CWS Market Review
July 8, 2016
“I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy.” – Warren Buffett
Eighty-four years ago today, the Dow Jones Industrials bottomed out at 41.22. That was an astounding 89% below its high from four years before. That was dark time for the world. Financial markets had collapsed and many people in Europe thought a solution lay in Totalitarianism.
Fortunately in America, investor confidence returned and stock prices rose. Over the next 84 years, the Dow gained more than 43,300%, and that doesn’t include dividends. That tremendous gain happened despite recessions, panics, corrections, wars, downturns, disco, bubbles and crashes. Every single time, the market has bounced back.
Welcome to the Post-Brexit World
That’s a comforting thought to remind ourselves as markets continue to adjust to the post-Brexit world. Just this week, the 10-year U.S. Treasury yield plunged to an all-time low of 1.36%. As crazy as that sounds, it’s still a lot better than the yields you see in Europe because, at least, it’s a positive number. In Switzerland, the entire yield curve—all of it, from zero to 50 years out—is negative! Around the globe, more than $10 trillion in government bonds have a negative yield.
At one point on Thursday, the S&P 500 got over 2,109. That’s nearly 6% above the post-Brexit low from seven trading before. The Volatility Index (^VIX), which is often called the Fear Index, has nearly fallen in half since its immediate post-Brexit peak. In Britain, the pound continues to fall. The currency is hanging at a three-decade low against the U.S. dollar.
Now Europe faces another crisis as the Italian banking sector is in free fall. The banks there are stuffed to the gills with deadbeat loans. The beautifully named, Banca Monte dei Paschi di Siena, which is the oldest existing bank in the world, is in dire condition. The authorities have banned short sales of Monte dei Paschi for three months. Think about this: The bank was founded twenty years before Columbus set sail, and it can no longer stand on its own. Of course it would look especially bad for the ECB if they couldn’t stop a crisis in Italy right after British voters said they wanted no part of the EU.
So when are rate hikes coming? That’s a good question. The futures market doesn’t see a rate hike coming from the Fed until March 2018, and that’s actually early compared with everyone else. Traders don’t expect the Eurozone to hike rates for another four years, and they don’t see the Bank of England moving until January 2022. It’s a no-rate world.
Last month, the Federal Reserve decided unanimously to forgo raising interest rates. That was the right call. Interestingly, it was their first unanimous vote all year. The decision against raising rates wasn’t much of a surprise. But what caught people’s attention is that the Fed cited the pending Brexit vote as a reason to be cautious about the state of the economy. Now that we’re past Brexit those comments make the central appear prescient, which doesn’t happen too often.
Personally, I think that’s all bogus. Here’s what really happened. The Fed got way ahead of itself in its interest rate projections. At one point, they thought they were going to hike rates four times this year plus another four times next year. The market never bought that line. But instead of admitting they had it wrong, the Fed went looking for outside events (China, Brexit) that could be blamed increased uncertainty. It’s a disingenuous excuse to change an untenable policy.
This week, the Fed released the minutes from their June meeting and it showed that members clearly uncomfortable with the idea of hiking rates. The Fed meets again at the end of this month, and there’s no way they’ll touch rates.
With the Fed on hold, the bond market has been as pleased as ever. Ten-year TIPs (inflation-protected bonds) again have negative yields. In the mortgage market, 30-year fixed-rate mortgage now average 3.41%. That’s close to a post-World War II low. Fifteen-year mortgages are averaging less than 3%. Not surprisingly, this has led to a refinancing boom, as borrowers look to save on their monthly mortgage bill. It’s odd to think that a referendum vote in the U.K. could have a large impact on the U.S. mortgage market, but that’s the reality of the interconnected world we live in.
What’s Working? The STUB Trade!
At the end of this month, we’ll get our first look at how well the economy did during the second quarter. The estimate from the Atlanta Fed is for growth of 2.4%, but the details are pretty good. The number crunchers at the Fed project that consumer spending rose by 4.3% last quarter. That’s encouraging.
The jobs market continues to look decent, although I’d like to see better numbers for wage growth. This week’s ISM Services report was pretty good. I’m writing this to you on Friday morning before the big June jobs report comes out. The report for May was pretty ugly and that was a catalyst for the bond market’s recent run. In fact, that helped start Wall Street’s latest love affair, the STUB Trade.
What’s the STUB Trade? That’s the sudden rally in Staples, Telecom, Utilities and Bonds. In fact, we can mark the precise beginning of the STUB rally to April 21. Since then, the S&P 500 is up less than 3%, but the Staples ETF (XLP) is up 6.5%. The Telecom ETF (IYZ) is up 6.5%, and the Utes ETF (XLU) and the Long-Bond Treasury ETF (TLT) are both up nearly 11%. Boring has suddenly become interesting!
It’s an unusual market where the hottest stocks around are things like Campbell Soup (CPB), Pepsi(PEP), Kellogg (K) and Colgate Palmolive (CL), but that’s what we’re seeing. Verizon is the top-performing Dow stock this year. Of S&P 500 stocks with market caps over $120 billion, meaning the really big boys, the two best performers YTD are Verizon (VZ) and AT&T (T).
The reason the STUBs are doing so well is that investors want to lock in those generous yields. It’s the same thing driving the refining boom. There’s even talk that the yield on the 10-year Treasury could fall below 1%. If the Fed isn’t going to raise rates, and has no plans to raise rates, anything that pays a decent yield is going to become a lot more popular.
What’s interesting about the fall in bond yields is that it seems to be largely driven by a fall in the term premium. Let me explain. The term premium is the extra payment you get when you offer to lend your money for a longer period of time. In plainer terms, that’s why long-term mortgages have higher rates. The lender is rewarded for renting out their money for more time.
What’s been happening is that the term premium has plunged, and that seems to account for the most of the move in bond yields. The wrinkle about the term premium is that it’s not connected to the economy. Instead, it’s driven by investor demand. That makes sense. If you’re a European investor, you might be understandably unpleased with your yield options in the Old World, and you’re more than happy to ship your money off to New York City.
The Wall Street Journal reports, “according to the New York Fed’s model, the term premium on the 10-year Treasury has fallen from 0.07 percentage points to a record low of negative 0.71 percentage points.” The Journal also notes that changes in European bonds are tracking the term premium more than Treasuries themselves. That’s a clear signal that our government debt is benefiting from a worldwide flight to safety.
On our Buy List, the STUB Trade is helping stocks like Stryker (SYK), Fiserv (FISV) and CR Bard (BCR). While these aren’t officially in any STUB group, these stocks tend to be highly correlated with them. Stryker is now a 30% winner for us this year.
As we get closer to earnings season, I want to highlight a few Buy List stocks that look especially good right now. With its high yield and low price, I have to mention Ford Motor (F). The automaker currently yields 4.7%. Their last earnings report crushed Wall Street’s forecast by more than 40%. I’ll again point investors toward Signature Bank (SBNY). The shares have gotten roughed up lately, but it’s a solid firm. I’m looking forward to another strong earnings report.
Wells Fargo Earnings Preview
Second-quarter earnings season kicks off next week. This is when investors finally get a chance to see how well their companies did during the second three months of the year. As usual, expectations have been pared back as we’ve gotten closer to earnings season.
Next Friday, July 15, our first Buy List stock, Wells Fargo (WFC), is due to report earnings. You can skip any suspense because the big bank rarely surprises us. The last 12 earnings reports have all been between 98 cents and $1.05 per share. Remember, there are a lot of highly paid analysts whose job it is to forecast WFC’s earnings, when all you need to do is say $1 per share every quarter, and you know you’ll be pretty close.
For Q2, Wall Street’s consensus is for $1.01 per share. That sounds about right. Wells just passed the Fed’s latest “stress test,” which means that if the world’s financial system goes kablooey again, Wells will make it out alive. Between you and me, I think these tests are a giant waste of time. The trouble isn’t the demons you’re aware of. What’s truly scary is the monsters you’re not even aware existed. The stress tests do show us what we’ve known, Wells is a well-run outfit.
With the stock being down this year, it’s also no surprise that Warren Buffett said he wants the Fed’s permission to buy even more shares. Wells is already Buffett’s second-largest position. Due to share buybacks, Buffett’s personal position combined with Berkshire’s share, put the total holding over 10% ownership of Wells. Buffett has said that Wells is the single investment he would feel safest to place his entire net worth in for the next ten years. Charlie Munger, Buffett’s alter ego, said that Wells is the standard by which they judge all other investments. That’s how highly they think of WFC.
With rates so low, this is a challenging environment for many banks. You’ll notice that every news cycle which indicates the Fed will hold off on raising rates, is usually matched with banks lagging the indexes. Even though Wells will report roughly the sane EPS as last year’s Q2, other big banks will probably post declines around 20%, possibly more. I should add that Wells has met or beaten Wall Street’s earnings estimate for 21 quarters in a row.
Wells is currently going for a decent price. It’s trading at less than 11.5 times this year’s earnings. It may take some patience, but Wells is a solid investment.
That’s all for now. Second-quarter earnings season kicks off next week. We’ll also get some key economic reports. The Fed’s Beige Book report comes out on Wednesday. That usually has a good summary of the economy broken down by region. On Friday, we’ll get the latest CPI report as well as reports on retail sales and industrial production. The economy appears to be improving from its weak performance in Q1. 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!