CWS Market Review – July 26, 2022

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This is an unusually busy week for the stock market. About one-third of the companies in the S&P 500 are due to report their earnings this week. There’s also a Federal Reserve meeting with an expected rate hike. If that’s not enough, we’ll also get our first look at the report on Q2 GDP.

So far, our Buy List earnings reports are looking quite good. I’ll have more details in the premium issue later this week. Fiserv, for example, released a nice earnings report this morning, and the company raised its full-year guidance. The stock rallied over 4.2% today.

Walmart Drops 8% on Profit Warning

This earnings season, Wall Street is keeping a close eye on how companies are dealing with rising costs. This is a tough issue because it works at both ends. Companies are facing rising input costs for their goods, and they need to pass along on their higher expenses to their customers. Some companies can do this effectively, while others cannot.

With investing we always want to look at “switching costs.” This is one of the key pillars of “wide-moating” investing.

Think of it this way: if Company X were to disappear tomorrow, how easily would consumers be able to move on? If its products aren’t available, could they be effectively mimicked somewhere else? For some companies, that’s not a problem but as investors, we want to focus on stocks that are nearly irreplaceable.

For many years, there simply was no substitute for Walmart (WMT). In fact, the company rose to prominence by being a substitute for Main Street.

I mention Walmart because after the closing bell yesterday, Walmart shocked Wall Street by lowering its guidance for this year. I should explain that Walmart is so large that its quarterly earnings report is effectively a report on American consumer behavior. The company will have sales this fiscal year of about $600 billion.

In May, Walmart said it’s expected to see its operating income for the year fall by 1%. Now it’s expecting a drop of 10% to 12%. The initial estimate had been for an increase of 3%. Walmart laid the blame on inflation. The retail giant said that higher prices are holding back shoppers.

This isn’t the first time Walmart said it’s having trouble. In May, the company said that it was sitting on too much inventory. That’s about the worst problem a retailer can face. The only way out is to slash prices and hope the goods finally move. In May, Walmart said that its inventory jumped by 33% during Q1.

On Tuesday, shares of Walmart dropped by close to 8%. The company’s warning scared the entire sector. Shares of Target and Amazon also got punished, but by not as much as WMT. Walmart is also a component of the Dow Jones Industrial Average so its fate has an out-sized impact on the stock market

Walmart, like many retailers, follows an off-cycle reporting schedule. Its fiscal year ends at the end of January. It does this so the holiday shopping season lands in one reporting quarter. This means that its fiscal Q2 will end at the end of this month. Walmart will report its results for Q2 on August 16.

Walmart said that it expects to see comparable-store sales growth of 6% for Q2. The problem is that the growth is coming from the low-margin areas. For Walmart, its groceries are nearly a loss leader. They only sell grocery items to get people inside. The apparel business carries much larger profit margins.

During an inflationary environment, consumers tend to focus on lower-priced items, be it beer or coffee or dining out. Once again, it’s about switching costs.

This spring, the big box retailers have been facing big problems of shifting consumer behavior. During the pandemic, shoppers used their stimulus checks to buy things like patio furniture. While that’s good, those tend to be one-shot items. Consumers aren’t going to buy patio furniture again next year. The issue isn’t as much about growth as it is about maintaining profitability.

Weakness at Walmart is not an encouraging sign for the overall health of the U.S. economy.

Are We in a Recession?

On Thursday, the government will release its initial report on Q2 GDP growth. Wall Street expects low but positive growth, but there is a good chance that growth will be negative. If that’s the case, it will be the second quarter in a row of negative GDP growth. For Q1, the economy shrank at a 1.6% annualized rate.

Two or more quarters in a row of negative GDP growth is often called the definition of a recession; however, that’s not technically correct. I hate to get into issues of semantics, but in this case it matters.

Two or more quarters of negative GDP is a convenient shorthand for a recession. Most times, that would align with a recession, but there can be exceptions. This could be one of those times.

The committee that decides when recessions begin and end is run by the National Bureau for Economic Research (NBER). This is from their website:

The NBER’s traditional definition of a recession is that it is a significant decline in economic activity that is spread across the economy and that lasts more than a few months. The committee’s view is that while each of the three criteria—depth, diffusion, and duration—needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another. For example, in the case of the February 2020 peak in economic activity, we concluded that the drop in activity had been so great and so widely diffused throughout the economy that the downturn should be classified as a recession even if it proved to be quite brief. The committee subsequently determined that the trough occurred two months after the peak, in April 2020. An expansion is a period when the economy is not in a recession. Expansion is the normal state of the economy; most recessions are brief. However, the time that it takes for the economy to return to its previous peak level of activity may be quite extended.

The problem is that the drop of 1.6% for Q1 sounds worse than it was. During Q1, consumer spending held up relatively well despite rising costs. This is an example of something sounding like a lame excuse, but it is true in this case.

I think it’s unlikely that the U.S. is in a recession at the moment. I would place the odds at 30%, give or take. However, I’m more concerned about where the economy is headed in the near future, and it’s not encouraging. If we were to look out some, then I would say there’s a 75% chance of a recession starting sometime in the next 12 months.

Expect the Fed to Hike Rates by 0.75%

Much of the direction of the economy depends on what the Federal Reserve plans to do. The Fed meets this week, starting today and concluding tomorrow. The Fed’s policy statement will be out tomorrow afternoon at 2 p.m. ET.

It’s very likely that the Fed will raise short-term interest rates by 0.75%. That will bring the target for the Fed funds target range to 2.25% to 2.5%. Traders on the futures markets think there’s a 25% shot of a full 1% increase. That’s probably unlikely, but it’s interesting that some people are expecting that.

What comes next? I think we can expect more rate hikes, but this is the problem for the Fed. If the economy starts to show weakness, there will be pressure to stop the hikes, or even cut rates.

In fact, futures traders expect a rate cut next year. That’s highly unusual. Quick pivots in Fed policy have certainly happened before, but I don’t recall a pivot that was expected.

The futures market now thinks the Fed will have its target range at 3% to 3.25% in June 2023. That’s 0.25% lower than the prior in meeting in May. A recession next year is a very real possibility.

Good Relative Performance for our Buy List

I’m always a little hesitant to highlight our performance when our Buy List is doing well. I don’t want to jinx it, but I will take a brief moment to point out that our strategy has been outperforming the market over the last several weeks.

Since April 4, the AdvisorShares Focused Equity ETF is down 7.49% while the S&P 500 ETF is down 14.06%. Yes, I’m guilty of some minor cherry-picking, but we’ve earned it. Being down less in a down market may not sound like a great result but it makes a big difference over the long term.

If you want to learn more about our ETF, you can visit our website here.

3M to Spin Off Its Health Care Business

Before I go, I wanted to mention today’s announcement from 3M (MMM). I discussed this stock last year as an example of a good company that’s been weighed down by legal costs.

For years, 3M was a great company. Blue chips don’t get much bluer than 3M. It’s beaten the market and consistently increased its dividend. Recently, however, the stock has lagged badly.

When a well-run outfit sees its stock lag, I take notice. The problem 3M faces is lawsuits regarding the environmental damage resulting from chemicals it used to use. There’s also a lawsuit regarding 3M’s earplugs for the military.

Today, 3M said it will spin off its health care business. It will also seek bankruptcy for its subsidiary that made the military earplugs.

I like to see companies break themselves up. Pay attention when a good company has a garage sale. This can often be very good for shareholders. The new companies are no longer burdened with the legacy costs of the parent companies.

With the health care business gone, 3M will be in three business lines; safety and industrial products, consumers products and electronics and transportation. It will still be a very sizeable company. The stock gained 5% today.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

Posted by on July 26th, 2022 at 7:58 pm


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.