ll also discuss what this policy means for the economy and our portfolios. I’ll also highlight upcoming Buy List earnings reports from Oracle ($ORCL) and Bed Bath & Beyond ($BBBY). But first, let’s look at why stocks are so happy with the Bearded One.

The Federal Reserve Embarks on QE-Infinity

I have to confess some embarrassment with the Fed’s news, because I had long been a doubter that the central bank would pursue more quantitative easing. I even said last week that this week’s policy meeting would be a snoozer. In fact, I was afraid the market was setting itself up to be disappointed. Instead, the market celebrated the news.

Now let’s look at what exactly the Federal Reserve did. The central bank said it will buy $40 billion per month of agency mortgage-backed securities (MBS). What will happen is the Fed will swap assets with a bank. The Fed will get a risky MBS while the bank will get low-risk reserves, which, I should add, are held at the Federal Reserve.

Here’s the problem: Since interest rates are already near 0%, the Fed can’t cut them any further. But the hope is that by buying MBS, the Fed can push down mortgage rates, which will boost the housing market, which in turn will boost the overall economy. At least, that’s the plan. Remember that the housing sector is a key driver of new jobs, and I noted on Thursday that the stocks of many homebuilders gapped up on the news.

The Fed Changes Course

The problem with the two earlier rounds of bond purchases is that while they certainly helped the financial markets, their impact on the economy was probably pretty slight. Some critics said that the Fed simply wasn’t being bold enough. What’s interesting is that this round of bond buying is smaller than the previous rounds.

But here’s the key: The Fed said something very different this time.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

In other words, this time the Fed’s plan is unlimited. Implicit in the above sentence is the Fed’s admission that its previous policy just wasn’t working. With the earlier bond buying, the Fed just said that they’re going to buy X dollar amount of bonds, and that’s that. There was no goal.

An idea gaining popularity among economists is that the Fed should buy bonds until some metric like the unemployment rate or nominal GDP hits a specific target. With today’s news, the Fed has clearly moved towards that position without expressly saying so. The Fed said that the bond buying would continue until the labor market improved “substantially” and “for a considerable time after the economic recovery strengthens.” The $40-billion-per-month figure is almost irrelevant in context of an open-ended policy. All told, the Fed will be pumping $85 billion into the economy each month.

What This All Means

I may sound overly cynical, but I suspect the Fed will buy bonds until the bond market shuts them off. (Remember when I talked last week about how the Spanish bond market scared the bejesus out of the European Central Bank?)

The Fed also said that it will keep interest rates near 0% through at least 2015. That’s very good news for a company like Nicholas Financial ($NICK). Another buried angle on today’s news is that the Fed is, in my opinion, giving up on the fiction that it has a dual mandate (low inflation and full employment). When it truly matters, the Fed only cares about employment.

Will this QE-Infinity work? I honestly can’t say. One fear is that mortgage rates are already low, and that hasn’t done much to boost the economy. Looking at the track of previous quantitative easings doesn’t make me overly optimistic that a third version will do the trick.

Let’s look at the probable outcomes for the market. I suspect that in the near term, cyclical stocks and financial stocks will get a nice boost. That’s what happened after the first two rounds of bond buying and Operation Twist. JPMorgan Chase ($JPM), for example, soared to $41.40 on Thursday, which effectively erased its entire loss since the London Whale trading loss was announced in May.

Since the Fed is willing to turn a blind eye toward inflation for the time being, I suspect that hard assets (like gold) and commodity-based stocks will do well. I also think that higher-risk assets will gradually gain favor. For example, spreads between junk bonds and Treasuries will continue to narrow. This will also give a lift to many small-cap stocks, especially small-cap growth stocks. In the long run, I’m not convinced the Fed’s decision this week will have a major impact on the economy. Perhaps the best outcome is that a Fed-induced burst of enthusiasm will give the economy and labor market more time to right themselves. Until then, I urge all investors to own a diversified portfolio of high-quality stocks such as our Buy List.

Earnings from Oracle and BBBY

Next week, we have two earnings reports due. Bed Bath & Beyond ($BBBY) reports on Tuesday, September 18, and Oracle ($ORCL) reports the next day. This will be an interesting report for BBBY because three months ago, traders gave the stock a super-atomic wedgie after the company warned Wall Street that their fiscal Q2 would be below expectations. Wall Street had been expecting $1.08 per share, but BBBY said that earnings would range between 97 cents and $1.03 per share. Traders totally freaked and sent shares of BBBY from $74 all the way down to $58.

For fiscal Q1 (which ended in May), I predicted that BBBY could earn as much as 88 cents per share, which was four cents above Wall Street’s consensus. In fact, the company reported earnings of 89 cents per share. Nevertheless, the weak earnings guidance was too much to overcome.

In the CWS Market Review from June 22, I said that the selling was “way, way WAY overdone.” Fortunately, I was right. Since bottoming out in late-June, shares of BBBY have steadily rallied. On Thursday, the stock closed above $70 for the first time in three months. BBBY is still a good stock, and business is going well, but let’s be smart here and not chase it. I’m keeping my Buy Below price at $70.

Oracle has been one of our best stocks this year. The company beat expectations in March and June, although the stock had a terrible month in May. This earnings report will be for their fiscal Q1. The company said that earnings should range between 51 and 55 cents per share, which is almost certainly too low. They earned 48 cents per share for last year’s Q1. Look for an earnings surprise. I’m raising my Buy Below price on Oracle to $35 per share.

That’s all for now. Don’t forget to check out the new “Buy Below” column on the Buy List page. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Morning News: September 14, 2012
Posted by Eddy Elfenbein on September 14th, 2012 at 6:35 am

Bernanke’s Battle for Jobs Eclipses Inflation Concerns

Asian Shares Rally On Fed Stimulus Measures

European Stocks Seen Sharply Higher on Fed Boost

Spain’s Aid Dilemma Takes Center Stage at Euro Crisis Meeting

Prices Surged for Producers in August

Gold At Six-Month High As Fed Fans Inflation Risk

Oil Climbs to Four-Month High on Fed Stimulus Plan

Fossil Fuel Industry Ads Dominate TV Campaign

Huawei: Australia Law Could Exclude China Firms

Home Depot to Shut Seven China Stores, Take $160 Million Charge

Facebook Outperforming Google in Ad Revenue From Browsing

Berkshire Posts 25% Intel Gain by Shunning Buy-and-Hold

A Bump in Path to Wall Street

Cullen Roche: A Disturbing Look Inside the Mind of Ben Bernanke

Joshua Brown: The New Rules

Be sure to follow me on Twitter.

Homebuilders Approve
Posted by Eddy Elfenbein on September 13th, 2012 at 1:23 pm

Here’s another way of looking at today’s news. Check out the action of the Homebuilder ETF ($XHB). You can tell that it approves of today’s Fed news.

Today’s Fed Statement
Posted by Eddy Elfenbein on September 13th, 2012 at 12:38 pm

I’ve doubted that the Fed was going to take on more quantitative easing but it appears they’re going to give it a try.

In short, the Fed is going to buy $40 billion per month of agency mortgage-backed securities. They’re also going to continue their policy of extending the maturity of their bond holdings (otherwise known as Operation Twist). This means selling short-term debt and buying long-term debt. Finally, the Fed is going to continue to reinvestment the dividends of their mortgage-backed securities into more mortgage-backed securities. Probably the biggest news is that the Fed now says that a highly accommodative stance is needed even after the economy shows signs of recovery.

Here’s today’s Fed statement.

Information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months.  Growth in employment has been slow, and the unemployment rate remains elevated.  Household spending has continued to advance, but growth in business fixed investment appears to have slowed.  The housing sector has shown some further signs of improvement, albeit from a depressed level.  Inflation has been subdued, although the prices of some key commodities have increased recently. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.  The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.  Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.  The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.  In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.  In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Jerome H. Powell; Sarah Bloom Raskin; Jeremy C. Stein; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen.  Voting against the action was Jeffrey M. Lacker, who opposed additional asset purchases and preferred to omit the description of the time period over which exceptionally low levels for the federal funds rate are likely to be warranted.

You’re Almost Always Exposed to Some Variable You Didn’t Realize
Posted by Eddy Elfenbein on September 12th, 2012 at 10:29 am

Blogger King Felix Salmon has a good post highlighting the relative performance of mutual funds. Or more accurately, the consistent underperformance of most actively managed mutual funds.

What I find interesting is that the relative performance of the actively managed funds is fairly strongly correlated with the relative performance of small-cap stocks. It’s not so much that active managers suddenly got dumb one year after being smart the year before. It’s more about sector rotation.

It’s not so much that active managers “decide” to be in small-caps. The aggregate of all mutual funds has to, by definition, show a small-cap bias. The reason is that actively managed funds need to be diversified, and, ideally for them, not correlated with the indexes.

What’s most fascinating is that the relative performance of active managers is related to small-cap relative performance even in asset classes outside of small-caps. What this probably means is that within any sector, let’s say large-cap, the active managers crowd into the small-caps of that sector. Hence the small-cap bias still lives.

We can add another twist that small-caps’ outperformance is somewhat correlated with the dollar since larger companies have greater foreign exposure. The lesson for investors is that you’re often exposed to some market or variable even when you think you’re not.

Consider the case of Long-Term Capital Management. In 1998, the hedge fund found out that when Russia defaulted on its debt, that impacted many of their trades. They had no idea they were so heavily exposed to such an event.

Barron’s: Medtronic Looks Cheap
Posted by Eddy Elfenbein on September 12th, 2012 at 12:44 am

Barron’s likes Buy List favorite Medtronic ($MDT):

In the 1990s, cutting-edge technology helped make Medtronic one of the market’s fastest growing big-cap medical-device makers.

But that was then. In recent years, Medtronic (ticker: MDT) has morphed into a slow-growing behemoth that has been hobbled by sluggish markets and safety concerns about some of its products.

The stock is currently trading 24% below where it sat five years ago.

But signs of a turnaround are evident as U.S. markets for implantable defibrillators and spinal devices are beginning to stabilize. Meanwhile, Medtronic’s effort to expand sales in emerging markets and launch new products can help it exceed tepid growth expectations.

The stock has gained 25% in the past year yet continues to trade at a cheap valuation. At roughly 11 times forward earnings, Medtronic could deliver 20% returns over the next year if Chief Executive Omar Ishrak can deliver on his promises regarding sales growth.

Add a 2.5% dividend yield, and “Medtronic is a cheap stock with an attractive dividend embarking on measures that can help move the stock price,” says BMO Capital Markets analyst Joanne Wuensch.

Founded in 1949, Medtronic makes devices that treat heart failure, fix damaged spines and monitor diabetes.

Revenue totaled $16 billion during the fiscal year that ended in April 2012, led by its cardiac-rhythm-management unit, which specializes in pacemakers and implantable defibrillators and generated roughly one-third of total sales.

But it’s been a tough time for Medtronic and the medical-device industry. Product prices are falling. A weak economy has hurt hospital admissions. Insurers are pushing back on expensive procedures.

And thanks to competition and government scrutiny of the stent and ICD markets, Medtronic’s former growth engine has run out of gas.

But chief financial officer Gary Ellis told investors Tuesday that Medtronic has reached an inflection point. Sales growth has begun to accelerate. And Ellis told investors at a Morgan Stanley conference that the headwinds facing its top markets “seem to be blowing away,” and allowing growth in other parts of the company to shine through.

Granted, Medtronic executives are playing things cautiously until they see signs that the device market will remain stable.

Last month, the company backed its previous guidance for the current fiscal year, which runs through April 2013, even though it had just reported sales growth for its latest quarter that exceeded its full-year target.

“Even though we were encouraged by [first-quarter results], we recognize that we need to deliver this kind of performance consistently over the long term,” Ishrak told investors during a conference call that same day.

Medtronic sees revenue growing between 2% and 4% this year and expects to earn between $3.62 a share and $3.70 a share, which suggests a 5% to 7% profit increase.

Right now, Medtronic’s biggest advantages remain its scale and the breadth of its portfolio, says T. Rowe Price analyst Mark Bussard.

The company also generates roughly $4 billion in free cash flow annually. And Ishrak plans to return half of it to shareholders through dividends and share repurchases.

Medtronic remains focused on improving profit margins with a goal to cut product costs by $1.2 billion in the next five years. And by then, emerging markets should make up 20% of sales, up from 10% today and new products will hit the market.

A new drug-coated stent called Resolute Integrity received approval from the Food and Drug Administration in February. U.S. sales should reach $384 million for the device, which has already captured 25% market share here and in Europe, according to some estimates.

A new heart valve that can be implanted without open-heart surgery should hit the U.S. market in 2014. And the following year could see the arrival of a novel treatment for uncontrolled hypertension called renal denervation.

By 2015, the Street sees Medtronic’s revenue exceeding $17.4 billion.

Of course, turnaround stories are risky. Investors want proof that Medtronic has turned a corner. So a dip in sales or any further volatility in big device markets will be severely punished by investors.

And a big ship like Medtronic doesn’t turn on a dime.

But for patient investors, Medtronic can deliver potent returns.

Help Wanted: Governor of the Bank of England
Posted by Eddy Elfenbein on September 11th, 2012 at 3:47 pm

Her majesty’s government is placing an ad in the Economist for the governor of the Bank of England. Here’s the ad:

HM TREASURY

Governor of the Bank of England

The position of Governor of the Bank of England will fall vacant when Sir Mervyn King retires in June 2013. The Governor leads the Bank of England, and plays an important role in setting monetary and regulatory policy, chairing the Monetary Policy Committee, the Financial Policy Committee and (from next year) the board of the Prudential Regulation Authority. The Governor represents the Bank in important international fora, such as the G7, G20, the European Systemic Risk Board and the Bank of International Settlements in Basel. The Governor is an executive member of the Bank’s Court of Directors.

The Governor will work closely with the Chancellor of the Exchequer and H M Treasury, which is responsible for setting the framework under which the Bank operates.

The new Governor will lead the Bank through major reforms to the regulatory system, including the transfer of new responsibilities that will see the Bank take the lead in safeguarding the stability of the UK financial system.

The successful candidate must demonstrate that they can successfully lead, influence and manage the change in the Bank’s responsibilities, inspiring confidence and credibility both within the Bank and throughout financial markets.

The successful candidate will have experience of working in, or with, a central bank or similar institution; or will have worked at the most senior level in a major bank or other financial institution. He or she will demonstrate strong leadership, management and policy skills; will have an advanced understanding of financial markets and good economic knowledge. He or she will be a strong communicator, have good interpersonal skills and will be a person of undisputed integrity and standing.

The closing date for all applications is 8:30 am on 8 October 2012.

Do they do this when they need a new monarch? I’m guessing that’s a no.

Bed Bath & Beyond Breaks $70
Posted by Eddy Elfenbein on September 11th, 2012 at 10:59 am

The stock market is creeping higher this morning after taking some losses yesterday. All eyes are on the Federal Reserve, which meets tomorrow and on Thursday. Ben Bernanke is also due to meet the press on Thursday after the meeting.

Wall Street almost universally expects more quantitative easing. I continue to be a skeptic. Perhaps the Fed will do something, but I doubt it will be much. In fact, I think Wall Street is setting itself up to be disappointed.

The good news is that our Buy List is doing well. I’m happy to see that Bed Bath & Beyond ($BBBY) has finally pierced $70 per share. The company is due to report earnings again on September 18th. I’m also pleased to see our financial stocks are doing well. Hudson City ($HCBK) is up to a new 52-week high, and JPMorgan Chase ($JPM) is close to breaking through $40 per share. Medtronic ($MDT) is also at a new 52-week high.

The College Bubble
Posted by Eddy Elfenbein on September 11th, 2012 at 10:26 am

In this week’s Newsweek, Megan McArdle asks, “Is college a lousy investment?”

She fears that the answer is “yes.”

In Academically Adrift, their recent study of undergraduate learning, Richard Arum and Josipa Roksa find that at least a third of students gain no measurable skills during their four years in college. For the remainder who do, the gains are usually minimal. For many students, college is less about providing an education than a credential—a certificate testifying that they are smart enough to get into college, conformist enough to go, and compliant enough to stay there for four years.

Here’s what I wrote three years ago.

Lately it’s been all the rage to complain about companies that are too big to fail. However, there’s another prominent American institution that’s also become too big to fail. It’s bloated, overstaffed and often fails to meet the most basic need of its customers.

Welcome to American higher education.

More Americans are wising up to the fact that college is a big fat waste of money. Sure, if you’re lucky enough, and smart enough, get into a big-name school, college is just fine. But for millions of other students, a four-year degree often puts them in a mountain of debt and doesn’t give them the skills they need in the job market.

First, let’s consider how long it takes many students to finish college. Even after six years, only 54% of college students even get a degree. For high-school students in the bottom 40% of their class and who go to a four-year college, an amazing two-thirds hadn’t earned a diploma after eight-and-a-half years. Sheesh, that’s worse than Bluto! I can’t think of another industry that has such a dismal record.

David Leonhardt recently wrote at the New York Times: “At its top levels, the American system of higher education may be the best in the world. Yet in terms of its core mission—turning teenagers into educated college graduates—much of the system is simply failing.” He’s exactly right.

Still, tuition costs continue to skyrocket. Between 1982 and 2007, tuition and fees rose 439% compared with just 147% for median family income. The trend shows no sign of stopping. One year at Yale now goes for $47,500. The University of Florida system wants to raise tuition by 15%, the maximum allowed.

Much like the housing bubble, the Higher Ed bubble is being driven by cheap, government supported credit. The problem is compounded by the fact that hugely important financial decisions are placed on the backs of 19-year-olds, many of whom simply don’t have the life experience to weigh the implications of a gigantic, 20-year debt load. Heck, at least the irresponsible mortgage borrowers during the crazy days were adults (even though many acted like infants).

One report shows that students from lower-income families need to pay 40% of their family income to enroll in a public four-year college. That’s a lot of coin to have some Marxist feminist theorist tell you about atavistic nature of late-stage capitalism. Please, you can watch the Oscars to learn that. Don’t think community colleges are a bargain, either. The average tuition is up to 49% of the poorest families’ median income from 40% in 1999-2000.

The pro-college crowd likes to repeat the claim that college grads earn $1 million more, on average, over their working lifetime. Sure, this is true, but college grads start out in a big hole. On average, they don’t even catch up to high school grads until age 33.

The debt load piled on students is scandalous. One in five students who graduated in the 1992–93 school with over $15,000 in debt defaulted on his or her loan within 10 years of graduation. We’re setting young people up for failure and ruin credit records. Thanks to the recession defaults are up 43% over the last two years. Many students go to grad school and pile on even more debt. The average law grad owes $100,000. Plus, many schools often use grad students as greatly underpaid professors in order to cut costs. Think of Lehman Brothers. Now imagine if they had a football team.

The loans fall especially hard on minorities since colleges love to boast their “diversity.” For African-American students, the overall default rate is more than one-third. That’s five times higher than white students and over nine times higher than Asian students.

What makes things even worse for many colleges is that the recent bear market put the squeeze on their endowments. Harvard’s endowment dropped by $11 billion and they announced they’re laying off 25% of their investment staff. Cornell’s endowment plunged 27% in the final six months of 2008. Yale lost $5.9 billion, or one-fourth its value. Lower endowments means…you guessed it, higher tuition.

School financing has exploded in recent years, doubling in just ten years. Total student debt now stands at over half a trillion dollars. The average borrow took out a loan worth $19,200. That’s a 58% jump since 1993.

Naturally, the government is set to make a bad situation worse. Last week, the House of Representatives voted to elbow Sallie Mae (SLM) out of the student loan biz and shift all student loans to a government-run, taxpayer financed system. So instead of government subsidized loans run through banks to students, we’ll now have a government monopoly. Hmmm…what could possibly go wrong?

I got a better idea. It’s a real simple government program. I call it, “Dude, you really shouldn’t be going to college.” Best of all, the program is very cheap. The costs are solely a postcard and my consulting fee. If don’t want to listen to me, fine, then listen to the folks at the ACT who say that only 23% of students have the skills to do well in college.

The good news is that Americans are catching on to the college scam. Admissions applications are dropping at elite school. Applications are off by 20% at Williams College. Middlebury saw a 12% decline and Swarthmore had a 10% drop. I believe this is just the beginning.

Crossing Wall Street Eleven Years Ago
Posted by Eddy Elfenbein on September 11th, 2012 at 10:19 am