CWS Market Review – May 31, 2013

“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.”
– John Maynard Keynes

Last Wednesday, May 22nd, the stock market experienced a very rare event. The indexes jumped up early in the day, hit a new intra-day high, then turned around and closed lower by more than 1% (see the chart below). That may not sound like much, but it totally freaked traders out, and they’re an irritable crew to begin with.

Why did this put everyone on edge? Because the last two times this happened were just before the market crashes of 2000 and 2007. Despite the big intra-day swing, the stock market is still holding up well, and I’m surprised at the number of folks who are convinced that we’re headed for an imminent downturn. Let’s look at the evidence.

Is a Market Crash Imminent?

As usual, I’m not going to bother with trying to predict what the herd will do. As investors, we need to accept reality on reality’s terms. The fact is that the bears have not been treated well by this market. As long as the S&P 500 stays above its 50-day moving average (right now about 1,598), I think we’re mostly safe. As always, I urge all investors to take a conservative approach and focus on high-quality stocks like the ones you see on our Buy List.

Speaking of our Buy List, it’s been red hot lately. I probably shouldn’t mention it, as it might jinx us, but our Buy List has finally caught up to the overall market. Since April 18th, our Buy List is up 10.43%, which is ahead of the S&P 500’s 7.32%. Ten of our Buy List stocks are up more than 20% for the year, and Microsoft ($MSFT) is up 31% this year.

Ford Motor ($F), in particular, has been a rock star for us. Did anyone else notice that Ford finally broke $16 per share on Thursday? Good, me too. As impressive as Ford’s run has been, the stock is far from expensive. Ford currently trades at less than 10 times next year’s earnings estimate. I’m looking forward to another good earnings report in late July. This week, I’m raising my Buy Below on Ford to $18 per share.

Several of our financial stocks have also been performing very well. On Thursday, both of our large banks, JPMorgan Chase ($JPM) and Wells Fargo ($WFC), hit new 52-week highs. I’ve been cautious on raising my Buy Below prices, but this week, I’m going to raise my Buy Below on WFC to $46 per share. Last week, I mentioned that Nicholas Financial ($NICK) looked especially attractive below $13.70. The sale didn’t last long. On Thursday, NICK jumped up to $14.82. I’ve also been very impressed with AFLAC ($AFL) recently. The stock came close to breaking $57 on Thursday. I still think AFL is a bargain.

What Do Higher Long-Term Rates Mean for Us?

At the end of September 2012, analysts on Wall Street were expecting 2013 earnings for the S&P 500 of $114.96. Today, the consensus is down to $109.53, yet the S&P 500 has gained more than 14% over that time. What’s changed is that the earnings multiple has slowly expanded. One dollar in earnings, or expected earnings, is worth more than that same dollar a few months ago. Every day, it seems like investors become less and less nervous. Interestingly, this week we learned that consumer confidence rose to a five-year high. (Just once, I’d love to see a rise in consumer confidence reported as a drop in consumer humility.)

The odd aspect of this rally is how gradual it’s been. It’s also as if we go up by a small amount each day. The S&P 500 has only had one 2% down day all year. But the interesting action lately hasn’t been in the stock market—it’s been in the bond market. After hearing warnings of this for months, long-term interest rates have finally started to rise. On Tuesday, the yields for the middle part and long end of the yield curve had their highest rates in more than a year. Bear in mind, of course, that interest rates are still very low. Uncle Sam can borrow for five years at a measly 1%. At the beginning of May, the five-year fetched 0.65%.

The move in the bond market is being mirrored by a similar move in the stock market. The difference is that stocks aren’t going down; they’re going up, but the more defensive names are trailing. Remember last week, when I talked about the Garbage Stock Rally? This is how it’s playing out.

We can really see evidence of this by looking at the weakness of utility stocks. Investors like to buy boring utilities, so they’re protected from sudden downdrafts. Yet we’ve had a bull market, and utes have gotten clobbered anyway. From April 29th to May 30th, the Utilities Sector ETF ($XLU) dropped nearly 9%. What’s happening is that investors are choosing growth over dividends. Interestingly, Warren Buffett just made a big purchase in the utility sector. Berkshire Hathaway’s MidAmerican Energy said it’s buying NV Energy for $5.6 billion.

Whenever bonds start to fall, there’s often a fear that we’re entering a debt crisis. This time around, these fears are simply nonsense. For one, stocks are rallying from the down turn in bonds. While this rally has seen cyclicals do well (like Ford), the real strength has come from financials (as I mentioned earlier). Twenty months ago, the Financial Sector ETF ($XLF) dropped below $11. On Thursday, it closed at $20.17. Last December, I tweeted, “I still think buying XLF, sitting back and cracking a beer will be a tough strategy to beat in 2013.” Indeed it has. The XLF is up 23% on the year.

This leads me to think that higher long-term rates signal growing optimism for the economy. The U.S. dollar has also been doing well. Remember that financial markets tend to lead the economy by a few months, so the strength for the economy hasn’t shown up just yet.

For now, I encourage investors not to be rattled by any short-term moves. We’ve had a long stretch of low volatility, and those don’t last forever. Get used to seeing higher interest rates. Mortgage rates have been climbing as well. I don’t believe the Fed is close to shutting off the stimulus. This is a very good time for stocks. Investors should focus on quality and be careful not to chase any stocks. Wait for good stocks to come to you. One stock that looks especially good right now is Oracle ($ORCL). The company is due to report earnings in about three weeks. I’m raising my Buy Below on Oracle to $38 per share.

Before I go, I want to make two more adjustments to our Buy Below prices. I’m raising CA Technologies’ ($CA) Buy Below to $29, and I’m dropping Cognizant‘s ($CTSH) down to $70 per share.

That’s all for now. There are a few important economic reports next week. On Monday, we’ll get the ISM report for May. The ISM has come in at 49.9 or better for the last 46 months in a row. Let’s see if the streak stays alive. For the latter half of the week, the focus will be on jobs. On Wednesday, ADP will release its monthly jobs report. The initial claims report comes out on Thursday. Then the all-important May jobs report comes out on Friday morning. 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

Posted by Eddy Elfenbein on May 31st, 2013 at 7:05 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.