CWS Market Review

October 26, 2012

“The future will soon be a thing of the past.” – George Carlin

For the last few weeks, I’ve warned investors to invest defensively, believing that we’re headed for rough waters. Well, that’s exactly what has happened. Last Friday, the S&P 500 had its worst drop in four months, and it closed just below its 50-day moving average. As I pointed out last week, the S&P 500 almost perfectly formed a Triple Top—three success tops. That technical signal made the bears a lot more confident, and the selling continued into this week. The S&P 500’s loss on Tuesday was nearly as bad as Friday’s. Then on Wednesday, the market closed at a seven-week low.

Fortunately, our defensive posture has served us very well. Our Buy List has outperformed the S&P 500 for six of the last seven days. Best of all, we’ve regained the lead against the broader market, and we’re now on track towards beating the S&P 500 for the sixth year in a row.

In this week’s CWS Market Review, we’ll survey some of our recent earnings reports. I was very pleased to see that AFLAC (AFL) topped Wall Street’s consensus by an impressive 11 cents per share. Not only that, but the duck stock guided higher, and it raised its dividend for the 30th year in a row. You can see why I’m such a big fan.

I’ll also take a look at some of our upcoming earnings reports. I think Nicholas Financial (NICK) looks especially good going into its earnings report. I’ll also have a few words to say about Ford ($F). But first, let’s look at why the recent downturn for the market probably won’t last much longer.

Stocks Are Poised for a Rally—but Not Yet

While Wall Street suffered its worst setback in a few months, I think stocks are prepping themselves for a strong year-end rally. The skies, however, aren’t clear just yet. Once the election passes and the problems in Spain begin to fade, I think the S&P 500 will make a run at its five-year high.

One of the reasons for my optimism is the nature of the recent sell-off. Cyclical stocks normally fall the most when the market drops. This time around, they’ve fallen the least. In fact, the Morgan Stanley Cyclical Index (CYC) outperformed the S&P 500 for eight days in a row (they finally lost on Thursday). This suggests that the economy continues to improve, albeit in an unsteady manner.

Just this past week, we got a good report on orders for durable goods, plus jobless claims fell by 23,000 and new home sales rose to a two-year high. The Federal Reserve met this past week, and their policy statement noted that the economy continues “to expand at a moderate pace.” The Fed said that household spending is up and the housing sector is improving. This is all good news.

Wall Street continues to be focused on earnings, while I’ve been more concerned with guidance. The third-quarter earnings season has been mostly good, but there have been some notable weak spots. The earnings “beat rate” is running at 71%, which is decent, but the revenue miss rate is at 61%. This tells us that profit margins are still being stretched.

One of the most ignored stories on Wall Street this year is that volatility has plunged. In fact, this has been one of the biggest volatility fades on record. Earlier I mentioned how the market’s drop last Friday was the worst in four months. If that loss had happened last year, it would have been the 31st worst.

But now traders are getting nervous again. The Volatility Index (VIX) has rallied quite strongly over the last week. Options players have especially been crowding into higher volatility bets. The VIX actually flirted with “backwardation” a few days ago. I think some of this is due to uncertainty about the election. That’s understandable. But volatility can work on the upside as well. Investors want to see the uncertainty get cleared up. It almost doesn’t matter if the news is good or bad; they just want resolution.

The important thing for us is that the numbers are still in the stock market’s favor. Analysts have been trimming their earnings forecasts for Q4, but the Street still expects earnings growth for the S&P 500 of 12.1%. I wouldn’t be surprised if that’s soon in the upper single digits. For 2013, analysts expect earnings of $114.30 for the S&P 500. That would be an increase of 13% over 2012. The index currently trades at 12.36 times next year’s earnings, which is quite reasonable.

When traders get nervous, they move toward safety and quality. Before, investors were afraid of anything but the most secure assets. Now, however, the market is more open to higher-quality stock—which has been a boon for our Buy List. Now let’s look at some recent earnings reports.

AFLAC Is a Strong Buy up to $55

After the closing bell on Tuesday, AFLAC (AFL) reported third-quarter operating earnings of $1.77 per share. This was 11 cents above Wall Street’s forecast. Digging into the details, AFLAC’s bottom line was helped by some tax issues, but don’t let that fool you—AFLAC’s core business is doing very well.

I won’t go into the exhaustive details, but if you want to learn more, then check out this transcript from this week’s earnings call. The company explains how they’ve reduced their exposure to Europe.

For future guidance, AFLAC said it expects Q4 earnings to range between $1.46 and $1.51 per share. Since the company has made $5.12 per share over the first three quarters of 2012, this means that the full-year guidance is expected to range between $6.58 and $6.63 per share. That’s an increase from the previous full-year guidance of $6.45 to $6.52 per share.

As for next year, AFLAC expects earnings growth of 4% to 7%. Working off the higher base for 2012, this implies earnings of $6.84 to $7.09 per share for next year. Wall Street currently expects $6.88 per share, so I expect to see that rise.

AFLAC also announced a 6.1% increase to its quarterly dividend. This is the 30th year in a row that AFLAC has raised its payout. Not many companies can say that. The quarterly dividend will rise by two cents to 35 cents per share. This is basically what I said would happen two months ago, but the stock market was expecting more. The initial disappointment, combined with the broader market sell-off, probably caused the shares to pull back some. Don’t be fooled. AFLAC is a very strong company. I’m raising my Buy-Below price to $55 per share.

Earnings from CR Bard, Reynolds, Hudson City and CA Technologies

On Tuesday, CR Bard (BCR) reported third-quarter earnings of $1.64 per share, which was a penny ahead of expectations, although revenue came in slightly lower than expected. For Q4, Bard sees earnings ranging between $1.64 and $1.68. Frankly, that’s lower than I was expecting. I still like Bard, but for now, I‘m lowering my Buy-Below price to $102.

Reynolds American (RAI), our tobacco stock, reported third-quarter earnings of 79 cents per share, which matched Wall Street’s consensus. Quarterly revenue fell by 3.8% to $2.12 billion, which was $60 million below expectations.

The most important news is that Reynolds reiterated its full-year forecast of $2.91 to $3.01 per share. I’ve looked at the numbers, and they should have no trouble hitting that. If you’ve been waiting for a pullback with Reynolds, then this is a good opportunity. The shares are down about 10% since late August. The stock currently yields 5.71%, which is outstanding. Reynolds American is a good buy up to $45.

Hudson City (HCBK) reported earnings of 12 cents per share, which was two cents below expectations. No matter. M&T (MTB) is still going though with the merger. Also, Hudson City confirmed that it’s paying out another quarterly dividend of 8 cents per share. HCBK remains a good buy up to $9 per share.

After the closing bell on Thursday, CA Technologies (CA), the IT management software firm, reported quarterly earnings of 59 cents per share which was inline with Wall Street’s forecast. Frankly, this was a rough quarter for CA; revenues fell 4.0% to $1.152 billion which was just shy of estimates. The company also lowered guidance for the second time this year. CA’s fiscal year ends in March. In May, they gave full-year guidance of $2.45 to $2.53 per share Then it July, they lowered it to $2.45 to $2.50 per share. Now CA sees full-year earnings ranging between $2.36 and $2.44 per share. The stock dropped 5% after hours on Thursday. Fortunately, the company still pays a generous dividend but I’m lowering my Buy-Below price to $27.

More Earnings Coming Next Week

We’re heading in the home stretch of earnings season. Next week, Harris ($HRS) reports earnings on Monday, October 29th. Then on Tuesday, Ford (F), Fiserv ($FISV) and Nicholas Financial (NICK) are due to report. Wright Express ($WXS) will report its earnings on Wednesday, October 31st. If you own Wright Express, or are just a fan, please note that the company has officially changed its name to WEX Inc.

I’m particularly looking forward to the earnings report from Ford (F). The company made news this week when it said its losses in Europe were worse than they had thought and that the company is closing plants there. Basically, Ford is doing in Europe now exactly what they did in the United States a few years ago. This belt-tightening strategy is painful, but it helped Ford survive the recession. Overall, Ford said it’s reducing capacity in Europe by 18%. Wall Street expects Ford to post earnings of 30 cents per share on Tuesday. Look for an earnings beat. Ford is a very good buy up to $12.

Nicholas Financial (NICK) has pulled back recently, and the shares now yield 3.55%. I’m expecting another good earnings report soon (say, 42 to 45 cents per share). NICK continues to be very cheap by any reasonable valuation metric. Wall Street has mostly ignored NICK, which is fine by me. I think investors assume that a used-car loan company must be a risky operation. Not at all. In fact, the quality of NICK’s loan portfolio has improved dramatically, and the outlook for low short-term interest rates is very good for them. NICK is a strong buy up to $15.

That’s all for now. Next week is another big week for earnings. On Friday, we’ll get the important jobs report for October. 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


Named by CNN/Money as the best buy-and-hold blogger, Eddy Elfenbein is the editor of Crossing Wall Street. His free Buy List has beaten the S&P 500 for the last five years in a row. This email was sent by Eddy Elfenbein through Crossing Wall Street.

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