CWS Market Review – June 14, 2019

“People calculate too much and think too little.” – Charlie Munger

The big news this week came on Sunday night, when Raytheon and United Technologies announced a merger agreement. This is exciting news, but the details aren’t so encouraging. I’ll discuss what I mean in a bit.

We also have a big Federal Reserve meeting coming next week. Wall Street expects the Fed to ride to the rescue once again. I’m not so sure. I’ll preview what to expect.

The stock market has already rallied back pretty impressively. The S&P 500 closed Thursday at its highest point in five weeks. Several of our stocks are at or near new 52-week highs.

Remember last year when Sherwin-Williams dropped 23% in a little over a month? Anything related to housing got smashed up. I’m glad we held on. This week, the stock made a new high. Sherwin is outpacing the market again this year.

Before we get to that, let’s look at the merger news between Raytheon and United Technologies.

Raytheon and United Technologies Are Merging

On Sunday afternoon, the financial media reported that Raytheon (RTN) and United Technologies (UTX) were in advanced merger talks. Shortly afterward, the news became official. The two defense giants are getting married. The deal is all stock.

On the surface, it’s a great fit. United Technologies is a Dow component and an outstanding company. Raytheon, of course, is a proud member of our Buy List. The new company will be called Raytheon Technologies. The companies said the merger will cut costs by $500 million, which would save the Pentagon (and taxpayers) a bundle.

There are some important details. UTX is undergoing a major strategic overhaul. The company recently bought Rockwell Collins. They now plan to be strictly a defense company. In November, UTX announced plans to spin off two of its divisions: Otis Elevator and Carrier.

Those deals will be done before the Raytheon deal. As such, RTN shareholders won’t get any shares in those two companies. According to the merger deal, RTN shareholders will get 2.3348 shares of the new company for every one they own now.

OK, that sounds great, but 2.3348 shares of what? There’s no precise way to know what that’s worth until Otis and Carrier are spun off. It’s like saying to a new homebuyer, “Congratulations on your new home! By the way, what you bought isn’t exactly what you see. Your house will be missing a few rooms.”

The deal says that Raytheon shareholders will own 43% of the new company, while UTX shareholders will own the other 57%. But that still doesn’t answer the question: how much are we being offered?

At one point, Raytheon was up 8% in Monday’s pre-market trading. The stock gapped up at the open, but gradually slid back during the trading day. Then on Tuesday, RTN fell nearly $10 per share. That’s not encouraging.

As merger premiums go, this was a flop. To be fair, President Trump made some critical comments about the deal, which probably weighed on the shares. The president has a valid point about industry consolidation. In the 1980s, there were 60 major defense contractors. Today, there are five.

Twenty years ago, the Pentagon blocked a merger deal between Lockheed Martin and Northrup Grumman. I’m not sure if that could happen anymore. From an anti-trust standpoint, the current deal doesn’t have much to worry about. The two businesses don’t overlap very much.

The companies said that the deal could bring an extra $20 billion to investors as a result of dividends and share buybacks, but some United Technologies shareholders aren’t pleased. Famed investor Bill Ackman sent a letter expressing his disapproval.

Raytheon and UTX understand they’re in a difficult spot. They have to compete against companies like Boeing, which makes tons of money off its commercial business. As a result, they can be a very competitive bidder on military contracts. That put a squeeze on profit margins, which creates a need to cut costs. As a result, there’s incentive to merge. This won’t be the last big deal you’ll see in this sector.

I’m not against a merger deal, but I would have liked to see a better offer. I think Raytheon is undervalued as it is, and it appears that UTX isn’t offering us any sort of premium. I should note that Raytheon has an enviable balance sheet. That’s important because defense/aerospace is a capital-intensive business, meaning you gotta spend a lot to make a lot.

The other issue for RTN shareholders is that their stock is basically stuck until the deal is finalized. I would expect RTN to track UTX closely for the next several months. As per the rules of the Buy List, RTN will remain a member of the Buy List for the rest of this year.

My take: I like the idea of a merger. UTX is a great partner. I think some merger deal was inevitable, but I don’t like the price. In fact, I’m not sure what the price is. But going by the market’s reaction, Raytheon should be getting more. I hope to hear more details soon. Raytheon remains a buy up to $190 per share.

Next Week’s Fed Meeting

The Federal Reserve gets together again next week. This is one of the meetings where the central bank revises its economic forecasts.

Lately, Wall Street has been asking for (demanding) interest-rate cuts in order to help out the stock market. I don’t think the Fed will play ball.

For one, the economic data isn’t that bad. The recent jobs report was a little light, but the unemployment rate is still just 3.6%. That’s close to a 50-year low. This week’s CPI report showed that consumer inflation is basically right in the Fed’s target zone.

The latest data from the futures market show investors think there’s a 31.7% chance that the Fed will cut next week. I don’t see a cut happening. Central bankers are cautious folks. I agree with the decision a few months ago to hold off on the planned rate hikes, but jumping in and cutting rates right now in something very different.

For the July FOMC meeting, the futures market thinks there’s a 90% chance the Fed will cut. That really surprises me. Traders think the Fed will cut again in September and a third time in December.

To give you an idea of how much things have changed, one month ago, traders saw a 9% chance of two rate cuts by September. Now the odds are 76%. The yield on the two-year Treasury, which is a good proxy for Fed policy, just dropped to its lowest yield in 18 months.

I think Wall Street has gotten ahead of itself. Next week’s meeting will include the Fed’s updated forecast for interest rates. I expect to see a cautious approach from the Fed. I also think Chairman Powell may try to talk down expectations in his press conference. Wall Street could be surprised by the Fed’s unwillingness to help them out.

Wall Street’s tamper tantrum really got going after a pair of President Trump’s tweets in early May threatened to ratchet up the trade war. However, there’s a big G20 meeting at the end of this month. I think there’s a good chance the president will announce some sort of breakthrough. That could take the pressure off the market. I don’t think the Fed wants to see itself as Wall Street’s servant.

Buy List Updates

Shares of Disney (DIS) got a nice boost this week after an analyst at Morgan Stanley raised his price target from $135 to $160 per share. I’m lifting my Buy Below on Disney to $150 per share.

Two weeks ago, Ross Stores (ROST) released another solid earnings report. As per tradition, the deep discounter offered pessimistic guidance. For Q2, Ross sees earnings of $1.05 to $1.11 per share. The cautious guidance held me from raising my Buy Below price. It shouldn’t have, however, so I’ll do it this week. Ross Stores is a buy up to $106 per share.

This week, I’m also going to drop the Buy Below on Signature Bank (SBNY) to $127 per share. That could be a good sign. It seems like every time I cut my Buy Below on SBNY, it starts to rally.

That’s all for now. The Federal Reserve meets next week on Tuesday and Wednesday. The policy statement is due out on Wednesday at 2 p.m. ET. On Tuesday, we’ll get the latest report on housing starts. The jobless-claims report is due out on Thursday. On Friday, the report on existing-home sales is released. 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