THE BULL MARKET REPORT for Monday, September 26, 2016

by Todd Shaver | Sep 25, 2016 | Weekly Newsletter 7pm Sunday

The Week Ahead
No rate hike! Stocks rallied. The Fed pushed out the potential for another rate hike to December. With all the political and economic uncertainty between now and then, however, the odds of a rate hike are only 50% currently. The slow methodical pace of interest rate normalization removes what had been a lid on equity prices and we should see indices move much higher in the months ahead.

The Presidential election is quickly approaching. The first round of debates is tonight. We will be watching closely. It could be that this political cycle is more disruptive to the markets than the Fed. Either way, we still think there are good opportunities to make money for stock pickers. This week we highlight Twitter, Ferrellgas, UPS and PayPal.

Here is How Last Week Progressed
Monday (9/19) - S&P 500 -0.6%
--- The week started off sluggishly.
--- New reports revealed that the US federal debt is growing at the fastest rate since 2008.
--- Legendary investor, Steve Eisman, who called the mortgage crisis and is the headliner in the movie “The Big Short”, revealed publicly what the next big short is: “When the world loses confidence in central banks and their quantitative easing policies.”
--- We observed more signs of financially leveraged earnings growth, as just one month after completing its largest bond offering ever, Microsoft announced the approval of an incremental $40 billion share repurchase program equal to roughly 9% of its outstanding shares. The bond sale was $20 billion, the fifth largest deal ever. (Verizon was the largest at $49 billion in 2013.) They sold it in seven tranches, going out to 40 years at just 4%. The firm will use some of the proceeds for the $26 billion purchase of LinkedIn.

Tuesday (9/20) - S&P 500 flat
--- Another day of standing in the same place.
--- Wells Fargo was on the hot seat for improper practices that enabled the reporting of higher than reality cross sale figures. The bank was blasted by the media and policymakers not just for the illegal behavior, but also for firing 5,300 low level employees rather than senior business leaders.
 --- JP Morgan published research agreeing with Donald Trump’s views that the Fed is political and accused Yellen of distorting asset markets and blowing bubbles.
 
Wednesday (9/21) - S&P 500 +1.1%
--- Stocks jumped higher on news from the Fed. No rate hike. The Fed now sees only three rate hikes through the end of 2017 and also cut their long-run US GDP expectations.
--- JP Morgan’s head quant proceeded to throw in the bearish towel now seeing nothing but smooth, levitating markets ahead.
--- Yahoo confirmed that over 500 million user accounts were hacked, believed to be a foreign country-backed.  
--- Research surfaced on Fannie Mae and Freddie Mae raising more concerns about the FHA’s decision earlier this year to make it cheaper for first-time home buyers to get into the housing market with sub-680 credit scores

Thursday (9/22) - S&P 500 +0.6
--- Big up day today.
--- The NY Fed released new estimates cutting its 3Q and 4Q GDP estimates to under 1.5% from 1.5-3.0%.
--- Germany's largest market research institute suggested that things for the iPhone 7 are not as great as the carriers would like the world to believe. According to the note, Apple iPhone units showed that launch weekend sales for iPhone 7 were down by 25% YoY compared to the first weekend for the 6S.

Friday (9/23) - S&P 500 -0.6%
--- Focus started to shift to Monday’s first presidential debate. News broke that most of Hillary Clinton’s deleted emails, subsequently recovered during an FBI probe into her email server abuse, won’t be made public until after Election Day, according to a timetable set Friday by a federal judge.
 
BMR Companies and Commentary
Twitter (TWTR: $23, +18%) CNBC reported that the company has received expressions of interest from a number of companies considering whether to make a bid and the board is said to be largely in favor of a deal. There is no imminent sale though Twitter has engaged with potential suitors looking at the possibility of a deal. Those suitors are believed to be Salesforce (CRM: $70) and Google (GOOG: $787), among others. Twitter is working with Goldman Sachs to explore the sale. Sources say that talks are picking up momentum and that a deal could result by year end.

In recent weeks, co-founder Ev Williams said in an interview with Bloomberg TV that the company has to weigh all options amid ongoing speculation it’s a takeover target. Williams initially declined to comment when asked by Bloomberg whether Twitter can remain an independent company. He went on to say, “We’re in a strong position now, and as a board member we have to consider the right options.”

CEO Jack Dorsey, the co-founder who took the top job again last year, is trying to reshape the company’s reputation and product mix to draw a more mainstream audience. The company is cutting deals to stream more live events, from sporting matches to political debates, and this year acquired an artificial intelligence startup to make live video look more professional.

BMR Take: The current situation feels eerily similar to LinkedIn, which was eventually acquired by Microsoft at a 50% markup. We’ve mentioned this many times recently: We believe there are two opportunities here. The first is for the company to start the turnaround, growing users and revenues and profits. The second is for a firm with a ton of cash or valuable stock to swoop in and pick up the company.  Google? Apple? Facebook? A Saudi Prince? A Steve Ballmer with all that Microsoft money?

Now – If you own the stock, what should you do from here? One of two things will happen from here: the stock will go higher or it will go lower. If the bidders go away, the stock will plummet back to $18 or lower. It will go higher if there is a bidding war. It might go to $25 or $30, even $35. So it’s a tough call. We can’t help you on this one. If we were to guess, we would say it would go higher, because we don’t think Salesforce will be the only buyer to surface.

We think the stock will go higher over time because management is working diligently to shake things up and make things happen. But this could take a year or two. Good luck with your decision.

Ferrellgas Partners (FGP: $16.83, -1%)

We are diving deeper into our recently added position, Ferrellgas. In particular, we researched the dividend coverage and risk of a dividend cut.

As we mentioned in our Research Report last week that Ferrellgas is a multi-billion publicly-traded Master Limited Partnership. What we didn’t mention is that there is concern about the prospect for maintaining the dividend. The $0.51 quarterly dividend amounts to $2.05 of annual payout to shareholders, but consensus EPS estimates call for a loss of $0.27 this year and a gain of just $0.40 next year. Accordingly, to continue making the payment, Ferrellgas will have to borrow money.

The bull case scenario for Ferrellgas calls for much greater than $2 of earnings power assuming crude recovers and all the benefits of the Bridger acquisition are realized. This would result in more than 100% dividend coverage.

However, should the operating backdrop continue to be challenging, we expect Ferrellgas to be able to weather the storm for at least several more quarters. Both Moody’s and Standard & Poor’s have a single B credit rating on Ferrellgas, which is not the junk status of C that could be more problematic.

While we see a path forward to once again having full dividend coverage, they are not there today and that carries risk. The current dividend yield of around 12% compares to a historic level of 7%. The market is already pricing in a dividend cut to around $1.25 from $2.05. This would not be unexpected.

BMR Take: Ferrellgas has maintained its dividend so far through this downtown. Many of its peers cannot say the same. We think this reflects the high quality of the Ferrellgas franchise and we think long term shareholders are getting in at very attractive entry points at today’s prices.

UPS (UPS: $109, +2%) We care about UPS, but that doesn’t mean there is no value in keeping an eye on how FedEx (FDX: $174, up 9%) is doing. There are a lot of read-throughs from one business to the other, as each is dealing with the same operating backdrop. Accordingly, we highlight some takeaways from the quarterly results out of FedEx earlier this week.

The bottom line is that core Express and Ground business was rock solid. Revenue increased slightly as improved base yields, higher package volume and increased freight pounds more than offset lower fuel surcharges and unfavorable currency exchange rates. FedEx Ground average daily volume grew 10% in the first quarter, driven by e-commerce and commercial package growth.

Additionally, pricing power is alive and well. As previously announced, effective January 2, 2017, FedEx Express will increase shipping rates by an average of 4%, while FedEx Ground, FedEx Home Delivery and FedEx Freight will increase shipping rates by an average of 5%.

BMR Take: UPS is scheduled to release earnings about a month from now, October 27th. The consensus EPS estimate is $1.44. UPS has beat consensus in each of the past eight quarters. All looks good for the quarter. We really like the stock for the short term and certainly for the long haul.

PayPal (PYPL: $40) PayPal and Visa recently partnered  to form a deal that extends PayPal’s reach offline, and one that some analysts say can benefit retailers in the long run. The new deal, which both companies announced separately during last quarter’s earnings results, is twofold. First, PayPal will no longer steer its users away from linking their accounts to Visa credit cards, as it currently does. Second, PayPal customers will be able to use Visa’s contactless mobile checkout technology, Visa Digital Enablement Program, to pay in retail stores with their smartphones.

Now that some time has passed, investors and analysts have been able to look deeper into the partnership. Here are some insights. The basic impact to the business model is that PayPal will be paying more to Visa per transaction, but in return benefit from a windfall of more volume through being associated with the Visa brand, resulting in incremental profits. Analysts are expecting anywhere of $10 to $100 billion of volume to run through PayPal resulting from the Visa partnership, where the initial impact may be modestly dilutive to earnings, but long term attractively profitable.

BMR Take: We see a compelling long term opportunity for PayPal in joining the ranks of Visa and MasterCard. While shares trade just over a 20 PE, PayPal’s ample war chest ($5 billion in cash, no debt and over $2 billion per year in free cash flow) could help drive EPS growth through share repurchases and accretive acquisitions. Add solid organic growth on top of that and you have a long term winner.

Upcoming Economic News
The focus will undoubtedly be on the Presidential debates this week. The debate continues over the health of the economy. Republicans argue there are signs of risk and much work to be done. The democrats argue Obama has led a great recovery since 2008 and the status quo is a safe path to stay on. What else is new?  🙂  Our take is that who the new president is, and what he or she attempts to do in the White House is uncertain and a long way off.

We do know this – the market hates uncertainty, so if anything, there will be a slightly negative pall overhanging the market. But this is nothing new.  It’s been this way all year and will stay this way well into 2017 as the new president takes office and “attempts” to make changes.  We put this in quotes because with gridlock in Congress, we really don’t see many changes ahead. Of course, things WILL change and things WILL surprise us. This is nothing new, and is par for the course.

Thus, we will continue to buy high quality stocks, and if you are afraid of anything that you just read here, or anything else that concerns you, we would suggest that you lighten up on equities, move to a larger cash position and if you wish to be in equities, look to the High Yield Portfolio for high dividends and more secure investments.

Words from Gary Jefferson
First Vice-President, Investments
UBS Securities

The days of buying a good company and watching it hit its earnings projections and move steadily upward over time are long gone.  So are the days of a broadly diversified portfolio being a sufficient risk-management strategy. It's all been replaced by high speed, shadow traders and hedge fund lemmings who have decided that investment fundamentals no longer matter. They (along with the Fed) have changed the investment landscape into an environment which is susceptible to large market shifts in either direction – what they call a "risk-on, risk-off" market. Just look at the past year – China unexpectedly devalued the yuan in August 2015; the Bank of Japan moved one of its policy rates below zero in 2016; and of course Brexit this past June. Each time, there was a huge spike in volatility accompanied by a wipe-out of billions of dollars of market value, followed almost as rapidly by similarly strong rallies. We are not saying that good stock selection or proper diversification no longer matter – they still do. However, with a risk-on, risk-off environment, investors absolutely have to adjust their emotions and understand the consequences of "sequence of returns".  

Half a century ago James P. O'Shaughnessy said, "The four horsemen of the Investment Apocalypse are fear, greed, hope and ignorance. Only one is not an emotion – ignorance. These four things have accounted for more losses in the market than any recession or depression, and they will never change. Even if you correct ignorance, the other three will get you every time..."

Thus, knowing that emotions can be very tough on investment returns, it's even that much more important to understand it in a risk-on, risk-off environment. Today, many of the major investment firms are, unfortunately, not exactly helping with the emotion issue.  UBS recently put out a big warning for the second time in a few weeks, telling investors that it expects the S&P 500 to drop by 8-10% as soon as October. The bank says that the recent move sharply higher in bond yields is a big trigger for a global stock selloff. Deutsche Bank has just made a bold call saying that all investors need to know about. The bank basically is saying that the world is fast approaching an inflection point which will flip a switch and deliver heavy losses to bondholders with rates rising sharply. And, Goldman Sachs recently put out a warning to investors to expect a sharp fall in equities. Yet, these same firms and most other major institutions we follow have other analysts or chief strategists who are calling for the S&P 500 to end the year with a new all-time high. It's an advisory tug-of-war that can be very tough on emotions, especially with the 24/7 media adding fuel to the fire.

There is little doubt that investing will continue to be an emotional roller coaster ride. Regardless of any huge spikes or declines in prices, try to remember that in the end it is all about earnings. If your dividend stocks drop, for example, it's no different than the Labor Day or after-Christmas sales that happen each year. At some point in the future, you will be glad for the opportunity to have bought more shares.  Don't beat yourself up because you didn't take a profit or you didn't buy something when it went on sale. Don't panic when everything in the media is "doom and gloom." In other words, if you can understand that it is your emotions causing you to react, rather than fundamental changes to your long-term investment goals, you should be much more capable of achieving those goals by avoiding the three horsemen, fear, greed, hope, that O'Shaughnessy wisely said, "will get you every time."

An Interesting Subscriber Comment

We had an email exchange with a subscriber. Here’s how it went:
He said: I know you cannot report on everything, and I really enjoy your reports, but do you still believe in Mazor and KMI? Just curious if moving money out of those, and into some of your more recent recommendations, might be a better financial decision.
Ron Shepro

We said this:
Hi Ron –
Well, we are just getting started with Mazor (MZOR: $22, up 2%), so no, we would not move from this.
KMI (KMI: $22, flat) – Long term hold.

After we went back and forth for a few days Ron said this:
Thanks for the great advice, I really appreciate what you do for all of us. Who needs Cramer.
Thank you,
Ron Shepro
Sales/GM | Buddy’s All Stars, Inc.
Phoenix, AZ

BMR Take:  Gotta love it.  Thanks for the kudos, Ron.  Good investing!

The Apple Corner
From UBS: Valuation: Raise price target to $127
We are raising our target price from $115 to $127 based on higher F17 EPS and target P/E of 14x up from 13x. Our confidence in iPhone 7 growth grows. Apple's discount to the market of 30% should narrow closer to its five-year average of 20%, which would be 14x.

Increased procurement could reflect demand or just timing
The UBS Asia tech team's latest estimates show iPhone 7 procurement plans for F17 have increased from 80 million to 90 million. This figure is higher than the iPhone 6, which fits with our thesis. We think Apple has become more conservative in procurement to avoid over-ordering.

BMR Take: It’s simply business as usual... business as normal at Apple. They are selling iPhones like hotcakes and the world continues to use mobile more and more each day. I know you have seen how the 20- and 30-somethings use the iPhone. They are on the phone constantly. Do you know any Samsung users? We think we know one person. They are very few and far between. Apple has a LOCK on the smart phone business and this lead is only going to grow. And every one of them is buying apps and buying music, and is wearing out their phone each day, which makes them candidates for an upgrade.  

Apple is going to set a new all-time high. When?  You tell me. Write me with your prediction at Info@BullMarket.com.  If we get more than 100 entries, the closest to the date gets a NEW APPLE WATCH SERIES 2!

More Apple News
Last week news broke that Apple may be interested in acquiring hyper car manufacturer and Formula One team McLaren. Could this be there big move into self-driving cars?

McLaren knows how to build cars. Their engineers have found unique ways to put mind-boggling capabilities in the hands of regular car owners. As for the potential deal with Apple there are plenty of synergies, both business-wise and culturally: The automation, the engineering, not to mention a potential tax advantage for Apple with McLaren being headquartered overseas. By acquiring this company Apple could solidify itself as a major player in the autonomous car space.

Apple is sitting on $232 billion in cash while McLaren is valued at around $2 billion. Meaning Apple has enough money to buy them 100 times over right now. The deal makes sense if you think about it.  Why try to reinvent a car from scratch (hello Tesla!)

As noted above, the stock’s been on a run along with the rest of the market. Today it’s trading at $113 after dipping to the low 90s during the summer.

Annaly Capital Mortgage (NLY: $10.79, up 3%) had a great week. They announced their latest dividend of 30 cents, payable on Halloween. The ex-dividend date is Wednesday so the stock will open for trading that day 30 cents lower.  Don’t be alarmed.  The 30 cents is generally made up over the following 3-4 weeks. It’s been like this for years. In fact, since inception in 1997, Annaly has paid over 10% per year, year in and year out and this year is no exception.

Note that the “world” out there always panics about Annaly when there is a hint of higher interest rates, because everyone thinks that they will have to pay more to finance their purchase of the assets that they buy. And the “world” sells off the stock and the stock goes down.  This actually happened slightly over the past month, dropping from $11 down to $10.50 last week. But as always, the stock popped right back up again.

What people forget is that the Fannie and Freddie securities they buy in the future will pay a higher rate, negating the higher cost of funds, so it all works out in the end. The company will do just fine with higher rates.  Besides, when rates rise they rise slowly.  Sure, if interest rates jumped a full point or two Annaly would have some issues.  But this very rarely happens.  It’s generally slow and steady. So in our book, there is no need for panic.  In fact, when this happens, it presents a buying opportunity, allowing you to buy more shares locking in those higher yields.

Microsoft (MSFT: $57, unch.) announced a stock buyback program of $9 billion. Thank you very much Satya!  The current $40 billion buyback that they implemented in 2014 ends at the end of this year and the company gave no details about the new plan. Microsoft also increased its dividend payout by 8%, which investors always love. The company has $115 billion in cash, with long-term debt of $40 billion. With operating income of nearly $25 billion a year, their financial position is extremely strong, and it's not really a surprise that they keep coming up with share buybacks in the order of tens of billions.

HIGH YIELD CORNER
What an interesting week for the markets. The S&P 500 gained over 1% even including Friday’s weakness. The move is largely a result of strong macroeconomic data; jobless claims fell surprisingly; the Fed’s dovish policy seems to be staying in place; and Moody’s released a study showing strong fundamentals in America’s economy. So where does that leave high yield alternatives to normal equities?

Just about everything outperformed the market, with the exception of high yield bonds. The SPDR High Yield Bond ETF (JNK: $37) rose 1% for the week, a bit lower than the market. But up is up, and a steady increase is actually a good thing for the junk bond market. We’re still seeing bankruptcies increase and credit risks, especially in Energy, are still there. But oil rose this week, which is making those risks seem less bothersome for the time being, and that’s keeping money in the corporate bond market.

This blind flow of cash into corporate bonds means we need to be choosy when investing in corporate bonds. Diversified funds that incorporate junk bonds with other high yielding assets remain a better alternative until bankruptcy rates level off or oil climbs up past $80 per barrel. That price point is crucial, because even the smallest energy companies can be profitable and pay their bills if oil sells for that much. Sadly, we’re nowhere near that price point, which means caution is still in order.

So where do we go for yield and corporate bonds? The Bull Market Report still likes the Pimco Dynamic Income Fund (PDI: $28), which rose 1% this week. No matter; its 9% dividend yield is amply covered by investment income and the fund’s undistributed net investment income has risen to $1.34 for the fiscal year. In accordance with regulations, the fund will have to return much of that to investors by December. If the fund only gives $1 (an unlikely scenario since the fund is still earning in excess of its payouts), that would mean a special dividend of over 3% and an annualized yield of nearly 13%.

Imagine that - for every $1,000 invested in this fund, you’ll get $130 per year. Compare that to investing in the SPDR High Yield fund, which gives a paltry $60 per year. And the distributions of that fund have been declining as junk bond defaults have risen and yields on corporate bonds have fallen.

This demonstrates a key point: Index investing does not work when it comes to corporate bonds. Pimco has access to high quality payouts and sophisticated tools to manage funds, which is why the Dynamic Income fund has been paying annualized dividends over 13% for years - and why it will likely continue to do so. Hold this fund and enjoy the high income stream.

Now let’s turn to REITs. We’ve written at length about how this asset class is soaring in 2016, and that a correction was inevitable. That correction began in August, but it seems to have come to an end. After some steep declines, the SPDR Dow Jones REIT ETF (RWR: $99) jumped 4% this week. With that recovery, the fund is flat for the past month and up over 3% for the past 3 months.

Our REIT picks have done better. Digital Realty Trust (DLR: $98) rose nearly 6%, and is likely just the beginning. This company is exposed to cloud computing, and profits heavily from growth in that industry. Since cloud computing is expected to see double-digit annualized growth for the decade ahead, there’s no reason to think that some of that won’t flow to Digital Realty Trust. On top of that, this company out earns its dividend by a healthy margin and has a history of growing dividends. It’s tempting to cash out and profit from the company’s 58% year-over-year stock price growth, but hold steady- there’s a lot more growth to come, as this fund’s dividends will just keep going higher.

Importantly, Digital Realty Trust’s dividend is not going to be threatened by a cyclical downturn. Yes, in 2008-2009 we saw dividend cuts and bankruptcies in the REIT industry. But the growth in data storage and cloud computing didn’t stop. Even if we see the economy collapse, we’re still going to be using computers, using the internet, and transmitting data. The market doesn’t see Digital Realty Trust as a recession-proof REIT. But it is - and that’s why we love it.

Finally, let’s address municipal bonds. Munis are a great asset class for tax-free income and stability. The iShares National AMT-Free Municipal Bond fund (MUB: $113), paying 2.3%, is up 2% year-to-date and was never down more than 2%. That’s incredible stability, which is good for peace of mind. But there’s another advantage to municipal bond funds - because of their low volatility, they provide an opportunity to sell shares when necessary and to jump back in when possible. And when you’re in, you’re getting tax-free income that far exceeds what any bank or U.S. Treasury can offer.

That’s why we added the Nuveen Enhanced AMT-Free Municipal Credit Opportunities Fund (NVG: $16.05) to The Bull Market Report High Yield portfolio a couple months ago. This week, the fund rose over 1%. The yield has dropped a bit as a result, but is still nearly 6%. Remember, that’s tax free.

We’re actually not happy to see the strong price growth this week, although things could be worse. The fund is up slightly over the past three months, and down over 1% for the past month. What does all this mean? Simply put, it means now is still a good time to buy more. We still like this fund and recommend buying more for a high yield opportunity that also offers greater liquidity than other high yield options. If you have extra cash that you want to put into the market to get some income, this is an opportunity, especially if you think you might need to access that cash in the next few months.

Looking at next week, we will be keeping a close look at oil prices and the action in REITs. Both will have wide implications for the high yield universe as a whole, and may provide us with more buying opportunities. For now, enjoy your gains for this week.

Good Investing,
Todd Shaver
Editor in Chief