CWS Market Review – July 1, 2016

The market is fond of making mountains out of molehills and exaggerating
ordinary vicissitudes into major setbacks.” – Benjamin Graham

As I wrote last week’s CWS Market Review, I was keeping a close eye on the Brexit referendum results from our cousins across the pond. Going into Election Day, the Remain camp appeared to have a slight lead. Once the polls closed, the media reported that it was too close to call, and that’s what I assumed as I wrote last week’s newsletter.

However, as soon as I instructed my valet to press “send” and email the newsletter to you, things started to change—and they changed dramatically. The Leave side gained momentum. Soon it became apparent that a majority of British voters wanted out of the European Union. Wow!

The Brits Vote to Leave the EU

This was a shock to the global political establishment—and to global financial markets. Last Friday, European markets plunged. The British pound dropped from $1.50 to a three-decade low of $1.32 (see below). All hell broke loose in England’s green and pleasant land. David Cameron said he’ll resign as Prime Minister. The Labour Party faces an internal revolt as well.

I started off last week’s issue talking about how calm things had become (ha!) and about how the S&P 500 hadn’t had a 1% drop in 54 days. Clearly, I jinxed it. On Friday, the S&P 500 lost 3.17%. That was its biggest drop in nearly a year.

All across the world, investors dumped stocks and ran to the safety of conservative assets. The U.S. dollar soared. So did the Japanese yen. The yield on the 10-year Treasury approached its lows from four years ago, which were the lowest yields since 1790!

Oh, and the idea of a Fed hike? As my New York friends like to say, “fuggedaboutit!” The Fed’s not going to do anything anytime soon. I don’t think we’ll see a rate increase this year. There’s even talk that the Fed’s next move would be a rate cut (which I strongly doubt).

The selling continued into Monday, and soon we heard dire predictions of what lay ahead. Britain was headed towards recession! Other countries were going to abandon Europe! Trade protectionism would sweep the developed world! The S&P 500 lost another 1.81% on Monday and closed a fraction above 2,000.

Then what happened? Everything reversed itself. The U.S. stock market rallied strongly on Tuesday, Wednesday and Thursday. The index gained more than 1% for three days in a row. A number of our Buy List stocks like AFLAC, CR Bard, Fiserv and Stryker broke out to new highs. By the closing bell on Thursday, the S&P 500 gained back 88% of what it lost.

In fact, if you had completely ignored the market from last Thursday’s close to yesterday’s close, you probably would have assumed not much happened. The index lost a scant 0.68% over that time. For a one-week period, that’s no biggie. Sure, a lot happened during that time, but you get my point.

I often tell investors that investing is unlike any other activity. Imagine if you went to a tennis instructor for tennis lessons and the instructor told you that the best way for you could improve your game would be to immediately stop playing tennis, put your racket in storage and don’t even think about tennis. You might think the instructor had lost his marbles. Yet, as odd as it sounds, that advice is quite sound for investing. The less you try, the better you’ll do. Not panicking last week was a wise move, yet it’s simply too hard for so many.

Markets are instruments that process information. That means they tend towards short periods of freaking out and long periods of not doing much. Last Friday and Monday were freak outs. The world assumed the British would vote to stay in the EU, and the world was wrong. That happens. The selling was exaggerated because the areas seen to benefit from a Remain victory had been rallying.

I can’t claim any foresight. I thought the Remain side would pull it out as well. The difference is that our strategy of focusing on high-quality stocks isn’t dependent on a particular election outcome. We’re prepared for whatever comes our way. Actually, some of the immediate effects, like a stronger yen, will help our portfolio. AFLAC (AFL) closed out Thursday at a new all-time high.

What’s the Impact of Brexit?

So what does all this mean for our portfolio? That’s a difficult question to answer, but I think the long-term effect will be minor. Remember that we’re hearing people who didn’t see this vote coming now confidently predicting what it all means.

Most importantly, this is almost purely a financial matter. Let me explain. There are really two economies. There’s the “production economy,” which consists of people going out and building things or providing services for people. That’s the real economy. Then there’s the make-believe economy, also known as the financial economy, which consists of people in expensive suits who trade pieces of paper.

The two economies are related to each other, but sometimes that relationship can appear to be rather distant. The stock for any particularly company can move sporadically, even though the company’s operations are as stable as ever.

In the case of Brexit, we’re talking about an event firmly based in the world of the financial economy. Many European banks dropped sharply on hearing the news, and many American banks did poorly as well, including our own Wells Fargo (WFC) and Signature Bank (SBNY). That’s probably due to the belief that interest rates are going to stay low. Long-term bond yields have been closely correlated with the relative strength of financial stocks, meaning bonds and banks are moving in opposite directions.

If I ran a London-based investment bank that many clients used as an entryway to the European economy, then I suppose I’d be very concerned about the future implied by Britain’s not being in the EU. Since I don’t, and since our Buy List doesn’t reflect anything like this, I can’t say I’m terribly worried about Brexit. I would be more concerned by a larger wave of voters protesting free trade, but that doesn’t appear to be a major concern. In fact, many in the Leave camp stressed that they’re not opposed to trade or immigration. Rather, the issue for them is their own parliament, not Brussels, deciding such matters.

I think it’s interesting that the major British stock index, the FTSE 100, is actually higher than where it was before the vote. Some of that, of course, is due to the weakening of the British pound. Even on Friday, shares of Hormel Foods (HRL) closed higher. HRL rallied on Monday as well. We are truly playthings for the market gods.

The Buy List at the Halfway Mark

The first half of 2016 is now over. I’m afraid to say that our Buy List has lagged the S&P 500 during the first half of this year; however, it’s not doing that poorly.

For the first six months of 2016, our Buy List is down 2.04%, while the S&P 500 has gained 2.69% (see below). Once we include dividends, our Buy List is down 1.45%, while the S&P 500 is up 3.84%.

What did we do wrong? Nothing really. The issue is that the stock market reversed course in early February. That rally has been led by many cyclical stocks and “high-beta” stocks, which are underweighted on our Buy List. For example, the Energy Sector ETF (XLE) is up more than 30% from its February low. Our Buy List doesn’t have any energy stocks, so we haven’t enjoyed a bounce like that. On the other hand, we never suffered a 50% crash as the XLE did in the 20 months prior to that.

Underweighting those sectors wasn’t a strategic decision. I just didn’t see that many bargains there. I’m still optimistic for our Buy List for the remainder of this year. The only stock that I’m leaning toward regretting is Bed Bath & Beyond (BBBY). But even that one is so cheap, we might as well stick with it.

Stryker (SYK) is our #1 winner so far this year, with a YTD gain of 28.93%. In the cellar is Alliance Data Systems (ADS), with a loss of 29.16%. Earlier this year, ADS dropped 19% in one day.

I always try to be up front about our track record. While the first half has been disappointing, I’m looking forward to better second half of 2016.

Buy List Updates

Despite the market’s drama of the past week, there hasn’t been much news impacting our stocks. One big story is that Wells Fargo (WFC) passed the Fed’s latest stress test. The bank is pretty solid, and it’s never had much trouble passing muster with the Fed.

Now that Wells’s capital plan has gotten its gold star from the Fed, the bank is free to raise its dividend. Wells has been, by far, the most generous of the major banks. Last year, WFC paid out 75% of its net income as dividend or share buybacks.

In April, the bank raised its quarterly dividend by half a cent, from 37.5 to 38 cents per share, but that was under last year’s capital plan. The board said it’s going to meet to decide what to do with the dividend. Wells Fargo is due to report Q2 earnings on July 15, two weeks from today.

In last week’s issue, I mentioned how the rising yen is good news for AFLAC (AFL). I wrote, “there’s talk of it soon breaking 100.” By soon, I apparently meant a few hours. Thanks to this week’s chaos, investors rushed to buy safe-haven assets like the yen. At one point, the yen got to 99 to the dollar. It’s since settled back at 103. That’s an impressive rally. Late last year, the yen had been going for 123 to the dollar. AFL closed Thursday at $72.16, which is a new all-time high. The company will report earnings again on July 28.

That’s all for now. The stock market will be closed on Monday in honor of July 4. Next week, the Fed will release the minutes of its last meeting. I suspect that much of that discussion is already out of date, but it will be interesting to hear what the central bank said. On Thursday, we’ll get the latest initial-claims report, plus the ADP payroll report. That leads us up to the big June jobs report on Friday. The last jobs report was a major disappointment. I’ll be curious to see if some of those numbers will be revised. 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 July 1st, 2016 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.