CWS Market Review – May 19, 2017

“Pride of opinion has been responsible for the downfall of more men on Wall Street than any other factor.” – Charles Dow

Wall Street’s deep sleep came to an end this week. The S&P 500 had a run of 16 straight days in which it never traded outside a band that was a little more than 1% wide. Then on Wednesday, the index suddenly dropped 1.8% for its biggest plunge all year.

Of course, that drop was from an all-time high close, so we can hardly say that there’s been a lot of pain on Wall Street. The major indexes are still having a very good year, and it’s only May. The move was such a shock since everything had, until then, been so complacent.

But here’s the key, Wednesday’s drop wasn’t spread out evenly. Many of the stocks that characterized the Trump Rally, like the big banks, fell the most. At the other end, defensive stocks fell the least. Some, like Hormel Foods, even rose a tad.

What does this all mean? There’s been a lot of talk that this is Wall Street’s verdict on President Trump. I don’t buy that at all. What’s really going on is that Wall Street is suddenly getting cold feet about another Fed rate hike. I’ve been warning that a rate increase next month would be a mistake. Some folks, apparently, are coming around to my side. I’ll have more on that in a bit.

On the earnings front, we got a very good report from Ross Stores, plus higher full-year guidance. I love it when that happens. Ross seems to be one of the players that’s standing up to the great Retail Apocalypse. I’ll also preview two Buy List earnings reports headed our way next week, from HEICO and Hormel. But first, let’s take a closer look at Wall Street’s worst day since September.

Wednesday’s Selloff Was about the Fed, Not Trump

In recent issues, I’ve said that it would be a mistake for the Federal Reserve to raise interest rates next month. The economy, sadly, just isn’t strong enough. Since I’m not a member of the Federal Open Market Committee, my views on the matter don’t count for much. But this week, the world may have shifted in my direction.

According to the latest futures prices, the market is placing 73.8% odds on a rate increase in June. That’s high, but it was even higher not too long ago. That’s why Wednesday’s selloff caught my attention. The worst performers were big banks and financial institutions. The best performers were high-dividend stocks like REITs and utilities, with some consumer cyclicals.

Whenever you see banks and dividend stocks move in opposite directions like that, you know that the market is arguing about the direction of short-term interest rates. Banks want short rates to go up. Dividend-payers want them to go down. When it’s a big drop like this, it’s almost as if the market is begging the Fed for some relief. I don’t know if they’re listening.

What makes this more interesting is that the economic news has been getting a little better recently. Still not enough to justify a rate hike, in my opinion, but we must consider all the evidence. For example, on Monday, the industrial production report was quite good. Economists had been expecting industrial production to show a 0.4% rise for April. Instead, it was up a full 1%. That’s the biggest increase in three years. Importantly, it’s for the month of April, which is in Q2.

A few weeks ago, we learned that the U.S> economy grew by a meager 0.7% for Q1. That’s pretty bad. Next week, we’ll get an update. But now we’re starting to get a few clues for what the Q2 numbers will be like. The Atlanta Fed has its GDPNow forecasting tool, which says that Q2 GDP is currently tracking at 4.1%. I have to be honest: that shocked me. I hope they’re right, but we still need to see more data.

Last Friday, shortly after I sent out the newsletter, the government released the inflation report for April. If you recall, the report for March was light—very light. Core inflation had its steepest drop in 35 years. The numbers for April were higher, but still quite subdued. Headline inflation rose by 0.17% for April, and core inflation was up by 0.07%. Except for March, that’s the softest in four years. No matter how you look at it, inflation just isn’t out there.

What’s interesting is that if the Federal Reserve were doing nothing, then it would, in effect, be tightening. Stable rates plus falling prices means higher real rates, and that’s what puts the brakes on the economy. That’s what’s been happening (see above), and it needs to stop. Don’t believe the hype that the stock market is revolting against Trump. It’s upset with a short-sighted Fed policy. The sooner the Fed changes course, the better. Now, let’s check out the strong earnings report from Ross Stores.

Ross Stores Earned 82 Cents per Share

After the closing bell on Thursday, Ross Stores (ROST) reported fiscal first-quarter earnings of 82 cents per share. This is for the months of February, March and April, which is typically the slowest time of year for Ross.

Ross had been expecting Q1 earnings between 76 and 79 cents per share, and comparable-store sales growth of 1% to 2%. In last week’s issue, I said, “This strikes me as conservative.” I was right, but I can’t take too much credit. We know that Ross likes to keep expectations low.

Barbara Rentler, Chief Executive Officer, commented, “We achieved respectable growth in both sales and earnings during the first quarter despite the uncertainty and volatility in the external environment. Operating margin of 15.2% exceeded our expectations due to above-plan sales and merchandise margin.”

I’m especially impressed by that operating-margin number. Retail is all about keeping control of costs, especially for a deep discounter like Ross. The retail sector has been getting creamed lately, but Ross is one of the few that have been holding up relatively well. As I’ve long believed, Ross is a rare retailer that’s Amazon-resistant.

Now let’s look at guidance. For Q2, which ends on July 29, Ross sees EPS ranging between 73 and 76 cents per share. That’s compared with 71 cents per share for last year’s Q2. Ross sees comparable-store sales growth of 1% to 2%.

Now for the good news. Ross is raising its full-year earnings forecast. The company now projects 2017 earnings between $3.07 and $3.17 per share. That’s an increase from the previous range of $3.02 to $3.15 per share. Ross made $2.83 per share last year; however this year will include an extra business week. Ross estimates that adds eight cents per share.

Ross recently increased its quarterly dividend from 13.5 to 16 cents per share. That’s an increase of 18.5%. Over the last seven years, the company has raised its dividend by 300%. Ross is on track to buy back $875 million in stock this year. Ross Stores remains a buy up to $70 per share.

Earnings from HEICO and Hormel

We have two more Buy List earnings reports coming next week, from HEICO and Hormel Foods. Both companies ended their fiscal second quarters in April.

HEICO (HEI) is one of my favorite little companies. They make replacement parts for the aircraft industry. It was our top-performing stock last year, and it’s doing pretty well this year. The company is due to report its earnings on Tuesday, May 23.

In February, HEICO had Q1 earnings of 59 cents per share. That was five cents more than estimates. I was very pleased to see that cash flow rose 24%. The company provides guidance for several metrics, except earnings-per-share, so we need to make a few guesses. But the good news in February was that they raised their 2017 guidance.

Previously, HEICO expected full-year sales growth of 5% to 7%, and net income growth of 7% to 10%. Now they see sales growth of 6% to 8%, and net income growth of 9% to 11%. Assuming share count doesn’t meaningfully change, that’s probably about $2.02 to $2.05 per share. HEICO also recently split its stock 5-for-4.

The consensus on Wall Street (that’s only six analysts) is for Q2 earnings of 50 cents per share. This stock has an amazing long-term record. If you had invested $100,000 in HEICO in 1990, today it would be worth $18.7 million. For now, I’m keeping my Buy Below for HEICO at $72. I may raise it depending on the earnings report.

In February, Hormel Foods (HRL) missed earnings for the second time in a row. For Q1, the Spam stock earned 44 cents per share, which was one penny below estimates. At the time, Hormel also lowered its full-year guidance to $1.65 to $1.71 per share, a decrease of three cents to both ends of the range.

The company cited “challenging market conditions in the turkey industry,” which, I have to admit, sounds kind of funny. Despite the earnings miss, the first quarter was Hormel’s 15th record quarter in a row. The fiscal Q2 earnings report is due out before the opening bell on Thursday, May 25. The consensus on Wall Street is for 40 cents per share.

Buy List Updates

On Monday, Moody’s (MCO) announced that they bought a Dutch company, Bureau van Dijk, for $3.1 billion. Moody’s will finance the deal with $1.3 billion in cash parked overseas, plus a $2 billion debt offering. They expect the deal to close in the third quarter. Bureau van Dijk is a global business-intelligence and company-information provider. Shares of MCO rallied on the news.

I also want to make a few adjustments to some of our Buy Below prices. This week, I’m lowering my Buy Below on Cinemark (CNK) to $43 per share. I’m also dropping Alliance Data Systems (ADS) to $249 per share.

That’s all for now. Next week will be the last work week prior to the Memorial Day weekend, which is the traditional start of summer. On Tuesday, we’ll get the new-home sales report, followed the existing-home sales report on Wednesday. I’ll be particularly interested to see Friday’s update to the Q1 GDP report. The initial report showed real growth of just 0.7% which was the weakest report in three years. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy