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.” A short-hand for early cyclicals is 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 yield. This is a good clue of where 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 yield. 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 literally was no spread at all.
This year has been a different story. The spread between six-month and one-year Treasury 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 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 to 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, has been more optimistic.
This week, we learned 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 ricked 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 hadn’t 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 out 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, they do well when rails so 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 they’re 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!