Time to Buy More #Shares? – 09/28/2014

Time to Buy More Shares?

by Mitch Zacks, Senior Portfolio Manager

Second quarter GDP was revised higher on Friday from an annualized rate of 4.2% to 4.6%. If this level of GDP growth can continue, the recent weakness in the equity markets presents a buying opportunity.

Here are a few reasons why it makes sense to continue buying the U.S. equity market:

  • Higher valuations. Right now, U.S. equities are valued at a level that is slightly higher than historical levels. However, bull markets rarely end at valuation multiples that are just slightly higher than historical levels. They end when valuation multiples are substantially higher and investors are swinging from the chandeliers. While the market remains somewhat expensive, it is by no means at the level we would expect at the tail end of a bull market.


  • Growing corporate earnings. If the economy continues to expand at a reasonable rate, corporate earnings growth should push the market higher. While the gains for the stock market will not be anywhere near what they have been over the past few years, most likely the stock market should appreciate around 6-9% over the next twelve months. Earnings growth is expected to be rather robust over the next few quarters.


  • We’re not heading in the wrong direction. The majority of the market’s losses occur in periods when we have both rising interest rates and a contraction in the economy. This combination historically hits stocks with a contracting P/E multiple at the same time corporate earnings are pulling back due to an economic slowdown. It looks increasingly unlikely, however, that we will be entering such an economic environment.


  • Economic expansion is still on track. The most recent GDP data suggests that we are going to see rising interest rates accompanied by economic expansion. If interest rates indeed rise but remain under historical levels, I expect the inverse to happen with P/E multiples. They should fall but remain above historical levels. If this occurs along with growth in corporate earnings, the current bull-market likely has some room to run.


  • Wage inflation remains incredibly low. This results from ( 1 ) an increase in the global supply of labor due to outsourcing and ( 2 ) technological changes that are causing capital to serve more as a replacement than complement for labor. Downward pressure on wages was not caused by the last recession. Instead, it was caused by a fundamental change in the economy. Therefore, it is not likely to reverse itself any time soon. The lack of wage inflation is keeping corporate profit margins at all-time highs which is a benefit for the stock market.


  • Without wage inflation, we will not see price inflation. This should enable the Federal Reserve to put off raising rates until mid 2015. Additionally, the strong U.S. dollar is putting pressure on the Federal Reserve to keep rates low in order to boost exports.


  • GDP growth in the remainder of 2014 will likely average 3% or better. Supporting this sustained above-trend growth are several broad trends: receding uncertainty; improving financial conditions, including gains in household balance sheets; absence of fiscal drag; and solid employment gains. Although housing remains a concern with household formation and residential investment struggling to regain momentum, there are some positives in recent data. As GDP growth strengthens corporate earnings, the stock market should push higher. Likely, small-cap stocks will come back stronger in the remainder of 2014 as they are less exposed to the weakness in Europe.


  • Forecasts are upward despite the expected end of QE3 in October. But it is important to remember that interest rates are going up because the economy is expanding. An expanding economy is a positive for the stock market even if the expansion is accompanied by rising rates. As a result, reasonably strong expected growth of corporate earnings and dividends combined with gradual interest rate increases supports my forecast for roughly a 4% gain in the S&P 500 over the remainder of 2014 and mid to high single-digit gains for the index in 2015.

Of course, there are also substantial risks to the equity market.

  • Intensifying concern about a potential deflationary dynamic in the Eurozone. This is prompting easy money policies, and if true deflation does materialize it would slow economic growth in the U.S. That in turn would put substantial downward pressure on corporate earnings. Nevertheless, the natural state of economies is not deflationary. A much more likely outcome is that the Eurozone over-reacts to the deflationary pressure and, as a result, interest rates stay lower for longer than investors are anticipating. The U.S. equity markets would then be pushed higher.


  • Substantial risk of a sharp slowing in China. This could have financial spillovers globally. Although a real concern, China’s economy is so centrally controlled that the day of reckoning is likely farther off than most people are anticipating. One only has to look to the recent action of the Chinese government in propping up its banking system to understand why I estimate that the Chinese Government will continue to prop up the economy for several years after a recession would have naturally taken place.


  • Fears of intensifying conflicts. Look to the civil war in Syria and the turmoil in Ukraine. These events could lead to additional, more serious sanctions with material consequences for European growth and adverse spillovers in financial markets. Generally, I think it is a reasonable bet that the situation in the Middle East will get worse before it gets better. As a result, we should see higher energy prices. This is a negative for consumer discretionary spending although we have yet to see energy prices spike. However, the growing global turmoil is unlikely to derail U.S. GDP growth. If anything, it will make the Federal Reserve a little more cautious about raising interest rates.

Most concerning to me is that while downside economic risks are receding, the market is too complacent. The readings on the VIX are way too low and I would not be surprised to see some near-term volatility increasing. Basically, it feels like we are overdue for a pullback.

However, while we are likely going to see some selling in the near term, the bullish thesis remains in place due to the economic expansion. As a result, any sell-off presents a good buying opportunity. At this point in time, the positives outweigh the negatives.


About Mitch Zacks

Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A. in Analytic Finance from the University of Chicago.

Mitch also is a Portfolio Manager for the Zacks Small Cap Core Fund ( ZSCCX ).





CWS Market Review – September 26, 2014

September 26, 2014

“The stock market is designed to transfer money from the active to the patient.”
– Warren Buffett

This market continues to be dominated by the strong U.S. dollar. This is a very important point that all investors need to understand. There’s barely a sector of the market that’s not being impacted by the rallying greenback. The difference is that lately, the market’s no longer going higher.On Thursday, the stock market had its second-biggest drop in the last 24 weeks. The S&P 500 lost 1.62% to close at 1,965.99. That’s a five-week low. The Dow slipped below 17,000, and the Nasdaq Composite was especially hard hit. That index closed below 4,500 for the first time since mid-August.

It was only one week ago that the market reached its “Alibaba Peak.” Last Friday morning, the S&P 500 touched its all-time intra-day high of 2,019.26, and 122 minutes later, Alibaba made its market debut. That may not be a coincidence.

On Thursday, the dollar index broke out to a four-year high, and you can see the evidence everywhere. The yield spread between U.S. and German bonds reached a 15-year high. Gold dropped below $1,210 per ounce for the first time this year, and the small-cap Russell 2000 Index is now down 8.1% since July 3.

In this week’s CWS Market Review, I want to take a closer look at an important issue that has been driving the stock market: share buybacks. For years, Corporate America has been buying back its own shares at an impressive pace. Now, however, the buyback party looks to be coming to an end — and that might be good news. I’ll explain why in a bit.

Later on, we’ll take a look at the solid earnings report from Bed Bath & Beyond. The home-furnishings stores leapt more than 7% on Wednesday after they reported strong quarterly earnings. Speaking of buybacks, a few weeks ago, BBBY went to the bond market to borrow money so they could buy back gobs of their shares, and that’s what helped drive their earnings success. Or I should say their earnings-per-share success. We’ll also take a look at Medtronic’s tax inversion and the dividend increase from McDonald’s (their 38th in a row). But first, let’s look at what’s driving all these buybacks.

Why Share Buybacks Are Beginning to Fade

Anyone else remember when companies use to have lots of shares outstanding? Every quarter, the number of shares has slowly been getting smaller. More and more companies have been using their cash hordes to repurchase their own shares. The benefit for shareholders comes down to simple math. Having fewer shares helps your earnings-per-share, and investors like that. Howard Silverblatt, the main stat guy at S&P, notes that 295 companies in the S&P 500 reduced their share count last quarter.

On one hand, fewer shares is a good thing for investors, as it makes their holdings more valuable. But my take is that I’d prefer to see companies use their cash to expand their operations. That’s the best way to reinvest shareholder money: grow the business. But I can’t fault companies for buying back so much stock. What’s the point of keeping your cash in the bank, where you’d get 0.01%? After all, stocks are cheap and buyback announcements make for great PR.

I have two major complaints with share buybacks. One is that companies shouldn’t be in the stock market game. It’s a great idea to buy back a stock that’s cheap, assuming it rallies later on. But a lot of companies have tossed enormous sums of money at very expensive stocks, only to watch those assets fall. Cisco Systems is a perfect example. Remember a bank called Lehman Brothers? They used to be in the news a lot a few years ago. Anyway, Lehman spent $1 billion buying its own stock during the six months leading up to May 2008. I wince whenever I think about that. The Economist notes, “In all, America’s financial sector repurchased $207 billion of shares between 2006 and 2008. By 2009 taxpayers had had to inject $250 billion into the banks to save them.”

I’m also leery of companies sitting on too much cash. Peter Lynch has referred to this as the “Bladder Theory of Corporate Finance.” Even Apple got complaints from investors like Carl Icahn and David Einhorn for the size of its cash position, and it´s promised to return more money to shareholders. I also don’t like how many companies issue huge amounts of stock options for executive compensation, but they use share buybacks to mask how much they’re diluting their share base. There are exceptions like DirecTV which actually reduce their share count.

But we need to consider the fact that buybacks are popular with investors. Merrill Lynch found that companies with the largest buybacks crushed the market last year. But this year, the biggest repurchasers are performing nearly the same as the rest of the market. Actually, slightly worse. Perhaps, buybacks have lost their cool.

That could be the case. There are early indications that the buyback fever is fading. In Q2, companies in the S&P 500 bought back $116.2 billion worth of stock. That’s a decrease of 1.6% over last year, and a drop of 27.1% from Q1. Of course, stock prices are higher as well.

But that’s not all. Ironically, this could be an optimistic sign, because it means that companies are spending more money on growing their operations. Or, as crazy as this may sound, actually give raises to their employees! When the financial crisis hit, buybacks were a no-brainer. Also, companies tend to be conservative with their dividend increases because it looks especially bad if you have to cut them later on. It’s generally assumed that a company will maintain its current dividend indefinitely.

There´s basic economics at work here. The U.S. economy has added close to nine million jobs in the last five years (we’ll get another jobs report next week). Those new jobs are an investment in a company’s future, and it’s encouraging to see firms take a more optimistic view of their future. A few days ago, Tesla said it’s building a new battery factory in Nevada. In response, the stock soared. In retrospect, the buyback craze was a result of low prices, low interest rates and a dragging economy. That’s coming to an end, and so too is the buyback frenzy. Now let’s take a look at a slumbering Buy List stock that’s taken full advantage of share buybacks.

Bed Buyback & Beyond

After the closing bell on Tuesday, Bed Bath & Beyond (BBBY) reported earnings for its fiscal second quarter. Earnings announcements have been rather nerve-wracking for the home-furnishings chain; the stock has plunged after the last three earnings reports.

I’m pleased to say that that streak has come to an end. Shares of BBBY jumped more than 7.4% on Wednesday after Bed Bath & Beyond reported quarterly earnings of $1.17 per share. The company had previously said that earnings would range between $1.08 and $1.16 per share. Last week, I said that I expected earnings in the top end of that range, so the results were even better than I was expecting.

What’s interesting about BBBY’s earnings is the impact of buybacks. The company has been gobbling up its own shares at a furious pace. Net earnings fell 10.2% from the same quarter one year ago; however, there were 10.7% fewer shares. Presto! Earnings-per-share rose.

Bed Bath & Beyond recently floated a $1.5 billion bond offering to fund its share buybacks. Last quarter, BBBY spent $1 billion to buy back 16.9 million shares. Working out the math, that means they paid less than $60 per share on average, so they’re already in the money. Once again, it’s basic economics. The bond deal costs BBBY 4.38%, so it’s not exactly a back breaker. In fact, Standard & Poor raised their rating on Bed Bath & Beyond to AAA- from BBB+.

I’ve often said that I’m not a big fan of share buybacks, but I’ll give credit to BBBY for being another firm that´s actually reducing its share count. The company isn’t finished with buybacks either. There’s still another $1.8 billion remaining in the current buyback program. BBBY projects its share count will fall by another 13 million by the end of the fiscal year.

Bed Bath & Beyond gave us guidance for Q3 and Q4. For the third quarter, which ends in November, Bed Bath sees earnings ranging between $1.17 and $1.21 per share. For Q4, which is the all-important holiday season, they see earnings ranging between $1.78 and $1.83 per share. For the entire year, their earnings forecast is $5.00 to $5.08. BBBY sees comparable-store sales rising by 2% to 3% in Q3 and 4% to 5% in Q4.

The full-year forecast is the first time they’ve given us a specific EPS range, but it exactly comports with the “mid-single-digits” language they’ve used for several months. Not once have they budged from that forecast. Since the company made $4.79 per share last year, the current EPS guidance translates to annualized growth of 4.4% to 6.1%.

Adding up the two quarterly guidance ranges gives us a full-year range of $5.04 to $5.13. I’m probably reading too much into that, but it’s something to note. Overall, this was a solid quarter for BBBY. The stock remains a good buy up to $70 per share.

Medtronic Down on Tax-Inversion Rules

This week, Medtronic (MDT) learned an important lesson that many of us have known for a long time — you simply can’t become Irish because you feel it. Shares of MDT dropped close to 3% on Tuesday, and still more on Wednesday and Thursday, after the government announced new rules for “tax inversions.” That’s what Medtronic is trying to do as it buys Ireland’s Covidien (COV) and moves its HQ to the Emerald Isle. The move would cut their tax bill by a good amount.

I’ll be honest with you — I don’t know what impact the new rules will have on the MDT/COV deal, and it sounds like no one else knows at this point either. The lawyers are still looking it over. The key issue is a company’s holding of cash outside the United States. In Medtronic’s case, they hold close to $14 billion outside the country. Medtronic wants to loan some of that to their new parent, but the new rules might stop that.

Bloomberg reported that Medtronic released a statement saying, “We are studying the Treasury’s actions. We will release our perspective on any potential impact on our pending acquisition of Covidien following our complete review.” Don’t let the recent sell-off rattle you. Medtronic remains a buy up to $67 per share.

McDonald’s Raises Its Dividend for the 38th Year in a Row

I wanted to say a quick word about McDonald’s (MCD), which has been a problem child this year. The company has been trying to right itself after several missteps. The results don’t yet reflect this, and the last sales report was truly terrible.

In the CWS Market Review from three weeks ago, I said I was concerned that Mickey D’s wouldn’t raise their dividend this year. I’m please to say that that wasn’t the case. Last week, McDonald’s announced that they’re raising their quarterly dividend from 81 to 85 cents per share. The burger giant aims to return $18 billion to $20 billion to shareholders from 2014 through 2016. The new dividend is payable on December 15 to shareholders of record as of December 1. Going by the new dividend and Thursday’s closing price, McDonald’s now yields 3.61%. McDonald’s remains a conservative buy up to $101 per share.

Two more things to mention. DirecTV (DTV) shareholders approved the AT&T merger with 99% of the vote. Also, Cognizant Technology Solutions (CTSH) is very cheap at the moment. The shares are at a seven-week low. If you can pick up CTSH below $45, that’s a very good purchase.

That’s all for now. The third quarter comes to a close next Tuesday. After that, we’ll get the important turn-of-the-month economic reports. The September ISM report comes out on Wednesday. There’s a chance it could hit a 10-year high. Also on Wednesday, we’ll get the ADP jobs report. Then on Friday will be the official jobs report from the government. The last report was on the weak side. I doubt that’s the start of a trend. 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

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 for the last seven years in a row. This email was sent by Eddy Elfenbein through Crossing Wall Street.
2223 Ontario Road NW, Washington, DC 20009, USA

Because This Time is Different – 09/15/2014

Historically speaking, the economy and stock market do quite well when the Fed starts raising rates. Yet this time seems to be giving investors a bit more concern. Why?

Because this time is different!

Yes, above is one of the scariest phrases for investors to utter. That is because it is often used when times are not truly different. Rather people just don’t want to properly heed the events of the past.

This is one time the statement does accurately apply. That is because this was not your typical recession and most certainly not your typical Fed intervention to spark life back into the economy.

Most of the time the Fed is raising rates about 2 years into a recovery leaving another 3+ years of boom time before the next recession arrives. In this case we are currently 5.5 years into the recovery and it is very unclear how the economy will react without all the extra stimulus. Plus, current stock valuations are based on how low bond rates are. If they start to rise in a meaningful way (like towards 3.5%) it will put downward pressure on stock prices.

Given the above you understand why the key elements to watch now are Fed policy changes and how it affects US treasury rates. All is well there now. But looking ahead there likely will be a world of change. And yes, this time may be different.


Steve Reitmeister ( aka Reity…pronounced “Righty” )

Executive Vice President

The Real #Investment Difference-Maker – 09/14/2014

by Mitch Zacks, Senior Portfolio Manager

At Zacks Investment Management we try very hard not to time the market. We try even harder to make sure our clients do not try to time the market.

The reason is very simple. Extensive data over multiple years shows that market timing as an investment strategy does not work.

Why does it fail?

Reason #1

First and foremost, market timing is impossible to do accurately over extended periods of time. The reason has to do with the market’s efficiency and the fact that any market timing decision entails not only deciding when to exit the market but also when to enter it.

The market by its very nature is extraordinarily efficient. This is a fancy way of saying that the stock market is very good at reflecting all the available information into stock prices. If stocks are expensive, there is a reason they are priced so high. Similarly, if stocks seem cheap based on historic valuation metrics, there is invariably a sound reason why they are priced so low.

How Do You Predict the Market’s Future Direction?

The key is to determine what you know that is unknown by all the other market participants. This information includes such items as when the next recession is going to occur, what will happen to interest rates, and whether there will be a global crisis that develops.

The problem is that this information simply does not exist. Any information that would affect the entire stock market or economy would be known to a large number of market participants. These people would already be acting on the information and thus prices would reflect those actions.

Additionally, let’s say you have access to this massive market-moving information and that all other investors are oblivious to the information. Not only do you need the facts to tell you when to exit the market but you also need the same high-quality, unknown yet massively important market-beating information to get back into the market again.

For instance, if you could have predicted the 2008 financial crisis, maybe you could have gotten out of the market in advance of the Lehman Brothers’ collapse. But would you have known to get back in at the point of massive pessimism when the S&P 500 hit its low of 676? (Currently, the S&P 500 is at 1985.)

The point is that not only was it necessary to predict when the market was going to fall, it was also necessary to predict when the market was going to rise. As I have said many times, the worst possible thing that can happen to an individual investor is that he successfully times the market once. It gives him a false sense of his own ability, and results in him being out of the market for extended periods of time and missing out on gains.

Reason #2

This brings us to the second major reason why it makes no sense to time the market. The base case for the market over a long period of time is to move upward. Historically, the stock market advances at an annual rate of around 6% above the risk-free rate. With the risk-free rate around zero, this indicates that a 6% annualized rate of return for the market is reasonable at current levels. It is important to note that this rate of return materializes through all sorts of political and economic catastrophes. Look what the U.S. equity market has faced since 1973:

Issues that Menaced the Market

1986: DOW AT 1800 – “TOO HIGH”

Now imagine that you could have predicted the yearly problems detailed above. Say for argument’s sake that you were capable of not only predicting the above events, but also knew exactly when the events were going to occur down to the exact month. What was the correct course of action to take?

In almost every case, the best strategy was to wait for the market to sell-off in response to the event and then buy more equities. When you take the perspective of a true long-term investor, the market movements around the above events are simply small fluctuations.

Of course, there are years and even a decade or two when the market will be full of sound and fury and not advance. In these periods, returns are limited to dividend payments from the stocks owned as prices do absolutely nothing. Also, along the way there are market crashes and corrections.

There has been true fear in the market, and I can guarantee you that at some point in time fear will return. Nevertheless, the key for an investor is to shun both the fear and the greed, and instead try to stay invested over a long period of time.

Look back at the list above. It is very clear that for long-term investors the best action historically has been mostly to:

Ignore the News and Stay Invested.

Make sure the allocation across various investment strategies is consistent with your risk level. This enables you to remain invested even in the face of higher than normal degrees of volatility.

We know that if we go out twenty years, even given current valuation levels, stocks will likely outperform most other asset classes. The basis for that knowledge is that it has been that way historically.

When helping individual investors, my challenge is to make sure that their allocations across assets and investment strategies is such that they can stay invested over a long period of time. and thus reap the compounded benefits of the returns in the equity market.

Thus, I strive to make sure a client’s asset allocation is consistent with the client’s risk level. Then that allocation can be maintained in the face of volatility over long periods of time. This enables the market’s returns to compound over time and generate gains for clients. At the end of the day, timing the market is not what makes the difference. Instead, it is time in the market.


About Mitch Zacks

Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A. in Analytic Finance from the University of Chicago.

Mitch also is a Portfolio Manager for the Zacks Small Cap Core Fund ( ZSCCX ).

Beware September? No, I dare say – 09/04/2014

According to the Stock Trader’s Almanac, September is the worst month of the year for the stock market. Now let’s peel away some of the layers of fear to present the not so scary facts behind this statement.

•  Average loss in September is only -0.5%.

•  46% of the time the month produces profits.

•  The last two Septembers have seen gains of +2.8% and +2.4% respectively. Not to mention +8.8% in the 2010 period.

So that means September is really not that ominous a time for stocks and the best trading strategy is based on the most recent measures. In that regard, we are still in the midst of a long term bull rally and recent data shows an accelerating economy.

Hardly bearish material now is it?

However, the market is pressing all-time highs. This has more investors clamoring for a correction before adding new positions.


Steve Reitmeister ( aka Reity…pronounced “Righty” )

Executive Vice President

CWS Market Review – August 8, 2014

August 8, 2014

“Far more money has been lost by investors preparing for corrections, or trying to
anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

After a very subdued June and July, the stock market has suddenly gotten a lot more interesting. The S&P 500 had gone 62 trading days in a row without a daily move, up or down, of more than 1%. That was the longest streak of its kind in nearly 20 years. Then we had three such days within two weeks, and we came very close to a fourth on Tuesday.On Thursday, the S&P 500 fell to a two-month low of 1,909.57. In an apparent homage to Meltdown Monday, the index reached its closing high of 1,987.98 on July 24. We’re now down 3.94% from that mark. Last week, the S&P 500 broke below its 50-day moving average last week, and we’re only 2.6% above the 200-DMA. It’s been 21 months since the S&P 500 last closed below its 200-DMA.

There are lots of reasons for the market’s new-found case of anxiety: Ebola, Putin, Hamas, ISIS. From its July low to its August high, the Volatility Index (VIX) soared 66%. Gold has been creeping up as well. Despite the increase in worrying, the fundamentals of the economy and stock market are sound.

Last Friday, for example, we had another good jobs report; the U.S. economy created 209,000 net new jobs in July. This is the first time in 17 years that the economy has created more than 200,000 jobs for six months in a row, and I think we can expect a seventh. On Thursday, the Labor Department reported that the four-week moving average of jobless claims fell to an eight-year low. We also learned last week that the ISM Manufacturing Index jumped to 57.1, which is its highest level in more than three years. There are lots of problems in the world, but an imminent recession in the U.S. isn’t one of them.

We’re nearing the end of second-quarter earnings season, and it’s mostly been a good one. Of the S&P 500 companies that have reported so far, 75% have beaten their earnings expectations, while 65% have beaten on sales. For Q2, the S&P 500 is on track to report earnings growth of 9.4% and sales growth of 4.2%. Despite all the loose talk of a new bubble, valuations haven’t changed much in the past year.

Our Buy List nearly made it through earnings season without a dud, but Cognizant Technology (CTSH) had to ruin it for us. On Wednesday, the IT outsourcer beat estimates by four cents per share, but lowered its sales guidance. Traders didn’t like that at all, and by the closing bell, CTSH lost 12.6%. I’ll have a complete rundown in just a bit (Spoiler Alert: I’m still a Cognizant fan.) I also want to review some Buy List members who may not make it onto next year’s list. We’re still a few months away from making our selections, but I want to share some thoughts with you. But first, let’s look at this newly volatile market.

What Are the Side Effects of QE?

Despite the big loss from Cognizant, our Buy List has been outperforming the overall stock market lately. Since we focus on high-quality stocks, we usually outperform the market during “worrying” stretches like we’ve seen recently.

Through Thursday, our Buy List is trailing the S&P 500 for the year (3.31% for the S&P 500 to -0.32% for us, not including dividends). Part of our underperformance this year is due to the rally being overfed by a lot of low-quality, crappy stocks. Even Janet Yellen recently said, while defending the overall market’s valuation, “valuation metrics in some sectors do appear substantially stretched, particularly those for smaller firms in the social media and biotechnology industries.”

She’s absolutely right. Look at a stock like Amazon.com (AMZN) which is down more than 23% from its high, and it’s still trading at 150 times next year’s earnings (the company will probably lose money this year). Last month, I mentioned the outrageous case of Cynk Technology (CYNK). The shares are down 97% since then.

This is a paradox of the market. On one hand, we want to see lower-quality names do well so capital can reach marginal businesses (and borrowers). But we don’t want to see the trend go overboard and cause investors to leave the good stuff behind. That’s partly what happened during the Credit Bubble. I remember how our Buy List trailed the market in 2006 and kept slightly ahead in 2007. But once the Financial Crisis took hold and all those garbage stocks got called out, our Buy List fell far less than the market. We recovered much more quickly as well. Why? Because we never bought the junk, so when the House of Cards tumbled over, our relative performance was outstanding.

This leads me to one of the big questions on the minds of professional investors: what are the side effects of the Federal Reserve’s unprecedented policies? The Fed has kept short-term interest rates near 0% for a long time. Naturally, any Fed policy will distort the market. I think too that some investors view this phenomenon in overly sinister tones, but I tend to view it rather dispassionately. The central bank is powerful, and it’s trying to entice investors to be more confident. That’s not easy to do, and 0% interest rates is a start.

One side effect is that investors grew too fond of junk bonds. Since the start of July, junk bonds have taken a sharp turn for the worse, and that’s probably a healthy sign. This is an important sector for investors to watch, even if you’re not invested there, because it tells us how the marginal borrower is doing. When junk bonds perform as well as other bonds, or even outperform them, that’s usually an optimistic sign for the economy. It hints that business is going well, and will probably continue to improve. But again, it shouldn’t be used to fund shady operations.

I’m also concerned that low rates have made share repurchases too easy to resist. I have no problem with companies borrowing money to fund their operations. But I’m concerned that easy credit has allowed too many companies to boost their EPS, not by growing their earnings but by reducing their share count.

This has also been a lousy year for small-cap stocks, and I can’t help but think it’s related to the Fed’s winding down of QE. Not that smaller companies benefit from the bond buying, but they prosper as the risks have been partly covered by the Fed. Why not, then, go for more aggressive names? But since July 3, the small-cap Russell 2000 is down 7.3%, nearly twice as much as the S&P 500. Investors want more safety, and they’re willing to pay for it.

What does this mean for us? Investors should focus on higher-quality names, especially dividend payers. Some Buy List stocks I like right now include Ford Motor (F), which is especially good below $17 per share. Oracle (ORCL) is a bargain below $40 per share. Ross Stores (ROST) can’t seem to catch a break, but if you’re able to get it under $65, you got a good deal. Earnings are due out soon. Now let’s take a look at our big flop of this earnings season.

Cognizant Technology Plunges after Earnings

On Wednesday, shares of Cognizant Technology Solutions (CTSH) got nailed for a 12.6% loss. At one point, the shares were down 17% on the day. The interesting part is that their Q2 earnings were quite good. Cognizant earned 66 cents per share, which topped Wall Street’s consensus by four cents per share, and quarterly revenues rose by 16.5% to $2.52 billion.

What caused traders so much grief wasn’t the earnings, it was Cognizant’s guidance. Actually, it wasn’t the earnings guidance — that was the same. It was their sales guidance that caused so much grief.

For Q3, Cognizant now expects earnings of at least 63 cents per share. Wall Street had been expecting 65 cents per share. But the company is keeping their full-year guidance at $2.54 per share, which is the same as it’s been. For Q3 sales, Cognizant now expects a range between $2.55 billion and $2.58 billion. Wall Street had been expecting $2.66 billion. For full-year sales, CTSH lowered their growth rate from 16.5% to 14%.

Cognizant’s CEO Francisco D’Souza said, “Due to weakness at certain clients and longer-than-anticipated sales cycles for certain large integrated deals, we are adopting a more conservative stance for the remainder of the year and revising our 2014 revenue guidance to growth of at least 14% over the prior year, while maintaining our full-year non-GAAP EPS guidance of $2.54.”

I can hardly say that I’m worried about a company that’s beating earnings and growing its top line by 14%. After Wednesday’s damage, CTSH is going for about 17.5 times this year’s estimate, which is a very good price. To reflect the selloff, I’m lowering my Buy Below on Cognizant to $48 per share.

Potential Buy List Deletions

According to the rules of our Buy List, the 20 stocks are locked and sealed for the entire year. No matter how much I want to make a move, I can’t touch any of the stocks until the end of the year. As usual, I only add and delete five stocks.

Now that we’re in the middle of summer, I want to share some of my preliminary thoughts on which stocks may not be around next year. Please understand that these are early indications, and I may change my mind before December. This also doesn’t mean that I don’t like these stocks at the moment. They’re simply on the short list to be cut next year. Ideally, when I make the change at the end of the year, the decisions shouldn’t come as a big surprise to regular readers.

At the top of the list is DirecTV (DTV). It’s here not because it’s done poorly, but because it’s done very well for us. Thanks to the deal with AT&T, it’s not clear how much longer DTV will go on as an independent company. I can’t make any predictions on the AT&T deal falling though, or when it might be completed, but I’d prefer to congratulate DTV, and move on to a new stock. DTV has been a big winner for us.

Unfortunately, CA Technologies (CA) has been much weaker than I expected. Quarterly revenues have dropped for nine quarters in a row, and will be probably do so again. We’ve been patient with CA, but the company’s problems run deep. I like the rich dividend, but frankly, not much else.

Moog (MOG-A) dropped sharply in February, but recovered very nicely this spring. The recent guidance, however, was not what I was expecting.

I haven’t given up on McDonald’s (MCD). The stock is cheap, but the problems for the burger giant are bigger than I expected. I think management realizes this, but turning around a company of this size won’t be easy. I still like MCD, but I want to see signs of improvement.

Medtronic (MDT) is a long-time favorite of mine, and the stock has done well for us. My concern is that the Covidien deal is a major undertaking, and the new entity will be quite different from the old Medtronic. I understand why Medtronic wants to do this deal, and it probably makes sense, but it may not be the company we want on our Buy List.

All 16 of the Buy List stocks with quarters ending in June have new reported earnings. There are only two Buy List stocks that have quarters ending in July, Medtronic (MDT) and Ross Stores (ROST). Medtronic is due to report on August 19, and Ross Stores will follow two days later. I’ll have more to say about both stocks next week. Before I go, I also want to lower my Buy Below on Qualcomm to $79 per share. The stock has continued to drift lower after the earnings report. I like QCOM a lot and expect it to recover.

That’s all for now. Next week will be a fairly slow week for economic reports. I’ll be curious to see Wednesday’s retail sales report. Consumer spending hasn’t been as strong as I’d like to see. On Friday, we’ll get the report on Industrial Production. The last three reports haven’t been that great. I’d like to see some improvement here. 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

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 for the last seven years in a row. This email was sent by Eddy Elfenbein through Crossing Wall Street.
2223 Ontario Road NW, Washington, DC 20009, USA

CWS Market Review – August 1, 2014

August 1, 2014

“I’m only rich because I know when I’m wrong…I basically have 
survived by recognizing my mistakes.” – George Soros

I’m currently enjoying a lovely vacation in Mont-Tremblant, Quebec, but I wanted to update you on the latest events on Wall Street, the economy and most importantly, our Buy List. The stock market evidently chose my vacation time to give us one of its worst days this year.

On Thursday, the S&P 500 dropped 2% to 1,930.71. That’s the index’s biggest loss since April 10th. Of course, by historical standards, a 2% drop is hardly a big drop, but it’s quite unusual for 2014. This is the third time in the past two weeks that the S&P 500 has moved by more than 1% in a single day. That didn’t happen at all in the 62 trading days prior to that. The Dow Jones Industrials have now given back their entire gain for the year.

So what caused the traders to freak out this time? It’s always hard to say exactly what event triggers any sell-off. Of course, there are several lingering concerns like Russia, Argentina and Syria, but it seems that investors were unnerved by, of all things, a 0.7% rise in the employment cost index for the second quarter. Expectations were for an increase of 0.5%.

This seems like an unusual event to cause such a big reaction. However, the employment cost report could foreshadow more inflation. Personally, I’d like to see a modest increase in inflation, but traders are hypersensitive on the issue, and given inflation’s historic impact on equity prices, it’s hard to blame them. I think it’s far too premature to worry over this issue. In fact, isn’t it good news for business that people are getting raises?

Fortunately for us, our Buy List only lost 1.51% on Thursday. Of course, our goal is to make money, not suck less than the overall market. However, Thursday’s reaction tells us that investors aren’t fleeing high-quality names as much as they are the more speculative stocks. The good economic news for this week was a stronger-than-expected GDP report for Q2. We also had a Fed meeting and several more Buy List earnings reports, but first, let’s take closer look at the surprisingly good GDP report for Q2.

Second-Quarter GDP Grows by 4%

Over the past few months, we’ve gotten lots of evidence indicating that the economy shook off a poor start to the year. A few weeks ago, I said that real GDP growth for Q2 even had a chance ofbeing as high as 4%. Well, that’s exactly what happened.

On Wednesday, the Commerce Department reported the U.S. economy grew in real terms at an annualized rate of 4% for the second quarter. That makes it the third-strongest quarter in the last eight years. This is very good news, and it’s a nice follow-up to the lousy performance for Q1. Technically, the strong number for Q2 was aided by inventory rebuilding. Interestingly, the opposite effect is what hindered GDP during Q1. Stripping out the impact of inventories, the turnaround in the economy from Q1 to Q2 wasn’t quite so dramatic.

The positive GDP news shouldn’t be that much of a surprise, since it confirms lots of other data we’ve seen, like jobs and corporate earnings. It’s interesting to note that one of the most accurate forecasters has been stock prices. Now we know why the market has been so happy!

Also on Wednesday, the Federal Reserve announced, as expected, yet another tapering. Slowly but surely, the economy is returning to something resembling normal. Starting in August, the Fed will purchase $25 billion worth of bonds each month. That’s $15 billion in Treasuries and $10 billion in mortgage-backed securities. There was one dissenter from this week’s FOMC statement, which was Charles Plosser, the head of the Philly Fed. Plosser thinks the Fed will have to keep rates low for a significant time after QE is done. I think he may be right, but honestly, that’s looking out pretty far ahead.

The earnings news for Q2 continues to be quite good. Of the S&P 500 companies that have reported so far, 76% have beaten analysts’ expectations, while 66% have topped their sales expectations. Unlike previous quarters, we didn’t need dramatic low-balling going into earnings season to get their earnings surprises. We’re not seeing blistering growth. Rather, it’s a lot of steady growth that’s been heavily aided by share buybacks.

Now let’s take a look at some of our recent Buy List earnings reports.

Moog Is a Buy up to $71 per Share

Last Friday, shortly after I sent you last week’s CWS Market ReviewMoog (MOG-A) reported fiscal Q3 earnings of $1.08 per share. That was four cents better than expectations. The problem was guidance. For all of 2014, Moog now says it expects earnings of $3.65 per share. Since we know that Moog has already made $2.59 for the first three quarters of their fiscal year, that translates to expected earnings of $1.06 per share for fiscal Q4, which ends in September. Wall Street had been expecting $1.15 per share. For 2015, Moog now expects EPS of $4.25. Wall Street had been expecting $4.56 per share.

That’s not good, and shares of Moog took a big tumble last Friday, but the stock has found a floor around $66 per share. I still like Moog a lot. The stock has done well for us, but I’m trimming our Buy Below to $71 per share. Let’s not lose sight of the fact that Moog’s “disappointing” guidance is still for earnings growth of more than 16%, and the shares are going for about 15.5 times next year’s estimate. Moog is a good stock.

AFLAC Is a Bargain below $60

We had three earnings reports on Tuesday. AFLAC (AFL) reported Q2 operating earnings of $1.66 per share, which was seven cents more than consensus. Remember that with insurance stocks, it’s better to look at their operating earnings to get a better sense of how the underlying business is doing.

The problem for AFLAC continues to be the dollar/yen exchange rate. Fortunately, the damage was far less than it’s been in previous quarters. AFLAC said they lost three cents per share due to forex. The company was also hurt by poor sales of new insurance premiums. That’s a bit more troubling, but I think AFLAC can close the gap.

As for guidance, CEO Dan Amos said, “If the yen averages 100 to 105 to the dollar for the third quarter, we would expect earnings in the third quarter to be approximately $1.38 to $1.47 per diluted share. Using that same exchange-rate assumption for the remainder of 2014, we would expect full-year reported operating earnings to be about $6.16 to $6.30 per diluted share.” Wall Street had been expecting $1.44 per share for Q3 and $6.24 per share for all of this year.

Even though AFL’s guidance range covered expectations, the stock got punished this week. On Thursday, the stock closed below $60 for the first time in nearly a year. I still like AFLAC; it’s a solid stock. But due to the recent pullback, I’m lowering my Buy Below to $66 per share; the stock is especially cheap below $60.

Express Scripts Rallies after Good Earnings

The big winner this week was Express Scripts (ESRX). The stock rose 2.1% on Tuesday, ahead of the earnings report. ESRX then jumped another 5% on Wednesday after the report. What’s interesting is that ESRX has been a pretty poor performer for us over the past five months. The lesson here is that good stocks will have their day; it just takes some patience.

Now let’s look at earnings. The pharmacy-benefits manager reported Q2 earnings of $1.23 per share, which was one penny better than expectations. Express Scripts also slightly narrowed their full-year range. The previous range was $4.82 to $4.94 per share. Now it’s $4.84 to $4.92 per share. The good news was that sales only fell 4.8% to $25.11 billion. Wall Street was expecting a 7.6% slide to $24.38 billion.

I said last week that our $74 Buy Below for ESRX was probably too high, but I didn’t want to change it just yet. I’m glad we didn’t, because I now think $74 is just right. Express Scripts is a very good stock.

Fiserv Beats by a Penny

Fiserv (FISV) is one of those fairly dull stocks that regularly churns out impressive earnings. If you’re not familiar with Fiserv, they do a lot of outsourcing for the financial-services industry. Three months ago, the company had a great earnings report, so I tempered my expectations this time. Fortunately, Fiserv came through again. On Tuesday, Fiserv reported Q2 earnings of 81 cents per share, which was a penny better than expectations.

CEO Jeffery Yabuki said, “Our second quarter’s results are in line with expectations, and helped fuel a meaningful increase in our adjusted internal revenue growth in the first half of the year compared to 2013.”

I had a feeling that Fiserv was going to alter their full-year guidance, and indeed they did. Fiserv raised the low end of their full-year forecast by three cents per share. The company now expects 2014 earnings to range between $3.31 and $3.37 per share. To give you some context, FISV made $2.99 per share for last year. Fiserv remains a solid buy up to $64 per share.

DirecTV Is a Conservative Buy up to $95 per Share

On Thursday, DirecTV (DTV) reported earnings of $1.59 per share for the second quarter. That was six cents better than expectations. As we’ve come to expect, DTV’s business in Latin American is en fuego. Last quarter, they added 543,000 subscribers in the region. That’s up more than threefold from a year ago. DirecTV now has 12.5 million subscribers in Latin America.

As good as these results are, don’t expect much action out of DTV. The stock is largely a bet that the AT&T deal will go off at $95 per share. Unfortunately, I can’t say when or if the deal will be completed, but I would say it’s quite likely. Direct remains a conservative buy up to $95 per share

Next Wednesday, August 6, Cognizant Technology Solutions (CTSH) will be the final Buy List stock to report for the June reporting cycle. (Medtronic and Ross Stores are our only two Buy List stocks with quarters ending in July, so they’ll report later in August.)

In May, Cognizant told us to expect Q2 earnings of 62 cents per share. Their full-year estimate is for EPS of at least $2.54. Shares of CTSH have traded in a very narrow range over the last six weeks. Look for a modest earnings beat, but I would be especially glad to see higher full-year guidance. Cognizant is a buy up to $52 per share.

That’s all for now. We get a few turn-of-the-month economic reports next week. Factory orders and ISM Services are on Tuesday. The trade report is on Wednesday, which could impact any revisions to the GDP report. Cognizant also reports on Wednesday. Consumer credit is on Thursday, and the Productivity report is on Friday. 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

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 for the last seven years in a row. This email was sent by Eddy Elfenbein through Crossing Wall Street.
2223 Ontario Road NW, Washington, DC 20009, USA