CWS Market Review – March 18, 2016

“A bull market is like sex. It feels best just before it ends.” – Barton Biggs

The Federal Reserve met this week, and finally, after months of exploring several other options, decided to agree with reality. The Fed no longer believes it will need to raise interest rates a few more times this year.

Wall Street responded, “Gee, you think so, Captain Obvious?” (I’m paraphrasing.) The stock market jumped to its highest level all year. The S&P 500 is now down a wee 0.16% for 2016, but remember how lousily the year started? This was one of the worst starts to a year in Wall Street history. By February 11, the S&P 500 was more than 11% in the hole. Five weeks later, we can see this has been a hugely impressive turnaround, and a few of our stocks, like Fiserv and Stryker, broke out to new highs this week.

I’ll break down what this week’s Fed decision means for us (spoiler alert: it’s quite good). We also got some surprising news on the inflation front. Core prices, which exclude food and energy, are rising at their fastest pace in years. I’ll tell you what it all means. But first, let’s take a closer look at what Janet and her friends at the FOMC were up to this week.

Wall Street Loves the Fed’s Softer Tone

The Federal Reserve had another policy meeting this week, and as expected, the central bank held off on raising interest rates. Frankly, that wasn’t much of a surprise.

But what was a surprise was the Fed’s new “dovish” outlook. Until now, the Fed projected that it would need to raise interest rates four times this year. Even as trouble spread in Europe and Asia, the central bank stuck to its guns. The Federal Reserve is the only major central bank in the world whose last move was a rate hike. Everybody else is cutting. Poor Mario Draghi at the ECB has slashed below 0% and he doesn’t seem to have plans to stop.

But Wall Street never went along with the Fed’s view. At the start of the year, traders expected a few more hikes, though not much. During the first part of the year (January 1 to February 11), the economic outlook badly deteriorated. Not only was oil moving in lockstep with the market, but so were the expectations for the Fed. As stocks sunk lower, the odds for more rate hikes became ever smaller.

At the time, we heard loud calls that the Fed had screwed up by raising interest rates in December. The Fed, we were told, had to placate the market gods by taking back the rate increase. Some people started to jabber that Janet would have to follow Mario into negative-rate land. Chairwoman Yellen was even asked this at last month’s Congressional testimony.

You could really see the sea change by looking at the bond market. At the start of the year, the two-year Treasury (which is often a good proxy for Fed policy) was yielding 1.02%. By February 11, it was down to 0.64%. In the futures pits, the odds for a June rate hike fell to 2%. Futures traders didn’t think there would be any rate hikes this year, or next. It was as if interest rates had become a thing of the past. You may recall that a lot of bank stocks got squeezed.

Then a funny thing happened. People suddenly realized that the economy isn’t that bad. Also, why would anyone want to get 0.64% for a two-year note if you could get three or four times that much from stock dividends? Or in the case of a Buy List stock like Microsoft, they could get four or five times that—not to mention that MSFT is a growing company.

“A Slightly More Accommodative Path”

In the last few issues of CWS Market Review, I’ve highlighted the better economic numbers. I’ve been careful to say that the economy still has a lot of room for improvement, but it’s far from dire. Wall Street finally got the message. On February 11, the S&P 500 retested the “Tchaikovsky Low” and broke it, and the bulls have been top dog ever since. On January 20, only 9% of the stocks in the S&P 500 were above their 50-day moving average. Now 90% are.

Which brings us to this week’s Fed news. At her press conference, Chairwoman Yellen said, “What you see here is a virtually unchanged path of economic projections and a slightly more accommodative path.” In other words, rates will be lower for longer.

Yellen gave two reasons for the policy shift. She noted that while the U.S. is getting back to normal, the rest of the world is still mired in slow growth. It’s especially hard for the Fed to raise rates when so many other central banks are cutting. The other reason is that the market has already done much of the Fed’s work for them. By that, I mean that lending standards have tightened.

So what we’re seeing is a twofold move. First, the Fed is abandoning its strongly hawkish cash for rate hikes, while Wall Street has abandoned its very strongly dovish outlook for a moderately dovish outlook. The two-year yield, in fact, is now back up to 0.87%, and traders think there’s a 40% chance of a June hike. What a difference one month makes!

Why does this matter for stock investors? It all comes down to math. If investors can get stiffer competition from fixed income relative to stocks, stocks will go down to compensate. Capital always goes to wherever it’s treated best.

Let me explain why the Fed’s move this week is very good for us. In addition to the policy statement, the Fed also updated its economic projections. In December, the FOMC expected that they would be raising rates four times in 2016, and another four times in 2017. The median projection thought rates would be around 2.5% by the end of 2017.

This week’s projections are far more realistic. A majority of members think rates will be under 2% by the end of next year. Given the Fed’s outlook for inflation, which hasn’t changed, that would mean that the Fed thinks real rates will still be negative 21 months from now. That’s amazing, and it’s a very strong signal for investors that stocks are still your best bet. Equities love easy money.

The Fed sent us a strong signal to stick with stocks, and the economy is still on the rise. Now let’s look at a surprising trend: the quiet emergence of inflation.

Is Inflation Coming Back?

On Wednesday morning, a few hours before the Fed’s announcement, the government released the latest CPI report. For February, consumer prices fell by 0.2%, but much of that was due to lower energy prices.

In this case, it’s important for us to look at the “core rate,” which excludes volatile food and energy prices. We’re not ignoring these costs—obviously, they are an important part of a household’s budget. But food and energy prices can be subject to transient factors like a supply disruption. What we want to know is, what’s the broader trend of consumer prices?

For February, core prices rose by 0.3%. This is the second month in a row in which core prices have run hot. Here’s some context: of the last 117 months, February had the fourth-highest core inflation, while January had the highest. Together, core inflation has annualized about 3.5% this year.

To be sure, that’s hardly a lot of inflation. People who remember the 1970s surely know what I mean. But it could be evidence that the economy has turned a corner. Companies now finally have some latitude to raise prices, but they’ll have to raise wages as well. When there are millions of Americans out of work, it’s easier to keep a lid on wage hikes. Now that the labor market is getting tighter, employers have to be more accommodating. This also may suggest that the lower labor-force-participation rate could be the new normal.

The stock market has an odd relationship with inflation. Historically, inflation has been bad for stocks. In fact, the only thing that’s been worse for stocks is deflation. What the market likes best is low and steady inflation. I’ve run the numbers, and inflation is pretty benign for stocks as long as it’s below 5%. We’re still well within that boundary.

Oil prices are also rising again. Let me rephrase that—oil is exploding higher. In the last 24 trading days, crude oil is up an amazing 53%. Personally, I’d welcome a modest amount of inflation. The key is that it steers us away from potential deflation. Once people know that prices are falling, they’ll hold off buying, and that causes prices to fall further.

Inflation also tends to benefit price-conscious businesses. That’s part of the reason why Walmart (WMT) became so dominant during the 1970s. Shoppers knew they could find bargains while prices seemed to rising everywhere.

I don’t want to sound the inflation alarm bells just yet, but it’s something we have to keep an eye on. Not only can inflation change the outlook for stocks, but it can alter the outlook for different kinds of stocks.

Buy List Updates

This is an unusual time for our Buy List because we’re in the lag period between earnings reports. Bed Bath & Beyond (BBBY) reports on April 6. Then after that, the Q1 Earnings Season will kick off with Wells Fargo (WFC) reporting on April 14.

Speaking of Wells, I think we can expect another dividend increase from the big bank next month. Wells currently pays out 37.5 cents per share for its quarterly dividend. They can easily bump that up to 40 cents per share. If I’m right, that means WFC currently yields more than 3.2%. Wells Fargo is a buy up to $52 per share.

I also wanted to highlight the big bounce in shares of Wabtec (WAB). The stock plunged from over $100 last year to as low as $60 a few weeks ago. Last month, the company issued fairly good guidance for this year. Since then, it’s been on an upward swing. Since February 9, WAB has gained 30%. Quality stocks go down, but value eventually shines through.

That’s all for now. Next week is the final full week of the first quarter. On Monday, we’ll get the report on existing-home sales followed by the new-home sales report on Wednesday. The durable-goods report is on Thursday. On Friday, we’ll get the second revision to Q4 GDP. The initial report showed growth of 0.7% which was later revised to 1%. 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 18th, 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.