CWS Market Review – December 16, 2016

“The best time to invest is when you have money.” – John Templeton

Just a reminder that the 2017 Buy List will be unveiled in next week’s CWS Market Review. I’m really excited for the new list. For 2017, the Buy List will be expanded to 25 stocks. We’ll start tracking the new Buy List on January 2, which is the first day of trading in the new year. As always, newsletter subscribers are the first to get the new list.

Now to the stock market. Earlier this week, the Federal Reserve decided to raise interest rates. This was only the second time in the last decade that the Fed has done a rate hike. But what caught Wall Street’s attention was the Fed’s forecast for the next few years. The central bank predicts it will increase rates three times next year, plus three times in the year after that and another three times in the year after that!

Let’s just say I’m a little skeptical of the Fed’s bold plans. In more technical language, that’s just nuts. Of course, the Fed’s predictions of what they plan to do haven’t had a whole lot to do with what they’ve actually done. And it looks like that tradition is alive and well.

This week, we got a nice earnings report from HEICO. I’ll go over that in a bit. I’ll also preview next week’s earnings report from Bed Bath & Beyond. But first, let’s look at this week’s Fed meeting and what it means for us.

The Fed Hikes…but What Next?

The Federal Reserve held one of its two-day meetings on Tuesday and Wednesday. This was probably one of the least-surprising rate hikes in the last few decades. Everybody and their dogs were expecting this rate hike.

The increase was so expected that it really became a non-story. At one point, the futures market pegged a rate increase at 100%. It’s hard to get more certain that that! The Fed’s new target for the Fed funds rate is now 0.50% to 0.75%. That’s an increase of 0.25%. The vote inside the Fed was unanimous.

Let me first say that Fed Chairwoman Janet Yellen did a good job. She conveyed the Fed’s intentions, plus she got all the FOMC members to go along. That’s not easy.

In the Fed’s policy statement, they said, “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

As you know, I’m well versed in the arcane dialect known as Fedspeak, and I’m happy to translate this garble into normal talk. Basically, the Fed is telling markets not to expect a lot more rate-hike activity from it this year. When it says “prevail in the long run,” the Fed is obliquely referring to the natural interest rate. This is the mysterious phantom interest rate that’s the theoretical equilibrium for the economy. If the Fed goes below the natural rate, they’re boosting the economy. If they go above it, they’re hitting the brakes. Well, the Fed plans to do a lot more boosting.

But here’s where it gets interesting. Economists had assumed the natural interest rate was 2% above inflation. Ever since the economy went kablooey a few years go, the consensus is that the natural rate is a lot lower. This means the Fed is trying to go below a target that itself has moved lower.

In their latest projections, the Fed thinks the natural rate is 1% above inflation. I think that’s probably too high. This is important, because the Fed thinks they’ll be dragging the economy along for a few more years. Here’s the key fact for us: Real short-term rates are expected to be negative for another two years. That’s a green light for stock investors.

Let me explain. People always want to know if the stock market is cheap or expensive. The answer is, compared to what? If short-term rates are going to be negative, that makes stocks a no-brainer. Sure, long-term rates have moved up. In fact, the two-year yield just touched a seven-year high this week (see above). But they’re still a long way from being any real competition for stocks. The bullish conditions for the stock market haven’t changed in the slightest.

Whenever the Fed holds a two-day meeting, it’s accompanied by updated economic projections and a press conference from Chairwoman Yellen. This week’s projections took me by surprise because the Fed sees themselves raising interest rates three times in each of the next three years. That would bring the Fed funds target from 2.75% to 3%. I suppose that’s possible but it seems like a very long shot. Bear in mind that the Fed is biased to always believe that its policies will work out just fine. Hence the need for rate hikes.

But is that true? I ain’t so sure. On Thursday, for example, we learned that inflation is still well contained. Consumer prices rose by 0.2% last month. The core rate increased by the same amount. With any real inflation, there’s no hurry to jack up rates. Maybe inflation will be an issue at some point, but for now, it just isn’t there.

What’s interesting is that much of the rest of the world is where the U.S. was a few years ago, economically speaking. As a result, we’re improving, while they’re still struggling to get on their feet. Our rates are going up, while their rates are negative. The higher rates from the Fed act like a magnet that sucks in money from all over the globe. That helped push the U.S. dollar up to a 13-year high this week. The euro got down to $1.04 per dollar, which is the lowest since 2003. Gold dropped to its lowest level in ten months.

This has been a very good time for stocks. The Dow has set 15 record highs since the election. On Wednesday, the index came within 34 points of breaking 20,000. The S&P 100 broke though 1,000. In the options market, insurance to protect yourself from a market drop is the cheapest in two years.

To be frank, the Trump Rally is starting to get a bit tired. I think we’ll see a bit of a pullback over the next few weeks. Nothing too scary, but I don’t want you to be caught off guard. Don’t chase after any stocks. Wait for good stocks to come to you. As always, stay focused on high-quality stocks such as those you find on our Buy List. Speaking of which, let’s look at this week’s earnings report from the biggest winner on this year’s Buy List.

HEICO Is a Buy Up To $81 Per Share

On Tuesday, HEICO (HEI) reported fiscal Q4 earnings of 65 cents per share. That’s up from 56 cents per share for last year’s Q4. Wall Street had been expecting 62 cents per share. This was a very good quarter for HEICO, and it wraps up a very strong fiscal year.

If you’re not familiar with HEICO, the company makes replacement parts for the aircraft industry. If some weird part of your chopper splits in two, you can’t just run down to Pep Boys, but HEICO can probably help you out.

For the last fiscal year, HEICO earned $2.29 per share. Earlier the company had projected net income to rise by 13% to 15%. As it turns out, net income rose by 17% while net sales rose by 16% to $1.38 billion. I was impressed to see their operating margin stayed the same at 19.3%. That’s a good sign.

HEICO also boosted their semi-annual dividend from eight to nine cents per share. That may sound small, but these do add up over time. HEICO said they’re looking to split their stock sometime early next year.

I love this nugget from their press release:

Considering the impact of cash dividends, prior stock splits and stock dividends, one share of HEI worth $8.38 in 1990 has become worth on a combined basis approximately $1,417, representing an increase of approximately 169 times the 1990 value and a compound annual growth rate of approximately 22%.

Not bad.

For 2017, HEICO sees net sales growth of 5% to 7% and net income growth of 7% to 10%. That works out to an EPS range of $2.45 to $2.52. Wall Street had been expecting $2.53 per share.

Shares of HEI pulled back a few dollars this week, but I’m not too worried. The stock is still up 40.8% YTD. This week, I’m raising my Buy Below to $81 per share.

Preview of Bed Bath & Beyond’s Earnings

Bed Bath & Beyond (BBBY) is due to report its Q3 earnings on December 21. This has been a tough year for Bed Bath. The home-furnishings store missed Wall Street’s consensus badly for fiscal Q1 and Q2. The stock had a terrible year until a few weeks ago when it started to make up for a lot of lost ground. Since November 4, BBBY has gained 23%. It’s now down 1% on the year.

The company hasn’t given guidance for Q3, but they have said they expect full-year earnings to range between $4.50 and $5 per share. That’s down from $5.10 per share last year and $5.03 per share for the year before that. They’ve already made $1.91 per share for the first half of the year.

The consensus on Wall Street is for Q3 earnings of 99 cents per share. It’s hard for me even to give a good estimate. I’d be very relieved if BBBY earned 99 cents per share last year, and I suspect the market would be as well. The problem is the company has grown overly reliant on coupons and share buybacks. That’s a good strategy when things are going well, but not when same-store sales are falling. Bed Bath is a good company, but they need to make a lot of changes, and soon.

One more quick item. On Wednesday, Express Scripts (ESRX) reiterated their 2016 EPS guidance of $6.36 to $6.42 per share. The company also said they expect 2017 EPS to range between $6.82 and $7.02. Wall Street had been expecting $6.93. I thought the numbers were fine, but traders weren’t so impressed. The stock got clocked for a loss on Wednesday and Thursday.

That’s all for now. Stay tuned for next week’s issue with the 2017 Buy List. Next Thursday, we’ll get an update on Q3 GDP growth, plus personal income and spending, and durable orders. The stock market will be open Friday but closed next Monday, the day after Christmas. 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 December 16th, 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.