November 28, 2016
by Todd Shaver | Nov 28, 2016 | 1pm News Flash
(This is normally part of the Weekly Bull Market Report. It was delayed and we promised that we would send it out as a News Flash. So here it is.)
The most significant news of the week was Black Friday. Amidst all of the noise about the stock market reaching new highs and growing questions about President-elect Trump’s conflicts of interest, cabinet nominations, and so on, the real news is what consumers are doing.
Several studies came out showing that foot traffic was weak on Black Friday. Reuters summarized the story this way: “Early holiday promotions and a belief that deals will always be available took a toll on consumer spending over the Thanksgiving weekend as shoppers spent an average of 4% less than a year ago.” That isn’t just Reuters pontificating, but is their summary of a study by the National Retail Federation (NRF).
Reuters acknowledges several reasons to be optimistic. For one, the U.S. “holiday shopping season is expanding,” with the NRF’s CEO saying early promotions and longer deep discounts are making Black Friday less important than it used to be.
So this isn’t actually horrible news on the surface, but it does tell us that we need to start looking at a new economic catalyst before investing our money. Yes, commodity prices, the Federal Reserve, and export policies are all important, but the U.S. retail consumer is important too and has been overlooked recently. With Black Friday, we should start to change that viewpoint.
Is this really important for high yield investors? Absolutely. Domestic consumption drives many of the small and middle-market businesses that are debtors to BDCs, so shoppers showing up is crucial for the health and safety of their portfolios. The UBS Etracs BDC ETF (BDCS: $22) rose a bit over 1% during the shortened trading week, and is up 9% year-to-date. That pales in comparison to Main Street Capital’s (MAIN: $37) 26% year-to-date climb. The stock hasn’t moved much since our sell recommendation, and was flat this week. Does this mean the momentum in our favorite and reluctantly-sold BDC is coming to an end? We believe so.
Which brings us back to the Retail issue. A broad and weaker holiday shopping season could cause a bit of a sell-off in BDCs that could bring Main Street’s historically astronomical price premium back down to Earth, and in turn motivate us to buy the stock again. We wouldn’t dream of buying Main Street at a discount, but a lower premium would be compelling. Hopefully the market will bring this opportunity to us so that we can bring Main Street back into our group of holdings.
The U.S. consumer is the driver of macroeconomic trends; when the U.S. consumer runs out of money, the entire world suffers. That’s what happened in 2008-2009, with a housing crash in America turning into an employment crisis in Europe, a currency crisis in Asia, a debt crisis in Europe, and a commodity crisis in developing markets. We still haven’t recovered from 2008-2009, which in part has made high yield assets more attractive. Now we need to consider what the future of the U.S. consumer will bring to high yield asset classes.
Beyond BDCs, there’s the Junk Bond question. High yield bonds are broadly based, ranging from issues in America and abroad in every sector imaginable. So you’d think they aren’t too dependent on the American consumer. It’s true that the dependency isn’t as high as with BDCs, but these firms still need a consumer to buy stuff to drive demand for their goods and services. So a strong Retail sector should, in theory, help keep bankruptcy rates in the Junk Bond market from rising too much.
The devil is in the details, however. A stronger U.S. consumer will mean more capital going to stocks in consumer discretionary and Retail sectors - and out of other sectors and higher risk asset classes. This means junk bonds could, in theory, lose demand despite stronger fundamentals. We’ve seen default rates and prices go up for junk bonds this year, so a disconnect between fundamental strength and prices is not unprecedented (arguably it’s quite common with high yield assets). So we can’t just buy junk bonds because the retail consumer is still spending at a healthy clip - and we can’t just buy junk bonds if retail becomes weaker than expected.
So what do we do? Simply put, we need to be judicious and diversified in our junk bond holdings. This is why we continue to recommend the Pimco Dynamic Income Fund (PDI: $28), which rose over 2% in the short trading week. This is partly a correction from being oversold following the Trump victory - the fund is still down 2% over the last month. But the climb is good news, because it brings us back into the green year-to-date. But with a fund like this one, we aren’t buying for capital gains - we’re buying for the dividend.
And now is a more important time to hold this fund than ever, because the fund’s special dividend announcement is just around the corner. This is arguably the most important single event in the fund’s year, and it’s more important now than it’s been in years for one simple reason: there is a lot of money up for grabs.
So far the fund has out earned its dividend by a healthy margin. This means that it has $1.52 in undistributed net investment income. This is cash that is just lying around that is rightly the shareholders’. If we subtract the regular dividend and assume zero coupon payments in December, that still leaves nearly $1.30 in income that is awaiting investors. This is a near 5% dividend payout on top of the over 9% that the fund pays out.
Let’s think about this for a moment. This is a fund that has a 14% annualized dividend payout without depleting its net assets. In fact, the fund’s NAV is over 13% higher than it was when the fund IPO'd.
This is why we have recommended this fund and continue to do so. There are many high yield bond funds out there with the promise of a 12% distribution or higher. Many of these funds have cut distributions in the past or have unsustainable payouts because they are paying out more than they are earning in income. Others may be covering their dividend payments in the short term, but have seen NAV erode over time. In fact, we cannot think of a single fund that pays a yield of over 12% that has not seen its NAV decline over time. Pimco Dynamic Income Fund is the only exception, and that’s why we recommend holding it.
When the distribution is announced, you might see a short-term price boost to the fund. This may be dramatic. The upcoming special dividend may be higher than any we have seen the fund pay out in the past, and that means it could attract a lot of attention it otherwise does not get. Should you sell when this fund shoots up in price? Absolutely not. This fund’s durable income stream is likely to last for a long time, making it the bedrock of any good high yield portfolio.
Finally, let’s touch on REITs because they are prone to the vicissitudes of the U.S. consumer, since so many of them have most or all of their assets in America. The SPDR Dow Jones REIT ETF (RWR: $90, up 1%) had a strong showing in the short week and has seen a slight recovery after its post-Trump slump. The fund is now flat for the past month.
That is admittedly much better than some of our picks over the short term. Omega Healthcare Investors (OHI: $29) is down 7% over the last month on sector worries thanks to poor performance at a competitor and worries that Trump will wallop the industry with rate hikes. That means Omega is now yielding over 8% and is down 17% year-to-date and down 14% since our recommendation. We do not recommend selling despite this poor performance. The company’s ability to maintain payouts with an FFO that is well over its dividend makes it a compelling hold; its ability to steal market share from competitor HCP (HCP: $29) is also being ignored by the market. We consider these facts great reasons to hold the company.
At the same time, we admit that it is likely to suffer if the Retail sector skyrockets. Investors will want to move their REIT allocations from a non-retail focused company to a more retail-focused one. This is why we have Kimco Realty (KIM: $26), which rose nearly 3% to end the week flat year-to-date. Kimco has also been hit hard by Trump jitters; the company was up over 20% at its peak in the summer. Higher interest rates could remain something of a risk to Kimco in the long term, but that risk is far outweighed by its 4% dividend yield, its solid cash flow and dividend coverage, its very low valuation at its current price level, and its growth potential. It’s important to keep in mind that Kimco’s PE (now 21) has remained lower over the past year than it was at any point after the Global Financial Crisis. That makes it a compelling buy, with the uplift from a strong retail season just making it more compelling.
In short, Thanksgiving gave high yield investors a lot to be thankful for. There are a lot of worries and a lot of bad press out there, but don’t let the fearmongering clickbait sway you. High yield assets still provide a lot of high quality income opportunities for the diversified investor.
November 21, 2016
by Todd Shaver | Nov 21, 2016 | Monthly Newsletter Daily 6am if new
The Week Ahead
We finished this week above the fresh all-time highs set just a week ago. But we raise the question - have we come too far to fast? The frenzy seen post- election is seemingly pricing in a lot of good to come from new leadership in Washington. Are expectations reasonable or too aggressive? We note that Caterpillar recently said even if a $1 trillion infrastructure spending bill was passed today, it would take at least a year for projects to start, given the timelines for making the equipment needed. And we haven’t yet passed a $1 trillion infrastructure bill nor have we any clarity about how one would be funded. This infrastructure example highlights one market over-reaction to Trump, which is happening across many more sectors.
Good stock picks can make money in any market. This week we provide some insights on our latest thinking for Under Armour, Tesoro, Facebook, Amazon, and Microsoft.
Highlights From The Past Week
Repatriation. Many people are asking the question - If new leadership in Washington does lower repatriation taxes so that US companies bring home the $2+ trillion currently parked overseas, what will the money be used for?
The prevailing view at this time seems to be that much of the capital repatriated from overseas will be returned to shareholders, via repurchases and dividends. This is good for the stock market and for investors like us. However, we need to keep a close eye on how everything develops. Some are saying if the money just goes to buybacks and dividends rather than capital expenditures, then we won't see the big benefits to job growth and middle class income. There is talk of a flat 10% repatriation tax which should bring billions back to the US, but we’ll have to wait and see!
Fiscal Stimulus. Like Andrew Jackson’s populism, people are saying that we’re going to build an entirely new political movement: It’s everything related to jobs. They will be able to push a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it’s the greatest opportunity to rebuild everything. Ship yards, iron works, new infrastructure projects get them all jacked up. We can just throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution. Exciting times! (We shall see.)
Interest Rates. The bond market bloodbath continues. The 10-year US Treasury yield is up a stunning 65 basis points from the Trump-win lows, spiking to 2.35% - the highest since December 2015. In fact, the entire Treasury yield curve is now higher in yield on the year, leaving most of everything newly issued in 2016 now under water. We are going to have to keep a close eye on where rates stand going forward. The cornerstone of fiscal stimulus will be low rates. But if the bond market re-prices rates much higher, the increased interest expense could throw a wrench in gears turning all of the current excitement.
BMR Companies and Commentary
Facebook (FB: $121, up 3% today)
Again, Facebook has found more miscalculated advertising metrics. The company said it has uncovered several more miscalculated metrics related to how consumers interact with content from marketers and publishers, and it unveiled additional independent review of some measurements to calm unease over the their data. An internal metrics audit found that discrepancies led to the undercounting or overcounting of four measurements, including the weekly and monthly reach of marketers' posts, the number of full video views and time spent with publishers' Instant Articles.
Does it matter? Should we be worried? What is the impact?
None of the metrics in question impact Facebook's billing. The only financial impact would be from customer perception about what has occurred, leading to customers shying away from spending money to advertise with Facebook because they have new concerns over these metrics. It is a stretch to go there. Facebook has well over 1 billion users. Just because a few mistakes were made on some back-office tasks doesn’t change how the business model connects advertisers to world. (We are not discounting this issue, but we think the market will perceive it to be a small matter. The company is already working on the PR to reduce the impact on perception.)
Let’s stay focused on what matters. Recall, it was a stellar quarter just recently reported. Facebook's Q3 earnings update that came in better than expected on top line revenues of $7.0 billion versus the $6.92 billion consensus and EPS of $1.09 was ahead of the Street's $0.97 expectations. Daily active users of 1.18 billion and monthly active users of 1.8 billion were both ahead of the Street's expectations as well. Management offered updated guidance on expense growth of 40-45% that was lower than the prior 45-50%. The negative takeaways were comments about decelerating revenue growth and heavy investments in 4Q16 and 2017. Many people think this was just management setting the bar low so they can beat it more easily. We agree.
BMR Take: If the first time miscalculated metrics didn’t shatter the Facebook growth story, we don’t think the second time around will. Clearly an operational mistake we don’t like to see, but we don’t see reason to exit our position in the stock over it. We think the company is set up to deliver better than expected financial results over the next several quarters. Stick around!
And this just in: Facebook will repurchase up to $6 billion in stock (first time they have ever done a stock buyback.) The buyback will start in the first quarter of 2017, using some of their $26 billion in cash. The market liked the news: the stock was up over a $1 in after-hours trading Friday.
BTW, we just noticed that Facebook’s all-time high is the same as Apple’s - $134. We wonder who will get their first. Our guess? Facebook. Why? Smaller market cap - $340 billion vs. $590 billion. Higher growth rate. So now we have two races to watch. Google vs. Amazon is the other. They both closed at the same price Friday. Love it!
Amazon (AMZN: $776, up 3% last week and up $16 today)
The word is CEO Jeff Bezos is telling executives to “Do what it takes to succeed” in India. Amazon fell a little behind in China early and business never quiet was able to recover to be as big as it could have been. Bezos is going on all in on India to ensure the same thing doesn’t happen twice.
Amazon had been India’s #2 ecommerce player. But that has changed. Bezos is now communicating to the market that Amazon has pulled ahead to be #1, with market share estimated around 28%.
India is a huge opportunity for Amazon. India has a population of 1.2 billion with about 40 million online shoppers. Goldman Sachs calls for ecommerce sales in India to grow 10-fold from today’s level of $11 billion over the next decade. And since only about one-third of Amazon’s sales are international, there is tremendous room for growth here. We understand that Bezos is going to invest another $3 billion in June into the India operation, in order to make the business even better. Amazon currently has over 80 million products selling in India. (This is not a misprint.) And they have more than 120,000 sellers, compared to 40,000 sellers a year ago. In June, the company said it will invest an additional $3 billion in India after it exhausted its earlier investment pledge of $2 billion. The company also launched its Prime membership program in July in more than 100 Indian cities, offering one-day and two-day delivery
BMR Take: Amazon’s stock has been down since the latest earnings report. The concern is that they are in a short term cycle of big investment spending. This news of more investments in India certainly plays right into the bearish outlook. Long-term, we think every dollar Bezos spends re-investing in the business will pay dividends later on. In the near-term, we brace for negative sentiment about how profits are being weighed down today due to these investments. Listen, we are not negative on the company nor the stock. We just want to give you both sides of the story. In fact, we think the market will shrug off this news and do what it always does, buy the story of bigger is better, awaiting huge profits in the future. But you never know…
Microsoft (MSFT: $61, up 2% last week)
Goldman Sachs upgraded the stock to Buy with a $68 price target. What’s the story here? Why did they upgrade? What are they now saying? Why is Microsoft all the sudden a buy?
The company got off to a strong start to FY17 as revenue and EPS came in above consensus estimates. The strength was driven by growth of Azure (the cloud business) and adoption of Office 365 (the web version of Office).
Many are now expecting the upcoming quarter to be an inflection point for Microsoft, as the company will complete the sale of its phone business and the acquisition of LinkedIn, signifying the end of the old and the beginning of the new.
We believe the integration of LinkedIn will enhance the value proposition of Microsoft’s entire platform, including Azure, Office 365, and Dynamics. As such, we believe the best is yet to come as we expect revenue growth acceleration and margin expansion ahead.
BMR Take: Glad to see Goldman Sachs come around to support our outlook. What a humbling game investing is. The world’s most powerful investment bank is playing catch up to a little tiny newsletter service out of Aspen, Colorado.
Goldman Sachs (GS: $210, +19% in the past two weeks)
Financials including Goldman Sachs rallied the most this past week. With rates finally rising, a steeper yield curve is good for banking and capital markets. More importantly, plans to roll back regulation are coming, which is huge for all of Financials, as they have had a bad stigma for years under the Elizabeth Warren era of denouncing Wall Street.
The regulatory discussion is currently all over the map right now about what we could see. The end of Dodd Frank? The termination of the Consumer Financial Protection Bureau? No more Volcker Rule allowing proprietary trading (again)? Some even say Glass-Steagall* could be on the table (again). Note that Trump has called for a general guideline of allowing new regulations to be implemented only if they replace two existing regulations. This all amounts to positive implications for Goldman Sachs.
*The Glass–Steagall Act describes four provisions of the U.S. Banking Act of 1933 that limited securities, activities, and affiliations within commercial banks and securities firms.
One more thing to ponder - who will Trump name as Treasury Secretary? The position once held by Alexander Hamilton is considered one of the highest honors in all of Finance for those asked to serve. Rumors are floating that Goldman’s CEO Lloyd Blankfein is possible candidate, as well as CEO Jamie Dimon of JP Morgan Chase.
BMR Take: Goldman is the #1 investment banking franchise. The investment banking business follows a boom-bust cycle. With the sharp rally recently, we are implementing a stop at $196 to protect our gains but we do not want you to miss more upside if the train keeps rolling. We added the stock at $147 in February, so we are up 43% in nine months.
Upcoming Economic News
Tuesday, November 22nd
Existing Home Sales – October
Time: 10:00 am
Forecast: 5.46 million
Existing home sales are projected to be little changed in October with tight inventories constraining transactions. Sales fell 0.4% year-over-year last quarter for the first decline of the past two years. Sharply rising Treasury bond rates will feed through into higher mortgage rates, adding another impediment to existing home sales growth.
Wednesday, November 23rd
Durable Goods Orders – October
Time: 8:30 am
Forecast: 1.0% overall, 0.2% ex transportation
Rising aircraft orders in October following two straight deep monthly declines can lead a strong overall gain in durable goods orders. Industrial demand has shown some recent promise; core capital goods orders increased 5.2% annualized in the third quarter against the previous quarter. Yet that recent burst in activity is tempered by the weak long-term trend; such orders fell 4.1% year-over-year during the same period.
New Home Sales – October
Time: 10:00 am
Forecast: 585,000
New home sales can dip a bit in October yet still point to strong long-term growth. Third quarter sales rose 23% year-over-year, as volumes continued to trend higher from depressed post-crisis levels. Though up substantially on an annual basis, last quarter’s 600,000 unit annualized pace trails the average rate of the past 20 years by 18%.
University of Michigan Consumer Sentiment – November
Time: 10:00 am
Forecast: 91.6
The post-election bounce in the stock market may ultimately feed into somewhat higher readings in consumer sentiment. The preliminary reading in the November Michigan survey was the highest in five months as consumers are reporting improved financial conditions. Renewed declines in oil prices can also spur stronger inclinations to increase spending on other items.
FOMC Meeting Minutes
Time: 2:00 pm
Given the jolt to interest rates and inflation expectations following the election, the minutes of the early November FOMC meeting will be somewhat stale. Yet the general push toward hiking the Fed Funds target in December will likely find additional support in the minutes. The next key question for monetary policy is how much policy tightening is likely in the year ahead. Economic projections released by the Federal Reserve next month will provide crucial guidance on this subject.
Twilio (TWLO: $37) had a good week, rising 17%. We’ve said many times how much we like this one, but the market has been hammering the stock these past few weeks. The turnaround in a week when most Tech stocks were hit hard, is impressive. Again, we think this is a $75 stock if they continue their phenomenal revenue gains that we saw in the past few years, and certainly last quarter. Twilio did $167 million in sales last year, up from $90 million the year before and the company is on a $1 billion annual run rate by the second half of 2018. Can’t wait for next quarter’s earnings. If strong, the stock should get back to the 50s and 60s in no time.
The Energy Corner
North Dakota’s crude-oil production in September dropped to the lowest level in more than two years. Crude production fell 1.1% on the month to 970,000 barrels a day in September, the lowest level since February 2014. North Dakota is home to the Bakken Shale formation, one of the world’s highest-cost oil fields. Growing confidence that crude prices will rise in coming months is sustaining the expansion of oil drilling in the shale patch. Rigs targeting crude rose 19 to 470 this week, the biggest increase in the last 16 months, according to Baker Hughes data reported Friday. Shale drillers have now added 155 rigs since an expansion started at the end of May. Gas rugs were flat, bringing the total for oil and gas up by 20 to 588.
This news just in - the Obama administration on Friday banned offshore drilling in the Arctic, setting a likely collision course with President-elect Donald Trump, who has vowed to “unleash” new energy production in the United States by rolling back restrictions on oil. Great – a new story for us to worry about.
So, US rig count is up sharply, which should produce greater volumes as we move into 2017. This counteracts the move by OPEC to cut production, which hasn’t been approved yet, and may indeed never happen
Interest Rate Corner
Federal Reserve Chairwoman Janet Yellen reiterated that an increase in short-term interest rates "could well become appropriate relatively soon" but offered no new signals about what the central bank will do at its meeting next month.
We are in the camp at The Bull Market Report that a ¼ point rise is baked in for December. Of course, she could surprise us with a ½ point rise, which would probably tank the markets like what happened last December. We hope she maintains some sense here. The 10-year Treasury note has exploded, from a low of 1.37% in July to 1.80% before the election to 2.34% Friday.
Tesla Update: It’s official: Tesla (TSLA: $187, down 2% last week) shareholders approved the acquisition of SolarCity. The company is now an unequivocal sun-to-vehicle energy firm. And Chief Executive Officer Elon Musk didn’t take long to make his first big announcement as head of this new enterprise. Minutes after shareholders approved the deal - about 85 %of them voted yes - Musk told the crowd that he had just returned from a meeting with his new solar engineering team. Tesla’s new solar roof product, he proclaimed, will actually cost less to manufacture and install than a traditional roof - even before savings from the power bill. “Electricity,” Musk said, “is just a bonus.”
If Musk’s claims prove true, this could be a real turning point in the evolution of solar power. The newly announced rooftop shingles are made of textured glass and are virtually indistinguishable from high-end roofing products. They also transform light into power for your home and your electric car.
“So the basic proposition will be: Would you like a roof that looks better than a normal roof, lasts twice as long, costs less and - by the way - generates electricity?” Musk said. “Why would you get anything else?” On a large house over a long period of time, the value of that electricity could exceed $100,000. The new roofing material he unveiled this past week is considerably cheaper, and it's considerably more promising for the future of rooftop solar power.
We love Musk. He never ceases to amaze and shock. Can he pull this off? Will he have enough cash to make it work? We think yes. But again, this stock could hit $150 before it hits $250. Volatile!
Goldman Sachs Maps Out Its Top Market Themes for 2017
They're heavily influenced by President-elect Trump.
Goldman Predicts: U.S. recession risk remains low in 2017
Goldman released its top 10 market themes for next year. "High growth, higher risk, slightly higher returns," is how their strategists view the year ahead - and it's clear that their outlook has been heavily influenced by the pending regime change in Washington.
Here's a brief summary some of the themes Goldman sees as forming the backdrop for investing in 2017. All thoughts and comments are for Goldman.
Expected returns: Only slightly higher
Relative to its 2016 forecasts, Goldman says owners of financial assets can reasonably able to expect more upside - but stresses that these returns will still likely remain low. The best improvement in the opportunity in global equities is in Asia ex-Japan, where we forecast returns of 12.5% (versus 3.8% for 2016.) At the other end of the equity spectrum, in Japan we are forecasting declines of 3.7% on the Topix (vs. +5.2% for 2016).
U.S. fiscal policy: A pro-growth agenda
President-elect Donald Trump's focus on infrastructure spending during his victory speech on Nov. 9 - rather than trade protectionism or immigration restrictions - catalyzed the risk-on sentiment that's pervaded markets.
Markets are starved for growth
This is plainly visible in the eagerness with which markets seized on Trump’s growth-focused message. It is also visible in the speed with which the market’s narrative on the economic outlook under Trump has shifted from uncertainty to growth. Fiscal stimulus in the U.S. will help reflate the economy, and stands a good chance of passing through Congress.
U.S. trade policy: Concerns are likely overdone
Goldman doesn't see an imminent trade war on the horizon, and expects any re-negotiation of agreements currently in place (like NAFTA) to focus on attempts to improve the prospects for the U.S. manufacturing sector. We think the popular media narrative on the downside risk of a trade war is overstated. Our tentative view is that Trump’s use of punitive tariffs will be just as pragmatic as President Obama’s, albeit more vocal.
Emerging markets risk: “Trump tantrum” is temporary
Emerging market assets have been crushed since the election, as the rise in Treasury yields has reduced the need to reach for yield overseas, and the potential for protectionist trade policies threatens to curtail growth opportunities.
Monetary policy: Focusing the toolkit on credit creation
Better-targeted monetary stimulus could help avoid some negative side effects associated with quantitative easing and negative rates that inhibit credit creation.
Corporate revenue growth recession: Signs of inflection
For years, S&P 500 companies have exceeded analysts' expectations on the bottom line more often than the top line during quarterly earnings seasons, as a combination of cost-cutting and shrinking share count, rather than soaring sales, fueled the growth in earnings per share. However, Goldman expects 2017 to confirm that the U.S. corporate sector has emerged from its recent 'revenue recession.' A firming global economy and recovery in oil prices from their February lows significantly buoys the outlook for revenue growth stateside.
For 2017, Goldman expects that modest improvements in the macroeconomic backdrop will help lift S&P 500 operating EPS by 10% and they have a year-end S&P 500 target of 2200, currently 2180 now. [Not terribly exciting if you ask us. We differ. We don’t normally predict, but we would certainly be looking for 2300 or 2400.]
Inflation: Moving higher across developed markets
Market-based measures of inflation expectations in the U.S. have spiked since the election, as traders bet that Donald Trump will be the inflation president.
What seems clear to us, as argued above, is that economic issues, notably tax cuts, infrastructure spending and defense spending, are high on the agenda - a recipe for reflation. We are forecasting large boosts to public spending in Japan, China, the U.S., and Europe, which should fuel inflationary pressures in those economies.
The next credit cycle: Kinder and gentler
While commodity-sensitive segments of the credit market have suffered pain in 2016, there hasn't been much in the way of contagion. Goldman's team expects more of the same in 2017, with the credit cycle not making a turn for the worse. The strong ‘business cycle’ component in the behavior of high yield defaults, and our view that U.S. recession risk remains low in 2017, leave us comfortable with the view that the inflection point is unlikely to materialize next year, despite the weak state of corporate balance sheets.
Mortgage Rates Surge After Election
Here is some news on the state of the mortgage market. Mortgage rates surged after the election win of Donald Trump. But housing experts say consumers shouldn't get carried away by the post-election wave. The advance of the past week or so, stoked by a surprise victory that turned economic expectations on their head, could soon settle.
"Consumers considering buying or refinancing now should stay patient, as we'll likely see rates stabilize once markets find a new equilibrium," says Zillow, the mortgage rate real estate company.
In the week ended Thursday, the average rate on the 30-year fixed-rate loan jumped to 3.94% from 3.57% the previous week, mortgage company Freddie Mac reported. A year ago the market was at 3.97%. The average for a 15-year mortgage climbed to 3.14% from 2.88%
The High Yield Corner
We have seen our first full post-Trump trading week, and it wasn’t bad. Actually, things were impressive considering the expectations and last week’s bull run. The S&P 500 rose nearly 1% by the end of the week, but the really interesting story is the difference between different stock groups. Large caps underperformed small caps significantly - this has a lot of important implications for high-yield investors, so is worth a closer look.
The Dow Jones Industrial was pretty much flat last week, while the Russell 2000 went up 2.6%. The difference between these two is the result of different trends between different investors: the risk-averse are more worried than the less risk-averse, who are willing to give small caps a chance in the hopes that they will deliver the higher-than-big-cap returns that they gave in the past. This has pushed small caps up to a 17% year-to-date return after rising 8% in the last month.
But here’s the really interesting part: the Dow Jones is up 10% year-to-date after a 4% return over the last month. The S&P, however, is up 7% year-to-date after rising 2% in the last month.
What this means is that risk appetites have grown in the last month while the more cautious are less eager to jump into the Trump rally. They aren’t avoiding it, but they aren’t going into it as much as the more risk-tolerant investors. In other words, we’re having a growing disagreement about future risks with the economy as a whole.
This is not uncommon, but wasn’t the case earlier in 2016. Both large caps and small caps had similar high returns for much of 2016 - and now that convergence is subsiding.
This is important for high yield investors for two reasons. First, junk bonds and BDCs tend to trade closely with small cap stocks as they attract similar investors: risk-tolerant institutions. Second, a market where the risk-averse are more cautious and the risk-hungry are less so often portends a bubble followed by a crash. That is not in the cards quite yet, but it does make one wonder if the industries getting a big boost - Financials in particular - might get overbought if they haven’t already.
With this as our backdrop, let’s take a look at how each asset class performed in the last week and why:
REITs - Initially REITs were the hardest hit by Trump’s victory on fears that his spending plans would kickstart inflation and thus increase REITs’ borrowing costs. This remains a concern, as the U.S. Treasury 10-year keeps going higher, but we’ve finally gotten to a point where the risks are priced in. Fortunately for REITs they already began correcting before the election, so this week’s return was just barely green, according to the SPDR Dow Jones REIT ETF (RWR: $89. Flat).
Results for individual REITs varied, but our picks did OK. Kimco Realty (KIM: $26) rose slightly, Digital Realty Trust (DLR: $90) rose over 1%, Omega Healthcare Investors (OHI: $28) was flat, Care Capital Properties (CCP: $24) rose 4%, and Government Properties Income Trust (GOV: $18.90) rose less than 1%. We also added a new REIT to our portfolio: Ventas (VTR: $60), which rose 2% this week. Ventas is one of the few REITs that is up year-to-date in the Healthcare space: rising 6% so far this year, but its price-to-FFO ratio and growth potential make it extremely attractive.
Junk bonds - The corporate bond market is now dominated with changing inflation expectations. Love him or hate him, but the market believes Trump is going to cause inflation to accelerate. This isn’t a testament to his failures or abilities, however; much of these expectations are the end result of the Fed’s constant efforts to improve inflation rates and a time when low oil prices and high supplies are priced in. There are many reasons beyond Trump to think inflation will not stay low forever, and having a president in the office (whoever it may be) who is focused on rising inflation with a House and Senate that will work with him, almost seems a perfect formula for rising inflation.
That is why junk bonds have done particularly badly after Trump, but the real surprising thing is that they didn’t do poorly for longer. Last week the SPDR Barclays High Yield Bond ETF (JNK: $36) rose over 1% and is now up 5% from the beginning of the year. Yet the fund has a near 7% dividend yield that is far higher than it has been in recent years. This is partly because of expectations of a rate cut for the fund*, which has happened in the past, so it’s important to keep in mind the more actively managed alternatives that aren’t tied to an index** and thus have more flexibility to ensure payouts remain constant. Note that the ETF recently registered $342 million asset inflows for a 3.15% increase.
*JNK's distribution cut is expected because the BofA High Yield index has fallen. Since JNK tracks that, its distribution should fall too.
**Active funds like PDI vs. passive indexing funds like JNK. In other words, “alternative funds that are actively managed" makes that clearer.
Our pick to take advantage of this strategy remains Pimco’s Dynamic Income Fund (PDI: $27), which had a nice 4% gain this week to offset last week’s massive decline. The fund is still down over 4% from a month ago which means it is poised to improve in recent weeks. The fund is also now flat year-to-date with a near 10% dividend and a looming special dividend that we believe will be at least 3%. That turns this fund into a 13% dividend payer with a sustainable dividend. That is almost impossible to find in the market (we know as we’ve looked for more, but Pimco’s fund seems to be it!)
Municipal bonds - Rising interest rates are a problem for all bonds, but they are actually worse for corporate bonds than municipal bonds because of the risks and the way these are structured. Yet looking at the municipal bond world lately, you’d think it’s the riskiest asset in the world. The iShares National Municipal Bond ETF (MUB: $108) fell 1% this week and is down 3% over the last month. The ETF is also down 2% for the year, making municipal bonds one of the few asset classes that has had negative returns for the year.
We have been wary of municipal bonds this year because of their massive run-up before the summer and rate hike concerns. We don’t believe rate hikes directly are a drain on municipal bonds, but fears about rate hikes often overshoot the real risks and cause a big and prolonged selloff. We saw this in 2015 and have seen this to a lesser extent this year. This is why we have only recommended one municipal bond fund this year: the Nuveen Enhanced AMT-Free Municipal Credit Opportunities Fund (NVG: $14:04). The fund is down 2% over the last week and is down 3% year-to-date. The most shocking figure is the three-months metric: the fund is down 14% in that time.
We expect these massive declines to reverse, but it is going to take a while for that to happen and it is difficult to time. While municipal bonds are already oversold, that does not mean the market knows they are oversold, and they can go down even lower. Nuveen’s fund is a good long-term hold and we expect it to hold its NAV for the long term, as it has done for over a decade already. However, we also expect greater volatility to hit this and all municipal funds. Anyone wishing to invest in munis now will have to endure these short-term price declines with patience, buying more as the stock goes down.
From one extreme of the risk/reward spectrum to the other, let’s turn to BDCs. The UBS BDC ETF (BDCS: $22) rose over 1% over the last week and has had a somewhat strong showing after the Trump election. While BDCs aren’t going up nearly as much as Financials, they are both rising for the same reason: an expectation that deregulation is going to cause credit to flow and the Financial sector to boom. BDCs cannot help but benefit from this, so they are rising with the Financial sector. However, they are not rising from an extreme bottom as Financials are, so the asset class’s 2% monthly return is a fraction of the double-digit returns of the Financial sector as a whole. This is unlikely to change.
At the same time, we have finally gotten to a point where Main Street Capital (MAIN: $36.50) has gotten overbought. The BDC is now up 16% from when we recommended it in April after rising 8% in the past month alone. We waited for this week’s dividend distribution to see if the stock would fall further after the payout, but it hasn’t; in fact the stock is up over 1% after its recent payout. That now means Main Street is selling at a 70% premium to its net asset value and it has passed our target price. We are keeping our price targets on Main Street, which means recommending selling at these levels and waiting for the price to correct before jumping back in. Main Street remains an excellent firm with impressive advisors and the capability to increase dividends for a long time, but the cost of that expertise and growth potential is too high now. We will buy again when the stock is more fairly priced.
Good Investing,
Todd Shaver, Founder and Editor in Chief
The Bull Market Report
November 20, 2016
by Todd Shaver | Nov 20, 2016 | Weekly Newsletter 7pm Sunday
The Week Ahead
We finished this week above the fresh all-time highs set just a week ago. But we raise the question - have we come too far to fast? The frenzy seen post- election is seemingly pricing in a lot of good to come from new leadership in Washington. Are expectations reasonable or too aggressive? We note that Caterpillar recently said even if a $1 trillion infrastructure spending bill was passed today, it would take at least a year for projects to start, given the timelines for making the equipment needed. And we haven’t yet passed a $1 trillion infrastructure bill nor have we any clarity about how one would be funded. This infrastructure example highlights one market over-reaction to Trump, which is happening across many more sectors.
Good stock picks can make money in any market. This week we provide some insights on our latest thinking for Under Armour, Tesoro, Facebook, Amazon, and Microsoft.
Highlights From The Past Week
Repatriation. Many people are asking the question - If new leadership in Washington does lower repatriation taxes so that US companies bring home the $2+ trillion currently parked overseas, what will the money be used for?
The prevailing view at this time seems to be that much of the capital repatriated from overseas will be returned to shareholders, via repurchases and dividends. This is good for the stock market and for investors like us. However, we need to keep a close eye on how everything develops. Some are saying if the money just goes to buybacks and dividends rather than capital expenditures, then we won't see the big benefits to job growth and middle class income. There is talk of a flat 10% repatriation tax which should bring billions back to the US, but we’ll have to wait and see!
Fiscal Stimulus. Like Andrew Jackson’s populism, people are saying that we’re going to build an entirely new political movement: It’s everything related to jobs. They will be able to push a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it’s the greatest opportunity to rebuild everything. Ship yards, iron works, new infrastructure projects get them all jacked up. We can just throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution. Exciting times! (We shall see.)
Interest Rates. The bond market bloodbath continues. The 10-year US Treasury yield is up a stunning 65 basis points from the Trump-win lows, spiking to 2.35% - the highest since December 2015. In fact, the entire Treasury yield curve is now higher in yield on the year, leaving most of everything newly issued in 2016 now under water. We are going to have to keep a close eye on where rates stand going forward. The cornerstone of fiscal stimulus will be low rates. But if the bond market re-prices rates much higher, the increased interest expense could throw a wrench in gears turning all of the current excitement.
BMR Companies and Commentary
Under Armour (UA: $31, down 3% for the week)
Sneaker outlet Foot Locker reported earnings. The CFO commented that inventory is fresh and well-positioned for the important holiday selling season, which keeps the company on track to achieve mid-single digit comparable-store sales gains and double-digit earnings growth.
So the shoe business is going well? Perhaps not so much for Under Armour. Foot Locker’s CEO raised concerns that the Curry 3.0 is not selling as well as anticipated. The CEO said the third iteration of the Curry basketball shoe is off to a slower start than the first two. Recall that Under Armour recently signed NBA All Star Stephen Curry of the Golden State Warriors to an endorsement contract. They took him on a marketing trip through China to stir up excitement, and expectations for what Curry and his dedicated shoe line-up could do for Under Armour’s brand and revenue have been set high.
Under Armour ended the week near a fresh 52-week low after the comments out of Footlocker hit the market.
BMR Take: We think all of the above is just market noise. The Under Armour brand is growing because Stephen Curry is now on the team. Whether his shoes sell a little more or less doesn’t really matter. Literally, the revenue doesn’t move the needle for the company, and it doesn’t change the fact that more and more big name athletes are increasingly likely to sign with Under Armour over Nike. We view weakness in the stock as a buying opportunity.
Tesoro (TSO: $83, down 3%)
Tesoro announced a $6.4 billion acquisition of Western Refining (WNR: $37, up 29%) It’s good news. The company expects 2018 EPS to go up 10-13% because of the deal.
Through the purchase, Tesoro adds two very respected refineries to the portfolio - El Paso, TX and St Paul, MN. This expands Tesoro’s footprint beyond the West Coast, which makes Tesoro’s portfolio even more attractive to a potentially larger buyer one day.
There are an estimated $350 to $425 million of cost synergies to be realized in the deal. This level represents about 33-45% of Western Refining’s normalized EBITDA. That is a big percentage! Typically, in M&A perhaps you see 10% synergies. The number is so big in this deal because of the nature of the refining business. It’s all about scale.
BMR Take: The Western Refining acquisition is yet another solid deal by Tesoro to build out the portfolio, which already ranked as the best asset on the West Coast. Net asset value post the deal is now expected to be around $140 versus the current stock price of $83. We, along with many people on Wall Street, see a lot of value management can create for shareholders by realizing net asset value. With this common knowledge on the Street why isn’t the stock trading at $125 or $140 now? You have to sell assets to unlock net asset value. Until then Wall Street will just give you credit for the cash flow you are generating from the assets. Phillips 66 (PSX: $84) trades at 120% of NAV because everybody thinks Warren Buffett is going to buy it. Right now Tesoro is a big lumbering asset that is just producing income. So the gap in valuation for Tesoro from the current price to NAV would close quickly if management were to sell off some assets, raising cash and reducing debt and readying itself for sale (to Warren Buffett.)
Facebook (FB: $117, -2%)
Again, Facebook has found more miscalculated advertising metrics. The company said it has uncovered several more miscalculated metrics related to how consumers interact with content from marketers and publishers, and it unveiled additional independent review of some measurements to calm unease over the their data. An internal metrics audit found that discrepancies led to the undercounting or overcounting of four measurements, including the weekly and monthly reach of marketers' posts, the number of full video views and time spent with publishers' Instant Articles.
Does it matter? Should we be worried? What is the impact?
None of the metrics in question impact Facebook's billing. The only financial impact would be from customer perception about what has occurred, leading to customers shying away from spending money to advertise with Facebook because they have new concerns over these metrics. It is a stretch to go there. Facebook has well over 1 billion users. Just because a few mistakes were made on some back-office tasks doesn’t change how the business model connects advertisers to world. (We are not discounting this issue, but we think the market will perceive it to be a small matter. The company is already working on the PR to reduce the impact on perception.)
Let’s stay focused on what matters. Recall, it was a stellar quarter just recently reported. Facebook's Q3 earnings update that came in better than expected on top line revenues of $7.0 billion versus the $6.92 billion consensus and EPS of $1.09 was ahead of the Street's $0.97 expectations. Daily active users of 1.18 billion and monthly active users of 1.8 billion were both ahead of the Street's expectations as well. Management offered updated guidance on expense growth of 40-45% that was lower than the prior 45-50%. The negative takeaways were comments about decelerating revenue growth and heavy investments in 4Q16 and 2017. Many people think this was just management setting the bar low so they can beat it more easily. We agree.
BMR Take: If the first time miscalculated metrics didn’t shatter the Facebook growth story, we don’t think the second time around will. Clearly an operational mistake we don’t like to see, but we don’t see reason to exit our position in the stock over it. We think the company is set up to deliver better than expected financial results over the next several quarters. Stick around!
And this just in: Facebook will repurchase up to $6 billion in stock (first time they have ever done a stock buyback.) The buyback will start in the first quarter of 2017, using some of their $26 billion in cash. The market liked the news: the stock was up over a $1 in after-hours trading Friday.
BTW, we just noticed that Facebook’s all-time high is the same as Apple’s - $134. We wonder who will get their first. Our guess? Facebook. Why? Smaller market cap - $340 billion vs. $590 billion. Higher growth rate. So now we have two races to watch. Google vs. Amazon is the other. They both closed at the same price Friday. Love it!
Amazon (AMZN: $760, up $21, +3%)
The word is CEO Jeff Bezos is telling executives to “Do what it takes to succeed” in India. Amazon fell a little behind in China early and business never quiet was able to recover to be as big as it could have been. Bezos is going on all in on India to ensure the same thing doesn’t happen twice.
Amazon had been India’s #2 ecommerce player. But that has changed. Bezos is now communicating to the market that Amazon has pulled ahead to be #1, with market share estimated around 28%.
India is a huge opportunity for Amazon. India has a population of 1.2 billion with about 40 million online shoppers. Goldman Sachs calls for ecommerce sales in India to grow 10-fold from today’s level of $11 billion over the next decade. And since only about one-third of Amazon’s sales are international, there is tremendous room for growth here. We understand that Bezos is going to invest another $3 billion in June into the India operation, in order to make the business even better. Amazon currently has over 80 million products selling in India. (This is not a misprint.) And they have more than 120,000 sellers, compared to 40,000 sellers a year ago. In June, the company said it will invest an additional $3 billion in India after it exhausted its earlier investment pledge of $2 billion. The company also launched its Prime membership program in July in more than 100 Indian cities, offering one-day and two-day delivery
BMR Take: Amazon’s stock has been down since the latest earnings report. The concern is that they are in a short term cycle of big investment spending. This news of more investments in India certainly plays right into the bearish outlook. Long-term, we think every dollar Bezos spends re-investing in the business will pay dividends later on. In the near-term, we brace for negative sentiment about how profits are being weighed down today due to these investments. Listen, we are not negative on the company nor the stock. We just want to give you both sides of the story. In fact, we think the market will shrug off this news and do what it always does, buy the story of bigger is better, awaiting huge profits in the future. But you never know…
Microsoft (MSFT: $60, +2%)
Goldman Sachs upgraded the stock to Buy with a $68 price target. What’s the story here? Why did they upgrade? What are they now saying? Why is Microsoft all the sudden a buy?
The company got off to a strong start to FY17 as revenue and EPS came in above consensus estimates. The strength was driven by growth of Azure (the cloud business) and adoption of Office 365 (the web version of Office).
Many are now expecting the upcoming quarter to be an inflection point for Microsoft, as the company will complete the sale of its phone business and the acquisition of LinkedIn, signifying the end of the old and the beginning of the new.
We believe the integration of LinkedIn will enhance the value proposition of Microsoft’s entire platform, including Azure, Office 365, and Dynamics. As such, we believe the best is yet to come as we expect revenue growth acceleration and margin expansion ahead.
BMR Take: Glad to see Goldman Sachs come around to support our outlook. What a humbling game investing is. The world’s most powerful investment bank is playing catch up to a little tiny newsletter service out of Aspen, Colorado.
Goldman Sachs (GS: $210, up 5%)
Another strong week for Goldman as the stock reached its highest level of 2015 and well as this year. It was only higher in 2007, hitting $248. Keep a tight stop in case the market starts to sell off, to protect your gains. But there’s a good chance we might see new all-time highs in Goldman in 2017.
Upcoming Economic News
Tuesday, November 22nd
Existing Home Sales – October
Time: 10:00 am
Forecast: 5.46 million
Existing home sales are projected to be little changed in October with tight inventories constraining transactions. Sales fell 0.4% year-over-year last quarter for the first decline of the past two years. Sharply rising Treasury bond rates will feed through into higher mortgage rates, adding another impediment to existing home sales growth.
Wednesday, November 23rd
Durable Goods Orders – October
Time: 8:30 am
Forecast: 1.0% overall, 0.2% ex transportation
Rising aircraft orders in October following two straight deep monthly declines can lead a strong overall gain in durable goods orders. Industrial demand has shown some recent promise; core capital goods orders increased 5.2% annualized in the third quarter against the previous quarter. Yet that recent burst in activity is tempered by the weak long-term trend; such orders fell 4.1% year-over-year during the same period.
New Home Sales – October
Time: 10:00 am
Forecast: 585,000
New home sales can dip a bit in October yet still point to strong long-term growth. Third quarter sales rose 23% year-over-year, as volumes continued to trend higher from depressed post-crisis levels. Though up substantially on an annual basis, last quarter’s 600,000 unit annualized pace trails the average rate of the past 20 years by 18%.
University of Michigan Consumer Sentiment – November
Time: 10:00 am
Forecast: 91.6
The post-election bounce in the stock market may ultimately feed into somewhat higher readings in consumer sentiment. The preliminary reading in the November Michigan survey was the highest in five months as consumers are reporting improved financial conditions. Renewed declines in oil prices can also spur stronger inclinations to increase spending on other items.
FOMC Meeting Minutes
Time: 2:00 pm
Given the jolt to interest rates and inflation expectations following the election, the minutes of the early November FOMC meeting will be somewhat stale. Yet the general push toward hiking the Fed Funds target in December will likely find additional support in the minutes. The next key question for monetary policy is how much policy tightening is likely in the year ahead. Economic projections released by the Federal Reserve next month will provide crucial guidance on this subject.
Twilio (TWLO: $37) had a good week, rising 17%. We’ve said many times how much we like this one, but the market has been hammering the stock these past few weeks. The turnaround in a week when most Tech stocks were hit hard, is impressive. Again, we think this is a $75 stock if they continue their phenomenal revenue gains that we saw in the past few years, and certainly last quarter. Twilio did $167 million in sales last year, up from $90 million the year before and the company is on a $1 billion annual run rate by the second half of 2018. Can’t wait for next quarter’s earnings. If strong, the stock should get back to the 50s and 60s in no time.
Two Questions from The Bull Market Report:
Last week, we asked you if a high stock price intimidates you. And we asked which stock, Google or Amazon that are both trading at virtually the same price, will win the ultimate race. Here is a letter from John Herlihy, one of our subscribers.
Hi Todd, To answer your first question, Yes, I do feel intimidated by the high price of those two stocks, although I am not sure "intimidated" is the right word. Logic demands some common sense, so that if a person's stock purchase gains by 2%, it doesn't matter whether you have 500 shares of an expensive stock or 5,000 shares of a less expensive stock, if the amount spent is the same. I play around with about $100,000. At $750 a share, that's about 135 shares. Doesn't sound like much. A $25 stock would be 4,000 shares. Just sounds better even if the profit would be the same on a percentage gain.
To answer your second question: I would go for Google. Amazon seems to be more at the risk of the market place and the consumer spender, while Google just seems to be a powerhouse, not necessarily at the whim of the consumer.
As always, I value (and treasure) The Bull Market Report and its stock advice. I couldn't do without it.
John Herlihy
University Professor
Qatar University
Doha, Qatar
And this was our response:
Hi John –
Just what we thought about a high-priced stock. It’s that good old human nature thing. And of course this is the reason that most companies split their stock. Of course, Google and Amazon don’t give a damn. Apple finally succumbed with the 7-1 split in 2014. (I wonder if they will ever succumb on giving back some of their cash!)
Hard to say who will win – tough to count out Bezos though, as his Cloud operation is exploding.
Thanks and good investing.
Todd Shaver, Editor in Chief
The Bull Market Report
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A Word from Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.
Yogi Berra proved once again last week why he's the greatest philosopher of the modern era with his Yogism "It ain't over 'til it's over." Instead of the Trump crash predicted by 99% of all the financial pundits, the market took off for its best week in over five years.
The Financial Times published an article last week laying out the seven key ways that Donald Trump is set to change America, and in doing so, change the investment landscape and financial markets:
1.Trade - Where Trump may tear up trade agreements and start a trade war by raising tariffs on China to 45%. We didn't come to the same conclusion as this fairly radical interpretation, but rather that he wants a level playing field for US companies. Remember, Trump's expertise is in making deals, not breaking them, and we believe the end result will be good for American business.
2. Foreign policy - Likely to change under Trump, such as abandonment of the deal with Iran and closer ties with Russia.
3. Healthcare - Likely to drastically change (for the better), as Trump has said he will get rid of Obamacare. We think this is a BIG deal for healthcare, big pharma and especially biotech companies, all of which should have a real tailwind next year from the expected changes. [Trump is already tempering his position, so stay tuned.]
4. Tax reform will be another huge area where Trump wants radical reform, promising that companies will not pay more than 15% tax and individuals less than now. This should be big for equities and not so good for bonds. In fact, bonds are already getting hit hard. The total global value of bonds declined by over $1 trillion these past eight days as U.S. President-elect Donald Trump’s policies are seen boosting spending and quickening inflation, according to Bloomberg. Bank of America Merrill Lynch data indicates that the $1 trillion-plus weekly plunge has only happened twice in two decades. Where is all that bond money going? The total global value of equities increased by $1.3 trillion during that same period.
5. The Supreme Court - Trump is likely to be able to easily replace one or two judges with his conservative picks.
6. Climate change policy - Trump has called climate change a “hoax” and says he wants to cancel the Paris accord and cut funding to UN climate initiatives.
7. Immigration - Trump wants to dramatically tighten immigration policy.
All of these policies tell us several things: overweight equities versus bonds; buy American companies with a higher degree of sales and production inside the US; be sure to include biotechs, pharma and healthcare in portfolios. If earnings growth next year is in the 12-14% range, we should have a very good equity market over the next 12 months. And, if the 10-year Treasury rate rises to 3%-3 ½% as some predict, bonds should struggle as will interest rate sensitive equities like utilities.
The Energy Corner
North Dakota’s crude-oil production in September dropped to the lowest level in more than two years. Crude production fell 1.1% on the month to 970,000 barrels a day in September, the lowest level since February 2014. North Dakota is home to the Bakken Shale formation, one of the world’s highest-cost oil fields. Growing confidence that crude prices will rise in coming months is sustaining the expansion of oil drilling in the shale patch. Rigs targeting crude rose 19 to 470 this week, the biggest increase in the last 16 months, according to Baker Hughes data reported Friday. Shale drillers have now added 155 rigs since an expansion started at the end of May. Gas rugs were flat, bringing the total for oil and gas up by 20 to 588.
This news just in - the Obama administration on Friday banned offshore drilling in the Arctic, setting a likely collision course with President-elect Donald Trump, who has vowed to “unleash” new energy production in the United States by rolling back restrictions on oil. Great – a new story for us to worry about.
So, US rig count is up sharply, which should produce greater volumes as we move into 2017. This counteracts the move by OPEC to cut production, which hasn’t been approved yet, and may indeed never happen
Interest Rate Corner
Federal Reserve Chairwoman Janet Yellen reiterated that an increase in short-term interest rates "could well become appropriate relatively soon" but offered no new signals about what the central bank will do at its meeting next month.
We are in the camp at The Bull Market Report that a ¼ point rise is baked in for December. Of course, she could surprise us with a ½ point rise, which would probably tank the markets like what happened last December. We hope she maintains some sense here. The 10-year Treasury note has exploded, from a low of 1.37% in July to 1.80% before the election to 2.34% Friday.
Tesla Update: It’s official: Tesla (TSLA: $188, down 2%) shareholders approved the acquisition of SolarCity. The company is now an unequivocal sun-to-vehicle energy firm. And Chief Executive Officer Elon Musk didn’t take long to make his first big announcement as head of this new enterprise. Minutes after shareholders approved the deal - about 85 %of them voted yes - Musk told the crowd that he had just returned from a meeting with his new solar engineering team. Tesla’s new solar roof product, he proclaimed, will actually cost less to manufacture and install than a traditional roof - even before savings from the power bill. “Electricity,” Musk said, “is just a bonus.”
If Musk’s claims prove true, this could be a real turning point in the evolution of solar power. The newly announced rooftop shingles are made of textured glass and are virtually indistinguishable from high-end roofing products. They also transform light into power for your home and your electric car.
“So the basic proposition will be: Would you like a roof that looks better than a normal roof, lasts twice as long, costs less and - by the way - generates electricity?” Musk said. “Why would you get anything else?” On a large house over a long period of time, the value of that electricity could exceed $100,000. The new roofing material he unveiled this past week is considerably cheaper, and it's considerably more promising for the future of rooftop solar power.
We love Musk. He never ceases to amaze and shock. Can he pull this off? Will he have enough cash to make it work? We think yes. But again, this stock could hit $150 before it hits $250. Volatile!
Goldman Sachs Maps Out Its Top Market Themes for 2017
They're heavily influenced by President-elect Trump.
Goldman Predicts: U.S. recession risk remains low in 2017
Goldman released its top 10 market themes for next year. "High growth, higher risk, slightly higher returns," is how their strategists view the year ahead - and it's clear that their outlook has been heavily influenced by the pending regime change in Washington.
Here's a brief summary some of the themes Goldman sees as forming the backdrop for investing in 2017. All thoughts and comments are for Goldman.
Expected returns: Only slightly higher
Relative to its 2016 forecasts, Goldman says owners of financial assets can reasonably able to expect more upside - but stresses that these returns will still likely remain low. The best improvement in the opportunity in global equities is in Asia ex-Japan, where we forecast returns of 12.5% (versus 3.8% for 2016.) At the other end of the equity spectrum, in Japan we are forecasting declines of 3.7% on the Topix (vs. +5.2% for 2016).
U.S. fiscal policy: A pro-growth agenda
President-elect Donald Trump's focus on infrastructure spending during his victory speech on Nov. 9 - rather than trade protectionism or immigration restrictions - catalyzed the risk-on sentiment that's pervaded markets.
Markets are starved for growth
This is plainly visible in the eagerness with which markets seized on Trump’s growth-focused message. It is also visible in the speed with which the market’s narrative on the economic outlook under Trump has shifted from uncertainty to growth. Fiscal stimulus in the U.S. will help reflate the economy, and stands a good chance of passing through Congress.
U.S. trade policy: Concerns are likely overdone
Goldman doesn't see an imminent trade war on the horizon, and expects any re-negotiation of agreements currently in place (like NAFTA) to focus on attempts to improve the prospects for the U.S. manufacturing sector. We think the popular media narrative on the downside risk of a trade war is overstated. Our tentative view is that Trump’s use of punitive tariffs will be just as pragmatic as President Obama’s, albeit more vocal.
Emerging markets risk: “Trump tantrum” is temporary
Emerging market assets have been crushed since the election, as the rise in Treasury yields has reduced the need to reach for yield overseas, and the potential for protectionist trade policies threatens to curtail growth opportunities.
Monetary policy: Focusing the toolkit on credit creation
Better-targeted monetary stimulus could help avoid some negative side effects associated with quantitative easing and negative rates that inhibit credit creation.
Corporate revenue growth recession: Signs of inflection
For years, S&P 500 companies have exceeded analysts' expectations on the bottom line more often than the top line during quarterly earnings seasons, as a combination of cost-cutting and shrinking share count, rather than soaring sales, fueled the growth in earnings per share. However, Goldman expects 2017 to confirm that the U.S. corporate sector has emerged from its recent 'revenue recession.' A firming global economy and recovery in oil prices from their February lows significantly buoys the outlook for revenue growth stateside.
For 2017, Goldman expects that modest improvements in the macroeconomic backdrop will help lift S&P 500 operating EPS by 10% and they have a year-end S&P 500 target of 2200, currently 2180 now. [Not terribly exciting if you ask us. We differ. We don’t normally predict, but we would certainly be looking for 2300 or 2400.]
Inflation: Moving higher across developed markets
Market-based measures of inflation expectations in the U.S. have spiked since the election, as traders bet that Donald Trump will be the inflation president.
What seems clear to us, as argued above, is that economic issues, notably tax cuts, infrastructure spending and defense spending, are high on the agenda - a recipe for reflation. We are forecasting large boosts to public spending in Japan, China, the U.S., and Europe, which should fuel inflationary pressures in those economies.
The next credit cycle: Kinder and gentler
While commodity-sensitive segments of the credit market have suffered pain in 2016, there hasn't been much in the way of contagion. Goldman's team expects more of the same in 2017, with the credit cycle not making a turn for the worse. The strong ‘business cycle’ component in the behavior of high yield defaults, and our view that U.S. recession risk remains low in 2017, leave us comfortable with the view that the inflection point is unlikely to materialize next year, despite the weak state of corporate balance sheets.
Mortgage Rates Surge After Election
Here is some news on the state of the mortgage market. Mortgage rates surged after the election win of Donald Trump. But housing experts say consumers shouldn't get carried away by the post-election wave. The advance of the past week or so, stoked by a surprise victory that turned economic expectations on their head, could soon settle.
"Consumers considering buying or refinancing now should stay patient, as we'll likely see rates stabilize once markets find a new equilibrium," says Zillow, the mortgage rate real estate company.
In the week ended Thursday, the average rate on the 30-year fixed-rate loan jumped to 3.94% from 3.57% the previous week, mortgage company Freddie Mac reported. A year ago the market was at 3.97%. The average for a 15-year mortgage climbed to 3.14% from 2.88%
The High Yield Corner
We have seen our first full post-Trump trading week, and it wasn’t bad. Actually, things were impressive considering the expectations and last week’s bull run. The S&P 500 rose nearly 1% by the end of the week, but the really interesting story is the difference between different stock groups. Large caps underperformed small caps significantly - this has a lot of important implications for high-yield investors, so is worth a closer look.
The Dow Jones Industrial was pretty much flat last week, while the Russell 2000 went up 2.6%. The difference between these two is the result of different trends between different investors: the risk-averse are more worried than the less risk-averse, who are willing to give small caps a chance in the hopes that they will deliver the higher-than-big-cap returns that they gave in the past. This has pushed small caps up to a 17% year-to-date return after rising 8% in the last month.
But here’s the really interesting part: the Dow Jones is up 10% year-to-date after a 4% return over the last month. The S&P, however, is up 7% year-to-date after rising 2% in the last month.
What this means is that risk appetites have grown in the last month while the more cautious are less eager to jump into the Trump rally. They aren’t avoiding it, but they aren’t going into it as much as the more risk-tolerant investors. In other words, we’re having a growing disagreement about future risks with the economy as a whole.
This is not uncommon, but wasn’t the case earlier in 2016. Both large caps and small caps had similar high returns for much of 2016 - and now that convergence is subsiding.
This is important for high yield investors for two reasons. First, junk bonds and BDCs tend to trade closely with small cap stocks as they attract similar investors: risk-tolerant institutions. Second, a market where the risk-averse are more cautious and the risk-hungry are less so often portends a bubble followed by a crash. That is not in the cards quite yet, but it does make one wonder if the industries getting a big boost - Financials in particular - might get overbought if they haven’t already.
With this as our backdrop, let’s take a look at how each asset class performed in the last week and why:
REITs - Initially REITs were the hardest hit by Trump’s victory on fears that his spending plans would kickstart inflation and thus increase REITs’ borrowing costs. This remains a concern, as the U.S. Treasury 10-year keeps going higher, but we’ve finally gotten to a point where the risks are priced in. Fortunately for REITs they already began correcting before the election, so this week’s return was just barely green, according to the SPDR Dow Jones REIT ETF (RWR: $89. Flat).
Results for individual REITs varied, but our picks did OK. Kimco Realty (KIM: $26) rose slightly, Digital Realty Trust (DLR: $89) rose over 1%, Omega Healthcare Investors (OHI: $28) was flat, Care Capital Properties (CCP: $24) rose 4%, and Government Properties Income Trust (GOV: $18.70) rose less than 1%. We also added a new REIT to our portfolio: Ventas (VTR: $60), which rose 2% this week. Ventas is one of the few REITs that is up year-to-date in the Healthcare space: rising 6% so far this year, but its price-to-FFO ratio and growth potential make it extremely attractive.
Junk bonds - The corporate bond market is now dominated with changing inflation expectations. Love him or hate him, but the market believes Trump is going to cause inflation to accelerate. This isn’t a testament to his failures or abilities, however; much of these expectations are the end result of the Fed’s constant efforts to improve inflation rates and a time when low oil prices and high supplies are priced in. There are many reasons beyond Trump to think inflation will not stay low forever, and having a president in the office (whoever it may be) who is focused on rising inflation with a House and Senate that will work with him, almost seems a perfect formula for rising inflation.
That is why junk bonds have done particularly badly after Trump, but the real surprising thing is that they didn’t do poorly for longer. Last week the SPDR Barclays High Yield Bond ETF (JNK: $36) rose over 1% and is now up 5% from the beginning of the year. Yet the fund has a near 7% dividend yield that is far higher than it has been in recent years. This is partly because of expectations of a rate cut for the fund*, which has happened in the past, so it’s important to keep in mind the more actively managed alternatives that aren’t tied to an index** and thus have more flexibility to ensure payouts remain constant. Note that the ETF recently registered $342 million asset inflows for a 3.15% increase.
*JNK's distribution cut is expected because the BofA High Yield index has fallen. Since JNK tracks that, its distribution should fall too.
**Active funds like PDI vs. passive indexing funds like JNK. In other words, “alternative funds that are actively managed" makes that clearer.
Our pick to take advantage of this strategy remains Pimco’s Dynamic Income Fund (PDI: $27), which had a nice 4% gain this week to offset last week’s massive decline. The fund is still down over 4% from a month ago which means it is poised to improve in recent weeks. The fund is also now flat year-to-date with a near 10% dividend and a looming special dividend that we believe will be at least 3%. That turns this fund into a 13% dividend payer with a sustainable dividend. That is almost impossible to find in the market (we know as we’ve looked for more, but Pimco’s fund seems to be it!)
Municipal bonds - Rising interest rates are a problem for all bonds, but they are actually worse for corporate bonds than municipal bonds because of the risks and the way these are structured. Yet looking at the municipal bond world lately, you’d think it’s the riskiest asset in the world. The iShares National Municipal Bond ETF (MUB: $108) fell 1% this week and is down 3% over the last month. The ETF is also down 2% for the year, making municipal bonds one of the few asset classes that has had negative returns for the year.
We have been wary of municipal bonds this year because of their massive run-up before the summer and rate hike concerns. We don’t believe rate hikes directly are a drain on municipal bonds, but fears about rate hikes often overshoot the real risks and cause a big and prolonged selloff. We saw this in 2015 and have seen this to a lesser extent this year. This is why we have only recommended one municipal bond fund this year: the Nuveen Enhanced AMT-Free Municipal Credit Opportunities Fund (NVG: $14:04). The fund is down 2% over the last week and is down 3% year-to-date. The most shocking figure is the three-months metric: the fund is down 14% in that time.
We expect these massive declines to reverse, but it is going to take a while for that to happen and it is difficult to time. While municipal bonds are already oversold, that does not mean the market knows they are oversold, and they can go down even lower. Nuveen’s fund is a good long-term hold and we expect it to hold its NAV for the long term, as it has done for over a decade already. However, we also expect greater volatility to hit this and all municipal funds. Anyone wishing to invest in munis now will have to endure these short-term price declines with patience, buying more as the stock goes down.
From one extreme of the risk/reward spectrum to the other, let’s turn to BDCs. The UBS BDC ETF (BDCS: $22) rose over 1% over the last week and has had a somewhat strong showing after the Trump election. While BDCs aren’t going up nearly as much as Financials, they are both rising for the same reason: an expectation that deregulation is going to cause credit to flow and the Financial sector to boom. BDCs cannot help but benefit from this, so they are rising with the Financial sector. However, they are not rising from an extreme bottom as Financials are, so the asset class’s 2% monthly return is a fraction of the double-digit returns of the Financial sector as a whole. This is unlikely to change.
At the same time, we have finally gotten to a point where Main Street Capital (MAIN: $36.50) has gotten overbought. The BDC is now up 16% from when we recommended it in April after rising 8% in the past month alone. We waited for this week’s dividend distribution to see if the stock would fall further after the payout, but it hasn’t; in fact the stock is up over 1% after its recent payout. That now means Main Street is selling at a 70% premium to its net asset value and it has passed our target price. We are keeping our price targets on Main Street, which means recommending selling at these levels and waiting for the price to correct before jumping back in. Main Street remains an excellent firm with impressive advisors and the capability to increase dividends for a long time, but the cost of that expertise and growth potential is too high now. We will buy again when the stock is more fairly priced.
That’s all for this week.
Good Investing,
Todd Shaver, Founder and Editor in Chief
The Bull Market Report
November 6, 2016
by Todd Shaver | Nov 6, 2016 | Weekly Newsletter 7pm Sunday
The Week Ahead
The S&P 500 on Friday logged its first nine-day losing streak in 36 years. However, the magnitude of the sell-off has been a modest decline of just 3%. The re-pricing better reflects election uncertainty and the likelihood of a December rate hike. While it can be tough to sit through markets grinding lower, we think such pullbacks offer good opportunities. This week we consider Facebook, Google, CBRE, Goldman Sachs, First Solar, Home Depot, Apple and Twilio.
Highlights From The Past Week
Overblown inflation fear roils markets Thus far, financial assets have fared poorly during the fourth quarter. Fear of a fundamentally unwarranted climb by Treasury yields has weighed on performance. The latest climb by the 10-year Treasury yield from a September average of 1.63% to a more recent 1.81% has been ascribed to expectations of a series of Fed rate hikes in response to a possibly much faster than 2% annual rate of inflation. However, the current bout of inflation anxiety may be overblown, as the Fed is constrained by long-term borrowing costs reaching burdensome levels, particularly regarding the effect to the national debt.
Housing-sector stocks plunge The fourth-quarter-to-date’s 8% plunge incurred by the Nasdaq Housing index reflects considerable worry over a possible rise in borrowing costs that will stifle housing activity. Markets remember all too well how a climb in mortgage rates during the “taper tantrum”* of 2013 reduced home sales. Yes, the 10-year Treasury yield could jump up to 2% or higher, but its stay will be limited if housing buckles under the weight of higher rates. Recall, the housing market is one of the primary sectors driving the economy.
* Taper tantrum is the term used to refer to the 2013 surge in U.S. Treasury yields, which resulted from the Federal Reserve's use of tapering to gradually reduce the amount of money it was feeding into the economy. The taper tantrum ensued when investors panicked in reaction to news of this tapering and drew their money rapidly out of the bond market, which drastically increased bond yields.
Risk-off trade seen in big FANG sell-off In the last week the so-called FANG stocks (Facebook, Amazon, Netflix, and Google) have stumbled. As earnings and outlooks disappointed, shareholders have awoken to the new normal low growth world and wiped out over $100 billion in market capitalization of the four horsemen of the Fed's wealth creation bubble.
BMR Companies and Commentary
First Solar (FSLR: $32, -20%)
First Solar, the world’s largest manufacturer of solar solutions, reported EPS of $1.22 per share for the third quarter, beating analysts’ bottom line expectations of $0.75. Unfortunately, the quarter’s profitability was not enough to please inventors.
Sales fell 46% to $690 million. Worse, CEO Mark Widmar slashed sales guidance for 2016 to $2.9 billion from $3.9 billion due to the timing of certain utility-scale solar project sales. Widmar withheld comment on the company’s 2017 outlook deferring until November 17th when First Solar will give an outlook update. The combination of the decline for 2016 revenues and uncertainty in articulating visibility to 2017 revenues and earnings left the investing community with little choice but to sell first and ask questions later. First Solar sold off over 14% after the release.
BMR Take: The long term view is unchanged. Solar is a key pillar of our country’s future energy infrastructure. First Solar is a market leader. We think the choppy near-term sales trends and much lower stock price present an attractive entry point.
Admittedly, the volatility and the fall-off in the stock is hard to watch. One positive is that the company is trading at a little over one times sales. The market cap is $3.2 billion with sales projected to be $2.9 billion this year. The company has for years been trading at 2-3x sales. When the company rights itself next year we can see the stock trading at least 2x sales which should give us a price in the 50s or 60s towards the end of 2017.
We understand this is not a pretty picture at the moment. But the company isn’t going to dry up and go away, not with $3 billion in sales, and not within an industry that has such unlimited potential.
Goldman Sachs (GS: $176, -1%)
Goldman Sachs' recently made its 3Q16 quarterly filing with the SEC, the 10Q. Reading through 10Qs offers extra insights on business trends. What we learned in Goldman’s 10Q this time was very positive.
Goldman experienced just three loss days in its trading business in the quarter. This is significantly lower than the uptick last quarter to more than 10 loss days. The recovery highlights greater control over volatile markets. This is a favorable trend for their trading business.
Also, we note progress with regulatory issues, specifically the Volcker rule. The Volcker rule constrains Goldman from trading for itself where there could be a conflict of interest with its clients. Consequently, Goldman has not been able to make as much money as prior to when the rule went into effect. However, in the 10Q, it was disclosed that the negative impact from the Volcker rule is moderating. We see this as a strong positive.
BMR Take: Goldman is the #1 investment banking franchise. Given our recent findings reading the 10Q, as well as the recent flurry of deal activity, we see compelling value in the shares.
CBRE Group (CBG: $26, +2%)
CBRE is the world’s largest commercial real estate and services firm. The company just released a new report that provides a comprehensive analysis of real estate trends in the 20 major cities of the world.
The report provides perspective on key variables such as economic trends, occupier trends, supply trends, rent trends, yield trends, and investment activity, so that investors can quickly and easily understand pricing and market conditions. We live in an age of cities. In the developed world, where the service sector drives economic activity, cities have reinvented themselves as vibrant live-work-play destinations.
Beijing, Boston, Chicago, Frankfurt, Hong Kong, London, Los Angeles, Madrid, Milan, Munich, New York, Paris, San Francisco, Shanghai, Singapore, Sydney, Tokyo, Toronto, Vancouver and Washington, D.C. are featured in the report as key targets for international investors. These cities were selected based on size, transport infrastructure, corporate presence, real estate investment flows and several other indicators of importance.
BMR Take: CBRE is one of the top real estate services companies in the world, operating under the radar to most outside investors. The company is active in each of the major cities around the globe. We continue to believe in the company and are waiting patiently for other investors to notice as well, to move this stock in the mid-30s where it belongs.
Home Depot (HD: $121, -2%)
Home Depot has been languishing in recent weeks. Concerns include a softening traffic trend, the cyclical nature of the business, and a lack of upcoming catalysts to push shares higher. We think these views are short-sighted.
The consumer sector of the economy remains healthy. While we might not be seeing households spend at a particularly fast pace, household net worth is back to all-time highs and unemployment is low.
BMR Take: Home Depot may not have the exciting appeal of a stock that could double, but this blue chip is on very stable ground and we expect solid performance to continue.
Twilio (TWLO: $32, -10%)
After reporting strong results in each of its first two quarters as a public company, the tone of business at Twilio this quarter continues to be very positive. Management pointed out on the recent earnings call that the inputs to the business remain strong, the fundamentals are solid, and it feels strongly about its competitive position. Twilio continues to demonstrate remarkable growth with its business-to-developer model, cloud communications platform, and steady stream of new product innovations, including Voice Insights and the Twilio Enterprise Plan.
We still see a path to profitability. Twilio’s operating margin of -5% was above consensus of -10%, while EPS of -4 cents was above consensus of -8 cents. Operating cash flow of -$700,000 and free cash flow of -$7.1 million were above estimates. Management said it targets operating income breakeven in 4Q17.
BMR Take: Twilio is the leading cloud platform for communications. Similar to Amazon Web Services, Twilio plays a critical role for software developers by allowing them to easily and securely build communications services. We see bright future prospects for the space as seen by very strong performances at Amazon AWS, Microsoft Azure, and Google Cloud. The end market cloud opportunity is exploding and we see Twilio participating in a big way. But what a volatile stock! Not for the faint of heart.
Facebook (FB: $121, -8%)
The company reported earnings results that were outright stellar. As we said in our News Flash Thursday morning, 3Q16 net income rose to $2.4 billion from $900 million a year earlier. Earnings came in at $1.09 per share up from 57 cents a year earlier. The $1.09 handily beat the 97 cents that analysts expected. The company said that mobile was responsible for much of this growth. Revenue hit $7.0 billion in the third quarter, up 56% from $4.5 billion a year earlier, topping expectations of $6.9 billion. Management said that 2017 is expected to be an investment year with technology hiring ramping, while also reiterating that ad load growth is expected to slow in 2H17 impacting ad revenue growth. The market didn’t take to that and hammered the stock.
We are not concerned. In each of the past several years, management has been upfront about things like this and set a similarly low bar. The outlook is very beatable and most analysts argue that nothing new really surfaced this quarter (except for this amazing growth.) Fast money is driving the near term trading trends for Facebook. When the focus returns to the fundamentals, we see a lot of upside ahead.
One key indicator of health was that the ratio of daily to monthly active users stabilized this quarter. This demonstrates stronger engagement trends, which confronts a key issue institutional investors have.
BMR Take: Facebook remains a top pick in the internet/social media sector. The fundamental prospects remain bright. Monthly active users increased 16% to 1.8 billion this quarter. Wow! That is a lot of people – 25% of the total population of the world. Some say Facebook is set up to become the most profitable advertising company in the history of the world. We are not fighting anyone on that at all.
Upcoming Economic News
Tuesday, November 8th
US Presidential Election
Time: All Day
This week all eyes will be on the big event, Trump versus Clinton. We expect a close race. The thinking on the Street is that if Clinton wins, things will remain calm and peachy, just like things are now with Obama. In other words, a Clinton win will maintain the status quo. However, if Trump wins, the uncertainly of what he is and what he will do will cause the market to head straight down. And of course, this has been happening for the past few months due to the uncertainty of it all. The market hates uncertainty.
We have a different take. Presidents have been coming and going for over 200 years. This is no different. The market will assimilate the victor and then be able to go up or down over time as the economy moves higher or lower. At the moment, the Fed has interest rates at record lows – they have never been lower. Yes, they may raise next month but then again they may not. In either case, the market will accept it and move through it. And the country will survive and thrive and we will see higher stock prices in the future.
After the winner is chosen the market will have this veil of uncertainty lifted. It may not be who you expect, nor be what you wanted but the market will be able to adapt to it and get back to business.
A Word From Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.
Last December the Fed hiked interest rates for the first time since the financial crisis of 2008. The market dropped a little, and then rallied back, dropped a little again, rallied back and then plunged straight down to result in what many call the worst January in the market's history. At the time, the market was experiencing an earnings recession with YoY earnings growth comparisons negative. It looks like 3rd Qtr earnings this year are going to finally be positive and break the streak of five consecutive down quarters. The question then becomes, "Can investors expect a repeat of last year's decline if the Fed hikes rates again this December now that the earnings recession is over?"
There is quite a bit of growing sentiment throughout the investment community (and excitement) that, because the earnings recession is finally over, we need not worry about a drastic decline based on any Fed hike this time around. Instead, they look for clear sailing ahead. But there are other experts who make a very valid argument that this market is not and has not been driven by earnings. The clear evidence for this is how it shrugged off five quarters in a row of earnings declines. Rather, the market has been all about low interest rates; i.e., there is no way it is trading at 18x earnings based on the earnings outlook. Thus, higher rates are a big threat to equities if this continues and current valuations provide little, if any, margin of safety at all. (Welcome to the wonderful world of clear and easy investment decision making).
We have always believed trying to time the market is never a good thing. However, while we don't believe a rate hike will be what triggers the next financial crisis, we do believe it has a potential short-term market risk attached to it. Long-term investors weather these types of risks year in and year out. Tactically, however, having some extra cash to take advantage of any pullback triggered by a rate hike could, at best, be a good thing and, at worst, not much of a bad thing. Kind of like, "Heads I win and tails we almost tie".
We are also not looking at a rate hike standing alone. Obamacare premiums are going up 25% for 2017. What we see is a double whammy for the average American – increased health premiums and a rate hike will directly and negatively affect the disposable income of nearly everyone. So, in spite of the end of the earnings recession, it is far from clear how the market may react to a rate hike considering other factors that tie in to it.
Adeptus Health Update (ADPT)
We loved this stock when we researched it in the Spring, as they were going to take over the hospital Emergency Room market, but by July we thought something was fishy, so we issued a News Flash on July 21st removing the stock at the $50 level. We even mentioned the possibility of fraud. Well, guess what? One quarter later the company announced terrible earnings and the stock which had sold off to the $27 level by Tuesday, the 1st of November, opened at $11 on Wednesday. It closed Friday at $8.50. Wow. What a story. We expect lawsuits.
Two Titles Here:
Update on Twitter - A Pure Speculative Play
The Options Corner
We have a hunch. We think Twitter (TWTR: $18.02) might just get bought out after all. We certainly don’t have any inside information and even if we did we couldn’t tell you about it! But we have been reading a lot about this company, the culture, the worldwide impact it has had and continues to have, the 317 million users. We can see someone stepping up and buying them now that the shark-feeding frenzy has worn off and the stock has receded. The company has a market cap of $12.5 billion now, down from $17.5 billion last month. That’s a lot of money, but to an Apple or a Google or a bunch of other companies that’s really not a lot of money. Someone just might step up to the plate with a nice $25 per share offer. Just a hunch.
Well, what if the stock is bought out for $28 a share? How would one profit from a move like this? You could buy a January 25 call for just 23 cents. 10 options that control 1000 shares would cost just $230. If the stock went to $28 the option would trade for $3.00 or $3,000. Not a bad profit. Of course, if the stock doesn’t go to $25 by January 20th, you would lose your entire $230. And if you did 100 options, controlling 10,000 shares for $2,300 and it went to $28, the option would be worth $30,000. Very interesting.
If you think you need more time, you could buy the January $25 2018 call (LEAP) for around $1.25. 10 options that control 1000 shares would cost you $1,250. If the stock went to $30, the option would trade for $5, or $5,000. Very interesting. (Oh – we just said that above!) Again – this is pure speculation. 90%+ of options buyers lose all their money, so be careful.
High Yield Corner
If you read the New York Times, then you saw this terrifying headline: "S&P 500 Index Marks Its Longest Losing Streak in 36 Years.” Scary, isn’t it? We are entering a period of intense de-risking that is causing people to sell off equities at a breakneck pace. The streak is pretty severe, but the trend is a lot like last year when stocks, bonds, and just about everything else fell shortly before (and after) the Federal Reserve’s rate hike in December. Something similar is happening now.
This time there are some extra jitters because of the election cycle, and several analysts have recently published notes warning that a Donald Trump victory could cause stocks to fall 5% or more. Whatever your politics, the volatility of the presidential election is something to be aware of and to look at objectively. The market is telling us that it does not want a Trump victory, with several economists and financial publications (including the Wall Street Journal, The Economist, and the Financial Times) warning that Trump’s win would be a bad thing. You need to be aware that many people are selling stocks off for this very reason.
Ironically, if the market sells off enough between now and election day, it might actually rise with a Trump victory even if the market still doesn’t like Trump. Why? Because the market hates uncertainty more than anything else, and until the election is over we will remain uncertain about what happens.
The volatility in stocks is amplified in the high yield world. Everything is down. The last month has been shockingly cruel for high yield assets. But not all of this is because of the election. The worst performers have been REITs. The SPDR Dow Jones REIT ETF (RWR: $89) is down over 7% in the last month. This massive decline is due to the run-up in REITs earlier in 2016. Many REITs are still up year-to-date, such as Bull Market Report pick Digital Realty Trust (DLR: $91), which is up 20% year-to-date and is still yielding a safe 4% with funds from operations far in excess of dividend distributions. Others aren’t doing so well. Omega Healthcare Investors (OHI: $29) fell over 6% this week and is down 16% year-to-date.
But Omega Healthcare is one of the best buys in the REIT space right now, which is why we encourage investors to double down on this great name. The decline has less to do with Omega’s fundamentals than with a sharp fall at HCP (HCP: $29.50), one of the biggest REITs, a S&P 500 constituent, and a dividend aristocrat. HCP is spinning off riskier assets which has negatively affected its income statement. EPS was a 6 cent disappointment partly because of the spinoff, and the firm’s future post-spinoff is less clear than many would like. Thus its sharp decline after reporting earnings this week.
But none of this has anything to do with Omega, which fell in sympathy because it’s another Healthcare REIT. This is indiscriminate selling. We recommended Omega over HCP for a number of reasons. Its FFO remains above distributions. The company announced results this week and, although FFO was one penny below expectations, it was up 5% on a year-over-year basis, and full year FFO is guided to be $3.39. Its annual dividend payments are $2.44, meaning the dividend coverage ratio is 140%. And that’s after the company raised dividends three times this year. There is more room for dividend increases and it is a very safe dividend. Should such a firm be yielding 8.4%? Of course not - but the market is scared and is indiscriminately selling. That makes it a great time to double down on Omega, and wait for it to recover. After the rate hike and election decision, that recovery is almost inevitable. (Powerful words from The Bull Market Report – hold us to it!)
The second-worst performers of late were the BDCs. The UBS Etracs BDC ETF (BDCS: $21) fell over 6% in the last month, after falling nearly 4% last week alone. The ETF has erased almost all of its gains and is no longer outperforming the S&P 500. This makes sense with such a volatile asset class.
Again, rising interest rates are a big part of the concern. Higher interest rates could cause non-performing debts to rise for BDCs, lowering their NAV and interest income. It will also make borrowing costs higher for BDCs, causing their profit margins to fall. This is all worrying - and is reminiscent of similar worries causing the industry to fall in 2015 (and in 2013 and 2011 before that).
That’s why we recommend a light and selective BDC allocation. Currently we only like Main Street Capital (MAIN: $33) and continue to rate it a hold thanks to its growing 8% total dividend yield including special payouts. Main Street reported earnings last week and beat on both net investment income and revenue. Its NAV is up 2% year-over-year, but its current price is a 50% premium to book value. That high premium is worrisome to risk-averse investors, which is why Main Street might not see much capital appreciation in the short term. However, its steady and long-term performance suggests it’s the best BDC to hold. We probably haven’t seen the bottom for BDCs yet, which is why we are cautious about the industry as a whole in the short term. Long term, though, we continue to like Main Street’s ability to continually deliver a high income stream, with no hint that this is going to stop anytime soon.
Let’s turn to MLPs. This was a wild week for oil, with reports and counter-reports about an OPEC oil production freeze deal causing spikes and declines in oil futures. It’s unclear whether Saudi Arabia and Iran are going to agree on an output freeze or not. This has big implications for MLPs, even the ones that do little in oil. Oil futures ended Friday down, finishing the week sharply lower. As a result, the Alerian MLP ETF (AMLP: $11.90) lost 5% of its value this week. The fund is now down slightly year-to-date. With MLP values so closely tied to the volatile oil market, it’s impossible to rate MLPs based on fundamentals alone, and it’s impossible to expect these to start trading higher if oil doesn’t go higher. A bet on MLPs is a bet on higher oil prices, and that’s frankly unpredictable. We remain cautious on MLPs and energy-related stocks as a general rule, but special opportunities can and do arise.
Finally, let’s turn to junk bonds and the corporate debt world. Rising interest rates are very bad for this asset class. It lowers the value of outstanding debts and makes it harder for companies to issue new debt and to pay back their new debts. Yet the Fed seems intent on raising interest rates next month. Thus the SPDR High Yield Bond ETF (JNK: $36) is down 2% over the past month after a 1% decline this week. The market is worried about rising default rates, but we remain contrarian on this point. Default rates have been rising for a while and high yield bonds have fallen in value for even longer as the market anticipated this dynamic. Keep in mind that the SPDR junk bond fund is down over 7% from the beginning of 2015, when the anticipated default rates really started to hit this market. We see the defaults and the interest rate increase priced in more readily than they were a year ago, so a steep decline isn’t likely. However, a short-term fall from now until the FOMC meeting in December remains a strong probability as short-term fear grips the market.
This is why we recommend doubling down on the Pimco Dynamic Income Fund (PDI: $28) despite its 3% decline this week. We recommend adding to this position slowly over the next three weeks. Its 9.5% dividend yield is about to get a huge boost, as the fund still has over $1 in undistributed net income, which will be paid out in a special dividend by the year’s end. Pimco Dynamic Income is trading at a slight premium to NAV (2%), and normally we would like to buy the fund at a discount. However, this is a tricky time to estimate when to buy PDI. Many investors may jump in after the special dividend is announced, which could happen any day this month. That could easily offset weakness in the corporate bond market. As a result, we suggest staggering purchases in PDI slowly on down days.
This is a moment of intense fear in the market. That fear is likely going to continue. Do not let it sway you; remember Buffett’s advice to be greedy when others are fearful. That’s what he did in 2009 and made a killing as a result. Now’s your chance. Don’t get swayed by the fear in the market and sell at the bottom. Wait this weakness out, perhaps adding to positions where conditions are clearly the most oversold, and enjoy the high income stream until the market realizes its error and starts buying again.
Michael Foster, High Yield Analyst
The Bull Market Report
Berkshire Hathaway (BRK-A and BRK-B) has a record amount of cash. At the end of June Berkshire had $73 billion and that is now up to $85 billion as of September 30th. Many are conjecturing on what the 86-year old Warren Buffett will buy next. This year he bought battery-maker Duracell for $5 billion and he paid $32 billion for Precision Castparts, a global supplier to the aerospace industry. The latter was one of his biggest acquisitions ever.
Operating earnings climbed 7% in the third quarter to $4.85 billion. Revenue was flat at $59.0 billion. The stock is trading at $214,545 per share! The stock is up 8% this year. The B shares are trading at $143, after a 50-1 stock split in 2010. The company is worth $353 billion, making it one of the world’s most valuable companies.
Apple Corner
Nothing much new this week, as the stock sold off as did most of the other heavyweights in the Tech realm. Apple (AAPL) closed at $109, down 4% for the week. They added another $750 million in cash to their coffers increasing the “pressure” on Tim Cook to do something with it: big dividend, buying some tech startups, and so on. We say “pressure” even though in reality there is not really any pressure for the company to do anything. They like it the way it is. We’re hoping that we will see an election relief rally later this week after the uncertainty is lifted. We are buyers here and expect a new all-time in the stock later this year or early next.
Good Investing,
Todd Shaver
Editor in Chief
The Bull Market Report
October 30, 2016
by Todd Shaver | Oct 30, 2016 | Weekly Newsletter 7pm Sunday
The Week Ahead
What a wild end to the week. In the last several hours of trading the probability of a Fed rate hike in December dropped from 75% to 70% as the US election noise started getting louder and louder. There is heightened uncertainty right now. In addition, late Friday FBI Director James Comey informed top members of Congress in a letter that the bureau had “learned of the existence of emails that appear to be pertinent to the investigation.” And the market sagged. After being up 100 points by mid-day it promptly dropped 150 points, before closing flat for the day.
Fortunately, US GDP roared back 2.9% in 3Q16. Moreover, we observed many companies deliver respectable 3Q16 earnings results. We continue to see equity to be much more attractive than bonds or cash. This week we highlight Qualcomm, Bristol-Myers Squibb, Under Armour, Visa, Alphabet, and Equity Residential.
Highlights From The Past Week
Global private equity leader switches gears. KKR ranks among the list of the best investment shops in the world. Earlier in the year they backed up the truck and bought distressed energy and commodity bonds during February lows and on Brexit concerns. They now say those distressed investments they made are paying off handsomely, in fact much faster than anticipated. Accordingly, they now see more balanced risk/reward and are exiting those trades.
Recession risk is rising. While many US labor market indicators look rosy, one is flashing lights of caution. We are referring to the Fed Labor Market Conditions Index, in particular the year over year growth rate trend. After falling just three times from 2012 to 2015, the index has fallen every month of 2016 except for one. And in July the annual change from July 2015 turned negative. That's only the eighth time in nearly 40 years the index was down on a year-over-year basis. This event occurred in 2002 and 2007 prior to the proceeding recessions. Again we can’t help but wonder - is this cycle coming to an end?
Mergers set a monthly record as election eve looms. We observed $245 billion of M&A this month, surpassing the prior record of $240 billion in July 2015, with last week’s $177 billion of volume the all-time high weekly record. We have recently seen a wave of major deals getting pushed through by Wall Street. Bankers are clearly not sitting on their hands and taking advantage of what might be the last window of opportunity, in terms of both market conditions and considering the election, they have to rake in big time fees. We’ve seen announcements of AT&T buying Time Warner, Qualcomm buying NXP, the FedEx/UPS of China go public, and now the long awaited IPO of Snapchat finally coming. Snapchat is expected to raise as much as $4 billion in its planned IPO at a valuation of $40 billion, making it the biggest social media company to go public since Twitter's IPO in 2013. These sorts of deals are clear signs of aggressive market behavior. The question is if and how long it can last?
BMR Companies and Commentary
Qualcomm (QCOM: $68, up 1% for the week – all prices are for the week)
Well, the rumor turned out to be true. Qualcomm announced it is buying NXP Semiconductors (NXPI: $100, down 2%) for $110 per share. The offer is all cash, which will be funded using offshore monies and newly issued debt of $11 billion. Putting the two companies together, annual revenues will be over $35 billion. The deal is expected to close by the end of 2017 subject to regulatory approvals. Consensus expectations call for the deal to lift Qualcomm’s existing EPS outlook by 20-30%.
The deal is a good one for Qualcomm on many levels. Qualcomm has been focused on expanding its business beyond mobile into a number of growing businesses. NXP has a strong automotive presence, which boosts Qualcomm's presence in a market that management has frequently said they want to target. The deal also comes with $500 million of expected cost synergies. Lastly, there will be ample free cash flow to maintain the dividend and grow it, all while de-leveraging.
The consensus 2018 EPS outlook now calls for EPS of $5.00. At $70, shares are now at a fair to lofty level of 12x an EPS figure that is far away. Recall, this stock’s PE can quickly flip to 10x as seen in the past. We think the risk/reward here is now balanced.
BMR Take: The most important question is, what do we do now? We continue to like the business, and the acquisition is a good strategic fit, but the stock is fairly valued, so we are exiting our position.
We added the stock to our portfolio at $43 in February and are exiting at $68.40 for a 59% gain. Now, what should YOU do with your stock? That’s up to you, of course. We like Qualcomm and believe in them long term so you may wish to stay in a little longer. The NXP deal is not done yet so there is some uncertainty here of course. If you think they are going higher, you can put a stop in place and if it hits a certain price below the current price then your order will get executed. This is a good way to ride a stock upwards, protecting your profits all the way up.
Bristol Myers Squibb (BMY: $51, up 2%)
It was a really strong quarter. The stock traded up as much as 8% on Thursday on the earnings release. We think this is the turnaround now starting. We are excited to see the shares regain confidence and momentum and start to make a run at the 52-week high of $77.
The immuno-oncology franchise has recently stumbled, but the core business is healthy and there remains prospects for a turnaround in immuno-oncology. Management says they are working through recent disappointing results from Opdivo and will still build a valuable immuno-oncology franchise. Moreover, just to provide some re-assurance, a new operating model was announced along with 3Q16 earnings that commits to roughly flat operating expenses through 2020.
If that wasn’t enough, in conjunction with earnings, the company announced a new $3.0 billion share repurchase authorization, that is incremental to the existing authorization with $1 billion remaining. This new buyback cushions the 2017 EPS outlook providing for $3.00 of EPS.
One of the reasons we really like the stock is the solid balance sheet and the downside protection it provides us. The company ended the quarter with $8.4 billion of cash with debt of $6.8 billion.
BMR Take: We believe now is an opportune time to be accumulating a position in this blue chip Healthcare stock. The nearly 3% dividend yield is a cushion while you wait for a turnaround.
Under Armour (UA: $31, down 18%).
We wanted to follow up on Under Armour considering the shock this quarter and our continued strong interest in the name. We believe buying the pullback presents a very attractive risk/reward proposition.
While management lowered their 2018 operating income targets, the fundamentals have just not changed. The company still has a roadmap to $7.5 billion of revenue in 2018 and to ultimately be a $10 billion revenue business, as compared to $4.9 billion of sales expected this year. That is explosive growth. Under Armour is one of the Top 3 fastest revenue growers out of all of the S&P 500. All that is happening at the moment is that management is taking down near-term profits a bit by increasing marketing expenses in order to ensure sales growth continues for a long time.
We expect Under Armour to continue to beat revenue guidance based on ongoing investments in faster growth segments like footwear and international, and aggressive demand due to its major marketing pushes with endorsements in golf and basketball.
Even with ramped up expenses, the outlook still calls for greater 20% EPS growth per year. The future is bright!
BMR Take: We think the pullback is an opportunity to accumulate shares. Under Armour is the new Nike. There are years ahead of good performance you don’t want to miss out on. The all-time high is $50, which is an attainable mark to beat as the revenue base is on track to double from here in the next 3-4 years.
Visa (V: $82, flat)
It was a solid earnings quarter for Visa. The stock traded down 0.4% following the Q416 earnings release this week, which included better than expected bottom line results of $0.79 on revenue of $4.3 billion that was modestly above consensus expectations. The issue was soft 2017 guidance, where management forecast annual revenue growth of 17% and EPS growth in the mid-teens as compared to consensus of 20%, and 19.5% respectively.
While the forward outlook was disappointing, we were pleased to see decently strong revenue this quarter. The drivers were healthy, in fact accelerating cross-border volume, US credit growth acceleration, new wins like USAA and Costco, and moderating headwinds from foreign currency and the oil patch. We are optimistic these factors can continue to drive further revenue upside. Our outlook is shared by Goldman Sachs, as they are calling for the 2017 revenue outlook provided by management to be very beatable.
BMR Take: Solid results. As expected. No big surprises. Just what we love about Visa. Steady. Stable. Consistent. We raise our price target from $85 to $95.
Equity Residential (EQR: $60, down 1%)
The company reported 3Q16 FFO (an EPS proxy of cash flow for real estate companies) of $0.78, which was in line with the consensus expectation, though down from $0.89 a year ago. Overall, this quarter’s result was okay.
However, the forward outlook was worse than expected. Organic income growth guidance was reduced again, to 3.95% from 4.00% prior on higher operating expense growth. Higher expenses were driven by a combination of real estate taxes, tenant incentives, and personnel costs as apartment deliveries have created a competitive environment.
With income growing by just 2.4% during 3Q16 versus a high of nearly 7.0% during 2015, we see 2017 (and possibly 2018) as being a very challenged in terms of upside to growth trends. Of course, the outlook is mixed. The top net operating income growth markets include Seattle and Southern California, up 6.4% and 6.0% respectively. Though there are lagging markets like New York, Washington DC, and Boston, which experienced -4.0%, 0.7%, and 1.5% growth respectively from a year ago this quarter. San Francisco and New York continued to be highly pressured markets due to new construction and decelerating job growth.
Also, the company is working on seven new apartment communities under construction, which are about 70% completed and 70% leased and will come online by 2018 to help cushion net operating income growth. But putting it all together, we see Equity Residential struggling to grow much from here over the next two years.
BMR Take: We like Equity Residential as a leader in the apartment real estate business, but are starting to view shares as fairly valued. You just received a special dividend of $3.50 on October 14th, which followed the $8.00 special dividend paid out in March 2016. This should have helped cushion your performance. While the current valuation is a 21% discount to net asset value, most don’t expect the valuation gap to close. We’d be inclined to remove this stock here, but in reality we’re doing ok here. We added the stock at $62 in June and have received $4 in dividends so our net cost is $58. But if it goes to $55, our Sell Price, we are indeed going to remove it.
Alphabet (GOOG: $795, down 1%)
Revenue of $22.5 billion beat the consensus of $22.0 billion and was up from $18.8 billion last year. EPS of $9.06 beat the consensus of $8.62 and was up from $7.35 last year. Great results! Alphabet is now the second most valuable company in all of the S&P 500 with a market cap of $550 billion, trailing only Apple at $613 billion.
What did we like about the quarter? First, websites revenue was up 23% driven by mobile search, YouTube, and programmatic advertising. Many once called for Google’s demise due to the smartphone, but mobile search was the largest contributor to growth as it benefited from increased engagement and a number of new search ad formats.
Second, we liked the fact that paid clicks accelerated to 33% growth, which was much faster than 29% seen last quarter, as strong YouTube engagement was a huge contributor. Recall that we believe Google has the best asset in all of media by way of YouTube.
Third, YouTube growth remains elevated, as it now reaches nearly half of US adults between 18-54 at least once per month. Our key point here is that while growth is good, they still only have half of the target market on board, so there is clear runway ahead for more and more improvement.
BMR Take: Very solid results. We are raising our price target from $850 to $900. This stock remains an excellent core holding.
Upcoming Economic News
Monday, October 31st
Personal Income & Spending – September
Time: 8:30 am
Forecast: 0.4% income, 0.4% spending
Personal spending looks to expand strongly in September after showing no change in August. Yet the long-term trend for consumer spending appears less hearty, with retail sales excluding autos and fuel rising a subdued 3.7% year-over-year in the third quarter. Income trends are restraining consumer outlays, as disposable income rose 3.4% year-over-year in the three months ending August - the slowest pace in over two years.
Tuesday, November 1st
ISM Manufacturing Index – October
Time: 10:00 am
Forecast: 51.5
The ISM Manufacturing Index is projected to continue showing positive but not overly strong levels in October. Manufacturing output rose in three of the past four months, yet was unchanged year-over year in September.
Vehicle Sales – October
Forecast: 17.3 million
Vehicle sales are forecast to fall back in October after spiking by 5% in September. Heavy incentives are needed to keep auto sales afloat after an extended boom period has faded out. The 1.2% yearly decline of vehicle sales last quarter is one of the poorest results in the past seven years.
FOMC Rate Decision
Time: 2:00 pm
Forecast: 0.25%-0.5% fed funds target range
The coming election and the lack of a post-meeting press conference rule out any probability of a November rate hike, despite policymaker protests to the contrary. Solid job figures in line with September’s results will allow for the first and only fed funds increase of this year in December. But consistently meek price growth trends may long delay further tightening to well after that point.
Friday, November 4th
Trade Balance – September
Time: 8:30 am
Forecast: -$41.8 billion
Rising commodity costs will widen the trade deficit in September. Moody’s Industrial Metals Price Index rose 11% year-over-year last month, the largest such gain in two years. This will ultimately raise the cost of imports to the US.
A Few Words from Gary Jefferson
First Vice-President, Investments
Jefferson Financial Group
UBS Financial Services
The third quarter earnings season is now in full swing and actual results so far have been solid. In fact, S&P 500 companies are beating consensus expectations by the largest amount in over four years. With results from 28% of the S&P 500 market cap reported we can say goodbye to the earnings recession. The numbers should continue to rise modestly as the remaining 72% of the market reports results. This gives us greater confidence that our estimate for 3% year-over-year growth for the quarter is on track.
Keep in mind that this is the first quarter of positive EPS growth in over a year. We expect EPS growth will continue to accelerate into 2017 as the drag from the Energy sector turns into a tailwind as comparisons get easier. We forecast 8% EPS growth for full year 2017.
Financials have been a key positive driver. An improvement in trading and investment banking revenues for the big banks has been a key positive driver so far this quarter, reversing very weak trends earlier in the year. While these businesses can be hard to predict, the initial read on fourth quarter trends is favorable. In fact, Q4 estimates for the sector have actually moved higher during earnings season. With global economic growth intact, inflation firming and the Fed likely to resume raising the fed funds rate (we expect a rate hike in December and two more in 2017) fundamentals look poised to continue to improve. As a result (and in conjunction with low valuations), we upgraded Financials from neutral to moderate overweight this month.
Growth segments of IT* remain strong. Results from Microsoft confirmed earlier results from Accenture, Adobe and Red Hat that Tech companies that are on the right side of the secular trends (cloud transition) are doing fine. On the other hand, legacy IT products and services remain challenging, as confirmed by IBM.
*Information Technology
Oil and gas weighing on industrials. Numerous industrial companies (including GE) have suggested that weakness in oil and gas spending has continued. While trends in spending will likely improve into next year, the recovery looks like it will be slow and shallow. As a result, EPS growth will likely lag the overall market.
We have long argued the market is more about earnings than anything else. However, it has been flat for a very long time and it seems apparent that the market is waiting for something to happen. The election being settled is an obvious and temporary concern. No one can predict how any election will affect the economy, but we believe it's safe to say that no President can single-handedly drive up nor destroy the markets. No matter which way it goes on the 8th, our market is part of a global marketplace where hundreds of inter-connected factors beyond just our President will determine what the future holds – and, again, we believe earnings are one of the most important.
We also suspect that once the election is over, the markets will seriously begin to wonder about how the economy will look with higher rates and a stronger dollar in place. An interest rate hike could, as it did last December, cause much greater volatility than what the election may bring.
Bottom line: Tune out the noise from the media. Scary headlines touting doom and gloom are more often than not unnerving to even the most even-keeled investor. The markets may experience some turbulence in the coming months. But, these short-term fluctuations shouldn't affect long-term portfolio performance. It's a cliché, but yes, volatility (a/k/a bad down days) often presents sound investment opportunities.
If we continue to have the expected earnings numbers come in, coupled with "no recession" on the horizon, the market has a real opportunity to break out to new highs by year-end. The only caveat to this scenario is a rate hike – it could cause a disruption. But, relying on a track record going back decades, keep in mind that stocks historically do just fine during the first two to three years of a new rising-rate cycle.
An upgrade: Kinder Morgan (KMI: $20, down 3%) was upgraded by Raymond James Financial from an "outperform" rating to a "strong-buy" rating. They now have a $27 price target on the stock, up from its previous target of $23. Kinder Morgan was also upgraded by BMO Capital Markets from a "market perform" rating to an "outperform" rating. They raised their target to $26 from $21.
Twilio (TWLO: $35, down 14%) Twilio is obviously not for the faint of heart. We like it immensely and think it is a double or triple from here, but it is very tough watching it go down each week. There is something going on and we’re not sure what it is, but we believe a year from now it will be a lot higher.
With that said, it is painful and you may not wish to stay along for the currently painful ride. And of course, the stock may go lower. Many days the stock will jump 5% in the morning and then fade during the day, so you know there are serious buyers out there. We all know that it is a recent IPO with a high PE. We know that it is volatile, but seeing it drop from the $60 level to almost half of that is disheartening. So if you can’t stand the heat, get out of the kitchen now. We think it will take until the next earnings release for investors to see that the company is still on track for big revenue and earnings gains ahead.
This is what we say in our research report that is on the website – the stock is in our Special Opportunities portfolio:
“Twilio has 30,000 customers – from small developers to large enterprises – who use Twilio to power some 75 billion annual connections that reach 1 billion devices. Match.com makes matches without revealing phone numbers; Airbnb sends rental notifications, and the American Red Cross deploys volunteers, all through Twilio. ING, the European banking giant, recently announced it was closing down 17 hardware and software systems across its global call centers and replacing all of it with Twilio. Twilio’s largest customer, WhatsApp, uses them to verify customer accounts and logins. Apps from Lyft, Expedia, Netflix, Coca-Cola, Salesforce and the New York Times all have Twilio inside. The company saw 70% growth last quarter.”
The stock went public at $15 in June and closed the first day at $29, up 92%. Here’s your chance to buy it at a reasonable valuation.
Apple Corner
Apple (AAPL: $114, down 2%) announced a new record stockpile – of cash: $238 billion, up $6 billion in the quarter. So that means they are producing cash at the rate of $460 million a week, or $92 million per work day. Unreal. And yes, most of that cash is overseas, in Ireland. As we’ve said before, this doesn’t upset us or concern us. It’s like being worth $10 million personally, and having $9 million of it in Ireland. That works for us!
Tim Cook says he has no plans to change where the cash resides as it would cost him 40% in taxes to bring it back. We at The Bull Market Report believe the tax code will be changed sometime in the next few years and that will allow the cash to come back and be put to work harder than it is now. Stock buybacks, buying new technology, super big dividend distributions – all of these will be in the cards in the future.
Again, $44 of every share you buy is in cash - 38% of every share. This is unprecedented in financial history.
AmerisourceBergen Takes a Hit
McKesson (MCK) hit a 52-week low Friday, falling 23% Friday, reaching $114 per share before bouncing back to $125 before market's close. The company reported worse than expected earnings of $2.94 per share, missing consensus estimates of $3.05 per share. McKesson also adjusted its earnings outlook lower.
This miss was attributed to pressure put on the drug pricing industry that the company doesn't expect to let up any time soon. Investors balked at the news, causing not only McKesson, but its peers, to fall. Competitors Cardinal Health (CAH) and AmerisourceBergen (ABC: $69) also fell Friday - 10% and 13% respectively - on the news.
This is devastating to us. We expected a lot more from ABC. We added them in April at $91 and were looking for triple digits this year. Instead, they have disappointed every step of the way. This is the last straw. We aren’t waiting for our Sell Price of $67. We are removing the stock now.
Tesla Posts Best Sales Ever and a Quarterly Profit
Tesla Motors (TSLA: $200, flat) posted its second quarterly profit as a public company and its best sales period on record, helped by the new Model X sport-utility vehicle. The stock hit $213 on Thursday but settled later in the day and Friday. Profits were $22 million, or 14 cents a share, compared with a loss of $230 million, or $1.78 a share, a year earlier. On an adjusted basis, it had per-share earnings of 71 cents. Revenue shot up to $2.3 billion. The increased sales and profit come as CEO Elon Musk pushes the company to create new models, including the Model 3 sedan slated for next year, and to finish building the world's largest battery factory.
The company announced new products - solar-powered glass roof tiles that eliminate the need for traditional panels and longer-lasting batteries aimed at helping to realize Musk's vision of selling a fossil fuel free lifestyle to consumers. Unlike most solar panels in the market (which are made of photo voltaic steels that are installed over traditional roofs), Tesla’s solar roofs are made of quartz glass. This means that there is no need for a roof, if you are using Tesla’s product. In addition to being aesthetically pleasing and remarkably like standard roofing tiles in appearance, Tesla’s tiles are also durable.
But note that much of this announcement of new products is contingent on the merger going through with Solar City. Boy, he’s living on the edge.
BMR Take: Musk is at it again. Big announcements for the future. And profits in the present. Gotta hand it to this guy. Again, this stock is very volatile – be careful. It’s on the way to $300 a share but may pass through $150 first. And if it hits $300, it’s going to $400.
Blackstone Group (BX: $25.50, up 6%) The company sold $7.2 billion in real-estate assets in the third quarter and investors have poured $70 billion into its funds in the first nine months of the year, pushing Blackstone’s assets under management to a record $360 billion. They have $100 billion available to spend on new investments.
Blackstone has been selling assets to the Chinese in a big way this year and for the last three. They sold 25% of Hilton Worldwide Holdings for $6.5 billion and sold Strategic Hotels and Resorts for $5.5 billion. It also unloaded the Waldorf Astoria for $1.95 billion. The firm is awash in liquidity and that bodes well for the firm for 2017.
But the stock continues to lag, which is killing CEO and co-founder Steve Schwarzman. We have said and will say again that he is doing everything in his power to get the stock higher and HE WILL SUCCEED. It may not be this year, but it will happen. No one is going to stop this man, who just happens to be the firm’s largest shareholder.
High Yield Corner
Politics stole the headlines just as the markets were getting ready to end the week. With news that the FBI is investigating Hillary Clinton’s emails again, the market took a nose-dive, causing the S&P 500 to end down nearly 1% for the week. No matter your political leanings, it seems clear that the market does not like what this investigation means for the election. Additionally, those concerns are even bigger for just about all high yield asset classes.
There are a couple of reasons for this. First is liquidity. If the market decides the presidential election is bad news for the economy and/or stocks, it’s going to hit the S&P, but it’s going to hit the corporate bond market even harder. This is because suddenly risk-averse investors will pull money out of the bond market, meaning less liquidity. Mutual funds, institutional investors, pension funds, and other big market participants who need to offload corporate bonds will find it harder to locate a buyer, causing prices to fall. Yields will rise as a result (prices up - yields down), which means borrowing money will cost even more for companies. This, in turn, will cause default rates to go higher and cause less companies to take out loans in the first place. With less access to capital, companies will stop investing, which will in turn lower productivity and GDP growth.
This is a downward spiral that could happen if the market panics - and the longer the panic, the worse the effects.
Of course, this is an extreme scenario. It would take months of investor panic to cause corporate bonds to go in this direction, and it’s unlikely that a presidential election could cause such a long-term reaction. In fact, when presidential election results impact the market, they tend to do so for a month or two at the most - not enough to cause the kind of disaster in the bond market we’re describing. However, this is no ordinary election, and the market has priced corporate bonds very, very high. As a result, there is greater danger in corporate bonds than we’ve seen in a long time.
To demonstrate just how expensive corporate bonds are, we only need to take a look at the BofA Merrill Lynch US High Yield Master II Effective Yield index. It’s a mouthful, but it’s an important financial metric that focuses on one thing: What is the average interest rate junk bond-rated companies need to pay on their debt. Back in February, that rate was 10%. It’s now 6%.
Let’s think about this for a minute. U.S. Treasuries are yielding a bit less than 2%. A-rated municipal bonds are yielding around 3%, with lower-rated municipalities yielding around 4%. Yet even among low-rated municipalities, the default rates are far less than 1%. Corporate bond default rates are approaching 6%. Is that higher risk really worth an extra 2% yield?
In a low-rate world, the answer would seem to be yes - but the Federal Reserve is looking to raise interest rates. By itself, this will raise yields on corporate bonds. Additionally, it will also cause less money to flow into corporate bonds and encourage higher yields. The low corporate yields in the current market, the promise of higher interest rates, and the political unrest could spell danger for corporate bonds.
This is a complex and multi-faceted situation, but understanding the context is important. Right now corporate bonds are priced to perfection and the coming storms indicate weakness might be around the corner. The corporate bond market is beginning to wake up to this. The SPDR High Yield Bond Fund (JNK: $36) fell over 1% this week. More declines are likely to come, especially since junk bonds have recovered from their correction this summer.
What’s even more worrying is the lack of movement in the BDC space. The UBS Etracs BDC Fund (BDCS: $21) ended the week flat, but BDC investors should be aware that this space is even more susceptible to defaults than the junk bond market. Investors should be hedging their BDC exposure in response to this, but they are not. This is likely being driven by two factors. Firstly, a lot of BDC investors have come into the sector in search of yield, and find few alternatives elsewhere. Secondly, and most crucially, a lot of BDC investors are relatively unsophisticated. Corporate bond markets involve institutional investors managing more money than there is in the stock market; BDCs, however, have a combined market cap in the tens of billions of dollars, meaning the entire industry is smaller than many investment banks and a few hedge funds. This is an inefficiency that will eventually result in greater BDC volatility.
Where does that leave us when we consider our one BDC pick - Main Street Capital (MAIN: $34)? Main Street ended the week up 1% yet again and is now up 17% year-to-date despite its NAV remaining relatively stable. We recognize there is greater risk in holding Main Street now than before, which is why we’re lowering our target price to $35 from $40. We want to hold onto Main Street to capture the December special dividend, but we also need to recognize the greater potential volatility in BDCs right now and the market’s stubborn refusal to acknowledge this mounting risk.
Finally, a word on REITs. What an awful week for this class of assets. The SPDR Dow Jones REIT fund (RWR: $90) fell over 3%. Again, Federal Reserve moves are causing fear in this sector. We still love Omega Healthcare Investors (OHI: $31, down 3%, after 61 cent dividend), Kimco Realty (KIM: $26, down 6%), and Digital Realty Trust (DLR: $93, down 3%). We recommend adding on the recent weakness here.
Government Properties Income Trust (GOV: $19, down 8%). It is hard to watch the market punish this company. They own great assets, have a solid dividend and strong coverage of the dividend. But we also think the market will punish it more as the market sours on REITs broadly. Some might say that the risks aren’t worth the potential reward right now, so you will have to make up your own minds on this. For the time being we are sticking with the company since we are still above the price where we added the stock in April at $17. But be prepared for a lower price on this one. We just feel there is so much value here that we can’t bring ourselves to remove the stock from our portfolio.*
*Note that the stock is in our Special Opportunities portfolio, but we are moving it over to the High Yield Portfolio.
Good Investing,
Todd Shaver
Editor in Chief
The Bull Market Report
