CWS Market Review – October 4, 2013

“A good decision is based on knowledge and not on numbers.” – Plato

The stock market has had a good time recently rallying when things have not happened. No taper, we’re up. No Syria attack, we rally. No Larry Summers, up again.

Now we have no government, and the market is starting to get annoyed. Well, we don’t literally have zero government, but we do have a government shutdown, and it’s looking like it might last a while. The Economist observed, “once a stalwart of good governance, America looks like a rodeo clown.” Traders clearly aren’t happy. On Thursday, the stock market took its biggest tumble in five weeks. More importantly, the S&P 500 closed below its 50-day moving average by a teeny 0.07%. That’s usually a bad omen.

First, the S&P 500 rallied for 11 out of 12 days. Now it’s fallen for 9 of the last 11 days. I’m happy to report that our Buy List continues to do very well. We outperformed the S&P 500 during the trip up, from August 30th to September 18th (6.36% versus 5.67%). And we’re beating the index on the way down, since September 18th (-1.78% versus -2.72%).

In this week’s CWS Market Review, I’ll discuss my outlook for the stock market amid the government shutdown. The good news is that earnings season is finally here. As I like to say, earnings season is Judgment Day for Wall Street. We’ll soon learn whose earnings were good, bad and/or ugly.

I’ll also preview next week’s Buy List earnings reports from JPMorgan Chase (JPM) and Wells Fargo (WFC). JPM has been causing us a lot of headaches recently, but I think we’re in store for a solid report. I’ll also discuss recent developments with some of our stocks. (Is Alan Mulally really considering leaving Ford for Microsoft? Nah!) But first, let’s look at why I’m not so concerned about the latest shenanigans in Washington but I am concerned about earnings.

The Stock Market Has Chilled Out in a Big Way

As I mentioned before, the S&P 500 rallied during the first part of September and has retreated ever since. But what’s particularly interesting is how calm the market has been. Volatility, in fact, is at a seven-year low. Thursday was the worst day in five weeks, but it was only a loss of 0.9%. That’s not that bad. During the third quarter, the average daily swing of the S&P 500 was a measly 0.45%. Compared with recent history, that’s peanuts.

Consider this fact: The S&P 500 has risen by more than 1.5% just once this year. Between 2008 and 2010, that happened 103 times. And that one day this year came on the very first trading day of the year. So we haven’t had a decent one-day jump in nine months. Sure, the market’s been going up, but it’s been an orderly and progressive climb.

Part of the reason is that the big concerns for Wall Street are gradually going away. Two years ago, the big concern was Europe. If you recall, each Friday was a nail-biter because traders didn’t want to hold their positions over the weekend when God-knows-what political bombshell could strike Europe. Two years ago, the stock market was down one day because of the news out of…wait for it…Slovakia. (Yes, I’m serious.)

My apologies to our friends in government agencies and bureaucracies, but our concern as investors should be the business operations of our stocks. We shouldn’t have to worry about who might bail out whom.

The market’s natural tendency is to search around for something to worry over and then blow it out of proportion. We’ve seen that time and time again this year. If the market can’t easily find something to fret over, it will keep on searching till it finds something. Anything.

Here’s my take. I don’t worry about any of these transient stories, but there is one big thing I do worry about: earnings. And to a much lesser extent, interest rates. But if earnings are good and the earnings outlook is good, I’m not panicking. That’s all there is to it. In fact, I would say that I’m not even concerned about a high-quality stock missing the Street’s earnings forecast by a penny or two, as long as the good trend remains intact. Remember Plato’s words: “A good decision is based on knowledge and not on numbers.” That’s the great benefit of owning good stocks.

It’s useless to speculate how long a government shutdown will last or what will happen with the debt ceiling. I’m confident in saying these issues will be resolved simply because they have to be. Members of Congress aren’t about to wreck the economy in an attempt to rescue it. To quote Ecclesiastes, “The king himself is served by the field.”

We also had some good economic news this week. On Tuesday, the ISM Manufacturing Index came in at 56.2. That’s the highest number in 30 months. Any number above 50 means the factory sector of the economy is expanding. Below 50 means it’s shrinking. The ISM report has a very good track record of aligning with recessions. For now, the economy is very much in the safe zone. But we shouldn’t take that to mean the economy will grow rapidly. In fact, I think it’s very likely that we’ll continue our current sluggishly positive growth.

The other big economic news was the ADP jobs report. Thanks to the government shutdown, there won’t be a BLS jobs report this week so we have to rely on ADP, which is a private payroll firm. According to ADP, the economy created 166,000 jobs last month. That was a bit less than expected but it’s basically inline with the current trend of meager job growth. This news will probably put more pressure on Ben Bernanke and his buddies at the Fed to hold off on tapering for awhile more. The recent talk is that tapering may start in December. Until then, the Fed is squarely on the side of investors. Now let’s look at some upcoming earnings.

Earnings Preview for JPMorgan and Wells Fargo

Next Friday, our two big bank stocks, Wells Fargo (WFC) and JPMorgan Chase (JPM), are due to report Q3 earnings. Both banks have been very profitable this year. Interestingly, both banks shifted into mortgages and have ridden the recovery in the housing market. A question for this earnings season is how much the recent rise in mortgage rates has impacted their business.

Wells Fargo made news last month when they announced layoffs in their mortgage unit. In early August, JPM laid off 2,000 people in their mortgage department. While that’s certainly unpleasant to see, I can’t say it’s much of a surprise. The market adjusts to prices, and the rise in rates has been dramatic. However, I suspect that the impact of higher mortgage rates will be less than many observers expect.

As far as banking fundamentals go, both banks continue to be very strong. Wall Street’s consensus is for Wells to earn 97 cents per share. That’s up from 88 cents per share last year. I think Wells can earn as much as $1 per share. The bank has beaten expectations for the last seven quarters in a row. Wells is a good value here. WFC is currently going for just over 10 times next year’s earnings. That’s about 25% less than where the S&P 500 is trading. Wells Fargo remains a solid buy up to $45 per share.

I feel like I’ve written enough about JPM’s tribulations. Jamie Dimon is a walking headline risk. Fortunately, the bank is making money so that will quell some criticism. I’ve said many times that I think it’s time for Dimon to leave. I’d also like to see the bank broken up. The spin-offs would be worth much more than the whole.

The consensus of the analyst community is that JPM will earn $1.29 per share. That’s down from $1.40 for last year’s third quarter. My numbers say JPM will earn $1.50 per share. I think Jamie is very talented at leading analysts to low-ball their estimates. Thanks to all the scandals, the stock is going for a very low valuation.

Let’s compare JPM’s valuation to that of Fiserv (FISV), another Buy List favorite. This isn’t highly scientific but I think you’ll see my point. Wall Street expects both companies to earn nearly the same earnings-per-share figure for next year; $6.66 for Fiserv and $6.05 for JPM. Yet, Fiserve’s share price is roughly double JPM’s. That tells you how skittish investors are. JPMorgan is a deep discount up to $56 per share.

Should Bill Gates Leave Microsoft?

Lately, there’s been a lot of chatter about some personnel shakeups at some of our Buy List stocks. Specifically, some big Microsoft (MSFT) investors said that it’s time for Bill Gates to step down as Chairman of the Board. Technically, shareholders can vote him out, but Bill owns such a big stake in MSFT that it’s nearly impossible to do.

I think the issue is very simple. If Bill Gates is more interested in philanthropy at this stage in his life, he ought to step down and concentrate on giving away his fortune full-time. I wouldn’t blame him at all. In general, I think Microsoft would be better served by some newer folks. I’m also not sure how involved Gates is in the day-to-day running of the firm, even as COB. Microsoft certainly has a lot of challenges ahead of them, but I like the stock on a valuation basis. MSfT is a good buy up to $34 per share.

There were also reports that Ford’s (F) brilliant CEO Alan Mulally might depart to become CEO at Microsoft. (If you recall, Steve Ballmer said he will retire in the next 12 months.) I strongly doubt this would ever happen. Mulally seems happy where he is, and he’s been doing a great job at Ford. Plus, the turnaround still has some time.

Speaking of which, Ford had more good news this week when they announced strong sales gains last month. September was their best sales month in seven years. The F-150 pickup had its fifth month in a row of sales topping 60,000. The Fusion and Fiesta are also doing well. Look for a strong earnings report from Ford later this month. Ford continues to be a very good buy up to $18 per share.

FBR Capital Upgrades AFLAC; $71 Price Target

Earlier this week, AFLAC (AFL) was upgraded by FBR Capital. It’s about time AFLAC got some praise from Wall Street. This is an excellent stock. FBR upgraded AFL to Outperform from Market Perform. The firm especially likes the Japan Post deal (and so do I). FBR raised their price target from $60 to $71 per share. The stock jumped back over $63 and came very close to hitting a new 52-week high.

Q3 earnings are due out on October 29th. The Q2 report was very strong. AFLAC topped the high end of their own range by six cents per share. In July, AFLAC told us to expect Q3 operating earnings to range between $1.41 and $1.51 per share.

AFLAC also said they expect full-year earnings between $5.83 and $6.39 per share. Since they made $3.31 per share for the front half of the year, that means they expect between $2.52 and $3.08 per share on the back half. They should be able to hit that range with little difficulty. Importantly, the yen/dollar exchange rate seems to have stabilized. The plunging yen took a big bite out of last quarter’s earnings. AFLAC remains a very good buy up to $64 per share.

Before I go, I wanted to add few more items. Bloomberg had a very good article discussing the issues facing DirecTV (DTV) and the satellite-TV industry. The Wall Street Journal had a good interview with the CEO of Stryker (SYK). I also want to raise my Buy Below price on Ross Stores (ROST) to $75 per share. The August earnings report was very good, and the stock is a solid value here.

That’s all for now. Earnings season officially starts next week, but it doesn’t really get going until the following week. Next Friday, we’ll have earnings reports from our big banks, Wells Fargo and JPMorgan. Also next week, we get the trade report on Tuesday. Then on Thursday, the government reports on the budget deficit for September, which was the final month of the fiscal year. 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 October 4th, 2013 at 7:13 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.