CWS Market Review
June 16, 2017
“If you’ve followed my forecasts, you’ve probably lost a lot of money.”
– St. Louis Fed President James Bullard
Well…it happened. As expected, the Federal Reserve raised interest rates again this week. I don’t like it, but we can’t always choose the ideal environment to invest in. If you wait for things to be perfect, then you’d never be in the market.
This was an important meeting for the Fed because they also explained what they intend to do with their enormous balance sheet. This has been a big concern on Wall Street. I’ll explain what it all means. Additionally, the central bankers updated their economic projections. I should explain that the Fed has a pretty dismal track record of predicting where things will go, but it’s still useful to look at their outlook for the economy.
Fortunately, the stock market continues to hold up well. The S&P 500 closed at another all-time high on Tuesday. However, there’s been a significant weak link in the market recently, and that’s big-cap tech stocks. Don’t feel too bad for these guys. They’ve been running up the score lately, so I can’t say it’s not wholly surprising to see them face a little pain. Outside of Microsoft, this recent trend hasn’t had a big impact on our Buy List. In fact, our Buy List has been doing quite well of late. Before I get to all that, let’s look at what the Fed did this week.
The Federal Reserve Raises Interest Rates
On Wednesday afternoon, the Federal Reserve released its latest policy statement. The central bank said they raised their range for the Fed funds rate to between 1% and 1.25%. That’s an increase of 0.25%. This was the second rate hike this year, and the fourth of this cycle.
As I’ve said before, I think this move is a mistake, and I won’t belabor the arguments against the increase. It happened, and we have to move on. I’ll note that there was one dissenting voice, Neel Kashkari of the Minneapolis Fed, who agrees with me.
On Wednesday morning, just hours before the Fed’s statement, the government released the inflation report for May. The report again showed that there’s absolutely no threat of inflation on the horizon. If anything, the rate of inflation has fallen off sharply over the last three months. It’s hard to justify rate increases to fight off an inflation threat that doesn’t exist.
During May, the headline rate of inflation fell by 0.1%. Economists had been expecting no change. Some of that was due to falling prices for gasoline. That’s why we also want to look at the “core rate,” which excludes volatile food and energy prices. But the core rate for May only rose by 0.1%. There’s simply not much inflation out there.
You may recall that March was the weakest month for core inflation in over 30 years. As with all stats, we don’t want to be fooled by one-point trends. There are always outliers, so we want to see more evidence. Indeed, that evidence came in the last two months. Core inflation for April and May were the second- and third-weakest of the last three years, trailing only March. So it’s not only that inflation is low: it’s actually going lower.
More troubling is that we’ve seen a swift reaction in the bond market. On Tuesday, the yield on the 10-year Treasury dropped to 2.1%. That’s the lowest point all year. After the election last year, Treasury yields soared on economic optimism, but that’s largely faded in recent weeks. The spread between the two-year and ten-year Treasuries is now less than 80 basis points.
In the Fed’s policy, they acknowledge the recent weakness in the economy, but they seem to feel that it will soon pass. I hope they’re right, but I just don’t see the evidence just yet. In fact, this week’s retail-sales report was another dud. Economists had been expecting a gain of 0.1%. Instead, retail sales fell 0.3% in May. This was the biggest drop in 16 months.
But the Fed thinks they’ve only started raising rates. According to the latest Fed projections, they expect to raise rates one more time this year. After that, the outlook becomes a lot less clear (the blue dots get much more dispersed). The Fed sees three more hikes in 2018, and possibly three more in 2019. That means it’s possible that the 2/10 spread could be negative as early as next year. Still, I don’t want to be too alarmist. By the Fed’s own projections, they see real interest rates staying negative for another 18 months. My point is that we’re not in the danger zone just yet, but we can see it on the horizon.
The Fed also unveiled its plans for what they intend to do with their $4.2 trillion balance sheet, or as the Fed calls it, their “normalization plans.” The Fed said they plan to stop reinvesting the proceeds of their bonds in gradually increasing increments. It will be a long, long time before the balance sheet gets back to normal. But the key point is that the Fed intends to raise rates at the same time they address their balance sheet. That point wasn’t always so clear.
The Great Tech Stock “Crash” of 2017
What’s happening with tech stocks? The tech sector has fallen four times in the last five sessions, and some of those drops have been pretty sharp. The stock market had been so placid for so long that a fairly minor bump in the road for large-cap tech stocks has rattled a lot of investors.
Let’s add some context here: tech stocks had been leading an already powerful rally. In fact, the rally hasn’t even affected the whole sector. A huge part of the gains have fallen on just five major stocks; Facebook, Apple, Amazon, Microsoft and Google. That’s right: the latest acronym hitting Wall Street is FAAMG.
At one point, Facebook, Amazon and Apple were all up over 30% for the year. That was more than three times the rest of the market. Not anymore! In the last week, the Tech Sector ETF (XLK) has dropped from $57.44 to $55.57.
I want to stress that the damage we’re seeing in tech is hardly unprecedented. What’s been unusual is the exceedingly low volatility visible until now. It’s the change from very, very low volatility to normal behavior that’s jarred Wall Street. Frankly, the current losses are very normal.
Our Buy List has largely side-stepped the FAAMG phenomenon, with the exception of Microsoft (MSFT). Shares of MSFT just pulled back below our $70 Buy Below price. Again, that’s following an impressive run-up. Of all the FAAMG stocks, Microsoft is the one I’m least worried about. The last few earnings reports have been quite good. Also, I’m expecting another dividend hike in September. For now, I’m not worried about Microsoft, but I think we’ll see more losses in the tech sector for a few more weeks. Now let’s look at some of our Buy List stocks.
Buy List Updates
There hasn’t been a lot of news impacting our Buy List stocks this week. The good news is that our performance versus the rest of the market continues to be strong.
This week, I want to make a few adjustments to some of our Buy Below prices. As always, please bear in mind that these are not price targets. Instead, they’re guidance for current entry into a stock.
First up is AFLAC (AFL). I’m lifting my Buy Below on the duck stock to $80 per share. AFL has gapped up recently. Paul Amos, the current president and CEO’s son, said he’ll be leaving the company. That probably takes him out of the running to be the next CEO.
I’m also raising our Buy Below on Fiserv (FISV) to $131 per share. This stock is as strong and steady as it’s ever been. I’m looking forward to another good earnings report next month.
I’m dropping my Buy Below on Ross Stores (ROST) to $66 per share. I still like Ross a lot, but the stock has been caught up in a poor environment for retail. I’m not worried about Ross. This will be a real bargain if you can get Ross below $60 per share.
Finally, I’m lowering my Buy Below on Snap-on (SNA) to $168 per share. This is another good stock caught in a downtrend.
That’s all for now. There’s not much in the way of economic news next week. On Wednesday, we’ll get the existing-home sales report for May. Then on Friday will be the new-home sales report. For now, the housing sector is a bright spot in the economy, while consumer spending looks tired. We’ll see how long this can last. Be sure to keep checkingthe blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!