CWS Market Review – August 7, 2015

“The first principle is that you must not fool yourself,
and you are the easiest person to fool.” – Richard Feynman

On Thursday, the Dow fell for the sixth day in a row. While that’s a newsworthy headline, truthfully, it tells us little about what the market’s been up to and more about how irrelevant the Dow has become.

For more than three years, the Dow has badly lagged the S&P 500, and it’s done particularly poorly in recent weeks (see below). That’s what happens when you’re weighted down with commodity stocks like Chevron (CVX) and Exxon (XOM). Yes, this too is a manifestation of the strong dollar. To paraphrase Comrade Trotsky, “you may not be interested in the forex market, but the forex market is interested in you.” The surging dollar has impacted everything.

Fortunately, the overall market is still holding up well. The S&P 500 continues to be locked comfortably inside its trading range. Not once this year has the index closed the day more than 3.5% from its New Year’s Eve close. Bespoke Investment Group notes that the S&P 500 has crossed its 50-day moving average 31 times this year. That’s tied for the second-most ever, and we’re only in early August. It’s just one big treadmill.

In this week’s CWS Market Review, I want to take a look at some of the recent economic data. Slowly, the economy continues to grow. The expansion is weak, but it shows few signs of trouble. We also had an outstanding earnings report from Cognizant Technology Solutions (CTSH). The IT outsourcer did our favorite two-step, the beat-and-raise shuffle. It’s now our top-performing stock this year with a 27.4% gain. Later on, I’ll cover some of our other Buy List stocks. But first, let’s take a closer look at the economy and why we can expect a Fed rate hike soon.

Expect the Fed to Raise Rates in September

Last week, the government released its initial report on Q2 GDP. They said that the economy expanded by 2.3% in real terms during the second three months of the year. Frankly, that’s pretty blah. I had been expecting a little more.

But there were some positive nuggets in this report. For example, Q1 GDP growth was revised up to 0.6% from a decline of 0.2%. Consumer spending, which is 70% of the economy, rose by 2.9% in Q2. That was probably helped by lower oil prices. Speaking of which, the energy sector is feeling the pain. Spending on mines and exploration fell a stunning 68.2% in Q2. That’s the biggest quarterly drop since 1986.

The government also revised the GDP data back in 2011, and it showed that the economy didn’t do as well as originally thought. This continues to be the weakest recovery since the end of World War 2. It will also likely be one of the longest.

The day after the GDP report came out, the Employment Cost Index (ECI) report was released, and it was terrible. It showed that American workers got their smallest wage increase in 33 years. The ECI, which is the broadest measure of labor costs, rose by just 0.2% in the second quarter. That was well below Wall Street’s expectations of 0.6%.

The reaction to the ECI on Wall Street was interesting. Initially, traders thought the Fed might not be so eager to raise rates with wage growth so tepid. Not so fast. The central bank has been dropping not-so-subtle clues that rates are going up, and going up soon.

If you recall, James Bullard, the president of the St. Louis Fed, recently said that there’s a good chance the Fed will hike rates at its next meeting, scheduled for September 16-17. I’ve said I was a doubter, but I need to reconsider my stand.

This week, Dennis Lockhart, the top dog at the Atlanta Fed, told the Wall Street Journal that the Fed is ready to move. This surprised me because Lockhart is generally considered to be a centrist. So if the Fed isn’t going to be dissuaded by a lousy ECI report, then they’re not going to be dissuaded by anything.

The bond market has reacted accordingly. The six-month Treasury yield closed Thursday at 0.2% (chart below). Sure, that’s not much, but it’s the highest yield since 2010. But the long end of the bond market is still pretty tame. One indicator I like to watch is the spread between the two- and ten-year Treasuries. This week, the 2-10 spread dropped down to 1.48%, which is the narrowest since April.

On Monday, the ISM Manufacturing Index for July came in at 52.7. That’s low, but it’s still positive. Any reading above 50 means the manufacturing sector is expanding, so it’s good to see improvement here. On Wednesday, the ISM Non-Manufacturing Index rose to 60.3. That’s very good—it’s a 10-year high. The ISM Employment Index jumped to 59.6, which is also a ten-year high. So you can see where Lockhart and Bullard are getting their optimistic views.

This week, the government also reported that personal income rose 0.4% in June while personal spending was up by 0.2%. That’s not bad, but remember that was back in Q2, and we’re nearly halfway through Q3. More recent data suggest people are still spending money. On Monday, for example, the automakers reported good sales figures for July. Trucks and SUVs are especially hot. This was good news for our very own Ford Motor (F). The New York Times reported, “S.U.V.s also powered Ford’s gains in July, with nearly its entire lineup posting double-digit growth. The Ford Explorer was up 23 percent, the Edge up 17 percent and the Escape up 10 percent.” Ford is still a buy up to $17 per share.

As much as I discuss the possibility of a Fed rate hike, we should put this in some context. Even after an increase, short-term rates will still be below inflation, and it appears likely that will last for quite some time. In fact, if we look at one of the Fed’s preferred inflation metrics, core PCE, we see that inflation rose from 1% annualized in Q1 to 1.8% in Q2. That means that even if the Fed raises rates by 0.25% or 0.50%, real rates will be lower than they were at the start of the year. There’s little reason to believe that the Fed’s plans will upset the stock market. Historically, it’s taken several rate hikes to wake up the bears. Now let’s look at our final Buy List earnings report for Q2.

Cognizant Beats and Raises Guidance

Three months ago, Cognizant Technology Solutions (CTSH) told us they expected to earn at least 72 cents per share for Q2. In last week’s CWS Market Review, I told you they “should easily beat” that, and I was right. Cognizant had a great quarter. Their healthcare business was especially strong.

For Q2, Cognizant earned 79 cents per share. Quarterly revenue rose 22.6% to $3.08 billion. The consensus on Wall Street had been for $3.03 billion. All down the line, this was a very good quarter for CTSH.

Best of all, Cognizant raised its full-year guidance. For Q3, CTSH expects earnings of at least 75 cents per share on revenue of at least $3.14 billion. Previously, Cognizant had said it expected full-year earnings of at least $2.93 per share. On Wednesday, it raised that to at least $3 per share. The revenue forecast increased from at least $12.24 billion to at least $12.33 billion.

Traders liked what they saw. Shares of CTSH jumped 6.4% on Wednesday. The stock has reclaimed its crown as our #1 performer on the year, with a YTD gain of 27.4%. This week, I’m raising my Buy Below on Cognizant Technology to $70 per share. Well done, lads.

2015 Is a Solid Year for Our Buy List So Far

I don’t like to focus too much on our Buy List’s performance over the short term, but permit me a small indulgence: Our Buy List has been kicking some serious butt lately. Thanks to stocks like Cognizant, this earnings season has been a very good one for us. Since July 17, the S&P 500 is down 2.03%, while our Buy List is up 0.92%. We’ve beaten the S&P 500 ten times in the last 12 days.

Through Thursday, our Buy List is up 6.61% on the year, compared with 1.20% for the S&P 500 (dividends not included). We now have 10 stocks up double digits on the year including six that are up more than 19%.

Our lead against the S&P 500 is so big that if our position in Stryker (SYK) suddenly plunged to $0 for a 100% loss, we’d still be beating the market. This is shaping up to be the eighth time in the last nine years that our Buy List has beaten the market. Best of all, we haven’t made a single trade all year.

Bed Bath & Beyond Is a Buy up to $65 per Share

One Buy List stock that’s not been a good performer of late has been Bed Bath & Beyond (BBBY). On Thursday, the home-furnishings stores closed at $63.19, its lowest price since October.

What’s gone wrong? Let’s take a step back and see where we stand. In June, Bed Bath & Beyond reported Q1 earnings of 93 cents per share. Not great, but it was within their guidance of 90 to 95 cents per share. The key metric is comp-store sales, which rose 2.2%. BBBY’s guidance had been for 2% to 3%. OK, but again, what we expected.

For Q2, which ends in August, Bed Bath said they expect earnings to range between $1.18 and $1.23 per share. That’s not great guidance, but it’s not terrible either. But ever since that report, the stock has been a loser.

In June, the company reiterated its full-year guidance was for earnings to rise between 0% and 5%. Since they earned $5.07 per share last year, that translates to an earnings range of $5.07 to $5.32 per share. That means the stock is going for about 12 times this year’s earnings. I think that’s a very good deal.

What I like about Bed Bath & Beyond is that they generate tons of cash, and they’ve been using much of it to buy back stock. Unlike many other companies, BBBY actually reduces its share count. I like that. What I don’t like is its spending so much money on a stock that’s down 17% on the year. That’s throwing good money after bad.

Last week, I cut my Buy Below on BBBY to $70 per share. I’m going to take the unusual step of cutting it again by $5 to $65 per share. I’ll warn you that this is a riskier play, but I think the market has overreacted. I’m going to keep our Buy Below pretty tight here.

That’s all for now. No Buy List earnings reports next week, but there will be some key economic reports. On Tuesday, the Labor Department reports on Q2 productivity. The retail-sales report comes out on Thursday. On Friday, we get industrial production and capacity utilization. Our two Buy List stocks with quarters ending in July are due to report in the week after next. Hormel Foods (HRL) will report on August 19, and Ross Stores (ROST) will be on August 20. 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 August 7th, 2015 at 7:08 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.