CWS Market Review
June 9, 2017
“It’s human nature to find patterns where there are none and to find
skill where luck is a more likely explanation.” – William Bernstein
Next week is the big Federal Reserve meeting. Wall Street has already convinced itself that the central bank will again raise interest rates. I’m afraid they’re right. As I’ve said for the past few weeks, I think a rate hike now is a mistake. How big of a mistake is still to be determined. In this issue, I’ll discuss what the Fed’s move means for us and our portfolios.
The good news for us is that the low-volatility rally continues to roll on. In the last 15 trading sessions, the S&P 500 has risen 11 times. The index’s single biggest decline was a mere 0.28% drop. That’s barely a nick. Here’s a great stat I saw from Callie Bost. She noted that since 1990, there have been 15 trading days where the difference between the daily high and low was less than 0.28%. Four of those have come in the last month.
There seems to be an odd paradox. The world appears to grow more volatile while the stock market grows more serene. Or, perhaps this isn’t the paradox it seems. Maybe investors are retreating from news of terrorism and missile tests for the relative comfort of stock investing. Whatever the cause, my top concern is an overly zealous Federal Reserve that looks to contain inflation, which is hardly a problem.
We got a nice earnings report this week from JM Smucker. The jelly people handily beat Wall Street’s estimates thanks to cost-cutting. I’ll have all the details in a bit. I’ll also give you some updates on our Buy List. But first, let’s look at the rate hike that’s almost certainly coming our way next week.
Get Ready for a Fed Rate Hike
On Tuesday and Wednesday of next week, the Federal Reserve gets together for another policy meeting. The two-day affair usually gets a lot of attention because it’s followed by a press conference from Fed Chairwoman Janet Yellen.
Much of Wall Street has this meeting circled on their calendars. They figure that if the Fed is going to strike, it’ll do it in June. At this two-day meeting, the Fed also updates its economic projections. These are more often referred to as “the blue dots” in honor of the Fed’s scatter plots.
Earlier this year, the consensus on the Fed was that it would raise interest rates three times this year plus three more times in 2018 and 2019. I thought this was nuts. I reassured readers that the Fed always starts out sounding as hawkish as it can but then gradually gives way. This time, it hasn’t.
During this cycle, the Fed first raised rates in December 2015. They followed that up with another raise in December 2016, and again in March 2017. Traders in the futures market think there’s a 93.5% chance that the Fed will hike next week. If they’re right, that would move the target for the Fed funds rates from 1% to 1.25%.
What about after that? Traders see the Fed standing pat for a few months. I think that’s right. But by the December meeting, another rate hike is in play. Right now, the odds are very nearly even money for a December hike.
I’ll briefly restate my opposition. The Fed should only move once there are signs that inflation is heating up. Those signs aren’t here yet. The commodity markets aren’t rallying. Oil has been falling lately. The latest CPI reports have been very tame. We’ll get the May CPI report on Wednesday, the morning of the Fed’s announcement.
Last week’s employment report was not terribly strong. The U.S. economy created just 138,000 net new jobs. Economists had been expecting 185,000. The numbers for March and April were revised lower. The growth in wages is actually decelerating slightly. The yearly growth number fell from 2.51% in April to 2.46% for May.
I don’t want to sound overly alarmist. There have been improvements in the economy. The last earnings season was quite decent. But as far as interest rates go, I think the Fed needs more time. I’m particularly concerned to see long-term interest fall. After the election, long-term yields soared on the prospects of greater economic growth. To be fair, yields at the long end had been rising since the summer.
We heard a lot about the Trump Trade, but that started to unravel in December. Three months ago, the 10-year Treasury was yielding over 2.6%. Lately, it’s gotten close to 2.1%. If the Fed follows through with its rate hike, the famous Two/Ten Spread will probably fall below 70 basis points. That would be a nine-year low. That’s still not in the danger zone, which is 0.00, but it’s getting close. The hidden story here is that the Fed’s “ceiling” for rate increases is probably a lot lower than folks want to admit.
What effect will the Fed have? Higher short-term rates would come as a relief to many financial stocks. In fact, we saw a nice bounce in Signature Bank (SBNY) on Thursday. At the opposite end, dividend stocks will lose some of their luster. A stock that yields 3% is a wonderful thing in a 0% interest rate world. It becomes gradually less impressive as interest rates climb higher. Now let’s look at our most recent Buy List earnings report.
Smucker Beats Earnings Thanks to Cost-Cutting
On Thursday morning, JM Smucker (SJM) reported fiscal Q4 earnings of $1.80 per share. That was eight cents more than expectations. For the whole fiscal year (ending in April), Smucker made $7.72 per share. Their previous guidance had been for $7.60 to $7.70 per share. In February, the company lowered the top end of its full-year forecast by five cents per share. As it turned out, the original guidance was pretty close to the mark.
“In fiscal 2017, we grew adjusted EPS by 7 percent over the prior year,” said Mark Smucker, Chief Executive Officer. “In the new fiscal year, we continue to execute our strategic plan for sustainable, long-term growth by capitalizing on changes in consumer preferences and the retail environment. We will fuel the momentum of our growth brands like Smucker’s® Uncrustables®, Nature’s Recipe®, and Café Bustelo®, while supporting our base businesses in coffee, peanut butter, pet food, and pet snacks. Accelerated cost savings and expanded capabilities are key components of our multi-dimensional strategy to deliver top- and bottom-line growth and increase shareholder value.”
Now for guidance. For fiscal 2018, Smucker said they expect earnings to range between $7.85 and $8.05 per share. That’s pretty good. Wall Street had been expecting $7.93 per share. They also said they expect net sales to rise by 1%. SJM pegs this year’s free cash flow at $775 million and capital expenditures at $310 million.
This was a good quarter for Smucker, but a lot of the earnings beat was thanks to cost-cutting. Don’t get me wrong—that still counts, but I would have liked to see more top-line growth. You can only cut costs so much.
The shares of SJM gapped up more than 2% at the open, but that didn’t last. By the closing bell, SJM closed at $128.51, for a loss of 1.81%. I should add that there’s a remote possibility that someone big will come along and try to buy SJM out. Smucker remains a buy up to $128 per share.
This earnings report will be our only Buy List earnings report until Q2 earnings season gets going in another five weeks. One outlier is RPM International (RPM). The company ended its fiscal year in May, but it won’t report its Q4 earnings until late July. Now let’s look at some recent news from our Buy List stocks.
Buy List Updates
We’re coming up on the midpoint of the year. In early July, I’ll have a more thorough breakdown of our Buy List’s first-half performance, but for now, I can say that it’s shaping up to be a pretty decent year for us.
Through Thursday, our Buy List is up 10.43% for the year, while the S&P 500 is up by 8.71%. Those numbers don’t include dividends (the Buy List yields a bit less than the S&P 500, but it’s not very much). I’ll include the dividend numbers in our first-half summary.
Our best performer on the year is Cerner (CERN), which is up by 43.78%. Second place is CR Bard (BCR), with a gain of 39.71%. We now have 11 Buy List stocks that are up more than 13% on the year. Six of our stocks are in the red. The biggest loser is Express Scripts (ESRX), which is down 12.25%.
This week, Sherwin-Williams (SHW) finally completed its $11.3 billion acquisition of Valspar. The deal was first announced 15 months ago. The problem was clearing some of the anti-trust hurdles. This is where another one of our Buy List stocks, Axalta Coating Systems (AXTA), came to the rescue. The companies decided to sell off Valspar’s North American Industrial Wood Coatings to Axalta for $420 million in cash. The regulators were cool with that, and it was a done deal.
The combined company will have revenues of about $16 billion. Sherwin said they’ll announce their Q2 earnings on July 20. At that time, they’ll provide guidance for the combined company for Q3 and all of 2017. This week, I’m lifting my Buy Below on Sherwin-Williams to $350 per share.
Intercontinental Exchange (ICE), is holding its first analyst day today, and the stock has been rallying, perhaps in anticipation. This is a good time for ICE to explain itself to the world, because too many investors see ICE as simply a trade-volume based business. In reality, ICE is becoming more dependent on data sales and technology fees. The company, for example, recently bought Bank of America’s index platform. Barron’s rightly said that Intercontinental Exchange is “misunderstood, underappreciated and underowned.” This week, I’m raising my Buy Below on ICE to $66 per share.
Earlier I mentioned that CR Bard (BCR) is our second-biggest gainer this year. As I’m sure you recall, Bard is in the process of being bought out by Becton, Dickinson (BDX). The deal calls for BCR shareholders to get $222.93 per share in cash plus 0.5077 shares of BDX.
The good news is that shares of BDX have been rallying. They’re even higher now than when the deal was announced in April. Going by Thursday’s close, Bard is valued at $320.32 per share. Bard’s actual shares are going for 2% below that. That’s quite natural since there’s a chance the deal could fall apart. I doubt it will happen, but we have to aware of the possibility.
The sizable cash portion of the deal protects Bard shareholders from large swings in BDX’s share price. It’s a relief to see that the market hasn’t turned against BDX for proposing such a large deal. The deal is expected to close this fall. If all goes well, you can expect to see that 2% discount for Bard gradually close.
That’s all for now. The big news next week will be the Federal Reserve meeting on Tuesday and Wednesday. The Fed’s decision will come out at 2 p.m. Wednesday afternoon, and it will be followed by a press conference by Fed Chairwoman Janet Yellen. The Fed will also update its economic projections (i.e. the “blue dots”). That morning, we’ll also get the CPI report for May. I doubt we had much in the way of inflation last month. 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!