The Week Ahead
What uncertainty! Confusion is seemingly everywhere we look. The Presidential debates are underway and the future direction of the country is in the balance. Both candidates are staying far away from discussing any meaningful fiscal reform. Trump’s plan for a $1 trillion infrastructure stimulus is 4 times greater than Clinton’s. Monetary policy is clear as mud. Markets were pricing a 63% chance of a December rate hike prior to the Jobs report, which missed badly, but I guess it didn’t matter because by the end of the day odds of the rate hike were 69%.
Many investment professionals are calling this moment among the most treacherous periods they’ve ever faced. After all, a 5-year certificate of deposit yields 1.80% or above many of the highest quality investment grade corporate bonds - how does that make sense? Bond bubble? We continue to stress to stay selective and disciplined with your investments, with good stock picks being the best opportunity for making money.
The newsletter was delayed today - we normally like to get this to you by 6 PM Eastern. Now you’ll just have to read this during the debate!
Highlights From The Past Week
Oil Recovery. The United States saw three new oil rigs brought online, bringing the total count to 428, according to Baker Hughes. The number of rigs marks the highest number of oil rigs in production since February, and with 15 straight weeks of increases in the rig count, we are in the middle of one of the biggest recoveries in US oil.
Labor market. The US added 156,000 new jobs in September, which missed the whisper number of 200,000 many were hoping for. Worse, the number was far weaker when observed from a quality standpoint – a surge in part-time jobs, the dip in full-time jobs, and the jump in multiple jobholders to the highest since the financial crisis.
Consumer credit. The latest consumer credit report revealed that in August, total US credit surged by $26 billion, smashing expectations of a $16 billion increase, and marking the third biggest monthly jump since 2001. This is not good. This borrowing is a byproduct of lack of savings and soaring healthcare costs.
Bank of Japan. In a fresh new move to counteract failing monetary policy, the BOJ announced it will now be targeting a 10-year interest rate of 0%. This is a new move for central banks called permanent "yield curve targeting." Markets have not experienced this before from any central bank and are having to learn quickly what it means. One conclusion everybody is worried about is that the BOJ is one step ahead of Europe’s ECB, which is one step ahead of Yellen at the Fed here in the US. This means if BOJ’s decade+ of extremely easy monetary policies have failed to the point of having to prop up their 10-year government rate from dangerous negative levels, then logic follows that Mrs. Yellen at the Fed here in the US is in for an ordeal of ultimately having to admit failed inflation targeting and is not far behind from having to deal with similar issues.
BMR Companies and Commentary
Facebook (FB: $129, +1%)
Facebook launched a local Marketplace this week. The Marketplace is a mobile app feature that connects local buyers and sellers – a Craigslist competitor. The new feature enables classified listings on Facebook that include a photo, title, description and asking price that are then viewable by the public. The Marketplace landing page shows a mesh of photos (with pricing) of local postings with complete search and filter functionality. Postings include Make Offer and Message Seller buttons, which are managed in the “Your Items” section. Facebook does not execute the final transaction, but instead focuses on making the connections and managing interactions between buyer and seller.
This is not the first time Facebook has tried a local shopping service. The difference this time is emphasis on mobile. In 2007, Facebook launched a Facebook App also called Marketplace with similar functionality of classified postings for friends and networks, but was desktop-centric. The service never gained meaningful traction and was eventually off-loaded. The new Marketplace is mobile-centric in terms of user-interface, ease of posting, and ability to manage posts and interactions on your phone.
Why does this matter? Marketplace ads are another feature to drive engagement, with positive benefit to usage if the feature gains transaction. Among the main bear cases about Facebook is that the company is unable to find new ways to sustain and grow user engagement. Well, Marketplace directly addresses this issue.
BMR Take: We remain positive on Facebook heading into the third quarter, as we believe strong engagement, pricing tailwinds, and underlying growth in advertisers position the company well for a potential EPS beat. Longer term, we are positive given the attractive revenue growth outlook supported by growth in global users.
Goldman Sachs (GS: $170, +5%)
Improving operating conditions should help Goldman Sachs. Investment Banking activity started percolating in 3Q16 after a slow start to the year, which could have bigger revenue implications into 4Q16. According to Morgan Stanley’s CFO at a recent conference, “It’s the first time in a long time we had real good breadth in terms of deal backlog for the industry.”
It has been a tough year for Mergers and Acquisitions (M&A). So far the trend has carried into 3Q16 according to analysis that track announced deals in real-time. The number of announced M&A deals declined 18% from a year ago in 3Q16. Worse, global announced M&A volumes for 3Q16 declined 27% from a year ago, as the deals we did see were of smaller size. The M&A business has always been boom and bust. While we aren't seeing the record activity experienced a year ago, we are fortunately still seeing a steady flow of business. We also point out that expectations were arguably too high for this year as last year's string of "mega" deals was not likely to be repeated.
Equity and debt capital markets businesses have been in a sluggish downtrend for a while. Encouragingly, we are seeing some pockets of strength. Global equity issuance activity during 3Q16 improved modestly from 2Q16 and global debt underwriting experienced another solid quarter as volume increased 21% from last year.
BMR Take: While M&A is having a tough year, the indications of improving backlog are welcomed. Global equity issuance and debt underwriting have improved slightly in recent months. With the stock trading at 91% of book value, we think valuation is compelling and continue to look for signs of an Return on Equity breakout to skew the risk/reward profile upwards.
Alphabet (GOOG: $775, flat)
This past week Google announced five new or updated hardware products, including a new flagship phone and Home device that are connected to Google’s updated Google Assistant* as it transitions from mobile first to artificial intelligence (AI) first**. While many of these new devices were expected and pre-announced at the company’s recent conference, the news is still a positive for the company.
* If you want to know all the details about Google Assistant, go here:
http://www.pocket-lint.com/news/137722-what-is-google-assistant-how-does-it-work-and-when-can-you-use-it
** "Mobile first" used to be the focus. Now it is “AI first.” It's how Tech looks at product cycles and where the world is going. They are saying that before, they would build everything with the primary focus on how to integrate Mobile. Now the focus is how to integrate AI.
The importance of Machine Learning, AI, and Voice are increasingly hard to ignore. These technologies are being embedded across products as digital is playing an increasingly larger role in our lives as connected devices proliferate. In many ways, we now view Voice as the new on-ramp to the Internet. Google’s voice activated Assistant is a central feature across devices, such as the new Pixel and Google Home. Strategically, at least 20% of Google’s queries are now voice enabled and we think of these new devices as an extension of Google’s reach that now includes the connected home.
Other product launches include Google’s VR headset, Daydream, Google Wi-Fi, and an updated Chromecast capable of streaming 4K video. While we view many of the announcements as a catch-up of sorts to devices currently on the market and as an extension of Search beyond laptops/tablets/phones, we believe they position Google well going forward as engagement expands across devices and increasingly through voice and AI.
BMR Take: The ecosystem Google is building is enviable. The intersection of hardware with new technologies like AI, voice, and machine learning, leveraged through an ecosystem of products creates a remarkable business. We think the stock is worth a lot more. Some analysts' price targets based on sum of the parts analysis suggest a value near $950/share.
First Solar (FSLR: $38, -5%)
We want to circle back to an industry we think has a great future, solar and wind power. There has been a lot of positive news flow for the industry in the past week. A summary is below. We continue to see compelling value in First Solar.
Solar and wind power plant deals are getting done at remarkably low prices. We conducted an analysis of recently released data for newly awarded wind and solar power plant projects around the world. Prices for power from new projects are plummeting to remarkable levels. We see the transition away from coal-fired power plants to renewable energy exceeding expectations. At this point, prices are now below the cost for power from new gas plants, according to Energy Information Agency analysis.
New deals in Mexico, Chile, and Dubai are coming in at less than $30/MWh (million watts/hour.) The second power auction from Mexico’s state-owned utility was completed last week with record low pricing for any technology type. According to analysis of the 56 winning bids, a 300MW solar farm was bid in at $27/MWh, which bests previous pricing records set in Chile and Dubai earlier this year.
Markets with a high preference for renewable energy (think lots of people who are on the "green living" train) - like Germany or California – are still struggling with striking the right balance between renewable and fossil fuel energy consumption. Why? Storage of renewable energy has been an issue. Fortunately, the trend toward lower prices means that these markets are more likely to soon start making the expensive investments in storage, in order to solve the problem. We see a dramatic increase in energy storage investments on the horizon which is ultimately a good thing for companies like First Solar.
BMR Take: We see well-capitalized, well-run companies like First Solar winning the long run opportunity in this market. We think concerns about the transitional 2017 year present an exceptional buying opportunity.
Brookdale Senior Living (BKD: $16, -8%)
Following our review of the 3Q16 senior housing market segment data, our thesis remains that inventory increases will outweigh demand, presenting pressure on earnings for operators. We think that secondary markets will experience more pain than the top 31 major metro markets. Fortunately, Brookdale’s geographic reach and scale is well-positioned to weather these trends.
Does the operating backdrop even matter for the stock though? Not so much in this case as expectations are already very low. With the stock trading well below real estate value, the market is clearly indicating little confidence in operational improvements. In other words, the weak operating backdrop is already priced.
What matters more to the stock is simply confidence in management’s ability to execute and a few one-off items. For the stock to work we need to see investors re-gain confidence is a few particularly concerning areas, specifically: 1) what the plan is for additional facility sales; 2) how much government reimbursement exposure can be reduced; 3) if further G&A and operating expense savings are possible; 4) more clarity about the ideal long-term leverage levels; and 5) more specifics about the plans for use of additional free cash flow for a stock buyback program. Answers to these questions can take the stock much higher.
BMR Take: Analysis suggests a real estate value of $6-7 billion versus the current market value of $3 billion. We are watching for management to focus on rebuilding investor confidence over a few key concerning areas, primarily leverage and the stock buyback. We expect operating conditions to remain tough, but with the stock trading so far under real estate value this critique is a moot point.
Gilead Sciences (GILD: $75, down 5%) had its price target raised by analysts at Royal Bank Of Canada from $95 to $105 on Monday. They now have an "outperform" rating on the stock. This is good news despite some negative news about their patent in Europe. The key patent for the Sovaldi drug has come under the scanner of the European Patent Office (EPO). The news from the EPO office confirms that part of the Gilead-held patent is already nixed by the officials. This development could mean that generic versions of the drug could hit the market four years earlier than expected, in 2024 rather than 2028. Revenues could be severely impacted. But these things can be challenged in patent court, all of which will take years, so we are not overly concerned.
Opko Health (OPK: $9.91, down 6%) The stock had a rough week as medical claims-processing firm Palmetto posted a no-coverage decision on Opko’s 4Kscore prostate cancer test. The 4Kscore had been widely perceived as a growth driver for this Medicare Processing firm. The company said this: “Opko believes there is more than enough scientific and clinical data to justify a positive local coverage decision by Medicare administrative contractors, and intends to work closely with these organizations to demonstrate the value of the 4Kscore test to improve individual patient care as well as the efficiency of healthcare systems.”
We feel that this is just a small bump in the road and that it will have little impact on the company going forward.
Upcoming Economic News
Wednesday, October 12th
FOMC Meeting Minutes
Time: 2:00 pm
Minutes from the September FOMC meeting will clarify how eager policymakers are to hike rates before the year is through. Fed Chair Janet Yellen has noted that labor market slack has proven to be greater than anticipated, which reduces the urgency to tighten policy. A December Fed Funds increase is likely.
Friday, October 14th
Retail Sales – September
Time: 8:30 am
Forecast: 0.4% overall, 0.5% ex auto
Retail sales are projected to rebound solidly in September after falling for the first time in five months in August. Steady job and income gains provide reassurance that August’s shortfall was only a temporary blip. But as the long-term boom in auto sales swings into reverse, the broad vigor of retail sales will be limited.
University of Michigan Consumer Sentiment – October Preliminary
Time: 10:00 am
Forecast: 92.1
The first reading on sentiment in the October Michigan survey is forecast to reach the highest level in four months as expectations about the future are on the rise. Yet the assessment of current conditions fell to a year-to-date low in September, perhaps as concerns about the election build. Getting past the election would remove a major source of uncertainty for both consumers and financial markets.
A Few Words from Gary Jefferson
First Vice-President, Investments
Jefferson Financial Group
We believe The Stock Trader's Almanac (STA) is without question the foremost historian of the U.S. stock markets. It has chronicled just about every conceivable stat that has to do with stock market patterns such as the 4-year presidential cycle; the best six months; sector seasons; the best and worst months, just to name a very few. STA has charted and identified a clear pattern of the market "predicting" a presidential win by an incumbent party or a win by the non-incumbent party going all the way back to 1950.
Last week, STA wrote, "As of today’s close S&P 500 is down 0.8% and appears to be casting its vote early against the incumbent party’s candidate. Admittedly it is too early in October to make such a call. However; it is notable that S&P 500 has already deviated from its typical path in October compared to past incumbent party victories. Should S&P 500 continue to track the Incumbent Party Defeat pattern, weakness is likely to persist until near the end of October before a modest rally ensues. This presidential election has been unique, and an unusual response from the market is not out of the question.
Recent weakness likely has more to do with the IMF lowering its growth forecast for the U.S., and an increasingly hawkish tone from the Fed. Brexit fears are also weighing with the British pound trading at its lowest level in decades today. These are all legitimate concerns, but nothing exactly new. The Fed has been a pendulum swinging between yes and no since the start of the year and U.S. (and global) growth has been tepid for years now while an actual Brexit is still unsorted. Earnings season just around the corner will either confirm concerns and fears or alleviate them."
That's the key – “Earnings season will either confirm concerns and fears or alleviate them.” With regard to your investment portfolio, forget about all the political noise (we know - it is almost impossible to do) because, at least historically, we are in somewhat of a win-win. If the market votes incumbent, STA's research shows that the market will trend up throughout October. If not, the market should still begin to rally near the end of the month possibly giving investors another good entry point for the anticipated year-end rally.
But it is still all about earnings. The broad NYSE Composite Index is at a lower level than it set more than two years ago, in 2014. Including dividends, the index has gained hardly 2%. Over the past two years, the behavior of the stock market is hardly an ongoing bull market
In other words, the broad stock market has basically gone nowhere in over two years. A well-diversified portfolio that included foreign stocks, gold and energy (commodities) and emerging markets like China did much worse. It's been a tough two years, and guess what? Earnings growth rates have been revised downward for six straight quarters. The market is clearly saying, "Show me the money". If we finally get the long expected bump up in earnings growth this 3rd and 4th quarter, that should alleviate fear that the recovery has stalled as well as concerns about recession. And that will trump emotions every time (no pun intended).
HIGH YIELD CORNER
The biggest news of the last week was the Jobs report from the Bureau of Labor Statistics. Nonfarm payrolls rose by 156,000, a big disappointment that drove the unemployment rate up a tick to 5%, a marginal rise, but any increase is bad news right now. The market is hoping for stronger demand from consumers to help companies’ revenues and earnings rise, but weak employment will not help that.
There are two macroeconomic theories going around right now regarding the future of the S&P 500. On the one hand, there is the “bad news is good news” crowd who are hoping that weak economic conditions force the Federal Reserve to slow or even halt its interest rate hikes, thus keeping more money in the stock market and bolstering the S&P. On the other hand, there is the “good news is good news” crowd who think the Fed is facing too much pressure to raise rates, and they cannot delay rate hikes much longer.
The latter crowd seems to be winning, and the proof is in Treasury futures that predict the Federal Reserve’s next move. These futures are predicting a 69% chance of a rate hike in December - even after the weak Jobs report. The market seems to have accepted that the Fed needs to move, no matter what happens to the labor market. With that in mind, we need fundamental strength to boost stocks.
We didn’t get that, which is why the S&P 500 fell nearly 1% last week. We’re still up over 5% year-to-date, so it isn’t all bad. Which brings us to High Yield.
Corporate bonds are still outperforming the S&P 500. The SPDR High Yield Bond ETF (JNK: $37) was flat for the week and is up over 8% year-to-date, excluding dividends. The market seems to have accepted the rising tide of default rates and isn’t worried too much that the weak Jobs report is going to increase defaults beyond the current clip. Since most defaults are still in the Energy sector, this makes sense, especially when we consider that oil rose this week on surprisingly low supplies in the U.S. Corporate balance sheets, especially in the Energy world, will not get worse even with the disappointing Jobs report - and that means corporate bonds are safe.
It’s no surprise that the Pimco Dynamic Income Fund (PDI: $29) had another good week. Rising over 1%, the fund is now up over 5% year-to-date and its dividend is safer than it’s ever been this year thanks to continually rising undistributed net investment income. This is an important point as we get nearer the end of the year. Investors may be tempted to sell, especially since the fund is over our initial target price of $28. However, investors need to wait and heed our new target price of $31. The reason for this is that a special dividend is going to come soon, and it is likely to be in excess of $1. The buying pressure to capture that special dividend plus the cash payout itself values the fund much higher than its current price point, which is why we recommend holding the stock until the end of the year unless the price surges - which is not entirely impossible.
Now let’s look at BDCs, since this industry was closely tied to oil at the beginning of the year and throughout almost all of 2015. That correlation seems to be breaking, as the UBS Etracs BDC ETF (BDCS: $22) was down slightly (less than 1%) for the week despite oil’s surge. BDCs have had an excellent year, with this fund rising over 8% year-to-date. Comparable metrics from the prior year are quite easy, and many BDCs have beaten the low expectations that were set in 2015. This has helped this sector rise. Additionally, oil-related defaults don’t seem to be increasing for most BDCs anymore, so a sigh of relief is blowing over the entire market.
This is why we still like Main Street Capital (MAIN: $34), which is up 19% year-to-date and actually went up slightly in the last week while the BDC market as a whole went down. This continued outperformance has caused a hefty premium for Main Street shares, which is why we recommend holding the stock with our new target price of $38. There are two reasons for this upgrade. Firstly, the company’s NAV is set to rise organically, which will close the gap between its premium pricing and its book value. Secondly, competition in the BDC world is not a threat to Main Street. This company is known for its high quality dealmaking among both investors and lenders, and that will reinforce the company’s business as it encourages more companies to seek out Main Street for loans. We see good reasons to benefit from this virtuous cycle by keeping our shares.
Finally, a quick word on REITs. The market has been extremely volatile, and last week was frankly a disaster for the sector. The SPDR Dow Jones REIT ETF (RWR: $92) plunged 5% last week. This is a diversified fund with “safe” REITs, so this decline is astounding. Popular low-yielding REITs like Realty Income (O: $61, down 8% this week) saw huge declines after big run-ups earlier this year. We have warned readers that a correction in REITs is likely to come soon, and we are in the midst of it. No one knows where the bottom will be, which is why we recommend adding slowly to REIT positions to capture the income these companies provide.
Our favorite REIT picks remain Digital Realty Trust (DLR: $92, down 6%), Kimco Realty (KIM: $28, down 3% - dividend paid of 25 cents), and Government Properties Income Trust (GOV: $20, down 10%). Each of these companies saw big declines last week along with the entire REIT market. Expect more declines to come, but see these as opportunities to get good quality high dividend payers at a discount. And don’t worry - after the market realizes its mistake, REITs will go back up again.
Note that Government Properties is below our Sell Price of $21 which we raised from $11 last week. If you are the nervous type you may wish to sell here, but as noted above we are still believers in the company. We are lowering our Sell Price to $17.
One more favorite, Annaly Capital Management (NLY: $10.02, down 5%) had another rough week. A reader wrote us this week:
Good morning Todd,
What a difference a week makes. I still cannot believe the pullback in REITs. Take for example, Annaly - wow. Do you consider NLY at $9.90 still a "buy"? The obvious follow up is the dividend safety. It seems with the share price drop, NLY is even more of a bargain.
Even if the Fed decides to increase in "any" upcoming month, a 0.25% increase should not be a negative. I wonder what the market is really trying to price in with these types of moves?
Thanks.
Vince Kostoff
We answered him here:
Hi Vince -
We have said this countless times. The market gets nervous when there is a hint of a rate rise. So Annaly has been knocked down more than 10% because of it. And this presents an amazing buying opportunity. The stock has done this countless times over the past 20 years and I am quite sure that the stock will be at $10.50 or higher sometime in the next 3-6 months.
The stock market is up 40 points as we publish this Sunday evening and the 10-year Treasury is down 2 basis points. Gold is coming back too – it’s up $11. Let this be the start of a good week in the markets.
Good Investing,
Todd Shaver
Editor in Chief