CWS Market Review – December 21, 2018

“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
― Ernest Hemingway, The Sun Also Rises

After nine-and-a-half years, one of the longest bull markets in history is on life-support. What started out as minor downturn has, since December, turned into a major sell-off. Ever since President Trump referred to himself as “Tariff Man,” the Dow has plunged nearly 3,000 points.

Of course, no downturn has a single cause, and the Federal Reserve’s fingerprints are clearly visible. This week, the Fed raised interest rates yet again, and it sees more hikes coming next year. The market reacted swiftly and negatively.

The numbers are remarkable. On Thursday, the S&P 500 closed at its lowest level in 15 months. In the last 12 trading sessions, the S&P 500 has lost 11.6%. The details are even uglier. Within the index, 423 stocks are now trading below their 200-day moving average. On Thursday, new lows beat new highs 175-0.

Never fear. In this week’s issue, I’ll walk you through the mess and explain what to do now. I’ll also fill you in on the recent earnings report from FactSet, which looked pretty good to me even though the stock pulled back. But first, let me remind you that I’m going to send you the 2019 Buy List this Tuesday on Christmas Day. This will be our 14th annual Buy List. I like to unveil the new Buy List a few days before the new year, just to prove to folks that I don’t play any games as far as timing goes.

As always, the new Buy List will have 25 stocks. I’m going to add five new names and I’ll delete five old ones. For tracking purposes, all 25 stocks are equally weighted based on the closing price from 2018. Then on January 2, the first day of trading for the new year, the new Buy List goes into effect. I’ll follow up with complete performance details. Now let’s get to this week’s unpleasantness.

The Fed Raises Rates and the Market Raises Hell

The Federal Reserve met again this week, and for the fourth time this year, the central bank raised interest rates. The target for the Fed funds rate is now 2.25% to 2.50%. As I’ve said before, I think raising rates now is a mistake. It’s true, the economy is getting better, but I still haven’t seen the normal pressures that signal an overheating economy.

The facts are pretty straightforward. Inflation is low. The dollar is strong. The Canadian dollar just hit a new low. Commodity prices are down. The price of crude just fell to a 15-month low. Housing is having a tough year, and some markets are struggling. But for some reason, the Federal Reserve has been determined to raise interest rates. Some folks speculate that they’re trying to prove their independence from a critical White House. Perhaps.

But what really spooked the market is the Fed’s apparent plans for even more hikes next year. The Fed’s policy statement noted that, “the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” The statement also said that “some further gradual increases” are needed. In other words, they ain’t done.

Along with the policy statement, the Fed released its economic projections for the next few years. The Fed members see two more increases next year. I think that’s way off base. In fact, if I were a Fed member (a big if), I would be leaning towards zero hikes for the next six months. Let workers see more gains. That’s more revenue for business.

The Fed is actually moving in the right direction. The forecast from September called for three hikes next year. One member was on record calling for five hikes! So while the Fed is moving in the right direction, they still have a lot more room to go. I like to look at the futures market to see what the serious money thinks, and they don’t see any rate hikes coming next year. (To be precise, it’s almost 50-50 on one hike next December.) In fact, the futures think there’s a very, very slight chance of a rate cut sometime next year.

Let me explain why I’m so concerned about rising interest rates from a stock-market perspective. Short-term interest rates are largely determined by the Fed. That, in turn, impacts long-term rates. That, in turn, influences stock valuations. If bond yields fall, then P/E Ratios can go higher. But if yields rise, then P/E Ratios will drop. The relationship is hardly perfect, but it’s good enough for our purposes.

Here’s a chart showing the 10-year Treasury yield in red along with the yield on the S&P 500 in blue. In this example, I’m using dividends instead of earnings, but the same principle holds. Notice how the lines were fairly close to each other in 2015, 2016 and 2017, but a big gap opened up this year. Now the market is adjusting.

Right now, earnings, the E in P/E Ratio, are growing quite nicely. However, rising yields are forcing the P/E Ratio down. The S&P 500 is currently going for about 14 times next year’s earnings. That’s not expensive. A year ago, Moody’s Baa Bond Index was yielding 4.2%. That’s up to 5.0% today. As a result, prices have shifted according to the new competition.

If someone can get 5% from a fairly generic corporate bond, why should he or she bother with stocks? As a result, the price of stocks has gone down to entice investors back. So what’s happening is that the market is shifting towards a more defensive posture. In simple terms, conservative stuff like bonds and defensive stocks are holding up well, while cyclical stocks (Industrials, Energy, Banks) are suffering.

How much longer will this last? Beats me, but I will say that selloffs usually end before anyone realizes it. Since its closing high three months ago, the S&P 500 has lost 15.8%. Traditionally, a 20% drop is considered a bear market. We may get there soon. In the short-term, the key for us to watch is the 200-day moving average. Whenever we’re below the 200-DMA, as we are now (by more than 10%), you know that the seas will be rough. Expect more volatility. We’ll get jerked higher and lower a lot, but once we clear the 200-DMA, things will get a lot calmer.

What to Do Now

The first and most important thing to do is not panic. In fact, that’s so important that I’ll make it the first and the second thing to do. Remember Warren Buffett’s dictum: “Be fearful when others are greedy. Be greedy when others are fearful.” Right now, there’s a lot of fear. I don’t advocate greed, but I do support disciplined buying.

I also don’t want you to concern yourself about waiting for the absolute bottom. In retrospect, people think of “the low” as a big event that…happens. In reality, no one realizes it at the time, and it usually happens a lot faster than you think. You can be sure there will still be people predicting the next big leg down.

In 2008, a major low came on November 20. Although this wasn’t the absolute low, it was a good time to buy. At the time, people were massively freaked out. The VIX was at 80. That’s crazy, but the prices were good.

Right now, investors should focus on high-quality stocks going for discounted prices. Let me touch on a few Buy List names that look particularly good thanks to the selloff. The first is Cognizant Technology Solutions (CTSH). The stock just hit a new 52-week low. The company expects earnings this year of at least $4.50 per share. At this price, that gives them a trailing P/E Ratio of less than 14. I also really like Ross Stores (ROST) below $78 per share. Torchmark (TMK) below $74 is a very compelling buy. TMK may be the most conservative stock on our Buy List. The final one I want to highlight is FactSet, which reported earnings last week.

FactSet Beat Earnings but the Shares Dropped

On Tuesday morning, we got our final Buy List earnings report of 2018. FactSet (FDS), reported fiscal Q1 earnings of $2.35 per share. That was a 15.2% increase over last year. It also beat Wall Street’s estimate by six cents per share. Quarterly organic revenue rose 6.4% to $353.1 million.

I’ve looked at the numbers, and they’re pretty good. The key stat for FactSet is Annual Subscription Value, or ASV. At the end of the quarter, ASV increased to $1.42 billion. I was pleased to see that FactSet’s operating margin rose to 28.6%.

“We are pleased with our first-quarter results and are encouraged by continued demand for our data and technology offerings. Our strategy to provide open and flexible solutions positions us well for another successful year of growth,” said Phil Snow, FactSet CEO.

At the end of the quarter, FactSet’s client count stood at nearly 5,300, while user count is now over 115,000. Their annual retention rate is over 95%. People love their service.

When the Q4 earnings report came out three months ago, FactSet gave us guidance for 2019. This week, they reiterated all those projections. The company sees 2019 earnings ranging between $9.45 and $9.65 per share. That’s up from $8.53 per share last year. FactSet also sees organic ASV rising by $75 million to $90 million in 2019, and they see operating margins between 31.5% and 32.5%. That’s quite good.

The market wasn’t pleased with FactSet’s results. The shares fell 4.2% on Tuesday and another 3.5% on Wednesday. Despite the drop, I don’t see anything wrong with the earnings report. FactSet continues to be an excellent company. Now it has a cheaper share price. If you can buy FDS near $200 per share, then you got a good deal.

Buy List Updates

Due to the recent downturn, several of our Buy List stocks are well below their Buy Below prices. For the time being, I’m going to take a light-handed approach to our Buy Below levels because it won’t mean much until the new Buy List goes into effect in January.

This week, Japan Post said that it will buy a $2.4 billion stake in AFLAC (AFL). I touched on this in last week’s issue, but it became a done deal this week. Japan Post now owns 7% of the duck stock.

According to the deal, after four years, Japan Post’s stake will rise to 20% of voting rights without buying any more shares. Once they hit 20%, Japan Post can record AFLAC’s profits as their own. AFLAC has held up relatively well for us recently. I remain a fan.

This week Danaher (DHR) offered its first earnings guidance for 2019. The company sees 2019 earnings ranging between $4.75 and $4.85 per share on revenue growth of 4%.

Thomas P. Joyce, Jr., President and Chief Executive Officer, stated, “We are very pleased with our 2018 performance year-to-date. We delivered strong revenue growth and operating-margin expansion, double-digit earnings per share growth and closed over $2B in acquisitions including IDT, a leading player in the genomics consumables market. We believe this year’s solid cash flow performance — in addition to our exceptional balance-sheet capacity — positions us very well for future strategic capital deployment.”

Joyce continued, “We have transformed Danaher meaningfully over the past several years, evolving into a higher-growth, higher-margin, and higher-recurring-revenue company. We have done this through a combination of organic and inorganic growth initiatives, which have helped drive market-share gains in many of our businesses. Looking ahead, with the power of the Danaher Business System as our foundation we will continue to focus on building a better, stronger Danaher and creating shareholder value for years to come.”

We don’t have the final numbers yet for 2018, but Danaher expects 2018 to be between $4.49 and $4.52 per share. Since only one quarter is missing, that’s probably pretty accurate.

That’s all for now. The stock market will close at 1 p.m. ET on Monday and then be closed all day on Tuesday, Christmas Day. There’s not much expected in the way of economic news. On Thursday, we’ll get jobless claims, housing starts and consumer confidence. Then on Friday, the home-sales report is due out. Be sure to keep checking the blog for daily updates. Stay tuned for the 2019 Buy List on Tuesday, and I want to wish everyone a Merry Christmas.

– Eddy

Posted by on December 21st, 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.