CWS Market Review
August 26, 2016
“Reversion to the mean is the iron rule of financial markets.” – Jack Bogle
I’m enjoying a little time off in sunny Florida. Apparently, the rest of Wall Street is on vacation as well, as the stock market continues its lazy summer.
The market’s daily volatility ain’t just low, it barely registers a pulse. Since Brexit, the S&P 500 has now gone 42 straight sessions without a daily decline greater than 0.7%. Compare that with the first 42 days of this year, when it happened 15 times!
We also had a very nice earnings report this week from HEICO, our top-performing Buy List stock this year. The company raised guidance for the third time this year, although the shares pulled back on Thursday. I’m actually raising my Buy Below price for HEICO. I’ll have more details in a bit.
Wall Street is looking ahead of Janet Yellen’s speech in Jackson Hole. The speech will come later today. I’ll discuss what it means for us. But first, let’s look at what’s happening just beneath the surface of a very quiet stock market.
Wall Street Warms Up to More Risk
In last week’s issue, I discussed the “low quality rally.” I want to expand on that subject a little bit this week. Standard & Poor’s runs a “High Quality” index for the bluest of the blue chips in the S&P 500. There’s an ETF geared to this index, with the symbol SPHQ. I like to track how well the SPHQ is doing against the broader market. I think of this as a quick-and-easy way of reading the market’s mind, particularly the market’s willingness to take on risk.
High-quality stocks have led the stock market almost continuously since late 2009. But that outperformance really took off at the end of the last year, and continued into the first few weeks of this year. If you recall, 2016 started out as the worst year on record for stocks. (How times have changed!) By February 11, the market was down more than 10% for the year.
What happened is that everyone got scared and rushed, insanely, to own blue chips at the expense of nearly everything else. Since April, however, high quality has lagged the market. There are two things going on here. One is the unwinding of the fear trend that sent everyone rushing to own high quality. Secondly, for the first time in a long time, investors are willing to shoulder more risk. Investors need to understand that this is a key turning point for the market.
When the market becomes less afraid of risk, it starts out well, and usually ends very badly. Don’t worry. We don’t have anything to be afraid of on that score. Our Buy List stocks are very high quality. However, we may hit a frustrating patch of underperformance. Again, there’s no need to worry. To every thing there is a season—and that includes junky stocks.
What’s interesting is that we see this same trend being acted out in the junk bond market. When analyzing the market, it’s always important to see if we can spot a similar trend being played out in a different market. At the beginning of the year, everyone was freaking out as they rushed into high-quality stocks; they were also running away from junk bonds. No one wanted any part of anything that had the slightest scent of risk. Junk-bond spreads (meaning the extra yield compared with investment-grade bonds) soared.
The high-yield carnage was also driven by the dramatic plunge in oil prices. Remember that oil will flow as long as credit flows. But once oil gets below around $35 per barrel, lenders get very nervous and demand a greater premium for the honor of using their capital. The oil and junk-bond markets both hit their lows on February 11, along with the stock market. Since then, everything has reversed course. It’s no coincidence that high-quality started to lag a few weeks later.
Here’s the key point I want to convey: oil, stock, high-yield spreads and daily volatility are all interrelated. Many markets, but they all reflect one thing. When daily volatility is so low, there’s more pressure to take on more risk. That means lower junk-bond spreads and lagging performance for investments like SPHQ. When oil rises, lenders are more eager to fund new projects, so yield spreads tighten.
What does this all mean? As investors, we shouldn’t view risk appetite as a good or bad event. It’s more like the tides: it just happens. But I encourage you not to climb the risk ladder in search of better returns. Stick with sound stocks at a good price like you’ll find on our Buy List.
The World Await Yellen’s Speech in Jackson Hole
Fed Chairwoman Janet Yellen is scheduled to speak later today at the Fed’s Jackson Hole conference. The title of the speech is “The Federal Reserve’s Monetary Policy Toolkit.” This has Wall Street a bit nervous. In previous years the Fed has used the Jackson Hole to announce important policy changes. It’s expected that she’ll sound some hawkish notes, but if you’ve been paying careful attention, that’s pretty much where she’s been this year.
I think the Fed is leaning towards raising rates but they want more evidence that it’s safe to do so. Bill Dudley, the head of the New York Fed, said the central bank could raise rates as soon as next month. John Williams of the San Francisco Fed said he’d hike right now.
The fact is that the economy is improving. The Atlanta Fed GDPNow expects 3.4% growth for Q3. The unemployment rate is holding under 5% and wages are starting to improve. That’s roughly what full employment looks like. The futures market now expects a rate increase in December. Interestingly, they don’t see another rate hike for several months after that.
Still, the bond market seems pretty calm. The two-year yield is good to watch to gauge the bond market’s view of the Fed. The two-year yield has gradually climbed up to 0.79%. That’s up but remember that at the start of the year, the two-year had been yielding over 1%.
I think Janet Yellen will hint that more rate hikes are coming without saying anything concrete. My hunch is that she wants to convey that rates are going up while trying to reassure investors that the pain will be minimal. Now let’s look at our one Buy List earnings report from this week.
HEICO Earns 62 Cents per Share
On Wednesday, HEICO (HEI) reported fiscal Q3 earnings of 62 cents per share. That’s up 22% from last year’s Q3. HEICO isn’t widely followed enough to have a true earnings consensus, but I did see it reported as 59 cents per share. For the year so far, earnings have risen 18% to $1.64 per share.
Sales for the quarter rose 19.1% to $356.1 million. That’s a company record. Sales for the year so far are up 18% to $1,013.0 million.
Laurans A. Mendelson, HEICO’s Chairman and CEO, commented on the Company’s third-quarter results, stating, “Our record quarterly results in consolidated net sales, operating income and net income reflect the impact of our profitable fiscal 2016 and 2015 acquisitions, as well as organic growth within both the Flight Support Group and Electronic Technologies Group.
As we look ahead to the remainder of fiscal 2016, we anticipate organic growth within our commercial-aviation aftermarket replacement parts and specialty-products product lines moderated by softer demand for certain component repair and overhaul parts and services. Further, we foresee modest full-year organic growth within the Electronic Technologies Group based on current forecasted product demand. During the remainder of fiscal 2016, we plan to continue our focus on new product development, further market penetration, executing our acquisition strategies and maintaining our financial strength.
Based on our current economic visibility, we are increasing our estimated consolidated fiscal 2016 year-over-year growth in net income to 13% – 15%, up from our prior growth estimate of 12% – 14%. In addition, we continue to estimate consolidated fiscal 2016 year-over-year growth in net sales to approximate 15% – 17%, our consolidated operating margin to approximate 18.5% – 19.0%, depreciation and amortization expense of approximately $62 million, capital expenditures to approximate $32 million and cash flow from operations to approximate $220 million.”
This is the third time this year that HEICO has increased its earnings guidance. The company only provides guidance for net income, not earnings per share. Let’s do a little math.
Last year, HEICO earned $1.97 per share. That means an increase of 13% to 15% works out to a range of $2.23 to $2.27 per share. However, HEICO’s shares are 0.4% higher this year, so that will dilute that range by about one penny per share. Since the company has already made $1.64 per share so far this year, we can expect 58 to 62 cents per share for Q4. Wall Street’s consensus, such as it is for little HEICO, was for 64 cents per share. As a result, shares of HEICO lost about 3.4% on Thursday. This week, I’m raising my Buy Below on HEICO to $76 per share.
Buy List Updates
I wanted to pass along some updates on our Buy List stocks.
This week, I want to lower my Buy Below on Alliance Data Systems (ADS) to $220 per share. ADS has pulled back since it had a pretty good earnings report last month. I’m not worried about ADS.
In June, Bad Bath & Beyond (BBBY) said it was buying One Kings Lane. This was part of the company’s effort to beef up its online business. Since the deal was so small, BBBY didn’t have to disclose the price it paid, but we did know that at one time One Kings Lane was valued at $900 million. This week, Recode reported that BBBY paid less than $30 million for One Kings Lane. In other words, it was practically a steal compared to its peak value.
This week, Hormel Foods (HRL) was upgraded by Credit Suisse and Edward Jones. The Credit Suisse analyst raised his price target to $43 per share.
Shares of Express Scripts (ESRX) got dinged for 6% on Thursday. The concern is that Mylan’s plan to cut the cost of EpiPen could hurt their bottom line. Mylan has blamed the “middleman” for higher drug prices. That’s a charge ESRX has strongly denied.
That’s all for now. Next week is the last full trading week before Labor Day. I think we can expect volatility to increase once traders get back from the Hamptons. On Monday, the government will report on personal income and spending. On Thursday we’ll get the ISM and productivity reports. Then on Friday, we’ll get the August jobs report. 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!