CWS Market Review – July 6, 2018

“Economics is extremely useful as a form of employment for economists.”
– John Kenneth Galbraith

I’ll be honest: this is a slow time for the stock market. Most of the big-time money guys are chilling in the Hamptons. Trading volume has been dead. Plus, this week the stock market closed early on Tuesday and was shut all day on Wednesday.

Yep, it’s summertime on Wall Street. Soon, however, things will get a lot more interesting. Second-quarter earnings season is set to begin in a few days. Most of our Buy List earnings reports will start coming out later this month. Of the 25 stocks on our Buy List, 21 will report earnings over the next few weeks.

In this week’s issue of CWS Market Review, I want to review some of the recent economic news. The good news is that the economy is behaving pretty well. What concerns me, however, is that the Trade War is quickly moving from rhetoric to reality. This could be trouble for the economy. I’m not the only one concerned. So is the Federal Reserve. Later on, I’ll update you on some of our Buy List stocks. I’m pleased to report that our Buy List has been beating the market quite soundly over the past few weeks. Before I get to that, though, let’s focus on where the economy is headed.

The Economy Is Improving, but a Trade War Could Spoil It

The jobs report for June will come out later today. I’ll have a chance to address it later, but we do know that the report for May was very good. Unemployment fell to its lowest level since the 1960s. The jobless rate for women hasn’t been this low in 65 years. The consensus on Wall Street is for the economy to have created 190,000 net new jobs in June.

Earlier this week, we got a preview of the jobs report with the ADP private payrolls report. According to ADP, the economy added 177,00 new jobs last month. In the last reading, initial unemployment claims fell to 231,000. That’s quite strong. We’re not far from the best report since 1969.

While the labor market looks better, the overall economy is growing, but not very fast. This could change soon. We won’t get the first estimate of Q2 GDP until the end of this month, but expectations are high. Q1 GDP came in at 2.0% (that’s annualized and adjusted for inflation). The economy has pretty much stuck to 2% for the last few years. Policy makers couldn’t have done a better job if they had tried, but the Atlanta Fed now estimates that the economy grew by 4.1% in the second quarter. That would be amazing if it turned out to be right. The New York Fed’s model is less optimistic, predicting 2.8% growth for Q2.

What about earnings? There the outlook is quite good. Wall Street expects Q2 earnings of $38.65 per share for the S&P 500. (That’s the index-adjusted number. Every point in the S&P 500 represents about $8.5 billion.) If that forecast is correct, it would be an all-time record. It would also be a healthy 27% jump over last year’s Q2. Bear in mind that these forecasts are usually a bit low.

What’s notable is that the Q2 earnings forecasts have been increasing. Typically, the forecasts start out high and are pared back until they’re slightly under the actual results. (That’s right. On Wall Street, it’s expected that you’ll beat expectations.) This time, expectations are much higher thanks to tax reform. At the start of the year, the Street had been expecting Q2 earnings of $35.95 per share. The current estimate is already 7.5% above that.

It’s not just earnings. We’ve also seen good news on the dividend front. During Q2, dividends for the S&P 500 rose by 8.1% over last year. This year, the S&P 500 will probably pay out $53 per share in dividends. That works out to a yield of just under 2%. On a side note, the S&P 500 has tracked a 2% dividend yield fairly closely for 15 years. The only exception was during the financial crisis. After that blew over, we went right back to 2%. A lot of people are paid a lot of money to value the stock market. Yet simple arithmetic probably would have done a better job.

We’re also concerned by the direction of Fed policy. The central bank has already raised interest rates twice this year. Two more hikes are probably coming. The Fed seems very likely to raise rates again in late September and possibly once more just before Christmas. Soon, this will put a squeeze on the economy.

On Thursday, the Fed released the minutes from its last meeting. This is the one where they decided to lift rates. The FOMC members were impressed by the strength of the economy. However, they said they were concerned over issues related to trade. “Most participants noted that uncertainty and risks associated with trade policy had intensified and were concerned that such uncertainty and risks eventually could have negative effects on business sentiment and investment spending.”

I share this concern. We’ve already seen that Harley-Davidson is looking to shift some production outside of the United States. Starting on July 6, the U.S. government will impose a 25% tariff on Chinese goods shipped to the U.S. Not surprisingly, China has said they’ll hit back. I don’t think anyone really “wins” a trade war. The Chinese stock market has been getting crushed recently. Honestly, these opening shots in the trade war probably won’t hurt the U.S. economy very much. The problem is how far this escalates. Let’s remember that China holds a cool $1.2 trillion in U.S. Treasuries, so it’s wise not to anger them too much.

Speaking of the Treasury bond market, the spread between the two- and ten-year Treasuries is now down to 29 basis points. One more hike could push it negative. The 2/10 spread hasn’t been negative in more than 11 years. This isn’t something to worry about now, but it could become a major theme in 2019. I talk about the 2/10 spread a lot, but I want to caution you not to think of it as a panic button. Since 1976, whenever the 2/10 spread has been between 0% and 0.50%, the stock market has gained an average of 13% the following year.

The proper outlook for us as investors isn’t one of fear but of prudence. This is related to a theme I’ve talked about recently, the market’s more defensive nature. Since June 6, the S&P 500 Low Vol Index is up 1.91% while the S&P 500 High Beta Index is down 4.42%. But before then, the market was all about High Beta. If we measure starting in early 2016, High Beta had a lead of more than 50%. That’s why the defensive market can last for a while.

It’s precisely this turn towards defensiveness that connects the themes of a tightening Fed and a looming trade war. Fortunately for us, the defensiveness has been a net position for our Buy List.

Buy List Updates

I want to be careful not to overstate this, but our Buy List has been acting much better than the overall market recently. As we know, the market can be very fickle, especially in the short term. This is why we’re so focused on the long term. Still, I want to highlight some of our improved performance.

Since June 1, our Buy List is up by 3.23% (not including dividends) while the S&P 500 is up a scant 0.07%. The Buy List is now up 2.82% for the year. This is the highest level for the Buy List since mid-March. Let’s look at some individual names.

Shares of Church & Dwight (CHD) touched a new 52-week high on Thursday. The stock has rallied impressively in the last month. I think of CHD as a classic defensive stock because a recession won’t have much of an impact on their household products.

Three months ago, CHD reported Q1 earnings of 63 cents per share. That was two cents better than estimates. The company also reaffirmed full-year guidance of $2.24 to $2.28 per share. CHD increased its expected sales growth to 9%. For Q2, they expect earnings of 46 cents per share. This week, I’m lifting my Buy Below on Church & Dwight to $57 per share.

Becton, Dickinson (BDX) is quietly turning into a nice winner for us this year. Through Thursday, shares of BDX are up 13.1%. With the last earnings report, Becton raised its full-year guidance by five cents per share at both ends. The company sees 2018 coming in between $10.90 and $11.05 per share. I’m raising our Buy Below to $250 per share.

Cerner (CERN) was our big disappointment last earnings season, as the company lowered guidance. At one point, CERN got down to $52 per share. Lately, however, the stock has acted much better. On Thursday, the shares closed at a three-month high. I hope to see improvement in the next earnings report. This week, I’m raising our Buy Below on CERN to $65 per share.

Sherwin-Williams (SHW) is another stock that’s turned a corner for us. The company started off the year on the wrong foot. Two months ago, SHW got down to $362 per share. The company now expects full-year EPS of $18.35 to $18.95. On Thursday, it broke $410. I’m lifting our Buy Below on SHW to $414 per share.

That’s all for now. We’ll start getting some early earnings reports next week. There’s not much in the way of economic reports although I’ll be on the lookout for Tuesday’s Small Business Optimism report. Also, the CPI report will come out on Thursday. So far, inflation has been fairly well contained. Typically, when unemployment gets this low, pricing pressures increase. We haven’t seen much of that yet. Let’s hope it continues. 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

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3 High Yield Stocks for Bottom Fishers

Dividend investors face an extra challenge of timing stock purchases. No dividends will be earned until shares are bought. There are several techniques on when to buy that I use and recommend to investors who follow my Dividend Hunter system. For more aggressive income stock investors, jumping into out-of-favor high yield stocks can produce excellent returns.

In my previous article, I discussed three stocks that have done well so far in 2018 (all up over 20% YTD) and which I expect to continue to post gains for the rest of the year. Buying stocks in an uptrend is the safer strategy. If the moves are driven by underlying fundamentals, you can expect the trend to continue if the fundamentals remain positive. The trade off is that rising stocks have been discovered, and usually carry lower yields. The three that I highlighted on Monday have an average current yield of 5.4%.

For investors searching for higher yields, there is the challenge in analyzing whether dividends are secure or in danger of reduction or elimination. These are often stocks that have dropped significantly in value, and most investors get scared or nervous about jumping on shares where the price has recently gone through a steep decline. Bottom fishing for high-yield stocks is a more aggressive strategy. The investor must be able to determine if the company can continue to pay dividends, and there is a need for patience. It can take months or even years for a stock to recover to pre-crash levels. The good part is that these stocks can pay double-digit yields, which is a nice wage to earn while you wait. Here are three high yield stocks that illustrate the strategy.

What Does This Huge Options Trade Mean For Oil?

When I write about large options block trades, it’s generally for one of two reasons. First, a lot of smart money is active in the options market. If a very big (i.e. capital intensive) trade occurs with options, it can often be a signal that there’s going to be action in the underlying asset.

Second, sometimes I just find an options trade very interesting and worth discussing. It could be because it’s an unusual trade or is an original way to handle risk management. Of course there are times when I write about a large trade because it’s interesting and may provide meaningful insight into the underlying asset.

A trade last week I came across meets both of those criteria. More specifically, I noticed a massive covered call trade in United States Oil (NYSE: USO).

USO is the most active oil ETF. While it has its flaws, trading USO is probably the easiest way for the average trader/investor to trade oil. Beyond trading oil futures themselves, USO is likely the most direct way to trade oil as well.

Covered calls can be intriguing to analyze because they can be successful in many different types of market conditions. However, one of the few situations which are “bad” for covered calls are when the underlying asset price blows through the short call strike. (It’s not entirely bad since you are still making money, but you could have made more money by just being long the asset.)

So, is this covered call trade suggesting there’s a limit on how far oil prices are going to rise? Let’s take a closer look at the position.

Posted by on July 6th, 2018 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.