CWS Market Review – September 6, 2013

“Sometimes your best investments are the ones you don’t make.” – Donald Trump

The Labor Day weekend is behind us, and the stock market has so far shaken off its August blues. The S&P 500 has rallied for three straight days this week and is back over 1,655. In fact, the index is getting close to breaking above its 50-day moving average. Since August 16th, we’ve closed below the 50-DMA every day but one.

Now all eyes are on the Federal Reserve and what it will do at its next meeting on September 17-18. Make no mistake, this is the most-anticipated FOMC meeting in years. The bigwigs inside the central bank have more than hinted to us that we can expect a paring back in the Fed’s asset-buying program. Of course, no decision has been made yet. Plus, even if there is a tapering announcement, we still don’t know how much it will be. Either way, over the next two weeks, you can expect a lot of opinion-makers opining on what the Fed’s opinion ought to be.

Fortunately for us, we don’t have to fret over such decisions. Our strategy remains the same. We’re focusing on high-quality stocks going for good prices, and it’s working. Despite the August slump, our Buy List holds a nice 4.7% lead over the S&P 500 for the year. By the way, did you notice the nice rebound in Ford ($F)? The automaker just reported its best sales months since 2006.

In this week’s CWS Market Review, we’ll preview the upcoming Fed meeting. I also want to cover the terrible deal Microsoft ($MSFT) just struck with Nokia ($NOK). (I really wish awful dealmakers like Steve Ballmer were in my fantasy football league.) I also want to share with you some names that I’m considering for next year’s Buy List. Plus, I want to touch on the very good ISM reports from this week. But first, let’s look at what Ben Bernanke and his crew at the Fed have in store for the economy, Wall Street and our Buy List.

Countdown to the September FOMC Meeting

The Federal Reserve meets again in two weeks, and this meeting is a biggie. Without making anything definite, Fed officials have used speeches and the media to hint that an announcement of tapering bond purchases is on the table.

Here’s where we stand. Since short-term interest rates are already close to 0%, the Fed has had to use its bond buying as an extra-special tool to help the economy get back on its feet. The Fed has also said that it will stop the bond buying first before it considers raising short-term interest rates. The Fed’s policy is that it won’t raise short-term rates until unemployment falls to 6.5%, which they don’t see happening until the middle of 2015 at the earliest.

So has the bond-buying program worked? That’s hard to say, and to some extent, I don’t care. At the least, we can say that the program has correlated with a recovery in the housing market and a surge in U.S. auto sales. The big winners in the stock market for the last year have been anything at the intersection of consumer finance and large-ticket consumer items. In plainer words, stuff people buy with borrowed money. That’s why the Consumer Discretionary ETF ($XLY) and stocks like Visa ($V) have done so well.

The stock market has been gradually rewarding riskier investments lately at the expense of safer areas. For example, utilities and consumer staples have been rather weak, but industrials have been strong. While financial stocks have been big winners since late 2011, they’ve been underperforming lately. I think this market shift is in anticipation of improved economic growth.

I think it’s a mistake to assume that the entire economy has been aided by steroids from the Fed. More than a few folks on Wall Street think that once the Fed’s assistance is gone, stock prices are due to crash. I disagree. The economy appears to have reached escape velocity, where every improvement builds on what came before. Analysts on Wall Street expect to see earnings growth of over 12% for Q3, and over 25% for Q4. If those forecasts are in the ballpark, the stock market is still cheap.

What’s really shocked people, including myself, is the rout in the bond market. As we look back at the 2013 investing year, May 2nd may turn out to be the key date. That’s when the bond market started to turn south in a big way. Except for very short-term rates which haven’t budged, most Treasury yields are at two-year highs, and they continue to rise. On Thursday, the yield on the ten-year Treasury broke 3% for the first time since July 2011.

Consider that the yield on the five-year jumped from a measly 0.65% in early May to 1.85% by Thursday’s close. Of course, in absolute terms, that’s still a puny yield, but it’s a big turnaround from what we’ve seen. It’s hard to believe that in the spring of 2011, the five-year was inching up over 2.35%.

The rise in yields has been greatest with the seven- and ten-year bonds (more than 130 basis points for each). Interestingly, short-term yields haven’t moved. What’s also caught my eye is that the spread among the longer-dated bonds has actually narrowed a bit. In early May, the 30-year yield was 116 basis points higher than that of the 10-year; now it’s down to 90 basis points. The biggest impact on the yield curve is happening in the middle.

As I explained in last week’s issue, I don’t believe the downturn in the bond market is due to fears of inflation or of the Fed’s shutting off the spigots. Instead, the higher yields are actually in anticipation of an improving economy. We got more evidence of that this week with a very strong ISM report on Tuesday. Then on Thursday, we learned that the ISM Services Index hit its highest level since 2005. We should also add the great sales report from Ford to the positive economic news pile.

So what’s all this mean? It seems that in May, the market saw Fed rate increases as being a long way off. Now it doesn’t. In May, the futures contract for the Fed funds in July 2015 rates got to $99.72. Recently, it’s been as low as $99.13. That’s a big shift.

I suspect that traders are probably getting ahead of themselves in predicting any rate increases. The Fed has said it wants to see unemployment down to 6.5% before it starts raising rates. I’m writing this early on Friday, ahead of the August jobs report, so I don’t know what the results will be (check the blog for updates), but we’re still a long way from 6.5%. The key for investors to understand is that the Fed isn’t going away anytime soon.

We don’t have much hard evidence yet on how the economy has performed during the third quarter. The ISM reports offer some clues, and the August jobs report will shed some light. The ADP report on Thursday showed an increase of 176,000 jobs last month, which nearly hit consensus on the nose.

Investors should continue to favor high-quality stocks. Our own Harris Corp. ($HRS) got off to a shaky start this year, but it has been impressive lately. We recently got a 13.5% dividend increase, and the stock hit a new 52-week high on Thursday. Later this month, three of our Buy List stocks are set to report: Oracle ($ORCL), FactSet ($FDS) and Bed Bath & Beyond ($BBBY). I’ll preview these reports in greater detail in next week’s issue, but the one that’s concerning me is Oracle. The last two reports have been duds, and I’m very reluctant to go against Larry Ellison, but I want to see solid performance in this report. Speaking of large-cap tech stocks, let’s look at the big story from this past week.

Microhard: The Awful $7.2-Billion Deal with Nokia

On Labor Day, Microsoft ($MSFT) announced that it’s buying Nokia’s ($NOK) devices and services unit for $7.2 billion in a deal that includes Nokia’s patents. I think this is another one of Steve Ballmer’s lousy deals, and traders agreed with me. Shares of MSFT dropped more than 4.5% on Tuesday (see chart below), which erased the entire surge from Ballmer’s retirement announcement. The stock has lost more than $18 billion in market value since the $7.2 billion deal was announced.

To quote myself, it’s usually a bad sign when news of your resignation causes a market-value increase of $24 billion. This latest deal shows us why the market so distrusts Ballmer. I’m afraid this is another in a long line of bad deals for Microsoft. Ballmer wasn’t joking around when he said he wants MSFT to be a devices company. You have to wonder how much longer the “soft” will be a part of Microsoft.

The Nokia deal is a deal made from weakness, and that’s usually a bad sign. On one level, it makes sense in that it brings together Windows 8 with its biggest hardware supporter. I suppose they think they can replicate the Google-Apple model. I’m not sure what was going to happen. Perhaps Nokia was going to ditch MSFT and go with Android, or maybe NOK was going to declare bankruptcy. That’s not unthinkable. The stock is still down more than 90% from its tech-bubble high. It’s very probable that Microsoft saw only bad scenarios unfolding and decided to make a move. Most importantly, I’m not sure why MSFT can succeed where Nokia has failed.

Microsoft is still on my Buy List, and will be until the end of the year. I’m very unhappy with this recent decision. The only positive thing I can say is that the Nokia deal isn’t that big relative to MSFT’s overall position. It comes to about 86 cents per share. Microsoft is sitting on a cash position of $61 billion, so this doesn’t exactly stretch their finances.

I added MSFT to the Buy List this year, and I’m not sorry I did. I still think the stock was going for a discount relative to its fair value. I also expect to see Microsoft raise its quarterly dividend later this month. The current dividend is 23 cents per share. I’m expecting an increase to 26 cents. Going by Thursday’s closing price of $31.24, that comes to an annual yield of 3.33%. I’m going to lower my Buy Below price on Microsoft to $34 per share.

Ten Candidates for Next Year’s Buy List

Now that we’re in the final third of 2013, I wanted to pass along a few names that I’m looking at as candidates for next year’s Buy List. As usual, I’ll add five new stocks and delete five current ones.

Please understand, this is just a preliminary list, and I won’t finalize next year’s Buy List until mid-December. There are currently ten stocks that I’m keeping a close eye on; IBM ($IBM), CVS Caremark ($CVS), Tupperware ($TUP), Express Scripts ($ESRX), DaVita ($DVA), Varian Medical Systems ($VAR), AutoZone ($AZO), United Stationers ($USTR), Bio-Reference Labs ($BRLI) and St. Jude Medical ($STJ).

Honestly, that list is heavier on healthcare than I would prefer, but that’s where I’ve been seeing high-quality bargains. I plan to have another list of next year’s candidates before the official list comes out in December.

Before I go, I want to make a few small adjustments to our Buy Below prices. In addition to lowering Microsoft’s ($MSFT) Buy Below to $34 per share, I also want to drop WEX’s ($WEX) down to $89. Nothing’s wrong with the stock. I simply want our buy ranges to reflect last month’s pullback. I also want to raise Ross Stores’s ($ROST) Buy Below by $1 to $71 per share. ROST has been doing very well for us.

Lastly, I’m raising CR Bard’s ($BCR) Buy Below to $119. The company just picked up Rochester Medical for a cool $262 million. Bard is paying $20 per share for Rochester, which is a 44% premium. This looks to be a smart deal, and BCR rallied on the news. Bard looks very good here.

That’s all for now. Next week, we’ll get important reports on retail sales and consumer credit. On Thursday, the Treasury Department will update us on how the budget deficit looks for this fiscal year, which concludes at the end of this month. This looks to be the government’s lowest budget deficit in five years. Of course, that’s comparing apples to trillion-dollar oranges. Still, this year’s deficit is projected to come in at a mere $680 billion. That’s nearly 38% below last year’s red ink. I want to see this trend continue. 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 September 6th, 2013 at 6:58 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.