CWS Market Review
April 7, 2017
“The stock market is designed to transfer money from the active to the patient.”
– Warren Buffett
The stock market has apparently reverted to its tame ways. For the last eight days in a row, the S&P 500 has closed between 2,352 and 2,369. That’s a fairly narrow range. Last week, I thought we might see some action when the S&P 500 briefly dipped below its 50-day moving average. That hadn’t happened since November, but the index failed to close below this crucial technical support level.
So the boring market has continued.
Even though the stock market peaked over a month ago, there hasn’t been much momentum in either direction. But there was some interesting news from Washington this week. We learned that the Federal Reserve is finally considering ways to reduce its gargantuan balance sheet. This could be an important issue later this year. I’ll tell you what it means.
Now we’re in April and first-quarter earnings season is about to begin. This could be one of the better quarters in recent years. I’ll you what to expect. I’ll also discuss this week’s earnings report from RPM Inc., plus I have some other Buy List updates for you. But first, let’s look at what the Fed has planned in order to unwind its gigantic balance sheet.
Don’t Panic Over the Fed’s Balance Sheet
On Wednesday, the Federal Reserve released the minutes from last month’s policy meeting. This is the one where the Fed decided once again to raise interest rates. This was a notable increase, because it wasn’t foreseen a month beforehand. By the time it happened, it wasn’t a surprise. But for those key weeks, the expectations completely changed. I think Wall Street was surprised by how forceful and direct the Yellen Fed could be.
The Fed has become pretty good at conveying its intentions to Wall Street. But that’s regarding interest rates. What about the Fed’s balance sheet? Before the world economy went kablooey nine years ago, the Fed’s balance was less than $1 trillion. Then the Fed got busy. Very, very busy. Today, the balance sheet is $4.5 trillion.
As you might expect, this is a wee bit disconcerting for investors and folks inside the government. The problem is that if the Fed moves too quickly and dumps its holdings, that could cause long-term interest rates to rise. The Fed has been reinvesting the proceeds of its securities, but that could end soon. According to the minutes from the March meeting, “Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year.”
As always, I apologize for quoting Fed officials. Despite their dull writing, this is actually a big, honking deal. First off, let’s make the important point that the Fed will keep using interest-rate adjustments as its main policy tool. For its balance sheet, almost certainly, the plan will be to deflate it slowly and quietly. We don’t want a repeat of Wall Street’s “Taper Tantrum” in 2013. My guess is that the first step will be a decision to end reinvestment of agency debt, not Treasury debt.
As we know, the bond market is notoriously ornery. Yes, they’ll scream and holler every step of the way. But ultimately, I doubt the Fed’s plans will have a sizeable impact on long-term rates. There’s simply too much demand from investors all over the world to hold U.S. debt. Plus, there’s no hurry for the Fed to lower its holdings. If need be, they can wait out a storm.
Instead, my fear is that the Fed will raise rates too much too fast. Looking at the data, there’s not a great need for higher rates. Later today, we’ll get the jobs report for March. We’ll see more job gains. I hope we’ll see more improvement in wages, but we have a long way to go. Inflation is still not a problem. While oil has moved up recently, it’s down for the year.
Eric Rosengren, the top dog at the Boston Fed, recently said he thinks the Fed needs four hikes this year. I’m sorry, but I just don’t get it. Maybe one more raise this year. Outside chance of two more. The problem, of course, is just because it’s a bad idea doesn’t mean the Fed won’t do it.
In the last year, long-term rates have gapped up significantly, and I’m starting to question how much of that is truly justified. I wouldn’t be surprised to see the yield on the 10-year Treasury fall back below 2%. Of course, much of this outlook is dependent on where the economy goes from here. Very soon, we’re going to get a slew of earnings reports. Let’s take a closer look at what Q1 earnings season has in store.
Preview of Q1 Earnings Season
According to the latest estimates, Wall Street expects earnings growth of 9.1% for Q1. What helps that figure is the comparison against weak numbers from a year ago. Still, if the forecast is correct, that would be the fastest growth rate since Q4 of 2011. Bank of America Merrill Lynch noticed a fascinating factoid. In company earnings calls for Q4, 52% of companies used the word “optimistic.” That’s the highest ever in data going back to 2003.
Another welcome change is that earnings estimates haven’t been slashed as they’ve been in previous quarters. It’s the norm to expect Wall Street’s forecasts to be pared back as earnings season approaches, but it’s been far more muted this time.
This earnings season will also be different because we’ll see better results from energy companies. The downturn in oil was brutal for many earnings stocks, but prices have rebounded. Typically, the big banks report early on in the earnings season. That often sets the tone for the rest of the earnings. Our own Signature Bank (SBNY) is due to report on April 17.
We’re also seeing decent topline growth. The early part of the bull market was often criticized for being driven by cost-cutting. Companies were growing their profits but not growing their firms. They were just laying off people. At some point, we needed to see more customers come in and buy more things. We’re now seeing more jobs leading to more spending leading to higher revenue. Wall Street currently expects Q1 revenue growth of 7.1%. That will be a five-year high. Not surprisingly, we recently saw consumer confidence touch a 16-year high.
We’re also somewhat safer now from an issue in previous quarters, namely the strong U.S. dollar. The greenback soared after the election, but it has pulled back since the start of the year. Last year, you may recall how often companies stressed that their “currency-adjusted” profits were doing just fine.
I’m particularly looking forward to the earnings report from Microsoft (MSFT). Wall Street currently expects earnings of 70 cents per share from the software giant. They should have little trouble topping that. Now let’s look at the only Buy List earnings report we’ve had in five weeks.
RPM Inc. Is a Buy up to $55 Per Share
On Thursday, RPM Inc. (RPM) reported fiscal third-quarter earnings of nine cents per share. That result, however, includes five cents per share related to the company’s “Restore intangible impairment and the European facility closure.” Looking past that, RPM made 14 cents per share, which was three cents better than estimates.
I should explain that RPM is on the February/May/August/November reporting cycle. As such, they’re one of our few Buy List earnings reports over the last several weeks. Since most of our stocks (and most stocks in general) ended their last quarter in March, we’ll see a flurry of earnings reports soon.
RPM’s earnings report is a bit unusual because only a very small portion of its annual profit comes during their fiscal Q3. By my rough estimate, Q3 makes up about 5% to 7% of RPM’s full-year haul. The company expects full-year earnings to range between $2.57 and $2.67 per share. That’s a reduction of five cents per share from their previous forecast due to charges I mentioned before. Quarterly revenue rose to $1.02 billion, which was just shy of estimates of $1.04 billion.
“Our businesses serving the U.S. commercial construction market again experienced solid organic growth. Most businesses in Europe were up in the low- to mid-single-digit range in local currencies, and current-year acquisitions contributed nicely to the segment’s overall sales growth. We were very pleased with the strong EBIT leverage achieved on solid top-line sales,” stated Sullivan.
RPM is a good example of a solid company that’s having a sluggish year. The key takeaway is that profits will be about the same as last year. There’s no reason to run. The shares pulled back 3.6% on Thursday. This week, I’m dropping my Buy Below down to $55 per share.
Buy List Updates
I also want to change a few Buy Below prices. Shares of Cerner (CERN) have been doing quite well recently. I’m going to bump our Buy Below up to $62 per share. It’s our top-performing stock this year, and it was one of our worst last year.
Shares of JM Smucker (SJM) have been trending downward over the past month. I’m lowering my Buy Below to $138 per share. Fiscal Q4 earnings are due out in early June.
I’m also going to raise the Buy Below on HEICO (HEI) to $90 per share, ahead of the stock’s split later this month. HEICO will be split 5-for-4, which means shareholders will be getting 25% more shares but the share price will fall about 20%.
That’s all for now. The March jobs report will be out later this morning. I expect to see more gains in nonfarm payrolls, but I’m especially curious to see any gains in earnings. There’s been some improvement here. There will be a few early earnings reports next week, but none from our Buy List. The stock market will be closed next Friday for Good Friday. This is the one day of the year when the market is shuttered and most government offices are open. 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!