CWS Market Review
June 17, 2016
“He that can have patience can have what he will.” – Benjamin Franklin
At the end of this month, the U.S. economic recovery will turn seven years old. (They grow up so fast!) Almost constantly for seven years, we’ve heard folks wonder, When will interest rates finally return to normal?
Yet, every single prediction for higher rates has been wrong. All of them—and there have been many. At some point, you have to draw the line and say that seven years is long enough. What we have now is normal. It’s the new normal.
This week, the Federal Reserve once again decided against raising interest rates. That was hardly a surprise. There’s now a reasonable chance the central bank may go all year without touching interest rates. We’ve seen a big disconnect between what the Fed’s been saying and what the Fed’s been doing. Hawkish talk and dovish walk.
In this week’s CWS Market Review, we’ll take a closer look at the Fed’s plans for 2016, and what they mean for investors. We also had some exciting news for our Buy List. Microsoft announced that it’s buying LinkedIn for $26.2 billion. We also have an upcoming earnings report from Bed Bath & Beyond. The home-furnishings stock has gotten beaten up, and I think it’s a good value here. But first, let’s look at what the Fed didn’t do and why they didn’t do it.
Welcome to the New Normal
If you look at the Fed’s projections from three years ago, they predicted that interest rates would be a lot higher by 2016. Yet here we are, and interest rates are still just above 0%. As low as they are here, rates are even lower in Europe. The 10-year bond in Germany is negative. This week, the Swiss Central Bank decided to leave rates unchanged at, hold on, -0.75%! Germany has negative interest rates out to ten year. Japan’s are negative out to 15 years and Switzerland’s are out to 30 years!
The Federal Reserve met on Tuesday and Wednesday of this week. On Wednesday afternoon, they released their latest policy statement, which said they’re keeping interest rates unchanged. Earlier this year, Janet Yellen and other Fed members have expressed their belief that rates need to go higher at some point. They’ve always left wriggle room, saying that they’re going to be “data dependent” and such. But whenever the time has come to strike, the Fed always seems to pass. They’ve only hiked once, and that was in December.
Two weeks ago, we got the May jobs report, and it was a bust. That convinced me, and a lot of folks besides, that the Fed wasn’t about to raise rates. The good news for the economy is that the unemployment rate is down, but there are still large gaps. Wage growth, for example, has been pretty weak. Business investment isn’t terribly strong. The economy probably did better in Q2 than it did during Q1, but it’s hard to make an argument that the economy is overheating.
Just look at inflation. This week, we got the latest CPI, and it showed that inflation is still well contained. Consumer prices rose by just 0.2% last month, which was below what economists had forecast. The core rate, which ignores food and energy prices, also rose by 0.2%. Inflation is hardly a problem.
Now comes the interesting part. In addition to the Fed’s policy statement, the Fed members also updated their economic projections. I should add that the Fed has a pretty lousy track record, but it’s interesting to see what they’re thinking.
There are 17 members who provide forecasts. Of that, six see the Fed raising interests just once this year, while nine members see two rate hikes. Not that long ago, the Fed was expecting four rate hikes this year, plus another four next year. How times have changed. With every meeting, it seems, the Fed gradually cedes more ground to reality. As I said, hawkish talk and dovish walk.
What struck me is that the Fed sees the real Fed Funds rate, meaning adjusting for inflation, as being negative through 2017. That means real rates are expected to be negative for another 18 months. At least!
The 10-Year Treasury Yield Plunges
The bond market responded by going absolutely bonkers. The yield on the 10-year Treasury got as low at 1.52%. That’s astounding. Think of what the market is saying here. You can loan your money to Uncle Same for a decade, and in that time, you’ll make a total return of 15%. That’s pathetic.
The 10-year bond yield reached its multi-decade low four years ago, when it touched 1.39%. At the time, I wondered if that marked the end of a 30-year bull market for bonds. By late 2013, the yield soared all the way up to crazy, insane, nosebleed levels. By that, I mean 3%. (Three whole percent!)
Here’s an interesting tidbit: The 10-year yield touched its generational low the same day Mario Draghi made his famous proclamation that he’ll do whatever it takes to preserve the euro—“believe me, it will be enough.” Four years later, there’s a couple trillion dollars’ worth of negative- yielding bonds floating around, and Draghi is now buying corporate bonds.
Let’s break down some math. The 10-year TIPs (inflation-protected bonds) yield a miniscule 0.15%. The regular 10-year yield closed Thursday at 1.564%. Compare that to the S&P 500, which has an indicated dividend yield of 2.18%, and that’s for the whole index. Remember that 85 stocks (or 17%) in the S&P 500 don’t even pay a dividend. Yet the financial markets are offering 60 basis points extra to take on stocks compared with bonds, and that ignores the big fact that stocks can raise their dividends. It’s right there in the name; fixed income is fixed.
The bottom line is that the market is asking you—begging you—to ignore bonds and lock in blue-chip stocks for the long term. There’s simply nowhere else to go.
I want to reiterate another point I’ve made a few times, and that the market has shifted toward cyclical stocks. That means stocks like transports, industrial, chemicals and energy. Unfortunately, our Buy List is underweighted in those sectors, so we haven’t ridden the recent rally as much as I would have liked.
For the time being, we should expect interest rates to stay near 0%. This is the new normal. I’m not expecting things to go back to where they were. The larger question, and one that I’m not equipped to answer, is, Have we reached the limit of what monetary policy can do for the economy? The Fed is powerful, but there are things even beyond their control. Perhaps the U.S. economy needs deep structural changes that can be addressed with free money. Until then, we should need Mr. Franklin’s advice and be patient.
Microsoft Buys LinkedIn for $26.2 Billion
Microsoft (MSFT) shocked us this week by announcing that it’s buying LinkedIn (LNKD), the resume folks, for $26.2 billion. That works out to $196 per share for LNKD, which is a 50% premium. That sounds like a lot, but it’s still well below LinkedIn’s peak price of $276 per share.
This is a bold move for Microsoft. It’s their largest deal ever. The software giant actually had the chance to buy LinkedIn more than 10 years ago for $250 million. Critics point out that this is an expensive buy, and I have to agree, but I’m leaning towards liking this deal. Microsoft has been rightly criticized for a string of lousy deals, but those were done by Steve Ballmer, the former CEO. Satya Nadella, the current CEO, seems to have a more cautious approach.
The deal will have almost no impact on Microsoft’s earnings this year or next. After that, it should start giving a boost to MSFT’s bottom line. Microsoft said they intend to finance the deal with debt. Moody’s said that they’re going to review Microsoft’s AAA-rating. My response: Who cares if they lose their AAA rating? They’re sitting on $117 billion in cash and liquid assets (much of that is outside the U.S.)
This ties in to what I said earlier about bonds. I imagine there are lots of European investors who are getting nothing on their bonds that would love to load up on some newly minted Microsoft bonds. Mr. Nadella can do them the favor of borrowing their money on the cheap. Microsoft still has its gigantic $40 billion share-repurchase authorization that it’s planning to wrap up by the end of this year. In other words, Microsoft has no problems with cash flow.
Shares of Microsoft dropped to $49 after the deal was announced, but have since rallied back to $50.39. I’m going to give Nadella the benefit of the doubt here. Look for a good earnings report from Microsoft on July 19. The shares currently yield 2.86%.
Bed Bath & Beyond Earnings Preview
We’re in one of the quiet stretches for our Buy List earnings reports. There’s only one earnings report due for the month of June, which is Bed Bath & Beyond (BBBY). The company is scheduled to report its fiscal Q1 earnings on Wednesday, June 22.
Shares of BBBY have been very unpopular lately, and I think the selling is overdone. The last earnings report wasn’t so bad. Earnings came in near the top of expectations. Same-store sales adjusted for currency grew by 2.1%. That’s not bad at all.
A big problem for Bed Bath is that their margins are getting squeezed. That’s a tough headwind for any business. The company made $5.10 per share last year. They said they expect earnings to be near the high end of their range of $4.50 to $5 per share. That means the stock is going for less than 10 times this year’s earnings.
Wall Street expects Q1 earnings of 86 cents per share, which is down from the 93 cents per share they made in last year’s Q1. Bed Bath also recently initiated a quarterly dividend of 12.5 cents per share. They also love to buy back enormous amounts of their own stock.
For all the talk of Bed Bath being stuffy and insular (which is fair), they struck back this week by announcing the purchase of One Kings Lane, an online retailer. One Kings Lane had been valued at nearly $1 billion. For a time, it was one of the hottest businesses around. They raised a ton of VC money, but weren’t able to get into the big leagues. Now Bed Bath has stepped in with an undisclosed offer. By all measures, BBBY is a cheap stock.
That’s all for now. We’re nearing the end of the first half of 2016. Next week, we’ll get reports on new and existing home sales, plus orders for durable goods. But the big event for world finance will be the Brexit vote on June 23, when Britain decides if it wants to remain in the EU. Polls show that it’s very close. 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!