CWS Market Review – March 27, 2015

“We wander for distraction, but we travel for fulfillment.” – Hilaire Belloc

Greetings from Manila! I’m writing to you from the Philippines, where I’m on vacation. It’s interesting that back home in Washington, I live a few blocks from the Federal Reserve, yet after having traveled 8,600 miles from home, one of the things that most strikes me is the purchasing power of the strong U.S. dollar. Even on vacation, you can’t escape economics.

While the pronounced rally for the greenback has been tough on domestic manufacturers, it’s a boon for Americans going overseas. The Philippine peso has held up better than many other currencies. I should also point out that while I’m here, the Philippine Stock Exchange Index just hit another all-time high. To be fair, I can’t take full credit for this. I will, however, note the fortuitous correlation.

The first quarter of 2015 ends next week, and soon we’ll get a look at Q1 earnings reports. I have to say that I’m not expecting very strong numbers. Once again, analysts have been slashing their forecasts, and we can largely blame the strong dollar. This doesn’t appear to be the start of a downturn for the economy, but merely a pause in corporate earnings growth. I’ll have more on this in a bit. I’ll also discuss this week’s stock split announcement from Ross Stores (ROST) and what it means for our Buy List. But first, let’s take a look ahead at what to expect for the Q1 earnings season.

Q1 Earnings Preview

Analysts now expect Q1 earnings for the S&P 500 of $26.75 per share. (That’s the index-adjusted number. Each point on the S&P 500 is about $8.9 billion.) At the start of the year, they had been expecting Q1 earnings of $30.57 per share. So that’s a big cut in just a few months. If they’re right, Q1 will have the smallest profit since Q2 of 2013. It will be just slightly below the profits from Q4 of 2014.

Let me be clear that this is merely a pause in earnings growth, not a broad-based decline like we would see in a recession. In fact, there was a similar pause in 2012-13. Looking at this upcoming earnings season is what has led me to stress the Strong Dollar Trade so frequently. The reason is that some sectors are being greatly impacted, while others barely feel the difference. For example, the Energy Sector is expected to see its earnings fall more than 62% for Q1. But healthcare is expected to show a 21% increase. As we often learn, stock prices and earnings may ignore each other in the short term, but they’re joined at the hip in the long term. The Energy Sector ETF (XLE) is currently more than 24% off its 52-week high, while the similar figure for Healthcare (XLV) is less than 5%.

There’s a point at which a strong dollar is no longer a good thing, and the harm it does to the domestic economy is real. This week, Bloomberg cited a study that showed that since 1972, whenever the dollar rallies by more than 25%, the S&P 500 falls by an average of 6.4% in six months.

The important Tech Sector is expected to show earnings growth of 18%. Lately, however, many large-cap tech stocks have been underperforming. On Wednesday, the Nasdaq Composite had its best one-day drop since April. My Buy Below for Microsoft (MSFT) is currently $45 per share, but if you can get it below $41.33, that’s a very good deal. That’s exactly where the stock would be for the dividend to yield 3%. Meanwhile, the 10-year Treasury yield currently stands at 2.01%.

Last week, I talked about the dividend increase at Oracle (ORCL). The stock initially reacted well, but has since given back its entire gain. Remember that the earnings report showed us that business is basically going well, and would be even better if not for that meddling dollar. At 14 times next year’s earnings, I think Oracle is a good deal.

The S&P 500 has fallen every day this week (please note, this has happened when I’m not around). But if the earnings slowdown is temporary, and I suspect it will be, the S&P 500 is still going for a reasonable valuation. Analysts currently expect earnings next year of $135 per share. I should add that I’m always a bit leery of analyst estimates, especially that far out. In this case, I’m using these figures to represent reasonable scenarios. That would mean the S&P 500 is going for 15.2 times next year’s earnings. That’s hardly a bubble. For now, we should expect soggy earnings for the next three quarters, but the profit outlook should improve before the end of the year.

Our Recent Bout of Deflation Is Over

Earlier this week, the government reported that consumer prices rose for the first time since October. Consumer prices rose by 0.2% last month. The “core rate,” which excludes food and energy prices, also rose by 0.2%. Of course, that’s small, but it’s a break from the recent trend.

The uptick in inflation is important for us because it gives the Fed more reasons to raise interest rates, and a rate increase may come soon. It’s hard to justify raised interest rates while prices are falling. Charles Evans, the head of the Chicago Fed, said he doesn’t expect a rate hike in June. I hope he’s right, but I’m afraid he’s not. The futures market currently thinks there’s a 65% chance that rates will rise before the end of the year. (By the way, a fund manager at Morgan Stanley thinks the Fed’s next move could be a rate cut.)

The recent tensions in Yemen have given a temporary boost to the oil market, but I doubt this will last. All the important signs point to lower prices for oil, but it won’t happen in a straight line.

Here’s a remarkable stat: The S&P 500 has now gone 27 days without posting back-to-back daily gains. That’s the longest streak in more than 20 years. The four-day selloff in the S&P 500 is the longest since January, but the index came very close to another all-time high last Friday. The highest close came on March 2, when the S&P 500 finished the day at 2,117.39. Last Friday, it got to 2,108.06.

Ross Stores to Split 2 for 1

On Tuesday, Ross Stores (ROST) announced that it split its stock 2 for 1. This means that shareholders will get twice as many shares, while the share price will drop in half. Ross closed the day on Thursday at $103.82.

This will be the fifth time in the last eighteen years that Ross has split 2 for 1. One share of ROST bought 20 years ago for $11.50 is now 16 shares at $103.77. Let me be clear that a stock split by itself doesn’t add any value. But it’s generally seen as good news, since profitable, growing enterprises split their shares every few years, and that’s what Ross has done.

Ideally, I think a company shouldn’t pay much attention to its share price. In my view, management should have more important things to do, like make a profit. As long as a company does well, the stock price should follow. Warren Buffett famously has never split Berkshire Hathaway (BRKA), and the “A” shares are currently worth $216,240.

You’ll often hear that stock splits “increase the liquidity” of a stock. That could be true, but I would be leery of any investment in which lack of liquidity is an issue. I’m sometimes amused by companies that are overeager to split their shares just so they can say they split their shares. For example, I don’t see why anyone would want to declare a 3-for-2 stock split. JetBlue (JBLU) once split its stock 3 for 2 three times in three years, yet their stock didn’t appreciate much at all.

If I had my way, only splits greater than 2 for 1 would be allowed. No 5 for 4s or 3 for 2s. Also, only stocks with share prices greater than $100 would be allowed. This would stop much pointless meddling by management.

The important news for us is that Ross continues to do well. Despite the stock’s poor showing during the first half of 2014, earnings are still quite good. Last month’s earnings report beat consensus by nine cents per share. Ross remains a good buy up to $107 per share. The split will take effect on June 11. One final note: As the stock splits 20 for 1, so, too, will our Buy Below Price.

That’s all for now. This Tuesday will be the final day of the first quarter. After that, we will get the important turn-of-the-month economic reports. On Wednesday, the ISM Index comes out. Manufacturing is still expanding, but the ISM has slowly declined for the last four months in a row. I want to see a turnaround here. The big jobs report comes out next Friday. The key isn’t the number of new jobs; I want to see if there’s been a marked increase in wages. That’s what will drive the direction of interest rates. The stock market will be closed next Friday for Good Friday. 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 March 27th, 2015 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.