CWS Market Review
March 17, 2017
“The natural-born investor is a myth.” – Peter Lynch
On Wednesday, the Federal Reserve decided to raise interest rates by 0.25%. This is only the Fed’s third rate increase since the financial crisis. The new range for the federal funds rate is 0.75% to 1%. That’s still rock bottom by almost any standard.
But what’s interesting was Wall Street’s reaction. Obviously, they knew the rate hike was coming. I told you so, and Janet Yellen all but said so. Still, stocks rallied on the news. In fact, some folks on Wall Street have taken to calling this move a “dovish hike,” meaning that even though the Fed raised rates, the central bank was cautious on the need for further rate hikes. Bonds rallied, and in the commodity pits, gold rallied as well. That doesn’t normally follow rate increases.
At her press conference, Fed chairwoman Janet Yellen said she didn’t share Wall Street’s enthusiasm. While Yellen noted that the economy has gotten better, she was clear that her outlook for gradual economic growth hasn’t changed at all. What’s going on? It seems like the Fed and Wall Street are headed in different directions.
In this week’s CWS Market Review, we’ll look at what the Fed’s move means for us. I’ll also take a look at how our Buy List is performing this year. It’s early, but we’ve jumped out to a small lead against the S&P 500. I’ll also fill you in on some news impacting our Buy List stocks. But first, let’s see why we have little to fear from higher rates. At least, so far.
The Fed Gives Us a Dovish Rate Hike
This week’s Fed rate increase was hardly a surprise. Officials at the Fed have gotten quite good at telegraphing their moves to Wall Street. So the big news wasn’t this week, as the expectation for what was in the pipeline was formed over the last few weeks.
Despite the news’s being well planned, the reception was unexpected. Stocks rallied on the higher rates, but the long end of the bond market rallied as well. In other words, long-term rates went down on the news that short-term rates went up. Gold also rallied. That’s not what the playbook says.
The best way to square this circle is to believe that Wall Street expects higher rates, but perhaps not as quickly as they assumed. Wall Street had been very optimistic about the economy, not just regarding stocks’ going up, but regarding which sectors this was going to happen in (tech, cyclicals). That’s what the Trump Trade was all about. But in her press conference, Janet Yellen was very cautious, “We haven’t changed the outlook. We think we’re moving on the same course we’ve been on.” I think the Fed’s view is that Wall Street simply hasn’t been listening to them. The Fed sees gradual growth, but the Trump Trade was predicated on rip-roaring growth. In that battle, my money’s on the Fed largely because they’re the ones who make the money.
Along with the Fed’s policy statement, its members also updated their economic forecasts. I should add that the Fed is notoriously bad at forecasting. I mean, even for economists, they’re really, really bad. Still, their outlook—the famous blue dots—tells us where they think the economy is going.
For this year, the Fed expects two more rate increases. Not too long ago, I thought that prediction was far too optimistic. Now it looks quite reasonable. The Fed sees another three rate hikes coming next year as well. In fact, the median is only one vote away from seeing four rate increases next year. If that’s accurate, it would bring the range for Fed funds to 2.25% to 2.5% in months.
The Fed sees inflation holding at 2%. That means that real short-term interest rates will remain negative for nearly two more years. There are few factors that are as bullish for stock investors as negative real rates. Effectively, the Fed is giving us no alternative but to invest in stocks. While much of the bull rally has been helped by share buybacks, there’s been real investment as well. It’s taken a while to wind its way to the real economy, but it’s there.
What happens next? The Fed meets again in May, and it’s doubtful they’ll raise rates. After that, the Fed gets together in mid-June, and another rate hike is very possible. The futures market currently thinks the odds are roughly 50-50. Right now, I’d say it’s 70-30 in favor of another rate increase.
But there are a lot of moving parts to this forecast. The keys to watch are inflation and the labor market. Last Friday, the government reported that the economy created 235,000 net new jobs. That’s a strong number. The unemployment rate dipped to 4.7%. Over the last year, average hourly earnings are up 2.8%. That’s not much, but at least it’s 0.6% ahead of core inflation. During much of the period from 2011 to 2014, wages basically stayed in line with core inflation. This means that workers saw no real wage increase. Now they are seeing one, even though it’s small.
Inflation is still not a threat. On Wednesday morning, ahead of the Fed’s announcement, the government reported that consumer prices rose 0.1% last month. That’s what economists had been expecting. The “core rate,” which excludes food and energy prices, rose by 0.2%, which also matched expectations. So while the labor market has been expanding, there’s been only modest inflation pressure. That helps explain the Fed’s cautious approach.
All of this will have an impact on the stock market. I think it’s very likely we’ll see better relative performance from defensive areas of the market. This includes areas like healthcare and consumer staples. When traders see a better economy, these areas tend to get left behind. I still hold to my belief that stocks may face a modest pullback soon. Say 5% to 7%. Nothing too serious, but enough to scare off some momentum traders. We have nothing to fear. In fact, it may give us some good buying opportunities.
Until then, I encourage investors to focus on a list of high-quality stocks such as you’ll find on our Buy List. Remember to pay attention to our Buy Below prices. In a low-volatility environment, there’s no need to chase after good stocks. Now let’s look at how well our Buy List has done so far this year.
Our Buy List is Up 7.61% so Far This Year
The year is barely one-fifth over, but I wanted to take a look at how well our Buy List is performing this year. I’m happy to say that it’s looking quite good for us. Through Thursday, our Buy List is up 7.61% for the year. That’s close to an average return for a full year, so doing it in eleven weeks ain’t bad. By contrast, the S&P 500 is up 6.37% (neither figure includes dividends).
Of our 25 stocks on the Buy List, 22 are positive for the year. Ten stocks are up by double digits, and fourteen are beating the overall market. Let me be clear that this is a very short time period, and we like to focus on the long term.
Of the stocks on our Buy List, Moody’s (MCO) is currently in first place. The credit-ratings firm is up 20.4% YTD. I always find it interesting that the top-performing stock is never one I would have guessed. Cerner (CERN) isn’t far behind, in second place with a gain of 19.0%. This stock was one of our worst performers last year.
Perhaps the most surprising stock recently has been Axalta Coating Systems (AXTA). In last week’s CWS Market Review, I mentioned how Akzo Nobel rejected PPG’s buyout offer. Traders assumed that put Axalta in play as another backup buying opportunity. In a very short time, shares of AXTA jumped from $29 to $31.
The rally continued into this week as the Royal Bank of Canada raised its price target on AXTA from $33 to $35 per share. The stock rose nearly 4% on Thursday to close at $32.28 per share. In the last seven trading days, AXTA has gained more than 11%. The stock is now up 18% on the year, making it our third-best stock this year.
This week, I’m going to raise my Buy Below on Axalta to $35 per share. I’ll also remind you to not expect a buyout offer from PPG, or anyone. If that happens, it’s good fortune, but you shouldn’t base an investment strategy on trying to guess who will be bought out next.
The worst performer so far this year is Wabtec (WAB). The rail-service stock is currently down 7% YTD. WAB actually started out the year well for us, but it got clobbered after last month’s lousy earnings report. The company badly missed earnings. I’m not worried about Wabtec at all. Give this one some time. They’ll be back.
Our second-worst performer this year is Express Scripts (ESRX). This is a good example of a company that’s doing well, but it’s caught in the middle of the healthcare debate. The shares are now at a three-year low. For this year, Express sees earnings coming in between $6.82 and $7.02 per share. This week, I’m lowering my Buy Below on Express Scripts to $69 per share. This is a very good stock going for a cheap price.
That’s all for now. Next week will be a fairly quiet week for economic reports. The existing home-sales report comes out on Wednesday. The report for January was a 10-year high. The report for new home sales will be released on Thursday. 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!