THE BULL MARKET REPORT - JULY 18, 2016

by Todd Shaver | Jul 17, 2016 | Weekly Newsletter 7pm Sunday

Dow and S&P 500 Hit Record Levels
It was amazing, wonderful even mind-boggling.   No we are not talking about Pokemon, we are reflecting on the record levels hit on Friday by the Dow and S&P 500.  Closing prices were a bit off record highs; nevertheless, any investment measure that sets a new record says a lot about investor confidence.  The term confidence is used here purposefully.  Looking at the tragic events in Nice on Thursday, the fact that all major European and US markets were calm on Friday is remarkable. The other barometer of confidence of course is Gold.  The metal fell 2.1% for the week. Logic would have predicted different results.  Almost everything about last week had a different and unexpected tone.  We learn something new every day.

Here is How The Major Averages Performed For The Week

Stocks at Record Levels - Follow The Money
When seeking investing success, it is often advised, “don’t fight the tape”.  In other words, if huge amounts of money are pursuing a limited number of stocks, prices will rise.  It is a simple matter of supply and demand.  It is never a good idea to apply intellectual reasoning during these times because prices will rise no matter what we think.  In the end, stocks discount the future and sometimes the future turns out better than anticipated.

According to Reuters, investors poured $12.6 billion into US equity funds last week, the second highest amount ever.  In addition, $4.4 billion went into high yield bonds as the search for yield continues.  More demand. Limited supply. Prices go up.

Last week’s record-setting milestone was surprising considering how bearish sentiment was immediately following the chaotic Brexit vote. This is a pretty impressive event.  But what made last week so interesting (and puzzling) is hidden below these numbers.

On Thursday, the government released the Producer Price Index for June showing a huge leap. The index was up 0.5% versus consensus of 0.2%, an annual pace of 6%.  In different times, investors would conclude the next step would be an increase in interest rates, generally not good news for stocks.  But for the first time in a while, stock prices hit record levels while the yield on the US 10-Year Note increased as well.

Aside from the search for yield, investors in the American economy did have several bits of good news to reinforce their faith.  Industrial output surged in June by 0.6% from big gains in the Auto sector, and Retail sales also increased 0.6% in June.  The Auto sector actually held down the overall result.  Excluding Autos, Retail sales increased 0.7%.

Bull Market Report Companies and Comments
CBRE Group (CBG: $28, up 5% for the week) We commented in our previous Bull Market Report newsletter how the stock was taking an unfair shellacking from the Brexit fiasco.  The stock was down 17% during this period and was acting as if the end of one of the world’s foremost Real Estate Services Companies was only a matter of time.  We didn’t buy into this at all.  The stock had a nice bounce last week and still remains well below the all-time high of $39 reached in March last year. Earnings for 2Q16 will be reported July 25.  Look for details in next week’s Earnings Preview.

Who will benefit more if every financial firm in London decides to move to other places in Europe? We know this won’t happen, but some of this is indeed happening as firms look to relocate their operations to Brussels, and Geneva and Paris, etc.  This is what CBRE does!  They help firms move, consolidate, and save money with their real estate needs.  Case closed.  We LOVE this quiet and powerful company.

PayPal (PYPL: $39, up 5%) We also recently pointed out how PayPal has a big share of its business in the UK.  The notion that this could spell the end of PayPal sent the stock into the type of tailspin that invites savvy investors to buy more of this gem.  The stock has appreciated 8% so far this year and now we can appreciate how the concern about Brexit is nothing more than a price discount in disguise.

Aetna (AET: $119, up 1%) The newswires last week carried lots of chatter about the pending Aetna/Humana combination.  Word was that both sides held a meeting with the Justice Department.  For some time there has been talk of Aetna being forced to divest several billion dollars of assets in order to get the deal done.  Sure, it would be great if this turns out not to be the case.  But we see no problem either way as there are plenty of buyers at favorable prices.  Aetna management is determined to get the deal done.  Earnings for 2Q16 will be out this August 2nd.

Kinder Morgan (KMI: $21, up 13%) The sun, moon and stars are finally in alignment for Kinder Morgan.  It helps that Crude prices have recovered.  It is also a good omen that drilling activity has picked up in the US and Canada.  The stock is up 35% year-to-date with a lot of the move having taken place in the last two months.  Wall Street is getting enamored once again because Kinder Morgan’s turnaround is starting to take shape.  It starts with a deleveraging of the balance sheet by selling underperforming assets. Two deals in recent weeks have netted $4.5 billion in a combination of cash and reduced debt.  More of this sort of music is coming.

Now, here is something for yield-oriented investors to consider.  The current 2.4% dividend offers a competitive yield.  This is good. But remember, Kinder Morgan’s current dividend of $0.50 a year was cut just last January from $2.00.  We don’t know when the full dividend will be restored.  But what we do know is the balance sheet deleveraging makes the prospects for some increases in the payout very likely.

Mylan Labs (MYL:  $45, up 2.4%) Mylan is the latest addition to our Opportunities in Healthcare Portfolio.   They are the world’s second largest generic drug company behind Teva Pharmaceuticals.  With more than 1400 products, Mylan is highly diversified. Mylan has distinct advantages and is using its size and financial muscle to accelerate its growth through acquisitions.  Over the past two years the company has entered into six agreements to acquire businesses, products or marketing rights.  The company has deployed more than $700 million in cash and $6.3 billion in stock in the process of becoming the industry leading consolidator of products and brands.  

The heavy initial costs of these transactions are behind it and this shows in Wall Street’s expectation for EPS to recover from $1.80 in 2015 to $4.95 this year, rising 20% in 2017 to $5.90.

When we find a company that is growing rapidly and selling at a low multiple, we get very excited.  The most critical of Wall Street analysts see Mylan’s EPS growth at a 14% annual average over the next five years.  That is the sort of rate that normally begets big premiums but here we have Mylan selling at less the 9 times 2016 EPS and 7 times next year’s estimates.  We are not making up these numbers; they are the average of 15 of the best drug analysts in the business.  Need we say more?  Mylan has to be one of best the real values we have come across in a long time.

Alphabet (GOOG: $720, up 2%) [Somehow we just don’t feel comfortable calling this company anything but Google. Alphabet just doesn’t roll off our tongue yet. I guess it will over time.]  Google is on a roll lately. It is the kind of roll that occurs with this company and a few others like Apple (AAPL: $98, up 2%) and Facebook (FB: $117, flat) from time to time where the stock TRICKLES UP day after day.  Google is TRICKLING UP lately.  (So is CBRE as discussed above, and so is Blackstone (BX; $25, up 4%) and so is Twitter (TWTR: $18.08, flat)). Google was at $702 the day before Brexit and $675 the day after. That sounds terrible but it is like a $70 stock going to $67 – not the end of the world.  The next day it went to $668, but has trickled up day after day to its present $720.  Love it.  

Where next?  Well, we added the stock in February at $765 so it hasn’t been the greatest performer in our arsenal.  But we are believers in the company and are confident that it will hit $1000 in the future.  They are a cash machine and have some of the smartest people in the world of Technology.  They have $73 billion in cash and just $8 billion in long term debt.  Sales have gone from $46 billion to $55 billion to $66 billion to $75 billion in the last four years.  Do you think this growth is going to stop?  No way.  

We could go on and on.  But we would suggest that Google is on sale here; you know, like going to the store and getting 20% off the price of a new car.  A year from now if the market stays steady and moves higher, we would expect to see an “8” or a “9” in front of the stock price. And wouldn’t it be grand if they decide to split the stock like Apple did.  Would they do a 7-1 split like Apple?  Or maybe a 10-1 split and bring the price down to $90!

BRIEF MENTIONS
Blackstone (BX; $25, up 4%) We think this is one of the most compelling buys of all of our stocks.
Under Armour (UA: $42, up 3%) Trickling up from $36 after Brexit.  The stock should be in the 50s or 60s.  
Goldman Sachs (GS: $162, up 7%) Not trickling up, but SURGING up.  $70 billion market cap for a company that knows how to mint money.  $215 52-week high last year. The stock should be in the 200s.
Qualcomm (QCOM: $55, up 1%)  4% dividend, $80 billion market cap.  We should see a slow and steady rise in revenues and earnings as the company moves into new markets.

Upcoming Economic News: Summer Silence
After a busy data-filled week just passed, the upcoming days are conspicuously absent of any market moving elements.  Aside from the normal New Jobless Claims (250,000 expected -  Wednesday at 8:30 AM) and June Existing Home Sales (5.5 million Thursday at 8:30 AM) there is little else.

Thoughts from Jefferson Financial Group

Gary Jefferson
First Vice President
Jefferson Financial Group

A week ago Friday a popular research firm had this to say: "We have a green light from all the important economic indicators (Manufacturing, Services, Employment, Retail, Sentiment and overall GDP). Add to that the ultra-low rates for bonds = buy stocks. This is what SHOULD happen.

“However, there are some very vocal bears like Soros and Icahn who are playing from the old investing textbook which sees slowing worldwide growth and low rates as signs of trouble. Indeed those measures have historically been true. HOWEVER, the new investing textbook which is focused on a world awash in low/negative rates says that this environment is plenty good enough for further stock advances. So yes, we should make new highs shortly. But don't be surprised if there is a hearty battle that ensues between bulls and bears at 2135."

So let's look at the big picture:

•    10- and 30-Year Treasury yields just hit all-time lows
•    The British Pound fell to a new 31-year low last week
•    The key European bank index dropped to a new multi-year low last week
•    US stocks (S&P500 Index) are at all-time highs

Which one of the above seems to somehow "not belong"? There is no doubt that stocks are acting resiliently, but bonds, banks and currencies are sending "caution" signals. For example, 17% of all loans in Italy are bad. By comparison, at the height of the '08/'09 financial crises, only 5% of US loans were bad.

In this market it is easy for anyone, advisors or investors, to feel confused and conflicted. After all, this is the fourth time this year the market has climbed up to these levels.  We prefer sticking with the basics when sorting through all the "noise." In other words, just look at earnings.

Last week was the beginning of earnings season with Alcoa, JP Morgan Chase, Citigroup, Wells Fargo, CSX, Yum Brands and Delta Air Lines reporting  

According to numerous 'experts', earnings are expected to be poor again this quarter with this quarter expected to be the fifth consecutive quarter of earnings declines. According to Thomson Reuters, earnings are expected to fall by 5% after a 5% decrease last quarter. The third quarter is also expected to be slightly negative. Energy companies are forecast to turn in the worst results again, with a roughly 75% reduction expected for the sector. Financials, whose results come in abundance this week, are expected to see earnings fall by about 5.5%.

What's our best guess in light of this scenario? The Fed will continue to flip-flop (Fed tightens policy through hawkish statements, then eases policy with a dovish speech – it has had 10 flip-flops in just over three years), and, while the flip-flops will likely continue, we don't expect any rate hike for the next six months. Combining low rates with all the political uncertainty and the ever-present oil wild card, stocks will likely remain volatile without really going much of anywhere until there are either stronger earnings or serious convictions that they are just ahead. That said, "Don't fight the Fed" and the "trend is your friend" are two of the oldest saws in the industry which have to be considered. A solid break above the old trading range top of 2135 could mean it is time to begin adding more stock exposure to portfolios – but let's see how the earnings season shapes up meantime, because right now stocks are pricing in earnings to perfection.

Apple and Google Want to Control Your Wallet -- But PayPal Has a Secret Weapon
From www.businessinsider.com

PayPal earned its fame as the internet's original electronic payment system for consumers. But thanks to an acquisition it made three years ago, PayPal is now a contender in one of the fastest-growing and most promising parts of the payments business. PayPal's secret weapon is Braintree, a payments startup it bought for $800 million in 2013. The deal gave PayPal vital technology for the back-end payment processing that's used by a slew of new apps and services, from Uber to Airbnb. It's a competitive business, but Braintree says it's seeing robust growth in an important part of its business, providing an important engine for its PayPal parent.

Braintree is doing three times as many transactions as it was this time last year. Assuming the average dollar amount per transaction hasn't dropped significantly, that increasing usage could help Braintree accelerate the growth in its overall payment volume, which totaled $50 billion in 2015 out of the $280 billion in payment volume PayPal did in 2015.

And at a time when companies like Apple, Google and Amazon are all trying to eat into PayPal's traditional market  with rival payment services, Braintree is providing PayPal with a new way to stay competitive. Braintree makes it easy as it lets developers quickly and easily build payment systems that blend right in with their own apps and websites. They can take credit cards, Bitcoin, Apple Pay, Google Pay, or whatever comes next, without having to be a specialist in any of those things. Just plug in Braintree and go.

Airbnb is a customer.  So are Uber, Pinterest, GitHub, OpenTable, and lots more companies large and small. When you pay for an Uber on your phone, no matter what payment method you use, it all gets invisibly handled by Braintree. So even when Tim Cook promotes Apple Pay at big Apple events, it's Braintree and its customers who get the push. Braintree is a strategic must-have for PayPal in many ways. While PayPal itself has rapidly improved its technology, both in terms of its app and its behind-the-scenes plumbing, the world is changing. People are doing more and more shopping from mobile apps. Braintree gives PayPal a way to always be a part of those transactions, wherever and whenever they take place, so long as developers put it in their apps. As computing becomes increasingly mobile, that's a shift PayPal needs to make to survive in the long-term.

PayPal’s drive is to help get merchants of all sizes to accept digital payments - a must in 2016, as smartphones and wearable technology promise to change the way we think of commerce.

How Brexit Will Affect the United States Economy and the Stock Market
If you have been current with recent events, you know that Brexit has become the latest news. While ordinary people may just read the news and gloss over it, economists, investors and other related stakeholders certainly don’t.  The term is a coinage from two words; “BRitain” and “EXIT”. It literally explains the Exit of Britons from the European Union. There have been several campaigns, debates and agitations for Britain to quit the European Union on the premise of protecting and restoring the country’s independence, culture and place and its identity in the world. Part of the cause arises from restricting and possibly eliminating immigration.

Whatever the reasons adduced for leaving the European Union, it is here now and the reality is the fact that it will tell on Britain’s economy. This is because without access to the open markets of the EU, there is the likelihood that Britain will lose significant trade.  With her agitation against migrants who have contributed to a greater percentage of her labor force, there will obviously be decreased job opportunities, lower productivity and slower economic growth in the country.

Great Britain consists of about a 6th of the economy of the EU, and the implication to the them is great. The Exit is akin to both Florida and California being lopped off our economy.

The EU happens to be one of the largest trading blocs in the world. This break will cause restructuring of trade deals and give birth to several global problems, many unforeseen. For one, Brexit could lead to a further breakup of the EU and the end of the use of the euro as their central currency.

In the wake of this Exit, most Americans (both consumers and business owners) are likely to restrict their normal spending plans, and restricted spending means slower economic growth for the US, which is not burning any barns down at the moment anyway. In addition, this Exit has caused serious volatility in stock markets globally. One of the characteristics of Americans is cutting short expenditures when things become bleak, and the future seems troublesome now with Brexit, as no one knows what will happen next. Adding spending reduction to the already sluggish world economic growth and high unemployment rate could have dire results.

Exit might further strengthen the dollar, lowering exports of US goods. This will make our manufactured products more expensive, and at the same time less attractive to outsiders, our buyers.

It will however be good news to American travelers, and we do love less expensive European travel.

More in coming weeks as things develop in Europe.

Options Corner

Buying Way-Out-of-the-Money Calls:  Pure Speculation
(A quick one this week, as this newsletter is LONG!)

We like Under Armour a lot.  The stock has been punished for no discernible reason.  At $42, it is down from its all-time high of $53 last year. We think it will come back nicely, so let’s look at buying an out of the money option.  Pure speculation.  Pure unadulterated risk.  (You know that buying options are risky. That’s why we like to sell covered calls.  Less risk.) But if you want to play with some money you could lose, you could buy the January 2018 70 call for about $1.00.  That’s the $70 call (the LEAP).  In a nutshell, if the stock does not reach $70 you lose all your money.  But if the stock goes to $75, you make four times your money.  If it goes to $81 you make 10x.  What’s the chance of Under Armour reaching $75?  Only you can answer that, but you are buying a fabulous company that is clearly undervalued, so there is certainly a chance it could happen.  And that’s what buying way-out-of-the-money options is all about:  There’s always a chance.

Too slim a chance?  Then look at the $50 call in January of 2018. This trades for about $4.50.  So you have about 18 months for the stock to get to the strike price + the premium ($50+$4.50, or $54.50) to break even.  Could the stock get to $54.50?  Again, only you can answer that.  If it does, you break even.  If it goes another $4.50 higher to $59 you double your money.  If it goes to $63.50, you have a 3-bagger.  And so on.  And if it doesn’t get to $50 by expiration?  You lose _____ your money. (Fill in the blank.  Hint:  It’s spelled “A-L-L.”)  

High Yield Corner
It was another strong week for the market, but high yield is showing signs of weakness. The S&P 500 gained 1.5% in the week to close at the record high levels we’ve enjoyed after the post-Brexit recovery, despite a small sell-off on Friday that may be more a matter of profit-taking than anything else. However, with the Nice tragedy and an attempted  coup in Turkey, markets might begin to get more concerned with the potential of volatility in the future, causing these record-breaking levels to fall a bit.

Meanwhile, High Yield was a mixed bag. The junk bond market was flat, with the Barclays Capital High Yield Bond ETF (JNK: $36) staying at roughly the same level after an early-week jump. This is not really a bad thing, since junk bonds are up about 7% for the year. As this has happened, bond yields have fallen to extremely low levels. The curiously named BofA Merrill Lynch US High Yield Master II Effective Yield, an index of below-investment grade corporate debt yields, fell to less than 7% by the end of the week, although the index was as high as 10% earlier in the year when we first recommended buying selective corporate bond funds.  The fears of massive defaults have not really materialized. While bond defaults are up, they are not impacting the best-of-breed bond funds that have wisely avoided such troublesome debts.

Here’s a chart of that Index if you are interested:
https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY

The same goes for the municipal bond market. Much confusion and fear surrounds this market, for one simple reason: it appeals to unsophisticated and risk-averse investors who often overestimate the likelihood of municipal bankruptcies. This fear drove munis far too low in 2015, and made them a steal earlier this year. The iShares S&P National AMT Municipal Bond Fund (MUB: $113, down 1%) has held on to solid gains for the year despite losing a chunk of those gains this week. After peaking two weeks ago, the municipal bond market is showing fear at a rate we have not seen since last year. Municipals are down nearly 2% from their peak two weeks ago, and further declines may come as investors lose their appetite for risk. Of course, when the prices come down, the yields go up.

Nonetheless, select municipal bond funds are showing renewed strength and have proven themselves. Recent Bull Market Report pick Nuveen Enhanced AMT-Free Municipal Credit Opportunities Fund (NVG: $16.08) has maintained a solid credit portfolio and has grown its NAV substantially since inception, with many of those gains coming this year. Despite those strengths, the fund is down 3% in the last week, but is still up 11% year-to-date. While further weakness in the municipal bond market may hit this fund in the short term, it may not. Now trading at nearly a 10% discount, the fund is a true bargain and the market may not allow it to get much cheaper, since its credit portfolio continues to increase in value.

We say other weakness in the Business Development Corporation world, with the UBS BDC ETF (BDCS: $21) falling 1% in the week. Like junk bonds, BDCs tend to fall in times of high risk and fears about credit quality, since these companies lend to smaller firms that cannot access the corporate bond market. This higher risk is compensated for with higher yields, as many BDCs yield over 8%.

The best ones, however, are bucking the trend. Main Street Capital (MAIN: $33) rose 1% in the week, effectively moving in the opposite direction by the same amount as the broader BDC market. Like the Nuveen Muni bond fund, Main Street has proven itself to be a rare gem in its sector, actually growing NAV per share significantly over the last few years. Main Street has also continually grown its dividend. But the last dividend increase was in 2015, so another is due. This is especially apparent when we see that the fund’s net investment income far exceeds payouts, leaving Main Street management plenty of room to increase payments to shareholders. Despite its high premium, we rate it a continued hold although significant capital gains profits could be had by selling since Bull Market Report’s first recommendation at $30.70 in April.

One exception to the weak high yield market is in the MLP sector. The Alerian MLP (AMLP: $12.90) is up over 1% for the week, holding a respectable 7% gain for the year so far. It’s also seen its beta, a measure of volatility, fall to 0.73 - a sign of improvement after the massive swings we have seen over the last few years. This may be a sign to start looking at higher quality MLPs, with a focus on how their ability to pay out dividends has been impacted by recent fluctuations in oil and natural gas prices.

Finally, the REIT sector was essentially flat, with the SPDR Dow Jones REIT ETF (RWR: $101) seeing less than half of 1% gains in the week. But the sector continues to be an impressive performer. Bull Market Report picks Government Properties Trust (GOV: $24) and Digital Realty Trust (DLR: $107) are up 52% and 41% for 2016, respectively. These are massive gains one doesn’t normally see from a dividend vehicle, and are a testament to how much growth potential high-quality REITs have despite the market’s misunderstanding of them in 2015.

Who Are You Going to Believe - The Experts and Politicians or Your Lying Eyes
Larry Gellman, Guest Contributor
Managing Director
RW Baird Private Wealth

That question - a paraphrase of the famous line attributed to both Groucho Marx and Richard Pryor seems to perfectly sum up the disconnect between our consistent bullishness in recent years and the increasingly daunting narratives of most pundits and politicians who have regaled us with predictions of doom and gloom and daunting assessments of the state and downward trajectory of our economy.  
 
In early 2009, our country was in the midst of the worst economic catastrophe of our lifetimes.  Millions of Americans were losing their homes and life savings while iconic banks and corporations that had survived the Great Depression of 1929 were suddenly collapsing left and right and faced bankruptcy.  The stock market averages around the world were in free fall.  In the U.S. we were shedding 700,000 net jobs a month for many months in a row.  After a decade of a Wall Street-fueled debt explosion and real estate and mortgage bubbles, it was suddenly virtually impossible for anyone to borrow money at any price.  Warren Buffet was called a great patriot for agreeing to loan money to Goldman Sachs and General Electric at an interest rate of 10%, and he received stock options as part of the bargain because 10% wasn’t considered adequate compensation for the risk he was taking.  In March of 2009, the S&P-500 Average had dropped from 1500 to 650, and the experts warned us that Obamanomics and Obamacare would ruin the economy.  Ads on the radio and TV featured respected pundits and gurus urging investors to keep their money in cash and gold to survive the upcoming disaster.
 
But, regardless of who or what is entitled to the credit for what has happened since, look where we are just over six years later.  The same S&P-500 is sitting at an all-time high of 2150, more than triple where it was just seven years ago.  The collapsed real estate market has now recovered and tens of millions of individuals and companies have been able to pay down their crushing debt and/or refinance at interest rates none of us thought we would ever see in our lifetimes.  We had added 12 million new jobs in the U.S. (73 consecutive months of job growth for the first time in history), and the unemployment rate has been cut in half from almost 10% to below 5%.  Our national annual deficit, which had ballooned to more than $1 trillion just a few years ago, has been cut in half.  For the first time in American history, just 11% of Americans are without health insurance and our fastest growing demographic (older folks) are collecting more than $35,000 a year in Social Security (much more than a working person making $15 an hour) and benefiting from Medicare having paid in at rates which assumed we would live to be 65, and instead most of us are living much, much longer.
 
A reasonable person would assume that in the face of these facts and the way things have gone in real life that a record number of Americans would be invested in stocks and be feeling pretty giddy about the bonanza they have reaped. But just last month data came out showing the percentage of Americans who own NO STOCKS AT ALL has never been higher in modern history.  And investors here and around the world are still willing to loan our country money for 10 years at a record low interest rate of 1.5%.  
 
The point: We have been consistently bullish on the stock market and remain so not because we are cockeyed optimists or to make a political statement.  We are bullish today because it is still possible to buy and own great American companies at reasonable prices, particularly when compared to the alternative investments that are available.  Having said that, it is important to acknowledge that the risks have grown.  The most obvious risk is the upcoming election.  In addition, as we recently saw with the surprise decision of Great Britain to pull out of the European Union, voters often don’t think things through as well as they should.
 
At the end of the day, we continue to believe that owning great companies and living a long time is still the best way to BUILD wealth.  That argument is even more compelling right now when investors are so pessimistic about the future.  
 
Going forward, out plan is to own a broadly-diversified group of outstanding companies which we believe present us with outstanding risk/reward opportunities.  We still believe that the best way to manage wealth is to continue to build it.

WELL SAID, Larry.  We at The Bull Market Report believe in the same things that you mention above.

Good Investing,
Todd Shaver
Editor in Chief
The Bull Market Report