The stock market has recovered a good deal from last week’s momentum-induced slide. The S&P 500 rallied all four days this week, and the exchanges are closed today for Good Friday. All told, this was the best week for the S&P 500 since July.
This is an exciting time for the market. We’re moving into the heart of earnings season. Already about one-fifth of the S&P 500 has reported earnings; 52% of the reports have beaten on revenues, and 63% have beaten on earnings. Both numbers are about average. (That’s right, on Wall Street, beating expectations is to be expected.)
Despite this resurgence, I think the market’s shift to value, which I discussed in last week’s issue, still has some room to play out. I expect to see growth names, especially the pricey ones, lag the overall market. Investors should continue to be conservative and not tempted to chase after bad names.
I’ll also talk about recent earnings reports from Wells Fargo (pretty good) and IBM (rather blah). Plus, I’ll preview a slew of Buy List earnings coming our way next week, including Ford, Microsoft and Qualcomm. But first, let’s look at where we stand with regard to inflation.
Those of you old enough to remember the 70s certainly remember inflation. It was the worst thing about that decade. Well…that and disco. Every week, it seemed, prices climbed higher, and the prime rate went up, up, up.
There’s no way to sugarcoat it. Inflation is devastating for investors. It eats away at savings, and it knocks stock prices for a loop. On December 31, 1964, right before inflation became a problem, the Dow closed at 874.13. Exactly seventeen years later, the index stood at 875.00. Stock prices had barely budged, yet the Consumer Price Index had tripled. Then, once inflation got under control, stock prices soared. So much of the 1980s bull market was really making up for lost ground.
Inflation also has an unusual impact on earnings. Not all earnings are the same, and inflation exacts a heavy toll on asset-heavy businesses. Companies with high assets relative to their profits tend to report ersatz earnings.
Let’s look at some recent figures. Last Friday, the Labor Department reported that the Producer Price Index rose by 0.5% last month. That was the biggest increase in nine months. Economists like to track prices at the wholesale level because it’s often an early warning sign of price increases at the consumer level. Digging into the details, the rise in the PPI was driven by a 0.7% increase in wholesale services and a 1.1% rise in food prices. The core rate, which excludes food and energy, rose by 0.6%.
Then on Monday, the Consumer Price Index report showed that consumer prices rose 0.2% last month. That’s still not much, but it was more than the 0.1% economists were expecting. The core consumer rate also rose by 0.2% for its biggest monthly increase in 14 months.
Of course, some of the bad news about inflation could really be good news about the economy. Consumers are buying more stuff, and workers are harder to come by. We had another good initial claims report this week. The price of shrimp, of all things, is at a 14-year high. There have been a lot of silly predictions of about the imminent return of hyper-inflation. Don’t be fooled: every single one of these predictions has failed. The truth is that inflation has been remarkably low—and not just low, but low and stable. The year-over-year core inflation rate has stayed between 1.5% and 2.3% for the last 35 months.
I’m not going to try to predict if inflation will come back, but we have to be realistic and watch the data. One important indicator is the spread between the 5-year Treasury yield and the 5-year TIPs. This is the market’s view of what the CPI will be over the next five years. The “breakeven” spread increased this week to 2.24%, which is up 0.13% since Monday. Also, the back end of the yield curve is starting to flatten. The spread between the 5- and 30-year Treasuries just narrowed to its smallest point in five years.
A few years ago, I ran the numbers on how the stock market reacts to inflation. Here’s what I found:
Now let’s look at some numbers. I took all of the monthly returns from 1925 to 2012 and broke them into three groups. There were 75 months of severe deflation (greater than -5% annualized deflation), 335 months of severe inflation (greater than 5% annualized), and 634 months of stable prices (between -5% and +5%).
The 75 months of deflation produced a combined real return of -46.77%, or -9.60% annualized. The 335 months of high inflation produced a total return of -70.84%, or -4.32% annualized. The 634 months of stable prices produced a stunning return of more than 177,000%. Annualized, that works out to 15.21%, which is more than double the long-term average.
Here’s an interesting stat: The entire stock market’s real return has come during months when annualized inflation has been between 0% and 5.1%. The rest of the time, the stock market has been a net loser.
The Fed’s target for inflation is currently 2%, and we’ve been below that for some time. Fed Chair Janet Yellen said that’s probably due to lower energy prices and lower import prices. I want to make it clear that I don’t think inflation is a problem or will soon be a problem, but the era of rock-bottom inflation may be over. To some extent, a small increase of inflation could be beneficial. American firms are currently sitting on more than $1.6 trillion in cash, and a small boost to inflation might cause them to spend more.
The bottom line is to ignore the doom and gloom crowd. There’s no danger of hyper-inflation but it’s very likely that inflation will creep up to the Fed’s target zone. That will be another reason for the Fed to raise rates. As long as the yield curve is steep, the math is in the stock market’s favor. But the steep curve won’t last forever. Now let’s look at some recent earnings.
Good Earnings from Wells Fargo, Blah Earnings from IBM
Last Wednesday, Wells Fargo (WFC) reported Q1 earnings of $1.05 per share, which beat estimates of 97 cents per share. This was the 17th quarter in a row in which Wells has reported earnings growth.
Wells continues to be the strongest large bank in the country. As expected, their mortgage business got hit hard last quarter, but we saw that coming. Still, Wells was able to grow its loan portfolio by more than $4 billion. Their total loan portfolio now stands at $826.4 billion.
The results were particularly welcome for two reasons. One is that the earnings from competitor and former Buy List member JPMorgan Chase were pretty ugly. The other reason is that shares of WFC were sliding going into the report. Clearly, some traders were nervous, and the results quelled that. Wells Fargo remains a very good buy up to $54 per share.
IBM’s (IBM) earnings were a different story. First, I have to remind investors that many cheap stocks are cheap for a reason. The question to ask is how serious are those reasons. IBM is in a rough patch right now. In many ways, I think the company is in a place similar to where Microsoft was a few years ago.
For Q1, IBM reported earnings of $2.54 per share, which matched Wall Street’s estimate. Big Blue had revenues of $22.48 billion, which missed estimates by $320 million. This is the eighth sales decline in a row. The details weren’t pretty. Hardware sales dropped 23%. System-storage sales also dropped 23%. Software sales rose by just 1.6%. The market was not pleased, and IBM got knocked for a 3.4% loss on Thursday.
Perhaps the most impressive part of the earnings report was that IBM reiterated its forecast of earning $18 per share for this year. Wall Street doesn’t buy it, but it’s noteworthy that IBM hasn’t backed away from that forecast. I like IBM here, but it’s a longer-term story. The stock is going for less than 11 times this year’s earnings. IBM is a good buy up to $197 per share.
Seven Buy List Earnings Reports Next Week
Get ready for a lot of earnings news next week. On Tuesday, CR Bard and McDonald’s are scheduled to report Q1 earnings. CR Bard (BCR) was one of the surprising winners in the early part of this year until the shares pulled back this month. On the last earnings call, Bard said to expect Q1 earnings to range between $1.83 and $1.87 per share. For the whole year, they see earnings between $8.20 and $8.30 per share. I like this stock. Bard has increased its dividend every year since 1972. Expect another increase in a few months. CR Bard is a good buy up to $152 per share.
McDonald’s (MCD) has beaten earnings for the last two quarters, which ended a period in which they missed earnings four times in five quarters. The fast-food joint is working to turn itself around, and some of the early results look promising. Wall Street currently expects Q1 earnings of $1.24 per share. I also like MCD’s dividend, which is currently over 3.2%. MCD remains a buy up to $102 per share. I’m keeping a tight range, so don’t chase it. Let’s wait until we see strong results.
On Wednesday, April 23, Stryker and Qualcomm are due to report earnings. Three months ago,Stryker (SYK) not only beat expectations but also guided higher for the year. Interestingly, the stock initially dropped after the good news. After that, the stock rallied until the middle of February and has bounced along ever since then. The Street sees Q1 earnings of $1.08 per share, which is probably a penny or two too low. I’m curious to hear what they have to say for guidance. For now, I’m keeping my Buy Below at $90, which may have to come down soon. But Stryker is a fine buy.
Qualcomm (QCOM) may be one of my favorite stocks on the Buy List right now. Next to DirecTV, it’s our second-best performer this year. The stock is inches away from another multi-year high. Last month, Qualcomm gave us a nice 20% dividend increase, and three months ago, they sang our favorite tune—the beat-and-raise chorus. A lot of tech heads will be watching this report for clues about Smartphone sales. QCOM is a buy up to $87 per share.
On Thursday, Microsoft (MSFT) will report its fiscal Q3 earnings. It’s odd to see MSFT and its new CEO get so much good press lately. It wasn’t that long ago that MSFT was written off as a dinosaur that was desperately behind the times. Thanks to the hate, we jumped in and made a cool 40% last year with Microsoft. The Street expects 63 cents per share, and I think we’re going to see a nice beat. MSFT is a very good buy up to $43 per share.
On Friday, April 25, Moog and Ford Motor are due to report. Moog (MOG-A) was a big disappointment last earnings season. They missed by a penny and lowered guidance. The stock got crushed—although by the early part of April, it had made back a lot of what it had lost. That’s one plus to owning high-quality stocks. They often bend but rarely break. In this earnings report, I want to hear if business has improved. Moog remains a good buy up to $66 per share.
Ford (F) is also one of my favorite stocks, and I think the shares are very much undervalued. This is a crucial time for Ford, as they’re rolling out several new models this year. Business is improving in Europe, and they may break even this year. The consensus on Wall Street is for earnings of 31 cents per share. I’ll tell you right now, Ford will beat that. Ford is a solid buy up to $18 per share.
That’s all for now. Stay turned for lots more earnings next week. You can see our complete Buy Listearnings calendar here. 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!