CWS Market Review
September 16, 2016
“I don’t expect the consensus to be right. I’m just surprised by how wrong it has been.”
– Jim Bianco
The volatility gnomes have returned to Wall Street! As I suspected, they didn’t wait long after Labor Day to make their appearance. This was a long, boring, low-vol summer for the stock market. Each today’s trading turned into a snoozefest.
That all came to an end last Friday, when the S&P 500 dropped 2.45%. The horror! Of course, that’s really not a huge move, but it’s jarring compared with a summer market that barely registered a pulse. Friday also snapped a string of 43 straight days without a 1% move, either up or down. It also started a three-day run of moves greater than 1%.
Investors need to understand the volatility gnomes like to move in wolf packs: nothing, nothing, nothing—then suddenly, they’re everywhere. The cause for the recent uptick in volatility is next week’s Federal Reserve meeting. Or more accurately, what the market thinks the Fed is thinking ahead of the Fed’s meeting. The Fed, of course, is equally obsessed with what the market’s thinking.
In this week’s CWS Market Review, I’ll break it down for you. I’ll also cover the troubling news at Wells Fargo. The bank has been fined $185 million for illegal sales practices. It’s pretty ugly stuff. I’ll also preview the upcoming earnings report from Bed Bath & Beyond. But first, let’s look at the market’s newly found fondness for volatility.
What to Expect at Next Week’s Fed Meeting
Financial markets were exceedingly calm this summer. The only exception was the period immediately following the Brexit vote. But even then, the market quickly returned to its somnolence within a few days.
Next week, the Federal Reserve gets together again, and it’s one of their two-meetings. This includes a post-meeting press conference by Janet Yellen. The Fed members will also update their economic projections.
The difference from this meeting is that more Fed members have been vocal about the need to raise rates soon. Bear in mind that central bankers are bred not to say anything remotely interesting. So if they’re speaking this forthrightly, it’s wise to take notice.
Sure, it’s possible the Fed could raise rates next week, but I’m in the doubter camp. For one, the election is less than two months away. The Fed probably wants to avoid even the appearance of being partisan. Another reason why I think the Fed will stand pat is that we got dovish comments from Fed Governor Lael Brainard. She’s known to be skeptical on the need to raise interest rates, so folks were curious if she had changed her tune. She hadn’t.
Specifically, on Monday Governor Brainard said:
This asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation. I believe this approach has served us well in recent months, helping to support continued gains in employment and progress on inflation.
Geez. Even when they say something interesting, it’s still dull.
Still, these comments helped spark a strong rebound from Friday’s selloff. After her remarks, Goldman Sachs cut their odds of a rate hike from 40% to 25% (still too high, in my opinion) while raising the odds of a rate hike at the Fed’s December meeting from 30% to 40% (still too low, in my opinion). I think a rate in December is very much in play.
Jeffrey Gundlach, who is always interesting to listen to, said the Fed may want to surprise the world by hiking rates next week. Counterintuitively, Gundlach thinks that by doing this, the Fed could show they’re not swayed by politics or the market.
The Fed has certainly noticed that the economy is improving, but there are still weak spots out there. For example, on Thursday, we got a disappointing retail-sales report for August. The Census Bureau said that retail sales fell 0.3% last month. That was our first monthly decline since March. This report is disappointing, because the numbers relating to consumer spending had been pretty good. Retail sales for July were revised from “unchanged” to 0.1%.
Also on Thursday, we learned that industrial production dropped 0.4% last month. Economists had been expecting a drop of 0.3%. As with retail sales, this was unwelcome news because industrial production had been recovering from a pronounced drop for much of last year.
The futures market currently thinks there’s a 12% chance of a rate hike next week (take note of Jim Bianco’s words in this week’s epigraph). But for the December meeting, it’s 46.2%. The main reaction within the stock market regarding guesses as to what the Fed will do can be seen between financial stocks and higher-dividend stocks like REITs and Utilities. When the outlook is for higher interest rates, that’s good for the relative performance of financial stocks. But when the outlook is towards lower rates for longer, that helps stocks with higher dividends.
It’s interesting to note that Financial stocks (XLF) have lagged for the last four days. I also can’t ignore how strong the Tech sector (XLK) has been lately. Apple added $50 billion in market value in three days. The tech rally probably reflects the broader trend of investors being much friendly towards riskier assets.
Assuming there will be no rate increase next week, that will draw extra attention to the Fed’s wording in their policy statement. In the Fed’s economic projections, Fed members will likely pare back their estimate for GDP growth for this year. The numbers are coming in well below the Fed’s estimate.
The Fed’s meeting will be on Tuesday and Wednesday. You get expect to see the Fed’s policy statement followed by Janet Yellen’s press conference on Wednesday afternoon. Now let’s look at the big fine leveled against Wells Fargo.
The Mess at Wells Fargo
Last week, Wells Fargo (WFC) was fined $185 million for using illegal sales practices. It’s really ugly what the bank was doing. Their salespeople were opening phony accounts for services customers hadn’t agreed to. It was so widespread, they opened two million bogus accounts. They even transferred customers’ money to new accounts, which resulted in fees for insufficient funds in the original accounts. There were instances of them opening bogus e-mail accounts to get customers into online services.
It’s easy to blame this on a few unscrupulous sales agents, but these practices were widespread throughout the bank. It all came down to incentives. The salespeople were trying to hit their sales goals.
In response, Wells has fired 5,300 employees (for context, in June, headcount stood at 268,000). While the bank agreed to pay the fine, they haven’t admitted to any wrongdoing.
What I find most troubling about this scandal is that it seems to be one centered on improper oversight. How come no one in house put a stop this sooner? The salespeople were rigging, it appears, Wells Fargo’s system as much as they were abusing their customers. This had been going on for years!
Whenever there’s a major financial merger, you’ll often hear about the magic of cross-selling as if the sum of one and one can be made to be slightly greater than two. Unfortunately, it doesn’t work this way. For the most part, people don’t use their primary bank for their mortgage.
What does this all mean for us as investors in Wells Fargo? That’s tough to say. The shares have now fallen for five straight days, for a total loss of 7.5%. That hurts, but it’s far from dire. As part of Wells’ overall business, the fine is barely a scratch. Last year, Wells made a profit of $23 billion.
Still, it’s a black eye to a formerly respected institution. Wells can get through this, but it will take bold action. For example, CEO John Stumpf needs to go, and he needs to go now. The terrible headlines need to stop. For example, the former head of Wells’s consumer-banking division is walking away with $124 million in stock and options. That’s outrageous.
Wells needs to get ahead of the scandal. Fire some top people. Don’t be defensive. Show the public that you understand what went wrong. I’m not recommending anyone dump the shares. The shares currently yield 3.3%, which isn’t bad. Due to the scandal, however, this week I’m lowering my Buy Below price on Wells Fargo to $50 per share.
Earnings Preview for Bed Bath & Beyond
From mid-August to early October, we enter a long stretch where there are no Buy List earnings reports. The only exception is Bed Bath & Beyond (BBBY). The home-furnishing store is due to report its fiscal Q2 earnings on Wednesday, September 21.
BBBY has been a disappointing stock for us this year. The company badly missed earnings last quarter. Wall Street had been expecting 86 cents per share. Instead, Bad Bath earned 80 cents. What really struck me is that comparable-store sales fell by 0.5%. For now, the company is standing by its full-year profit range of $4.50 to $5 per share. Last year, they made $5.10 per share.
For Q2, Wall Street expects earnings of $1.17 per share. The one positive I’ll say about this stock is that its valuation is quite cheap. If BBBY hits the middle of its earnings range, the stock will still be going for about nine times earnings. That’s quite low.
That’s all for now. Next week’s news will be dominated by the Federal Reserve meeting. The Fed’s policy statement is due out at 2 p.m. on Wednesday. The Fed will also include updated economic projections from all 17 members, not just voting members. Additionally, Janet Yellen will give a press conference. Also on Wednesday, Bed Bath & Beyond will release its second-quarter earnings 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!