CWS Market Review – June 6, 2014

“I don’t expect the consensus to be right. I’m just surprised by how wrong it has been.” – Jim Bianco

This has been a remarkably efficient stock market. I say that because it’s effortlessly made fools of everyone.

Remember all that talk about “a bubble” and that we’re “due for a correction”? Well, apparently Mr. Market wasn’t cc’d on that. On Thursday, the S&P 500 rallied for the 14th time in the last 19 sessions. The index hit yet another all-time high. (I was particularly impressed when it blew past the historically significant 1,929 marker.)

As we look at this rally, we have to keep in mind all the negative news that could have tripped us up—like the lousy Q1 GDP report, or the ongoing tensions in Ukraine. None of that seems to matter. Everyone, it seemed, was expecting a mass rotation out of bonds. Didn’t happen. Instead, bond yields have plummeted this year.

Despite the market’s resiliency, what’s truly been remarkable is how little trading volume there’s been. In less-technical terms, where the heck did everybody go? Trading volume has plunged, and the bull just doesn’t care. In this week’s CWS Market Review, we’ll take a look at what this low-volume, low-volatility rally means for us and our Buy List.

I’ll also highlight some of the recent economic news. We had some interesting drama on our Buy List recently. Shares of Stryker spiked after the company denied a report that they were looking to buy Smith & Nephew. Then another one of our Buy List stocks, Medtronic, had the same rumor hit them! What’s going on? I’ll untangle it all in a bit. But first, let’s look at where the economy stands.

Finally, an All-Time High for Jobs

On the first business day of each month, the Institute for Supply Management releases its Manufacturing Index. I like to keep a close eye on the ISM report for a few reasons. One is that it comes out so quickly. A lot of economic reports come weeks after the fact. It’s also one of the econ reports that’s not endlessly revised.

The ISM also has a good track record of lining up with recessions and expansions. Here’s how it works: Any number above 50 means that the manufacturing sector is expanding, while readings below 50 mean it’s contracting. When the index is below 45, it usually corresponds to a recession. The ISM Index has been 49.0 or better for the last 59 months in a row, which lines up exactly with the current expansion.

On Monday, ISM had some problems. They had to revise their May report not once, but twice. It’s embarrassing, but they finally settled on a figure of 55.4, which was only 0.1 below what Wall Street had been expecting. That’s a decent number, and it suggests that the manufacturing sector is still healthy. For now, I don’t believe there’s a risk of an imminent recession.

On Monday, we also learned that construction spending rose by 0.2% in April. Frankly, that was a bit weak. Economists had been expecting an increase of 0.7%. Also on Monday, we learned that housing inventory is up 10.5% from a year ago. This is very important, since there was so much overbuilding during the expansion. All that excess inventory had to be burned off. Inventory is still quite low, and prices have been rising. Housing isn’t the biggest part of the economy, but it’s probably the biggest part in determining the direction of the economy.

Then on Tuesday, carmakers reported good sales for the month of May. Sales for GM rose 13%, and sales for Chrysler rose 17%. Sales at Ford ($F) rose only 3%, but that’s actually a decent performance. Ford’s been cutting back on its incentives in an attempt to manage its inventory. This was the best May for Ford in ten years. On Thursday, shares of Ford got as high as $16.89, which is a six-month high. I like this stock a lot. Ford remains a solid buy up to $18 per share.

Now about the jobs report. As usual, I’m writing this newsletter to you early on Friday morning, and the big jobs report will come out later this morning. In fact, it’s probably out by the time you’re reading this (check the blog for updates). It’s always a hazard guessing how many new jobs were created. The government is very clear that their estimates have a very wide error range (the standard deviation has been 236,000), but that doesn’t stop Wall Street from playing the guessing game. What’s more important to me, however, is the general trend of new jobs. Fortunately, that’s been rather good lately. Of course, there are still lots of unemployed folks out there, especially long-term unemployed.

On Wednesday, ADP, the private-payroll folks, said that 179,000 private-sector jobs were created last month. That was below expectations, but I should caution you that ADP doesn’t have a great track record as a bellwether for the government’s report. On Thursday, the Labor Department said that unemployment claims rose to 312,000 last week. That’s a good number. Since this number bounces around a lot, economists like to focus on the four-week moving average, which is now at a seven-year low.

It’s very likely that Friday’s jobs report will show that we finally surpassed the peak employment set in January 2008. In other words, it’s taken us six and a half years to create a few thousand jobs. As rough as that sounds, the economy lost 8.7 million jobs in 25 months. It then took another 51 months, more than twice as long, to make them all back. Wall Street has high expectations for this report. The current consensus is for 213,000 jobs. The economy added 288,000 jobs in April.

Also on Thursday, the Federal Reserve released the big “Flow of Funds” report. This is always an interesting report to see. According to the Fed, U.S. household net worth rose to $81.8 trillion at the end of Q1. In the last five years, our net wealth has risen by more than $26 trillion.

Overall, the broad economy appears to be doing well. More folks on the Street expect GDP for Q2 to be over 3%. It could be as high as 4%. One of the better economist reports is the Fed’s Beige Book. It’s a bit on the wonky side, but it has some good tidbits. The most recent Beige Book reported growth in all 12 of the Fed’s regions.

Another one of my favorite economic indicators is the yield spread between the two- and ten-year Treasuries. While the 10-year has rallied this year, it still yields 219 basis points more than the two-year. That’s a big gap. Whenever that spread turns negative, you can be sure the economy will soon hit a rough patch. The 2-10 spread has a much better track record than a lot of highly paid folks on Wall Street. The 2-10 has been over 200 basis points every day for nearly a year.

Hey, Where Did Everybody Go?

On Thursday, the S&P 500 closed at 1,940.46, which is another all-time high. But what’s interesting is that the market has rallied on very low volatility and low volume. The trading volume has declined remarkably. On Wednesday, trading in the S&P 500 ETF ($SPY) hit a new low for the year.

Last month, an average of 1.8 billion shares were traded in the S&P 500 companies. That’s the lowest volume in six years. During May, an average of $26 billion was traded each day in S&P 500 companies. That’s down from $32 billion in April.

Also, the market’s breadth continues to narrow. On May 23, the S&P 500 made a new high, but only 24 stocks in the index made a new 52-week high. I’ll warn you that these are traditionally negative signs; the problem is that you never know when the trouble will begin.

Earlier this week, the Volatility Index ($VIX) dropped down to 11.29, which is the lowest level in more than a year. (Warning: math stuff ahead.) If you’ve ever wondered what the VIX is, it’s the market’s estimate of the S&P 500’s standard deviation over the next month. The hitch is that it’s expressed in annualized terms. To turn it into a monthly figure, just divide the VIX by the square root of 12, which is 3.46. So the current VIX of 11.68 means that traders think the S&P 500 will move up or down by 3.37%, or about 65 points, over the coming month.

Only two years ago, the European bond market was ready to sink into the Adriatic. Now bond yields in the Old World are at their lowest point since the Battle of Waterloo. Mario Draghi just dropped the deposit rate from 0% to -0.1%. The European Central Bank is now the first major central bank in the world to go to negative interest rates. So much of the European economy is still in shambles. In 1914, Lord Grey famously said, “the lamps are going out all over Europe.” This time, it’s not a metaphor.

On this side of the pond, the market still seems reasonably priced despite the rally. Analysts on Wall Street currently expect earnings this year for the S&P 500 of $119.82. The estimate for next year is $137.38, but that’s probably too high. As long as yields stay low, the spreads are wide, and the economy is generating more than 150,000 new jobs each month, then the bull case is intact.

As always, investors should focus on high-quality stocks like the ones on our Buy List. As long as they’re below my Buy Below price, I think they’re good buys. Right now, I especially like AFLAC ($AFL), Bed Bath & Beyond ($BBBY), Ford ($F), Oracle ($ORCL) and Wells Fargo ($WFC).

Smith & Nephew & Stryker & Medtronic

Here’s a bit of an odd story. Last week, the Financial Times reported that Stryker ($SYK) was looking to bid on Smith & Nephew ($SNN), a British orthopedics company. But Stryker was all, “um…no, we’re not planning any bid.”

Here it gets a little confusing. Stryker had been interested in SNN, but they were only in the evaluating stage. Now that Stryker has said they’re not going to make a bid, according to British law, they can’t bid for six months. But SNN is allowed to go to them.

Once Stryker pulled itself out of the running, shares of SYK shot up. I mentioned this in last week’s issue, and I raised our Buy Below. Stryker has continued to rally, and it recently broke $86 per share. Stryker continues to be a good buy up to $87 per share.

This week, another of our Buy List companies is rumored to be very interested in Smith & Nephew, and this time it’s Medtronic ($MDT). But Medtronic is much more serious about a deal than Stryker ever was. With the implementation of the Affordable Care Act, everyone is looking to cut costs. This is driving pressure for medical-device makers to merge. Everyone wants to have “scale.” With a merger, Medtronic could also lower its tax bill by moving its HQ overseas. (That’s right, Her Majesty’s corporate tax is lower than Uncle Sam’s. Someone alert George III.)

So far, Medtronic has not commented, but I think a deal is a very real possibility. Usually, the acquiring firm sees its share price drop, but when the news broke yesterday, shares of Medtronic gapped up about $3 per share. The stock pulled back on Thursday, but it’s still higher than when the news broke.

I can’t say I’m a big fan of this deal, but I recognize that this, or something very similar, will have to happen. Medtronic remains a good buy up to $65 per share.

Buy List Update

Our Buy List has been uncharacteristically sluggish lately. For the year, the S&P 500 is up 4.98%, while our Buy List is up 2.67% (not including dividends). Of course, that’s not a huge deficit, and I think we can make it up by the year’s end, but it’s not how our Buy List usually behaves.

I don’t shy away from highlighting underperformance, but I don’t get rattled by it, either. The problem has mostly been very recent. Since May 12, the S&P 500 is up by 2.31%, while the Buy List has barely budged, up 0.19%. A lot of this reflects the changing character of the rally. As we’ve discussed before, fewer and fewer stocks are leading the market higher.

What’s interesting is that 11 of our 20 Buy List stocks are actually leading the market this year. The problem is that a small number of big losers like Bed Bath & Beyond and CA Technologies have weighed heavily on our gains.

Before I go, I want to tighten up two of our Buy Below prices. I’m dropping CA Technologies ($CA) down to $31 per share, and I’m also lowering eBay ($EBAY) to $55 per share. I still like both stocks, but I want our Buy Belows to more closely reflect the current prices.

That’s all for now. Next week is a slow week for the market. The only big economic report will be Thursday’s report on retail sales. The earnings reports for companies with quarters ending in May will start to come in. We have two of those of our Buy List: Bed Bath & Beyond and Oracle. Both are due to report later this month. I also expect to hear dividend news soon from CR Bard and Medtronic. 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 June 6th, 2014 at 7:12 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.

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