CWS Market Review – June 3, 2016

“If you’ve followed my forecasts, you’ve probably lost a lot of money.”
– St. Louis Fed President James Bullard

Yeah, thanks for that tip, James, but we’ve already shied away from following the Federal Reserve’s predictions. Still, the central bank is kinda hard to ignore. There’s another big Fed meeting in two weeks, and the top brass is hinting that they’re serious about a rate hike. I honestly don’t know what will happen, but I think raising rates now would be a big mistake.

In this week’s CWS Market Review, we’ll take a closer look at where we stand with the economy, the Fed and Wall Street. More importantly, we’ll zero in on how it impacts our portfolios.

Later on, I’ll cover the very good earnings report from HEICO. The company raised guidance for the second time this year. (I love it when our stocks do that!) HEICO is now our #1 performer this year, with a YTD gain of 22%. When you have a well-diversified portfolio, you never know who’s going to have an all-star year.

I’ll also bring you up to speed on some other Buy List stocks, plus I’ll tell you which ones look particularly cheap at the moment. But first, let’s look at what the Fed might have planned for us later this month.

The S&P 500 Rises to a Seven-Month High

Wall Street has been in a good mood lately. The Nasdaq Composite has rallied for seven straight sessions. The S&P 500 closed Thursday at 2,105.26, which is a seven-month high. The index is now just 1.2% from its all-time high close reached a little over a year ago.

While the recent uptick is nice to see, I’m not ready to celebrate a breakout just yet. As we’ve seen, the broad market indexes have been fairly range-bound for the past 18 months. The 2,100 barrier has been tough to break. We also have a few hurdles in our way, like the upcoming Fed meeting, plus the Brexit vote in the U.K.

One factor I like about the market’s rally is that it’s been fairly broad, meaning more stocks are joining in on the fun. Charlie Bilello, one of my favorite technicians, points out that 66% of stocks on the NYSE are trading above their 200-day moving averages. That’s the most since July 2014.

We’re also seeing that different sectors like Utilities, Tech and Industrials are all near new highs. For example, Amazon.com is at a new high, and that’s getting a lot of attention (I was asked about it this week on CNBC). Yet fairly bread-and-butter stocks like Johnson & Johnson, Lowe’s and Illinois Tool Works are also at new highs (alas, CNBC did not ask me about ITW).

At the moment, Wall Street is focused on the June 14-15 Fed meeting. At this meeting, the Fed will also update its economic forecasts, and Chairwoman Yellen will host a post-meeting press conference. She and other Fed officials have signaled their willingness to raise interest rates in the coming months. This has been in contrast to what Wall Street, and I, think is needed.

For the most part, I believe the Fed has overestimated the need for higher interest rates (and Mr. Bullard apparently agrees). While there have been some improvements to the economy, there are still large areas of weakness, especially in the labor market. I could certainly understand the need for a rate increase if we saw rising consumer prices and decent wage gains. Instead, commodities like oil are rebounding after a steep fall, and wage growth has been fairly lackluster.

While I think a rate hike now would be a bad idea, I can’t say that a 0.25% increase would sink the economy. We got through the first rate hike from late last year. Second-quarter GDP will probably be a lot better than Q1. I‘ve also noticed that many heavy-industry stocks have been doing well. From our Buy List, Wabtec (WAB) and HEICO are good examples. That may suggest that the industrial sector is gaining strength. This week, we saw that the ISM Manufacturing Index for May was 51.3. That’s not great, but it does mean that the factory sector is expanding.

If I had to guess, I’d say the Fed won’t raise rates at this meeting, but I’m far from certain. Right now, the futures market thinks there’s a 20.6% the Fed will raise rates. But for the July meeting, the odds rise to 58.5%. After that, the futures market expects the Fed to sit on its hands for a few months.

The bond market is already taking notice. The yield on the one-year Treasury is up to 0.68%. Of course, that’s not very high, but it’s near the highest yield in more than seven years. Not that long ago, the one-year Treasury yield was bouncing around between 0.1% and 0.2%. Still, much of the world is talking about negative interest rates. This week, the ECB decided to keep deposit rates at -0.4%. If that’s not enough, next week, the ECB will start buying corporate bonds.

One interesting stat to watch is the spread between the two- and ten-year Treasuries. I’ve talked about the 2/10 spread before. It’s been one of the best economic indicators of the last three decades. Whenever the spread has turned negative, meaning the two-year yield has exceeded the ten-year yield, economic trouble has shortly followed.

The 2/10 spread recently narrowed to less than 95 basis points. It hasn’t been that narrow since 2007. What this means is that lenders are becoming more discerning with their loans. Let me be clear: we’re still a long way from the danger zone, but within the credit markets, the tightening cycle has begun. Just this week, JPMorgan CEO Jamie Dimon said that the auto-loan business is “a little stressed.” Eventually, tighter credit spills over to less consumer spending.

If the Fed hikes, and the long end of the bond market doesn’t respond, then the spread will get narrower. But consumers aren’t so sour just yet. This week, the Federal Reserve released its Beige Book report. This is a pretty wonky report, but it often has good insight into the economy. I was surprised to see the Beige Book mention that labor markets were “tight,” which would suggest that wages are improving. The report was largely optimistic for the economy.

I’m not concerned yet about higher interest rates, but it certainly could be a problem in the near future. A few months ago, I looked at the data and found that the stock market has performed much better when the difference between the 90-day and 10-year Treasuries has been greater than 1.21%. The difference is currently 1.51%.

As investors, we’re in a good spot now, but it’s important that the Fed not cause any damage. Now let’s take a look at the excellent earnings report from HEICO.

HEICO Is a Buy up to $70 per Share

On Wednesday of last week, May 25, HEICO (HEI) reported fiscal Q2 earnings of 57 cents per share. This was another good quarter for the aircraft-parts supplier. Not enough analysts follow HEICO for us to claim that there’s truly a “consensus” on Wall Street, but I had been expecting earnings of 55 cents per share. HEICO had earned 49 cents per share in last year’s Q2. Quarterly sales rose 20% to $350.6 million.

Laurans A. Mendelson, HEICO’s Chairman and CEO, commented on the Company’s second-quarter results, stating, “We are very pleased to report record quarterly results in consolidated net sales and net income driven by record net sales at both operating segments and record operating income at the Electronic Technologies Group. Our outstanding performance reflects profitable contributions to earnings from the fiscal 2015 and 2016 acquisitions, strong quarterly organic growth within the Electronic Technologies Group and continued increased demand within our Flight Support Group’s aftermarket replacement-parts and specialty-products lines.

The good news is that HEICO also raised its guidance for this year:

Based on our current economic visibility, we are increasing our estimated consolidated fiscal 2016 year-over-year growth in net sales to 15% – 17% and net income to 12% – 14%, up from prior growth estimates in net sales of 14% – 16% and growth in net income of 10% – 13%. Additionally, we anticipate our consolidated full-year operating margin to approximate 18.5% – 19.0%, depreciation and amortization expenses to approximate $62 million, capital expenditures to approximate $32 million and cash flow from operations to approximate $220 million.

This is the second time HEICO has increased its guidance this year. Unfortunately, HEICO only provides guidance for net income and not earnings-per-share. The company earned $1.97 per share last time, so we can infer a full-year EPS between $2.25 and $2.30 (assuming a stable number of shares). That’s seems very doable. HEICO has already earned $1.03 per share for the first half of this year.

The shares reacted very well to the earnings report. At one point, HEI broke $67 per share. I had been holding off on adjusting our Buy Below price, but this earnings report shows us that the company is doing very well. This week, I’m raising my Buy Below on HEICO to $70 per share.

Buy List Updates

A few of our lagging Buy List stocks have started to perk up. High-quality stocks may disappoint you for a few months, but they tend to bounce back. Stocks like Wells Fargo (WFC) and Biogen have recently broken out to fresh four-month highs.

Remember back in March when Oppenheimer downgraded Fiserv (FISV)? The firm also pulled its $100 price target. Fortunately, we ignored it. Fiserv had another great earnings report in April, and the shares hit yet another new high this week of $106.65. Fiserv remains a solid stock.

Shares of Alliance Data Systems (ADS) are finally showing signs of life. I won’t mince words—ADS has been a big disappointment for us this year. In January, the stock plunged 19% in one day. But lately, ADS has rallied, and it just touched a four-month high. The stock is now up more than 27% from its February low. This is exactly why we focus on the long term.

Three weeks ago, I said that Biogen (BIIB) hasn’t done well for us this year, “but I think it’s ready for a turn.” It’s still early, but it looks like I was right. The biotech stock recently breached $291 per share, and it’s at its highest point since the start of the year. Keep watching this one.

Look for another dividend increase from CR Bard (BCR). The company usually announces the new dividend in early June. My guess is they’ll raise the quarterly payout from 24 to 27 cents per share. Bard has increased its dividend every year since 1972.

Express Scripts (ESRX) is another disappointing stock that’s starting to come back. Shares of ESRX are now at their highest level since January. The company has had a lot of drama this year, which has weighed down the stock, but let’s not forget how profitable they are. I’m expecting another good earnings report in July.

Shares of Ford Motor (F) dropped this week after a disappointing sales report for May. Ford’s truck business is still doing well, but their car business didn’t live up to expectations. I still like Ford a lot here. Look for another good earnings report in late July. The dividend currently yields 4.5%.

There are a few Buy List stocks that look especially good right now. I mentioned Biogen before, but I think this one has room to run. I also like Bed Bath & Beyond (BBBY). I realize it’s a frustrating stock to own but the price is very low. Earnings are due out on June 22.

That’s all for now. I’m writing this to you early Friday, and the May jobs report comes out later this morning. Wall Street expects a gain of 160,000 jobs, but this number may be distorted by the Verizon strike. Still, the key figure to watch will be wage growth. On Tuesday, we’ll get the productivity report, and on Friday, the government reports on the budget. 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 June 3rd, 2016 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.