CWS Market Review – June 8, 2018

“If you would know the value of money, go and try to borrow some.”
– Benjamin Franklin

The stock market suddenly got a lot more interesting this week. The Nasdaq Composite broke out to a new all-time high. So did the small-cap Russell 2000. The Dow is back over 25,000, and the S&P 500 rallied for four days in a row. The index recently touched its highest point in more than two months.

The market isn’t so much celebrating good news as relieved that the prospect for bad news has dissipated. Global tensions seem to be relaxing. There may even be some sort of détente with North Korea. In the last few weeks, the price of oil has dropped more than 10%.

One piece of good news came last Friday, when the government said that the unemployment rate fell to its lowest since the 1960s. In this week’s issue, we’ll take a closer look at the market and the economy. I’ll also discuss the disappointing earnings report from Smucker. I also have several Buy List updates for you this week (nice rebound for Ross Stores!). But first, is this really the best economy in half a century?

The Best Economy in 50 Years?

Last Friday, the government released the jobs report for May, and it said that the U.S. economy created 223,000 net new jobs last month. That figure beat expectations of 190,000 jobs. The unemployment rate ticked down to 3.8%, which tied the cycle low from April 2000. However, if you work out the decimals, the jobless rate is actually the lowest since the 1960s. (Well, since December 1969.) For women, it’s the lowest jobless rate since 1953.

Despite the good news, there are some noticeable holes in the current expansion. For one, it’s always a bit dicey to compare unemployment rates over such a long period of time. The economy is quite different from what it was in 1960, and so is the labor market. While the economic numbers are improving, we’re still not seeing much in the way of wage growth. In the last year, average hourly earnings were up 2.7%. That’s okay, and it’s above inflation, but it needs to be better. The equation is simple: higher wages means more shoppers.

The Federal Reserve meets again next week, and it’s a near-certainty that the central bank will raise interest rates. This will be their seventh increase of this cycle. To recap, the Fed raised rates once in 2015, another time in 2016, then three times last year and already once more this year. This will bring the target range for Fed funds up to 1.75% to 2%.

Not too long ago, it looked like there might be four hikes this year, but that’s probably off the table. For now. With this meeting, we’ll get a post-meeting press conference with Chairman Jay Powell. The Fed members will also update their economic forecasts. These forecasts are notoriously poor, but I have to give the Fed some credit: they’ve largely stuck to their recent rate-hike plans.

I’ve tried to stress to investors that rising interest rates are Kryptonite to a stock rally. However, and this is crucial, it usually takes a few hikes to do any real damage. We’re now getting close to the point where the Fed funds rate is equal to the dividend yield of the S&P 500. In 2009, that would have seemed like it was light-years away.

I like to keep track of the “real” Fed funds rate. That’s the rate adjusted for inflation (I prefer using the core rate). After next week’s hike, the real Fed funds rate will be very close to something it hasn’t been in a long time—a positive number! In real terms, the Fed has been handing out free money for over a decade. I think we’ll need one more hike to finally push real Fed funds into positive territory. As a very general rule, it’s hard to be against stocks when the Fed is handing out free checks. The Fed’s low-rate policy has certainly been a key driver of this long rally.

But what about next year? According to the Fed’s last projections, they see three more hikes next year. But there was wide dispersion, meaning the individual estimates are far apart. That’s why next week’s meeting is so important. We’ll probably get a better idea as to the Fed’s thinking. Three more hikes could do some damage to the economy and the market.

There are a few things to consider. One is that long-term rates have come down some. That’s kinda like the ceiling for short-term rates. Trouble usually happens when short rates exceed long rates. My favorite indicator is the 2/10 Spread, which is now at 45 basis points. That’s down about 90 basis points in the last 18 months. We’re not in the danger zone yet, but it’s no longer unthinkable.

Smucker Drops after Poor Earnings

On Thursday, JM Smucker (SJM) got dinged for a 5.4% loss after the jelly company reported disappointing earnings. Smucker reported fiscal Q4 earnings (after a few adjustments) of $1.93 per share, which was well below the company’s own guidance of $2.17 to $2.27 per share. Wall Street had been expecting $2.18 per share. The CEO blamed the miss on “industrywide headwinds and certain discrete items.” More on that in a bit.

Smucker also had disappointing guidance for the coming year. Smucker sees this year’s earnings (ending in April) coming in between $8.40 and $8.65 per share. Wall Street had been expecting $9.18 per share.

There are a few reasons for Smucker’s slide. For one, Canada announced retaliatory tariffs on American jam, which is a core SJM product. The company is also facing higher costs, which places it in the tough position of passing said costs on to consumers. This is a tough environment to raise prices. Bear in mind that Smucker is a lot more than jelly. They also make Jif peanut butter and Folger’s coffee, and they have a pet-food division, which is the company’s largest.

Last quarter, sales of Smucker’s consumer foods fell by 1.8%. Pet food was flat, while coffee was up 0.5%. For the quarter, net sales fell by 0.1%. The issue really comes down to pricing, and how much latitude Smucker truly has. Everyone in the industry is facing the same issue. These results suggest that Smucker may have to give in and deal with lower margins. To be fair, Smucker has already started to adjust its business model to better compete in a challenging market. For example, they’re looking to sell off their baking business.

Last year, Smucker made $7.96 per share. The stock closed Thursday at $100.80, which is exactly 12 times the lower bound of their full-year guidance. This week, I’m dropping my Buy Below on Smucker down to $114 per share. I still like Smucker, but the company needs to make some important adjustments in order to meet a difficult environment.

Buy List Updates

Our philosophy of investing is to focus on great companies and hold them as long as we can. This has two important benefits. The first is that it’s less work, which is always nice. But more importantly, it’s a superior system because it removes us from the irrationality of the day-to-day market. I often stress this, but we got a good lesson recently from Ross Stores (ROST).

I’m a big fan of Ross, and it’s been part of our Buy List for several years. The deep-discounter reported earnings on May 24. They beat expectations, but their guidance wasn’t that hot. Well, that’s what Ross always does, so I paid it no mind. I thought the earnings report was just fine, but the market gods were not pleased. Shares of ROST dropped nearly 7% the next day.

In last week’s issue, I wrote, “I’m not at all worried about Ross Stores.” Sure enough, Ross has rallied six times in the last seven days. The stock closed Thursday at $85.09. Not only did Ross make back everything it lost, but the stock is even higher than it was going into earnings.

I will freely admit you that I had no idea Ross would snap back so quickly. Of course, I was puzzled by the drop in the first place. But this is the reality of stock investing. Sometimes, weird things happen. This is precisely why we lock in on great companies and let time do the heavy lifting. This week, I’m raising my Buy Below on Ross Stores to $90 per share.

Another stock that’s rising from the ashes is Alliance Data Systems (ADS). Poor ADS has been one of our worst stocks this year. The stock went from a high of $278 in January down to $192 in early May. The last earnings report was pretty good, but that wasn’t enough to halt the selling. Lately, however, ADS has turned a corner. The shares closed Thursday at $220.57. It’s too early to declare victory, but things are finally going in the right direction. Check out this recent article from Forbes, “Why Alliance Data Is Trading at a Discount.”

Carriage Services (CSV) made some news this week, which is pretty rare. The funeral-home company made some complicated moves to restructure its balance sheet. This was to correct for, in their words, “unforced errors.” Since the company had to issue more shares, they reduced their four-quarter EPS guidance to $1.33 to $1.38. I think the moves are to Carriage’s long-term benefit. Don’t abandon this one.

In early May, Continental Building Products (CBPX) missed earnings by a penny per share. During the next trading day, the stock got as low at $25.70 per share. That was a loss of over 7%. I was impressed that the company didn’t change its full year forecast. Here we are five weeks later, and CBPX is up to $31.45 per share. That’s a 14% gain in the last 23 days. I’m raising our Buy Below on Continental Building to $34 per share.

We’re done with Buy List earnings reports for a while. FactSet (FDS) is due to report on June 26, but that’s it until Q2 earnings season starts up in mid-July. RPM International’s (RPM) fiscal fourth quarter ended in May, but their earnings will probably be out in late July.

That’s all for now. Get ready for a Fed rate hike next week. The Federal Reserve meets on Tuesday and Wednesday. The policy statement will come out at 2 p.m. on Wednesday. We’ll also get a look at the updated forecasts. There will also be some key economic reports. The retail-sales report will come out on Thursday. Then on Friday, we’ll get to see the latest report on industrial production. 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