CWS Market Review – August 27, 2024

(This is the free version of CWS Market Review. If you like what you see, then please sign up for the premium newsletter for $20 per month or $200 for the whole year. If you sign up today, you can see our two reports, “Your Handy Guide to Stock Orders” and “How Not to Get Screwed on Your Mortgage.”)

“The time has come for policy to adjust.”

So said Fed Chairman Jerome Powell last Friday at his highly anticipated speech at the Fed’s annual conference in Jackson Hole, Wyoming. He basically said what everyone expected him to say: the time has come to lower interest rates.

This is a big deal. After all, the Fed hasn’t lowered interest rates since Covid. If you exclude that since Covid was a very unusual event, then the Fed hasn’t cut rates for pure economic reasons in 15 years.

The only questions now are when and by how much. Powell left both unanswered but Wall Street expects action soon. In his remarks, Powell noted how much the economy has improved:

“Inflation has declined significantly. The labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic. Supply constraints have normalized.”

The story is not a complicated one. The Fed responded to Covid by dropping interest rates to the floor. That, and a lot of government money, helped spark the worst bout of inflation in 40 years. Even the lower rate is still higher than where it was during much of the 2010s. Here’s a look at the CPI:

The Fed responded to inflation by jacking up interest rates by 5.25% in 16 months.

It worked. After peaking two years ago, inflation has gradually retreated – not that prices are down – but the rate of increase is down.

“After a pause earlier this year, progress toward our 2 percent objective has resumed. My confidence has grown that inflation is on a sustainable path back to 2 percent.”

Maybe. I have to confess that the Fed’s rate hikes did less damage to the economy than I expected, and higher rates certainly haven’t stopped the stock market. As you may recall, Powell and the Fed initially believed the uptick in inflation was “transitory.” The feeling was that as long as inflation expectations were low, then inflation would be low. That turned out not to be the case, and inflation was anything but transitory.

Why Interest Rates Are So Important for Stocks

I know I spend a lot of time going on about the Fed and interest rates, and I do so because it’s central to the stock market. Interest rates are important for two reasons. One is that interest costs are a major portion of a company’s income statement. Higher rates take a big bite out of the bottom line.

When rates are low, it’s easier for companies to finance expansion plans or to buy out other companies. Higher rates grind that to a halt. Not only are companies impacted but so are consumers. A company like a homebuilder can see its business evaporate when mortgage rates get too high.

The other key reason is that interest rates are in competition for investors’ money. In 1981, you could have locked in a 15.8% yield in a 10-year Treasury. Why buy stocks when you can get a low-risk return that high? Indeed, stocks had to plunge in value just to keep pace. Around that same time, the S&P 500 was trading for less than 6.5 times earnings.

In retrospect, I think the Fed responded to inflation the way it should have responded to the financial crisis of 2007-2008. The Bernanke Fed was very careful when it should have acted earlier and more aggressively. It was two years ago at Jackson Hole that the Powell Fed finally rejected the transitory idea and made it clear that the Fed would do whatever it takes to beat inflation.

On Friday, Powell also noted that the jobs market is cooling off, but what’s interesting is that it’s not dropping as it would normally ahead of a recession. Instead, the jobs market is seeing “a substantial increase in the supply of workers.” What this means, in the Fed’s view, is that the jobs market probably won’t be a driver of inflation anytime soon. I think that’s the key in why the Fed decided to alter course.

Powell also defended himself with some excuses that might be considered a little convenient. For example, Powell said that once inflation broke, it became a global issue because it rested on “rapid increases in the demand for goods, strained supply chains, tight labor markets, and sharp hikes in commodity prices.” In other words, things were affecting everyone.

Powell strongly wants to prevent the public from having higher inflation expectations. That’s what happened in the 1970s. If people expect inflation to rise, then it’s easier for prices to rise. Once the expectations take hold, they get embedded and it’s not easy to change them. I think Powell is particularly sensitive to the issue of expectations.

By 2022, we had a very unusual economy. The labor market was very tight and there were twice as many jobs as there were unemployed people. So, how come the jobs market wasn’t wrecked by the Fed’s anti-inflation crusade? That’s a puzzle to me.

According to Powell:

“Pandemic-related distortions to supply and demand, as well as severe shocks to energy and commodity markets, were important drivers of high inflation, and their reversal has been a key part of the story of its decline. The unwinding of these factors took much longer than expected but ultimately played a large role in the subsequent disinflation.”

Powell was very reticent on what the Fed has planned. The next FOMC meeting is in three weeks and market participants overwhelmingly expect a rate cut. Right now, the odds are at 65% for a 0.25% cut and at 35% for a 0.50% cut.

The following meeting is in November, shortly after the election. At that meeting, traders narrowly expect a 0.5% cut. Traders expect another 0.25% at the December meeting. Add it up and the Fed is expected to slash rates by a full 1% before the end of the year. For 2025, Wall Street expects more cuts of 1.25% to 1.50%.

Overall, lower interest rates should be good for the stock and the housing markets. Not only are lower rates good for the market, but I expect value stocks to continue to prosper. Many of these issues lagged the market as investors fell in love with the Mag 7. That love affair may have run its course. Tesla (TSLA) hasn’t made a new high in close to three years. Amazon (AMZN), Google (GOOGL) and Microsoft (MSFT) are all off more than 10% from their highs.

Heico: The Quiet 83,000% Winner

One of our Buy List stocks, Heico (HEI), issued a very good earnings report after yesterday’s close.

Heico has been a great stock for us this year. The shares are up more than 38% YTD. I’ll discuss Heico’s results in greater detail in Thursday’s premium issue, but I’ll highlight a few key stats for you (you can sign up for our premium issues here).

For its fiscal Q3, Heico’s EPS increased 31% to 97 cents per share. That beat Wall Street’s consensus of 92 cents per share. For the first nine months of this fiscal year, Heico’s earnings are up 23% to $2.67 per share.

For the quarter, Heico’s sales were up 37% to $992.2 million. Their operating income increased 45% to a record $216.4 million. I was impressed to see Heico increase its operating margin by 1.1% to 21.8%. Q3 EBITDA rose 45% to $261.4 million.

Heico is a great example of a niche business that’s not well-known. In 30 years, the stock is up 83,000%.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

Posted by on August 27th, 2024 at 5:29 pm


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.