CWS Market Review – January 16, 2015

“There’s no shame in losing money on a stock. Everybody does it.
What is shameful is to hold on to a stock, or worse, to buy more
of it, when the fundamentals are deteriorating.” – Peter Lynch

The stock market has suddenly gotten a lot more volatile. We went all of 2014 without a losing streak of more than three days. Since Christmas, we’ve had two five-day losing streaks. So far, the U.S. stock market has lost nearly $1 trillion this year.

Last year was the calmest year for stocks since 2006. The average daily change for the S&P 500 in 2014 was 0.53%. So far this year, we’re running at more than twice that. If you recall, the S&P 500 had a three-month stretch last year when it didn’t close up or down by more than 1% in a single day; but in the last five weeks, it’s happened eight times. On Thursday, the S&P 500 closed below 2,000 for the first time in a month. This is the index’s worst start for the year since 2009.

So what’s behind the market’s vicissitude? There are several events coming together, but most of them are a result of our good friend, the Strong Dollar Trade. I’ve written about this before, but every investor needs to understand what this means. Just this week, the euro slumped to a nine-year low against the dollar. The Swiss National Bank responded by scrapping the franc’s price cap against the euro. All over the globe, forex trading went bonkers. Within minutes, the franc skyrocketed 38%.

The rising dollar is putting a lot of pressure on commodities which are priced in dollars. On Tuesday, spot West Texas Intermediate broke below $45 per barrel. Then on Wednesday, copper plunged 5.3% for its biggest loss in nearly six years.

Underlying the Strong Dollar Trade is the belief that the U.S. economy is semi-strong while Europe and Asia are weak. But our economy might not be as healthy as we thought. We just learned that last month’s retail sales were the weakest in a year. This week marked the beginning of Q4 earnings season, and we’re starting to see how the soaring greenback has impacted different companies.

Confused? Don’t be. I’m pleased to report that our Buy List is well-positioned for whatever the market throws our way. In this week’s CWS Market Review, we’ll take a closer look at the earnings outlook and what it means for us. We’ll also break down the latest ructions in Europe. Later on, I’ll discuss the latest earnings report from Wells Fargo ($WFC). The big bank is doing well in a challenging environment for banks. I’ll also preview upcoming Buy List earnings reports from eBay and Signature Bank. But first, let’s take a look at how the Strong Dollar Trade is impacting the world.

Looking at the Fourth-Quarter Earnings Season

The Q4 earnings season has officially begun. This is an important earnings season because it’s our first look at how the plunge in oil has affected the corporate bottom line. In the weeks leading up to earnings season, analysts had been slashing their estimates, especially for energy stocks.

In October, Wall Street had been expecting earnings to rise by 8.5% for Q4 and by 9.5% for Q1. That’s been pared back a lot. The Street now expects earnings growth of 2.0% for Q4 and 2.8% for Q1. As you might guess, energy is mostly to blame. From the end of June to the end of December, full-year 2015 earnings estimates for energy stocks dropped by 28.9%. For the rest of the S&P 500, estimates dropped by 1.5%. Actually, that probably understates the impact of energy, since the mega-caps like Chevron ($CVX) and Exxon ($XOM) aren’t down nearly much as many of the small- and mid-cap energy stocks.

The irony is that if OPEC hadn’t been so greedy and let oil shoot over $100 per barrel, then no one would have put so much money and effort into fracking or horizontal drilling. It’s now a game of who’s going to blink first, the shale guys or OPEC. All across Wall Street, oil experts are playing a guessing game of “how low can it go.” Goldman said that oil will have to be near $40 to fend off new supplies. Bank of America and Societe Generale say that oil’s going below $40. Barron’s speculates that oil could hit $20 per barrel.

AAA said that the average price at the pump is $2.101 per gallon. That’s the cheapest gasoline has been since May 2009. OPEC has shown every sign that they’re cool with this drop and that they’re ready to let oil slide down even more. Neither side is ready to blink. In December, Iraq exported more oil than it had since the 1980s.

As I see it, a black swan is a white swan that got doused with $44 oil. Experts estimate that the supply of crude is outpacing demand by two million barrels every day. The oil bear has put the squeeze on the Russian bear. The situation in Russia is so bad that Mikhail Prokhorov, one of the big-time oligarchs, is selling his majority stake in the Brooklyn Nets. Does plunging oil hurt stocks? We don’t have a precise answer, but previous oil bears have been good for stocks.

We can assume that lower oil is very good for consumers, and that’s been helping retail stocks like Ross Stores ($ROST). But we got a surprise this week from a weak retail sales report for December. Sure, more people are working, but last week’s jobs report showed that average hourly earnings fell in December. There’s also the fear that the oil bust could lead to a collapse in capex spending. That’s a fancy way of saying that energy companies won’t shell out as much money for new projects since oil’s so cheap. That could also lead to layoffs in the energy sector.

The lousy average hourly earnings data may cause the Federal Reserve to rethink any rate-hike plans. The Strong Dollar Trade really overwhelms everything. Wholesale inflation just recorded its biggest drop in three years. Charles Evans, the president of the Chicago Fed, said that inflation may not hit 2% until 2018. Evans doesn’t want to see rates go up until next year at the earliest. He may be right. It looks like the Strong Dollar Trade is already doing its own monetary tightening, beating Yellen to the punch. That’s why the bond market continues to rally. This week, the yield on the 10-year Treasury dipped below 1.80% for the first time since May 2013 (see below). The yield on longer-dated bonds has fallen even more. The spread between the 10- and 30-year yields is at a six-year low.

Wall Street can be unforgiving if a stock misses earnings. On Wednesday, JPMorgan Chase ($JPM), a former Buy List stock, got nailed for a 3.5% loss after the bank missed the Street’s earnings consensus by 12 cents per share. JPM’s legal costs were $2.9 billion last year. I realize that sounds bad, but it’s an improvement over the $11.1 billion from 2013. Bank of America ($BAC) and Citigroup ($C) have also been weak. On Thursday, Best Buy ($BBY) got taken to the woodshed after they warned of tough times ahead. Stryker ($SYK) just said that the strong dollar will nick this year’s earnings by 20 cents per share. The previous forecast was 10 to 12 cents per share.

The real pain lately has been among “high beta” stocks, meaning the stocks that go up the most when the market goes up. Many richly valued Internet stocks like Twitter ($TWTR), Google ($GOOGL), Netflix ($NFLX), Priceline ($PCLN) and Amazon ($AMZN) have been poor performers. Investors should continue to concentrate on high-quality stocks like the ones on our Buy List. Two stocks on our Buy List that look especially attractive right now are Qualcomm ($QCOM) and Hormel Foods ($HRL). Now let’s look at Europe’s fight against slipping into deflation.

Europe’s Battle Against Deflation

Europe can’t seem to catch a break. The economy in the Old World is still flat on its face. Unemployment in the eurozone is 11.5%, and the latest stats show that Europe now faces a real threat of deflation. Mario Draghi, the head of the ECB, recently said, “If inflation remains low for a long time, people might expect prices to fall even further and postpone their spending.” A deflationary spiral is a central banker’s worst nightmare.

Draghi has been fighting intransigent European (read, German) politicians to get behind his efforts to do a large-scale Quantitative Easing, just like Bernanke did, but for Europe. Only since the latest batch of lousy economic stats has he finally prevailed. Like Bernanke, Draghi has cut rates down to nothing, and Europe is nowhere close to the ECB’s 2% target for inflation. Five-year bond yields in Germany, Finland and Switzerland have all turned negative. That means, you have to pay for the privilege of lending the government your own money!

The ECB’s next meeting is on Thursday, January 22, and that’s when Draghi will unveil his stimulus plan. This is part of the reason why the euro’s been tanking against the dollar, and why the Swiss Fed decided to abandon its currency cap (see the crazy chart below). The Swiss National Bank lowered interest rates from -0.5% to -0.75%. Now there’s the question of a price tag for Draghi’s bond-buying. Analysts have been kicking around numbers from 500 billion to 800 billion euros. Some say it could even be one trillion euros. I think Draghi is a very determined guy. Remember, he’s the one who said in 2012 that he’ll do “whatever it takes” to save the euro.

What’s Draghi going to buy? Well, that’s a really good question. His problem is that he’s going to have to buy enough bonds to make an impact, but that will mean he’ll have to buy bonds of more profligate countries, which opens him up to the charges of rewarding poor decisions. My view is that if Draghi has broad enough support from the important people, he can win his fight against deflation.

Europe’s problems don’t end there. On January 25, the Sunday following the ECB meeting, Greek voters go to the polls. The far-left Syriza party, led by the charismatic Alexis Tsipras, is expected to do well. Syriza has promised to bail out of Greece’s bailout.

The problem for investors is that that could trigger a nasty chain reaction. Europe lent Greece 240 billion euros in exchange for the government’s implementing austerity policies. Those policies are hugely unpopular. Germany has made it clear that they won’t be blackmailed by Greece, and they’re fine with Greece exiting the euro. This could turn into a massive headache for everyone. Honestly, I don’t see it coming to that, but it’s not a far-fetched scenario. Hopefully, some sort of compromise will be worked out. Now let’s look at the first earnings report from our Buy List this earnings season.

Wells Fargo Earned $1.02 per Share for Q4

On Wednesday, Wells Fargo ($WFC) led off earnings season for our Buy List. The San Francisco bank reported earnings of $1.02 per share, which matched Wall Street’s view. Net income rose slightly from $5.37 billion to $5.38 billion. This was Wells’s 18th consecutive quarter of profit growth.

Wells was much more fortunate than other big banks (like JPM) because they focus more on deposits and lending rather than trading. Looking at the top line, WFC’s revenue rose 4% to $21.44 billion. The Street had been expecting $21.24 billion. Wells clearly benefited from loan growth. Total average loans rose 4% to $849.4 billion. On the downside, Wells said that expenses rose to their highest point in two years.

WFC’s net interest margin (that’s the key metric for any bank) fell a bit to 3.04%. That’s still good. For the whole year, Wells had net income of $21.82 billion on revenue of $84.35 billion. That’s an increase of 4% and 1%, respectively. For the year, Wells earned $4.10 per share.

Overall, I’m pleased with their performance, and I recognize that the environment is less friendly towards banking. Last year, Wells’s return on equity was 13.7%. That compares well with JPM, which had an ROE of 9.8%. So far this year, the S&P Bank Index is down 8.8%, while shares of WFC are down 6.5%. This is why we focus on high-quality companies; they do better when times are rough.

Wells Fargo is also being hurt by a sluggish housing market, but I think that will gradually improve over the next several quarters. The stock got nicked after the earnings report, so this week I’m lowering my Buy Below on Wells Fargo to $54 per share.

Earnings Preview for eBay and Signature Bank

We have two more Buy List earnings reports coming next week. eBay reports Q4 earnings on Wednesday, January 21, and Signature Bank, a new member of our Buy List, reports earnings on Thursday, January 22. (You can see a complete Earnings Calendar for our Buy List stocks
here.)

Three months ago, eBay ($EBAY) had a good earnings report. The online-auction house earned 68 cents per share, which was a penny more than expectations. Quarterly revenue rose 12% to $4.4 billion. The report pleased Wall Street. From the October low to the December high, shares of eBay soared 25%.

I was a little disappointed by their guidance for Q4. eBay said they see earnings ranging between 88 and 91 cents per share. Frankly, I think that’s too low. I’m expecting a modest earnings beat. On the revenue side, eBay sees the numbers as ranging between $4.85 billion and $4.95 billion. Again, that strikes me as conservative.

Here’s my view: eBay is a very solid business. Last year, they probably generated more than $3.5 billion in EBITDA. Also, they have more than $15 billion cash in the bank. Of course, eBay also has the PayPal spinoff planned for the latter half of 2015. Revenues at PayPal are growing at more than 20% per year. eBay continues to be a buy up to $60 per share.

Signature Bank ($SBNY) is one of the five new members of our Buy List this year. Signature isn’t very well-known, but it may be the quietest success story in banking. They’re rarely in the news, and that’s exactly how they like it. But their performance tells the story. Signature’s loan-delinquency rate is about one-tenth of the industry average. They also keep a tight rein on overhead, which runs about 40% below industry average.

Three months ago, Signature reported Q3 earnings of $1.52 per share, which was six cents better than estimates. That was their 20th-straight quarter of record earnings. Earnings for Q3 grew by 27.7%. Shares of SBNY have drifted lower recently with other banking stocks. I started Signature with a Buy Below of $133, but I may tighten it up after next week’s earnings report.

That’s all for now. The stock market is closed on Monday in honor of Dr. Martin Luther King’s birthday. Earnings season heats up next week. On our Buy List, eBay and Signature Bank are due to report. We’ll also get important reports on housing starts, building permits and inventories on crude oil. On Thursday, the ECB has its big meeting to introduce its asset-buying program. 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 January 16th, 2015 at 7:09 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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