CWS Market Review – August 21, 2020

“Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership of a business.” – Peter Lynch

It finally happened: the stock market made a new all-time high. On Tuesday, the S&P 500 closed at 3,389.78. That eclipsed the old peak, which was reached one day shy of six months before. Take that, Covid.

This means that this year, we’ve had one of the sharpest bear markets in histor, followed by one the sharpest bull markets in history. It’s all happened this year, and we’re not even to Labor Day.

A lot of people have asked me: How can it be that the economy is so beaten up while the stock market is doing so well? More than a few have wondered if there’s some shadowy manipulation going on behind the scenes. Please. But there’s nothing unusual going on, and it’s not a secret government plot.

In this week’s issue, we’ll take a closer look at the seeming disconnect between the market and the economy. I’ll also go over Thursday’s earnings report from Ross Stores. The deep-discounter surprised us by earning a small profit. I’ll also preview next week’s earnings report from Hormel Foods. Believe it or not, Spam’s sales have benefited from the age of Covid. I’ll also look at some recent news from our Buy List stocks. But first, let’s look at the dichotomy of the economy and the stock market.

The Disconnect Between the Economy and the Stock Market

Unemployment is over 10%, yet Apple (AAPL) just crossed $2 trillion in market value. How can the stock market be rallying when the economy is flat on its back and so many people are suffering? It’s a good question, and the answer goes to the heart of investing.

I’m happy to tell you that it’s not the result of any dark conspiracy. Instead, these are two very different trends. The stock market looks forward as investors try to anticipate events that will happen a few months down the road. However, most economic data are backward looking. The most recent GDP report covered the time period of two to five months ago. In fact, we rarely have a good idea of how the economy is doing at this exact moment.

Not only that, but most economic data are subject to countless revisions. Sometimes data are updated years after the fact. We don’t even have a good idea of the workings of economic history.

Here’s an interesting graph. I took the annual change in the economy (the horizontal axis) and compared it with changes in the stock market (the vertical axis). It looks like a totally random scatter plot. I don’t see any correlation whatsoever.

That’s not to say that there is no relationship between financial markets and the real economy. My friend Josh Brown likes to use this analogy. Imagine you see a woman walking her dog in the park. The woman generally walks in a straight line. The dog, however, darts around in every direction.

Since the woman has the dog on a leash, they eventually go in the same direction; it’s just that one does it following a more chaotic route. Here, the woman is the economy, and our frenetic canine is the stock market. Sure, it will take many more steps, but the dog will get where the woman is going.

It’s also not unreasonable to think this might be a proper valuation for the stock market. Remember, the two keys for valuation are earnings (which have dried up) and interest rates. Those have gone down significantly. The yield on the 10-year Treasury recently reached its all-time low.

Low bond yields are very good for stock valuations. This is because they make bonds tougher competition for stocks. That’s why stocks have to rally to keep up. As well as stocks have done, they’re still trailing bonds this year. Of course, it’s nice to have the Federal Reserve as your top customer.

Also, lower bond yields make it easier for companies to borrow money. Just recently we’ve seen stocks like Intercontinental Exchange and Middleby raise money from the bond market. With yields so low, why not?

We should also consider that the economy is no longer shrinking. In fact, it’s probably rising at a rapid clip. Not enough to bring us back to status quo ante, but very fast by historical standards. This is probably what the stock market was anticipating a few months ago. According to the Atlanta Fed’s GDPNow estimate, their model sees growth of more than 25% for Q3.

The bottom line is to not worry about a rising market amid a soggy economy. It’s not an historical outlier. One of the best parts of our investing strategy is that we don’t worry if the current market “makes sense” or not. Instead, we just focus on good companies. Speaking of which, let’s look at the recent earnings report from one of our favorite retailers.

Ross Stores’s Surprise Profit

After Thursday’s close, Ross Stores (ROST) reported its fiscal Q2 results. Once again, this quarter, which was the 13 weeks ending in August 1, was heavily impacted by the economic lockdown. Ross closed all of its stores on March 20, and the company started reopening some stores on May 14. By the end of June, most of its stores were open again.

Impressively, Ross actually made a profit for its Q2. Sure, it’s a small profit, but remember, the deep discounter posted an 87-cent loss for Q1. For Q2, Ross made $22 million which works out to six cents per share. Small, but it beat Wall Street’s consensus which had been expecting a loss of 26 cents per share. For context, Ross made $1.14 per share for last year’s Q2.

Business is still tough. Total sales dropped from $4.0 million last year to $2.7 million this year. Comparable-store sales, which is a key metric for retailers, dropped by 12%.

CEO Barbara Rentler said the re-openings were helped by pent-up demand and aggressive markdowns to clear out old inventory. She noted that the average store was open for 75% of the quarter. That took a toll on ROST’s operating margin.

Looking ahead, Ms. Rentler said, “As we move into the third quarter, trends have not materially changed from the second quarter, with comparable store sales for the first two-and-a-half weeks trending down mid-teens versus last year. There remains significant uncertainty on how the pandemic will continue to evolve and affect consumer demand and the economy, and the potential exists for additional government-mandated shutdowns if COVID-19 cases remain elevated or further increase. Given these risks, we will continue to plan and manage our business very cautiously. Due to the limited visibility we have on these risks, we are not providing sales or earnings guidance at this time.”

The bottom line is that Ross is doing as well as can be expected. Shares of Ross trended lower the last two days. Perhaps some traders were anticipating bad results. Well, they didn’t get it. This report was much better than expectations, and it tells me that Ross will thrive once the economy gets back to normal. Ross Stores remains a buy up to $92 per share.

Hormel Foods Earnings Preview

Hormel Foods (HRL) is scheduled to report its fiscal Q3 earnings on Tuesday, August 25. After that, we won’t have much in the way of earnings reports until mid-October. The only exceptions are FactSet (FDS) and RPM International (RPM), which should report sometime in September.

I often tell investors that Hormel is a lot more than Spam. At the same time, don’t overlook Spam. It’s been particularly popular this year. At Bloomberg Opinion, Alan Minter notes that in the 15 weeks ending June 13, sales of Spam jumped 70%. During Covid, Americans stocked up on Spam, and they’re still buying it. Last year was Spam’s fifth year in a row of record growth. Spam is particularly popular with Asian-American and Hispanic customers.

In May, Hormel reported a tough quarter for its fiscal Q2. That’s right as the lockdowns started. Organic sales rose 6%, but earnings fell to 42 cents per share, which matched Wall Street’s consensus.

Hormel currently has over $600 million cash on hand. The company is in a strong financial position with limited debt and consistent cash flows. Total debt is $315 million, up from $250 million at the beginning of the year.

As a defensive stock, Hormel didn’t fall nearly as much as the rest of the market did in February and March. It also didn’t rise as quickly as the market did since then. Still, it’s up 16% this year which is well ahead of the S&P 500. For next week’s report, Wall Street’s consensus is for sales growth of 3.3% and earnings of 34 cents per share.

Buy List Updates

In May, shares of Ansys (ANSS) slipped after their guidance fell below expectations. It’s up 25% since then, and on Thursday, the shares got to another new all-time high. This is why we focus on high-quality stocks. Ansys has been a big winner for us this year.

Deutsche Bank initiated coverage on Check Point Software (CHKP) with a Hold rating. They have a price target of $128. I usually don’t pay much attention to analyst upgrades, but I wanted to pass this news along.

Marc Rubinstein has a very good post on Intercontinental Exchange (ICE) and what makes it tick. ICE just shelled out a huge chunk of money to buy Ellie Mae, a firm in the mortgage business. ICE plans to float $6.5 billion in bonds to finance the deal. This week, I’m raising my Buy Below price on ICE to $110 per share.

This week, Middleby (MIDD) said that it’s going to float $550 million in convertible bonds. The bonds are due in five years, and the interest rate is 1%. Middleby is doing this as part of a plan to “enhance our capital structure and provide greater financial flexibility.” These moves usually rankle investors in the short term. Sure enough, shares of MIDD are off by 10% over the last three sessions. Don’t worry about Middleby. The stock remains a good buy up to $106 per share.

Trex (TREX) got to another new high for us this week. Through Thursday, Trex is up 63% for us this year.

That’s all for now. This is a slow time for Wall Street. Many of the big shots are enjoying the waning days of summer on Martha’s Vineyard or at the Hamptons. There are, however, a few key economic reports coming out next week. On Tuesday, we’ll get reports on new-home sales and consumer confidence. On Wednesday, it’s durable goods. Then on Thursday, they’ll update the Q2 GDP report. If you recall, the initial report showed a decline of 32.9%. We’ll also get another jobless-claims report. 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 on August 21st, 2020 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.