CWS Market Review – July 7, 2017

“Investing is the intersection of economics and psychology.” –Seth Klarman

We’re now in the second half of 2017. The first half was a pretty good one for us—and for the market as a whole. I’m pleased to say that our Buy List is beating the overall market. If all goes well, this could be the ninth time in the last eleven years in which our Buy List has beaten the Street.

So far, the second half of 2017 looks like the first. Trading has been fairly quiet, but the overall outlook remains positive. Soon things will get a lot more interesting. The second-quarter earnings season is about to kick off. This is when we learn whose business has been performing and whose hasn’t.

While the overall economic outlook is still solid, there are weak spots spreading. For example, the auto sector is not looking good. The industry just had another poor sales report. This week, we also got a look at the minutes from the last Fed meeting. This is when the central bank decided to raise rates again. I’ll tell you what it means for us and our portfolios. But first, let’s look at how our Buy List did during the first six months of 2017.

Our Buy List Is Beating the Market

Through June 30, the 25 stocks on our Buy List gained 10.10%. Including dividends, we were up 10.66%.

That was enough to beat the S&P 500, which was up 8.24%. With dividends, the index was up 9.34%. So we’re beating the market. Not by a lot, but we’re ahead.

Eighteen of our 25 stocks were up for the year. Fourteen were up more than 10%, and four were up more than 29%. CR Bard (BCR) just edged out Cerner (CERN) for first place, 40.7% to 40.3%. Our biggest loser on the year was Ross Stores (ROST), the deep-discount retailer, which was down 12.0%.

Let’s also remember that we haven’t made one trade all year.

Preview of Second-Quarter Earnings Season

Twenty-one of our 25 stocks will be reporting earnings over the next month. (I’m including RPM International. Their quarter ended in May, but their earnings report will come out at the same time the June quarter stocks are reporting.) Earnings season runs from mid-July until early August. Expect to see increased volatility in our stocks. Let me caution you that even companies with good earnings reports can see their stocks fall. Traders aren’t always so rational. It’s simply how the game works.

For the S&P 500, analysts expect to see operating-earnings growth of 20.6%. (You may see different numbers reported. I take mine right from S&P. I think operating earnings is the best metric to focus on.)

The second quarter should be the fourth quarter in a row of rising earnings. Prior to that, the S&P 500 suffered through a nasty streak of seven quarters with declining earnings. A lot of that was due to the rising dollar and falling oil prices. For the most part, Wall Street looked beyond that “earnings recession.” Profits have definitely improved, and Q2 looks to see an all-time record for earnings.

Analysts currently expect Q2 earnings of $31.00 per share. That’s the index-adjusted number. Every one point in the S&P 500 is worth about $8.567 billion. If that forecast is correct, it would top the previous record of $29.60 per share from the third quarter of 2014. That would also give the index trailing four-quarter earnings of $116.41 per share. Based on Thursday’s closing price, that means the S&P 500 is going for 19.84 times trailing earnings. That’s high, but I wouldn’t say it’s an obvious bubble.

The $31.00 forecast for Q2 is down from the start of the year. On December 31, analysts saw Q2 earnings coming in at $32.24. Please note that analysts’ forecasts almost always start out too high. As we get close to earnings day, the forecasts get pared back until they’re actually a bit too low. When earnings finally come out, about two-thirds of companies beat their expectations. Only on Wall Street are you expected to beat expectations. In fact, you’ll often see a stock fall that merely matched expectations. Apparently no one saw that coming.

For all of 2017, Wall Street now sees the S&P 500 earning $128.26 per share. For 2018, the forecast is for $145.96. Let’s be clear that both numbers are wildly off, but at least it’s a starting point. That would mean the S&P 500 is going for 18 times this year’s earnings, and 15.8 times next year’s. Again, that’s high, but I wouldn’t say it’s a bubble.

Dividends Continue to Rise

Another argument in the bulls’ camp is the continued strength of dividends. A lot of folks think this is simply smoke and mirrors generated by the Federal Reserve. I disagree. Last quarter was another solid quarter for dividends from the S&P 500. This was the 29th quarter in a row of higher dividends for the index.

The S&P 500 paid out $12.12 per share in dividends last quarter. For Q2, dividends were up 7.42% from last year’s Q2. This was the third quarter in a row of acceleration (meaning, higher rate of growth). Dividends are up 117% since Q2 of 2010, while the index is up 107%. No one wants to hear this, but during this bull market, the S&P 500 has largely matched dividend growth. In fact, the S&P 500 has strayed terribly far from 50 times its four-quarter dividends (meaning a 2% dividend yield).

Through the last four quarters, the S&P 500 has paid out $47.22 per share in dividends. That works out to a dividend yield of 1.96%. I’m not declaring this to be the single perfect measure of market value. I’m simply saying that this has been where the market has stayed for a long time. And it’s still right there.

The Minutes from the Fed’s June Meeting

I’ve told you many times that I was against the Federal Reserve’s decision to raise interest rates last month. I hope I’m wrong, but I think the Fed is being too aggressive at this moment in the cycle.

This week, the Fed released the minutes of their June meeting. The minutes showed that the Fed thinks the recent decline in inflation won’t last. The FOMC thinks inflation will eventually stabilize around 2%.

My concern is that the decline in inflation combined with the rate increases has worked to push real interest rates (meaning, after inflation) well above where they ought to be.

A few folks at the Fed also said that lower volatility in the stock market may be boosting share prices too much. That also could explain why long-term bond yields remain so low. I’m a bit skeptical. I don’t think the Fed should be too concerned about equity prices. As for lower bond yields, that may suggest that the Fed has a lower interest-rate “ceiling” than they may realize.

The futures market currently expects just one more rate hike in the next 12 months. They expect it to come in December. Even at the Fed’s meeting in June 2018, the futures market thinks there’s less than a 40% chance of a second rate hike.

Nothing here is written in stone, and I’ll note that long-term yields have gapped up over the past eight trading sessions. Perhaps investors are expecting stronger growth numbers. The Atlanta Fed now expects Q2 GDP growth of 2.7% for Q3. It had been at 3%. Last week, we learned that the economy grew by 1.4% in Q1.

For now, I suggest not getting too worried about the macro-economic picture. The upcoming earnings reports are far more important. In addition to good numbers from our stocks, I’d also like to see clearer guidance for the rest of the year. By the middle of the year, companies usually have a better grasp of how their customers are behaving. Investors should continue to focus on high quality and make sure they have some steady dividend-payers in their portfolios. Now let’s look at one of my favorite mid-cap stocks.

Barron’s Highlights HEICO

There hasn’t been much company-specific news on our Buy List stocks. That will change when earnings come out. Last week, I was pleased to see Barron’s highlight HEICO (HEI). This is a wonderful company that’s not very well known. It seems like the financial media spend the majority of their time on a handful of very well-known stocks.

HEICO has been a huge winner for us since we added to our Buy List at the start of last year.

Here’s a brief sample of what Barron’s had to say:

Heico is probably one of the best companies you’ve never heard of. That’s because it serves an obscure segment of the world’s economy: It sells replacement parts to the airline industry. The aircraft-components business has grown by 5% a year for more than 50 years, along with global passenger volumes. But because Heico has found a durable, low-cost niche in aerospace, its revenue has been growing by three times that rate since 1990, when the Mendelson family took charge.

(…)

Heico is beloved by its customers and the FAA, whose lead many of the world’s other regulatory bodies follow. A new entrant could attempt to make PMA parts as Heico does, but would have to spend years, if not decades, earning the trust of the airlines and the FAA. Heico has cracked the oligopolistic nature of the aerospace industry, and is now a member of the club.

Shares of HEI gapped up more than 4% on Monday. HEICO continues to be a buy anytime you see the shares below $75.

That’s all for now. Later today, the June jobs report will come out. Next week, several Fed officials will be speaking. We may get a better idea of what the central bankers are thinking about the economy. On Wednesday, the Beige Book report comes out, which is a pretty good overview of the economy. On Friday, we’ll get reports on retail sales and consumer inflation. 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 July 7th, 2017 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.