CWS Market Review – October 7, 2016

CWS Market Review

October 7, 2016

“You can get in way more trouble with a good idea than a bad idea,
because you forget that the good idea has limits.” ― Ben Graham

This week will go down as the week when the interest-rate doves finally surrendered. It’s now clear to anyone paying attention that the Federal Reserve is going ahead with a rate increase in December.

In this issue of CWS Market Review, I’ll tell you why it’s happening and what it means for the market and our portfolios. We also have Q3 earnings season starting next week. Next Friday, Wells Fargo, the naughty boy of the banking industry, will be our first Buy List stock to report. I’ll tell you what to expect.

Also in this issue, I’ll cover the recent drop on the part of Cognizant Technology Solutions (preview: don’t fret about it). I’ll also run down some of the other news impacting our Buy List stocks. But first, let’s look at why Wall Street is now convinced the Fed will soon strike.

Oh, It’s On! Expect a December Rate Hike from the Fed

The first week of every month is an exciting time for all econo-stat nerds. This is when we get several economic reports, and the thrills end on Friday, when the government releases the all-important jobs report for the previous month.

What I’m calling the jobs report is actually a few different reports, but the key stats are Non-Farm Payrolls (or NFP, as the cool kids say), the Unemployment Rate, the Workforce Participation Rate and Average Hourly Earnings. The September report will be coming out later today.

Goldman Sachs says they expect to see an increase of 190,000 jobs and the unemployment rate drop to 4.8%. That sounds about right. But unless the report is absolutely dire, I strongly doubt it will deter the Fed’s plans for raising rates in December. Earlier this year, the Fed had been looking for any excuse to keep rates unchanged. (Brexit! China!) After the last meeting, it became clear that they’ve now locked in a course of hiking rates.

The Fed is serious. There were three dissents at the last meeting, and those no-votes wanted interest rates to go up immediately. There’s clearly a growing chorus of rate-hikers inside the FOMC, and the news this week has aided their cause.

In the Fed’s eyes, the key to today’s jobs report will be average hourly earnings. That number has been slowly creeping higher (finally). The equation is simple: More income means more buying. That means higher prices and more profits. It’s interesting to see how well oil has been doing lately. Oil just closed above $50 per barrel for the first time since June. Since the February low, the 36 energy stocks in the S&P 500 have added over $310 billion in market value.

Let’s take a step back and look at the news we got this week. On the first business day of each month, we get the ISM Manufacturing report. To be technical, this is called a “diffusion index.” That’s a fancy way of saying that any number above 50 is good, and below 50 is bad.

We got a bit of a surprise this week when the ISM number for September came in at 51.5. That was a very nice rebound from 49.4 for August. Wall Street had been expecting 50.4. This signals that the factory sector is gaining strength. This is important because manufacturing had been hurt for several months thanks to lower energy prices. This report is almost certainly more ammo for the hawks inside the Fed.

More evidence has been mounting. Last week, we learned that consumer confidence rose to a nine-year high. On Wednesday, the ISM services index jumped to 57.1. That’s an 11-month high. Wall Street had been expecting 53.1.

The Doves Are Throwing in the Towel

To me, the clearest sign the interest-rate doves are throwing in the towel (I think I’m mixing metaphors, but bear with me) is the move in gold. On Tuesday, the yellow metal plunged over 3% for its worst day in nearly three years. I thought it was interesting that on Thursday, gold closed just barely below its 200-day moving average. Gold had been above its 200-DMA for eight straight months. Trust me, commodity traders do not mess around with these technical levels. Higher real rates are bad for gold.

On Thursday, we got more optimistic news on the jobs front when initial jobless claims came in at 249,000. That came very close to breaking a 43-year low. In April, there had been a report of 248,000, but I think we’ll dip below that soon. Since the jobless-claims number tends to bounce around, economists prefer to look at the four-week average. Sure enough, that’s at another 43-year low.

Futures traders currently pin the odds of a November hike at 15.5%. Let me be clear: I strongly doubt the Fed will raise rates a few days before the election. But traders see the odds of a December hike at 63.9%. I think that’s roughly 35% too low, but aside from that, it’s basically accurate.

We should also look at the internals within the market. The U.S. dollar, for example, continues to do well. In fact, the British pound just dropped to a 31-year low. Prime Minister Theresa May said she’s going ahead with plans for Brexit. Some folks thought she might take a soft approach. Apparently not.

You may remember that utility stocks got off to a great start this year. By the middle of the year, the utility sector had gained 21%. Not bad for “boring” stocks. What happened is that investors realized that the Fed wasn’t about to follow up its December 2015 rate hike with another so quickly. That led investors back into higher-yielding stocks. Well, those days are gone, and utes have been feeling the pain. The Utility ETF (XLU) has lagged the S&P 500 for the last eight days in a row.

The mirror image of that trade was the poor performance of banking stocks. Remember that banks do well in a relative sense when short-term rates rise. Banks got clobbered at the start of the year, but lately, they’ve staggered to their feet.

Let me add that I really like Signature Bank (SBNY) below $125 per share. The bank will probably earn about $8 per share this year, and $9 and change next year. Barclay’s recently raised its rating on SBNY. Obviously, the medallion loans are a problem, but it won’t last. Look for a good earnings report from SBNY later this month, along with more medallion losses.

Don’t be too concerned that higher rates will sink the market. Historically, the stock market usually does well as rates start to rise. It’s not that higher rates are good–rather that both the market and the Fed are responding to the same thing, an improving economy. The danger isn’t rising rates—it’s excessive rates, and we’re still a long way from that. The two-year Treasury is at just 0.85%.

What to expect from here? Going forward, I think we’ll see continued strength in cyclical stocks. Generally, that means commodities, energy and heavy-industry stocks. On our Buy ListHEICO (HEI) and Wabtec (WAB) are good examples of cyclicals. This is part of a larger trend of investors warming up to riskier sectors. Tech stocks, for example, did very well during Q3. High-yield bonds have also been popular, as have High-Beta ETFs (SPHB).

The key for investors is to focus on high-quality names, and not to let any market breaks rattle you. This is a good time to be in the market. Now let’s look at some news from the Buy List.

Cognizant Technology Solutions Drops—and Gains Some Back

Last Friday, Cognizant Technology Solutions (CTSH) said that an internal investigation revealed that the company may have violated the U.S. Foreign Corrupt Practices Act. Reading between the lines, I assume that means bribes to facilities in India. Cognizant notified the SEC and DOJ. The same day, the company’s president resigned.

In Friday’s trading, the stock got a super-atomic wedgie from traders. At one point, CTSH was down 17.4% for the day. By the closing bell, the stock had shed 13.3%. I was surprised it had fallen so much. After all, the company caught itself and did the right thing. There’s no evidence that this is a major scandal.

We know all too well that Wall Street likes to sell first and ask questions later. Fortunately, the shares have recovered some lost ground. From last Friday’s low to yesterday’s close, CTSH gained 12.7%. Until we know more, I’d siding with Cognizant. Remember that the last earnings report was quite good. I’m expecting more good news when the Q3 report comes out. For now, I’m lowering my Buy Below Price on Cognizant Technology Solutions to $56 per share.

In last week’s issue, I talked about how Wabtec (WAB) apparently had approval for its merger with Faiveley. This week, the EU made it official. That’s very good to see. Shares of WAB have been trending higher since the summer. This week, I’m lifting my Buy Below on Wabtec to $87 per share.

Bed Bath & Beyond (BBBY) is apparently trying to move beyond the coupon. The home-furnishings stock is well known for its coupons, but that’s been squeezing margins in recent quarters. BBBY has starting testing a program where, for $29 a year, shoppers get a 20% discount, plus free shipping. If this sounds a bit like Amazon Prime, that ‘s not a coincidence. The new program is called Beyond+. I expect to see it rolled out for everyone soon.

Next Friday, Wells Fargo (WFC) is due to report Q3 earnings. Obviously, any announcement will be overshadowed by the terrible cross-selling scandal. I’ll repeat my desire to see John Stumpf step down. As bad as the fine is, it’s barely a speck in WFC’s overall profits. For the last 13 quarters, Wells has reported a profit between 97 cents and $1.05 per share. In all likelihood, they’ll run that to 14 quarters. Wall Street’s consensus is for $1.01 per share. That’s probably on the light side, but not by much. Any report will be bad news for Wells. If they beat earnings, they’re filthy rich. If they miss, they’re incompetent. The good news for investors is that the recent selloff has dropped WFC to a favorable price.

That’s all for now. Earnings season begins next week. Alcoa will be the first to report on Wednesday. Well Fargo reports on Friday. Also on Wednesday, the Fed will release the minutes of its last meeting. This may give us clues as to how many hawks there are inside the FOMC. Then on Friday, we’ll get the retail-sales report for September. 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!

– Eddy

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Named by CNN/Money as the best buy-and-hold blogger, Eddy Elfenbein is the editor of Crossing Wall Street. His free Buy List has beaten the S&P 500 eight times in the last nine years. This email was sent by Eddy Elfenbein through Crossing Wall Street.
2223 Ontario Road NW, Washington, DC 20009, USA
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