The Weekly Summary
The market recovery that started when calmer heads prevailed on Monday evaporated on Friday as comforting words from the Federal Reserve were unable to cut through new tariffs from China and tough talk from the White House. As we write this, it's looking like tomorrow will be another down day.
We've seen a lot worse. Admittedly, it's not fun to see what looked like a promising week slip away, leaving the S&P 500 and our recommendations down around 1.5%, with another 1% decline brewing overnight. However, as long as the economy remains relatively robust and corporate earnings hold up, there's no reason to get nervous.
The Fed is still our friend. The next interest rate cut may be only three weeks away. We also doubt that the market has had time to fully appreciate last month's rate cut just three weeks ago. Until that happens, the situation looks no worse than what we faced when summer 2018 came to an end.
Stocks are fairly valued relative to future growth prospects. Taxes are low. Expectations are realistic. And yes, the trade war continues. None of this is new. None of it has changed. The only thing that's changed is that investors and corporate executives alike are getting frustrated with a lack of clear guidance from Washington. Until we get clarity, stocks are stalled at least until the next earnings cycle starts in mid-October. We're willing to wait through a few stormy weeks to reap the rewards ahead.
There’s always a bull market here at The Bull Market Report! This week we're providing two separate "Big Picture" views, one tactical and one that's more strategic. The High Yield Investor updates on two of our more esoteric recommendations, the PIMCO Dynamic Income Fund and AllianzGI Equity & Convertible Income Fund, while Gary Jefferson continues to debunk persistent chatter about the yield curve "inverting" in recent weeks.
Meanwhile, it's a great chance to focus on the core of our strategy, the Stocks For Success. We still love Amazon, Alphabet, Microsoft, CBRE Group, Blackstone and PayPal. If you've forgotten what turned all of these stocks into juggernauts, this will help. They're here for the long haul. So are we.
Key Market Indicators
BMR Companies and Commentary
The Big Picture: Splunk's Acquisition Agitation
While most investors would be happy to see their chosen stocks keep making money forever, others get caught in a mindset where every consideration vanishes but the exit. These are the people who routinely sell Splunk (SPLK: $119, down 5% last week) every time a quarter goes by with no acquisition announcement. As far as they’re concerned, the company only exists to attract a lucrative offer from somebody bigger.
We question that logic because we know how the corporate consolidators actually think. When someone like Microsoft, PayPal or Salesforce.com pays a premium to absorb a smaller rival, valuation usually takes a back seat to strength. Dynamic companies with solid balance sheets, aggressive business plans and the growth trajectories to back them up are naturally more attractive than those facing resistance creating new markets or competing in established ones.
Good companies get taken out at a high price. Every day their management teams negotiate with potential suitors makes them more valuable and sweetens the ultimate offer. In the meantime, shareholders see the progress, giving the stock room to climb on its own. That’s what success looks like. Succeed long enough on your own and you find yourself in the consolidator’s role, buying small companies to bolt their capabilities onto what you already have.
That’s how the buyers keep growing. Splunk is at that stage now, which is in the background of its post-earnings swoon last week. Some people were really hoping that Salesforce.com would take it out. Maybe one of these days management will get an offer they truly can’t refuse.
In the meantime, we like our companies as going concerns. They’re attractive on their own and have a compelling business plan and the resources to achieve their potential. If someone wants to accelerate that glide path by paying a premium above the present value, we won’t complain . . . but if anything, it’s a little disappointing because it takes a great stock off the market. We’d rather have them stick around and keep making money year over year.
Splunk has made BMR subscribers about 45% a year for the last 3.5 years. Accepting a takeout offer, even if it’s in the $150 zone, ends that journey with one last exclamation point.
That said, deal activity is getting more intense and the price tag on each major acquisition is rising. People in the Technology sector in particular see bigger deals ahead. We might not see Splunk get bought out any time soon, but any of our Aggressive positions and most of our smaller High Technology stocks would make some consolidator a tempting prize.
Just look at Roku (ROKU: $138, up 5%). It’s come a long way for us in the last 14 months, but it’s still “only” a $16 billion company. Someone like Apple could pay cash once they get serious enough about controlling the burgeoning Streaming Video market. That day is coming. For now, we’re happy to let the stocks evolve on their own.
The Bigger Picture: Far From The End Of The World
Wall Street has been an extremely bumpy ride this month, with the S&P 500 down 4% and the BMR universe dropping 3% since the trade war stole the spotlight from the most supportive Federal Reserve meeting in ages. And indications as we write this Sunday evening are for a big drop at the opening Monday. A little shell shock is natural. After all, it isn’t the end-to-end decline that hurts as much as the emotional impact of weeks of reversals and accumulated uncertainty.
We did the math and August is indeed shaping up as 25% more volatile than average, based on the way stocks have been swinging in the hours between the market open and the close. Normally we’d expect to see a 1.3% range from intraday low to the high. This month is tracking above 1.6%, which puts it on the edge of the top quartile in terms of volatility.
In other words, we should expect to see 3-4 months this wild every single year we’re in the market. Last year saw ambient volatility surpass what we’re seeing now in February, October and December. None of them were great months for investors, but they were all survivable. The world did not end.
Of course an uptick in volatility often takes stocks down, but the math at this point is far from apocalyptic. Normally the S&P 500 goes up seven months of the year and drops in the remaining five. The only suspense is which seasons will be the bullish ones and how large the moves will be in both directions.
However, when stocks are moving this fast during a typical day, the odds of a “good” month drop to about 50-50. Again, that’s far from an automatic loss, much less any kind of sell signal. It’s simply an expression of the statistical facts. When stocks are moving fast, volatility spikes. Any sudden lurch to the downside will generate wild intraday swings.
The open question is how long this choppy season lasts and how bad it gets. As a worst-case scenario, we went back to 2007-9, just in case you’re still wondering whether a similar recession is on the immediate horizon. Intraday volatility hit 1.8% in October 2007 when the market was in the earliest stages of deterioration, drifted in slightly elevated territory as the pressure built and then spiked with the Lehman Brothers collapse in September.
After that, it took another eight months for the wild swings to recede to normal levels. All in all, investors needed to hang on for a year and a half. If you’re concerned about a repeat of that cycle, we suggest making sure a combination of dividends and cash reserves will take you through that length of time while waiting for the market to recover from an especially nasty downswing. Bear markets of that scale only happen a few times per century of course and we’re only a decade out from the last one. But for those looking to cover themselves from the worst likely scenario, these are the numbers.
We’re a long way from a repeat of 2008. While it only took 60 days for the S&P 500 to slip into 10% correction territory, the 20% bear market threshold didn’t come for another six months. In most down cycles, that would be close to the end. That time around, volatility got extreme before the healing began.
Corrections happen. Even recessions are a natural part of every long-term investor’s life. But based on the last one, people who stayed liquid and resisted the urge to liquidate doubled their money in the decade that followed.
That’s a decent long-term return for a few months of patience. And of course all of this is purely to quantify the worst downswing in generations. We see no sign of the current shudder turning into anything like that storm.
After all, we expect at least 2-3 months like this in every 12-month period. Wall Street was probably overdue a little rain. Once the clouds clear, stocks still look like the best investments around. The fundamentals aren’t deteriorating precipitously the way they did in 2007. Until they do, it’s just a little sprinkle.
Amazon (AMZN: $1,750, down 2% -- all returns are for the week)
Amazon may be up only 16% YTD, but it's been a wild ride. The stock is positioned to pop back into the $1,900-$2,000 range where it traded for most of the summer.
The 2Q19 numbers were mixed, with revenue jumping 20% YoY and 17% from 1Q19 to $63 billion, but EPS of $5.22 fell short of analyst estimates (consensus was $5.57). Management also lowered 3Q19 income to $2.1-$3.1 billion, lower than the $4.4 billion the market had been expecting. The company also posted the lowest quarterly net income in a year, with just $2.6 billion.
However, all of this is being driven by the $800 million the company is spending to upgrade its facilities in an effort to speed up delivery times. Faster delivery means more revenue and net income in the long run, so Amazon is willing to trade some short term pain for long term gain. (What else is new for this company!)
Jeff Bezos pointed out that free one-day delivery is now available to Prime Members on over 10 million items, and “we’re just getting started.” Plus, the company’s high margin Amazon Web Services grew 37% YoY to $8.4 billion. Yes, Microsoft is picking up steam in cloud computing (which we’ll get to in a moment), and that’s why AWS slipped from 41% YoY growth during 1Q19. But 37% is still astounding, and this is still by far the dominant market leader, so it’s worth focusing on the big picture here. Amazon may have lightly stumbled in this earnings call, but that’s only because its eyes are on the long-term prize. Don’t expect this gentle stumble to send the company reeling any time soon.
BMR Take: Amazon just opened its largest-ever campus in India, where the company is committing $5 billion to grow into that burgeoning market. The company is also growing out its Portland Tech hub, not to mention building its famous ‘HQ2’ in Virginia outside of Washington, DC. Plus, AmazonFresh – the company’s grocery delivery business – is expanding into secondary markets at the moment like Houston, Phoenix and Minneapolis. This plays into the faster delivery times initiative that Bezos and company have been laser-focused on. In short, Amazon isn’t done disrupting the world, in fact – to quote Bezos again: “We’re just getting started.”
Microsoft (MSFT: $133, down 2%)
Despite AWS’ market dominance, Amazon isn’t the only game in town anymore when it comes to cloud computing. Microsoft is gaining market share with its Azure platform. And the company has formed strategic partnerships with brand names like Walgreens and CVS. One great thing about having Amazon as a competitor is that literally every other retailer in the world hates Amazon. That old adage of ‘the enemy of my enemy is my friend’ helps Microsoft here, as retailers are eschewing AWS for Microsoft’s Azure, which is helping the platform reach close to 20% market share for cloud computing software.
Reliance Industries is another example. The Indian Telecom giant recently announced a 10-year partnership with Microsoft. Reliance will build data centers across India which will be hosted on the Azure network. Expect more of these partnership announcements – both domestically and internationally – as companies look to compete with Amazon (which means partnering with Microsoft).
2Q19 revenue came in at $34 billion, for a 12% YoY gain. EPS of $1.37 beat analyst expectations by $0.16. Azure grew an astonishing 64% YoY, which technically counts as deceleration, since 1Q19’s growth rate was an out-of-this-world 73%. We’ll take 64% growth all day long. Plus, the Microsoft’s larger business line of Intelligent Cloud Services (which Azure makes up a single segment of) grew 20% YoY to $11.4 billion.
BMR Take: The stock is up 33% YTD and is at its all-time high. With the fast-growing, high-margin Azure in full blastoff mode, expect continued revenue and EPS growth for some time. We’re reiterating our $166 Price Target, and of course our ‘Would Not Sell’ mantra. Why would anyone sell Microsoft at the moment, when the future is looking so bright?
Alphabet (GOOG: $1,151, down 2%)
Another company experiencing booming cloud growth is Alphabet (GOOG: $40, down 3%). Management is looking to triple its cloud sales force over the next few years, and while the company doesn’t reveal its Google Cloud revenue numbers, estimates are that Google Cloud controls around 10% of total market share. With Microsoft’s Azure nearing 20% and exposing some chinks in Amazon’s armor, it’s not a surprise that Alphabet is making a serious push into the Cloud Computing space. Amazon still leads with 33%.
Alphabet is a company with its fingers in a lot of pies. There’s the search engine monopoly Google; video streaming platform YouTube; AI computer DeepMind; self-driving car Waymo; and navigation app Waze (plus many others). The company routinely recruits the best of the best when it comes Technology, so expect continued innovation across multiple industries for many years to come.
Total revenue came in at $39 billion for a 19% growth rate for the quarter. Income tripled YoY to $9 billion, thanks to a tripled operating margin of 24%. YouTube helped drive the company’s advertising revenues up to $33 billion, for an 18% YoY gain. The good news is that YouTube isn’t even fully-monetized yet, and already it’s the company’s second largest revenue driver.
BMR Take: The stock is up 11% YTD. The China trade war and an inverted yield curve aren’t going to impact Alphabet’s business model. Companies will still be advertising, and people will still be using the internet. In fact, it could even be argued that digital advertising may increase during the next recession, as companies shift away from costlier traditional methods. We’ll have to wait and see, of course. Regardless, Alphabet is a company that will keep accomplishing big things for a very long time.
CBRE Group (CBRE: $49, down 5%)
Management gave us another strong quarter. Revenue came in at $6 billion for a 12% YoY gain. EPS of $0.81 beat estimates by a nickel, and EBITDA grew 7% to $470 million.
The global Commercial Real Estate (CRE) market remains vibrant, most especially in the Americas, where 70% of CBRE’s portfolio is located. And the company has $1 billion of capital left to invest during the remainder of 2019, and that’s including the planned acquisitions. So there’s a lot of potential here. The company is also spreading its wings internationally with plans for its Trammell Crow subsidiary to acquire Telford Homes, a leading multi-family residential developer in London.
Management believes the UK market is in the early innings of a secular shift in institutionally-owned urban rental housing. In other words, there’s a booming market on the horizon, and CBRE wants to get in early. Should Brexit place downward pressure on Real Estate prices in the UK, expect the company to pounce even further (that $1 billion of dry powder will come in handy).
BMR Take: The stock is up a solid 23% YTD, and is currently sitting 11% off its all-time high. The company has been acquiring smaller firms left and right (Custom Spaces for Tech consulting, Mainstream Spaces for facilities management), and continues its push towards global expansion. Real Estate is always a nice defensive play, and CBRE is a global Real Estate powerhouse. Enough said.
Blackstone (BX: $49, up 3%)
Speaking of global powerhouses, Blackstone fits that classification to a T. The company is a Private Equity behemoth that has been diversifying into global Real Estate and seeing some major growth as a result.
As we’ve noted several times before in this newsletter, the Private Equity (PE) world is awash in capital, as hedge funds are imploding and institutional investors are subsequently fleeing to the relative stability of PE. That led to the company hauling in $1.5 billion in 2Q19 revenue, which beat the consensus estimate of $1.15 billion. Fee earnings rose 24% YoY to $420 million, and those will continue to increase as the company produces more assets under management (AUM).
PE firms earn fees on the money they manage. Total AUM here now stands at nearly $550 billion, a 24% YoY gain. Close to $400 billion of that is fee-earning, a 16% YoY boost. PE and Real Estate both lead the portfolio, with a combined $100 billion of inflows over the last 12 months ($30 billion in 2Q19 alone). In short, Blackstone is a behemoth that keeps on growing thanks in part to the tailwinds of the broader macro-economy. PE is having a moment in the sun, and Blackstone sure isn’t missing out on its share of Vitamin D.
BMR Take: With the stock up 68% YTD and sitting at its all-time high, investors would be forgiven for placing a ‘Sell’ order. That said, we believe the future looks as bright as the recent past, so we’re planning to raise our $52 Target Price just as soon as Blackstone reaches that level. At the rate the stock is going, it won’t take long.
PayPal (PYPL: $106, flat)
PayPal is up 26% YTD, but the stock crossed the $120 mark in July and spent most of the summer above its current trading level. The stock fell after a rough 2Q19 earnings call, where management guided next quarter’s revenue to $4.35 billion, which is just shy of the $4.45 billion consensus. Full-year revenue was also cut, and the announcement momentarily put the stock on ice.
We think the market is overreacting here. There are a lot of great stories happening for the company that are being overlooked given the lower 3Q19 revenue guidance. Venmo, for example, put up $24 billion in total payment volume during 2Q19, for a 70% YoY increase. That contributed to the 24% YoY increase in total payment volume for the entire company, which came in at $170 billion. Operating margin also increased from 15% a year ago to well over 16% last quarter. That shows efficiency, and helped the EPS come in at $0.86, three pennies above consensus estimates.
While it’s true that issues like the potential for a looming recession and Brexit do impact PayPal’s bottom line, which is why management is being extra conservative with its forecasts, PayPal is a fundamentally strong company that went on an acquisition binge last year and beefed up its product line as a result. PayPal just launched instant transfer to banks from Venmo, and expect more product upgrade rollouts as the company fully synergizes the acquired technologies from last year’s spending spree.
BMR Take: Even with the slight stumble, the stock has performed extremely well over the last seven-and-a-half months. The company is upgrading its product line and expanding into key territories like Europe (international money transfer service Xoom is now in 32 European markets). We’re reiterating our $125 Target Price which the stock nearly reached in July. We believe it’ll get there before the year is out of the overall market stays steady.
A Word From Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.
Let's put an end to this "inversion" mania once and for all. We see a glaring contradiction in the fact that so many market "experts" and commentators stressed nothing but economic doom and gloomy uncertainty while at the same time telling everyone that flat or inverted yield curves were foolproof predictors of a recession.
Last week we said that we were not calling for a recession and we stand by that belief. How do we reconcile that conviction with the volatile reaction? As Sgt. Friday so eloquently said in every episode of Dragnet, "Just the facts, Ma'am, just the facts."
According to the Federal Reserve Bank of Atlanta, GDP growth in the third quarter of 2019 is projected to be 1.9%. These guys don't joke around. They don't play with numbers or hope they end up somewhere in the ballpark. It is also an undeniable fact that we have never had a recession with GDP growth and low unemployment.
We repeat: there has never been a recession so long as there was GDP growth and low unemployment, and today we have not just low unemployment but practically unprecedented full employment. Almost everyone who wants a job can find one.
Did we have an inversion? Yes. We concede it happened for a few moments and that while a flat yield curve is not what we want to see for a long term, it will take a much longer and deeper inversion to truly signal any real predictor of a recession.
Does that mean there's a recession right around the corner? No. Absolutely not. While there is evidence that the past three "inversions" were followed by recessions, there is a big difference today. In the prior three instances, the Fed kept tightening, thereby making the situation worse.
The Fed had already cut rates before this tiny inversion took place and they meet again in three weeks, when they are expected to cut rates again for the second time this year. The odds are currently at 74% that we'll get another cut, with more and more people speculating that it could be 50 basis points this time.
Thus, we agree with former Fed Chair Janet Yellen, who commented on the inversion by saying “on this occasion it may be a less good signal, and I think the U.S. economy has enough strength to avoid a recession."
She's right. The biggest reason why the yield curve inverted is because there's an enormous demand for our Treasuries. And it's easy to see why. With the slower growth rates around the globe, and the pervasiveness of near-zero yields and negative yields in bonds of other countries, where else are bond investors going to put their money?
They aren't coming here to buy our bonds because they think we're headed into a recession. They are coming because our economy is the best in the world and our bonds are the safest. Especially in light of the fact that the Fed should continue to cut rates, there just isn't any real economic evidence that the economy is approaching a recession.
Here goes our broken record again: full-year GDP growth is on pace for 2.6%, which is stronger than the average annual GDP of this entire 10.5 year expansion. Unemployment is near record lows. Consumer confidence is near record highs. And corporate earnings continue to impress.
One signal excites us. For only the third time in 61 years, stocks are yielding more than bonds. The S&P 500 currently yields 1.91%,while the 10-year Treasury yields 1.6%. This means an investor who buys an index fund will earn more over the next decade than an investor who buys bonds, even if equities go nowhere.
And companies have been raising their dividends by an average of over 5% annually for the past ten years. This is one of the best and most accurate signals in stock market history. This doesn’t mean, of course, that stocks can't sell off more in the short term. But as Patrick Henry famously said, "I know of no way of judging the future but by the past."
We would not be surprised to see some additional volatility as we approach the action-packed month of September, so let's put the "inversion" behind us until the real data points and not the media reveal that a contraction is imminent.
The High Yield Investor
By John Freund
VP of High Yield
The Bull Market Report
Let’s start this week off by taking a look at PIMCO Dynamic Income Fund (PDI: $32, up 3%, Yield = 8.2%). This past week, Chief Investment Officer Dan Ivascyn pointed out that he is implementing a defensive strategy at the moment, given that any trade agreement – even a narrow one – will likely result in yield prices snapping back up. Despite its ‘nosebleed yields’ compared to the rest of the developed world, Ivascyn says the U.S. is still one of the best places to buy bonds.
PIMCO invests in a portfolio of mostly non-agency mortgage-backed securities (MBS). Non-agency means the MBS aren’t backed by the federal government, making them a higher risk / reward proposition. Since housing is directly susceptible to interest rates, it’s good that PIMCO is treading cautiously here. Yes, the Fed has been lowering rates, which is great for housing starts and the Mortgage industry as a whole. But who knows what the future will bring?
Inflation will play its part in Fed decision making, as will the China trade war. We believe the trade war will end either next year or possibly the year after. If Trump is re-elected, China will cut a deal. If the Democrats win, they will end the trade war. The Fed should continue to lower rates in the interim period in order to spark the economy. That’s good news for the MBS sector and great news for PIMCO.
And when the trade war does eventually end, the underlying economy will receive a short-term jolt, and that will be even better news for MBS and PIMCO. Really the only bad news comes when the Fed starts raising rates too fast, that ordinary Americans hold off on purchasing mortgages. There’s no real threat of that in the short term.
The U.S. housing market is coming off a strong 2018 as well. MBS-focused closed end funds (CEFs), including PIMCO, outperformed the broader CEF market last year, thanks to rising home prices and income levels, coupled with a low mortgage delinquency rate and unemployment rate. While housing starts sputtered a bit during the Fed’s period of interest rate hikes, now that rates are coming down we expect these metrics to see-saw.
We’d also be remiss if we didn’t mention the big story out of Germany this past week, which was the introduction of negative interest rates on 30-year bonds. This is the first time the Germans have made 30-year bondholders pay for the pleasure of locking their capital up with the German state for three decades. It remains to be seen if this will catch on with the rest of Europe, but don’t bet on it. And we’re not concerned about negative interest rates coming to the United States any time soon. The downward pressure on rates globally signals underlying strength for the housing market.
The stock is up 8% this year, and has basically been flat since March, as investors remain tepid given the broader macro outlook. No one is going to go rushing into PIMCO at the moment. That said, there’s no reason to rush for the exits either. The long-term outlook is strong, even if the short-term will be slightly bumpy. And in the meantime, we’re collecting our 8.3% annual yield, which provides us with a double-digit positive return for the year. So who’s complaining?
The stock is also trading at a premium of around 10% to its NAV. The average premium for the year has been 13%, so the stock is looking cheaper on that metric, even though it’s trading at a premium. (PIMCO has traded at a Premium for nearly its entire existence.) The stock did touch $33 in early June, and we’re expecting PIMCO to get back there sooner rather than later.
And last but not least, PIMCO is growing its undistributed net investment income (UNII), with a fiscal YTD coverage ratio of 110%, but the company has been covering by 125% over the past three months, so PIMCO is producing even more UNII than it was earlier in the year. So the dividend is well-covered. Additionally, the company maintains one-and-a-half months of UNII in reserves, so even if UNII production slips, the company can safely cover the dividend while it re-jiggers its portfolio.
AllianzGI Equity and Convertible Income Fund (NIE: $21, flat, Yield = 6.8%) is another CEF in our portfolio. The stock is up 13% YTD, and had a strong 1Q19. Net assets grew 4% YoY, and the NAV grew 3%. The stock is trading at an 8% discount to its NAV, which is a very healthy discount given the tailwinds this company is riding. The fund’s top holdings include prominent blue chip stocks like Alphabet, Apple, Facebook, Visa and Starbucks. Allianz utilizes two complex strategies – convertible holdings and covered calls – to produce greater returns and a higher overall dividend than simply purchasing the basket of stocks on one’s own would generate.
An investment in Allianz provides an investment into a nicely diversified cross-section of the U.S. economy. While some folks see a recession around the corner, we’re cautiously optimistic. That said, Allianz is a nice defensive play against the onset of a recession, since owning blue chips is a great way to mitigate potential losses should the market turn. Plus, the stock produces a healthy 6.8% yield, so fixed income investors can get their fix here as well. Management has kept the dividend in place since the post-Great Recession cut, so we’re not concerned about a dividend slash any time soon.
Like PIMCO, Allianz has been basically flat for most of the year (that’s after the stock’s January burst out of the gate). We’re fine with that performance, happy to bank the 7% yield and content with the current 13% YTD gain. Allianz is likely to bounce around in the $20-$23 range for the rest of the year. Even the lower end of that range gives us a solid return (when combined with the dividend), and that’s why we hold this stock. The discount to NAV also gives it some wiggle room on the upside should economic indicators continue positive.
All told, PIMCO and Allianz won’t be our biggest winners this year (not even close), but they’re not supposed to be. These stocks are for hitting singles and doubles, not home runs. Right now we’re standing solidly on second base with both, which is exactly where we want to be.
Todd Shaver, Founder and CEO
The Bull Market Report