The market started the day strong on good news from the housing department with housing starts and building permits coming in better than expectations. New home starts came in at 917K versus 911K expectations, while building permits came in at 946K versus 925K expectations. After that, though, the market dipped and has started to show some cracks over the past three days as it continues to lose momentum since its longest winning streak since the 1960s. Cyprus' need for a bailout has put a dent in market confidence and given investors/traders a reason to take some gains off the table. The issue has increased the dollar, while dropping the euro. A strong dollar is bad for American equities as it causes our goods to be more expensive abroad. At the same time, we have seen a number of crises hit the market over the past couple years that could not derail upside: Italy, Spain, Greece, Ireland, the sequestration, the fiscal cliff, and more. With the Fed continuing to pump money into the market, we continue to see more upside. Tomorrow's FOMC rate decision will be much more impactful at home than Cyprus, which like most European news, gets swept under the rug after a couple weeks.
Stocks To Trade:
Cisco continues to look solid. The company has performed well despite weakness over the past several days, and we believe it has a lot of opportunity moving forward. The company has strong value, solid growth opportunities, and won a key court case last week. First, let's take a look at value in Cisco. The company has a P/E over 12, future P/E over 10, and price/sales at 2.5. The company shows value on all three indicators. Value is typically viewed at under 18 on P/E, under 15 on future P/E, and under 3 on price/sales. Cisco possesses all three. The company, though, shows much better P/E valuations than price/sales. Why is that? The company has strong margins (operating margin at 22% and net margin at 20%), and that should attract investors. Despite value, are there growth opportunities for Cisco?
The company is expected to see 6% growth in revenue this year and next year. Additionally, CSCO is anticipated to see around 6-8% growth in earnings in both years. We believe these growth rates are very solid for the valuations we mentioned. What will be powering that growth? First off, the company recently released a new optimization product that is attractive. Here are details about it from CRN:
Cisco ... ushered in a new solution that will enable its Integrated Services Routers to help companies monitor and manage the growing number of applications tapping into their networks from the cloud and the bring-your-own-device (BYOD) trend. The solution, called Integrated Services Router with Application Experience (ISR-AX), will give way to a new family of Cisco routers the company says converges network optimization, security and application management services onto a single box. Raakhee Mistry, senior marketing solutions manager with Cisco's Enterprise Networking Group, said ISR-AX still provides Cisco's flagship routing and WAN optimization technologies, but it is aimed more at helping organizations monitor and optimize the performance of business-critical applications.
The new product line is very attractive for big bandwidth. Pacific Crest noted that the company has potential for $10B in growth of sales in big bandwidth. Wunderlich also noted that CSCO would price their product at 35% below the current market, which is attractive. The reduction in price does keep margins in check, but we believe that the potential for growth should provide significant enough earnings boost to power shares higher. If the company saw $10B growth in sales at a net margin of 18%, it would add $1.8B in earnings. Converted to EPS, this market could add 0.34 to EPS. That boost would increase EPS 20%. Further, the company did not lose a key patent case to VirnetX last week. Avoiding losing that trial is helpful to CSCO as it would have been a large hit to the company.
Trade: CSCO, Long
Entry: Break of $23
Another stock we like right now is Michael Kors. The retail company has seen some recent correcting that we believe is giving investors/traders an opportunity. The company is a strong growth stock in the fashion retail industry with plenty of future opportunity. Recent pressure for shares has been due to some notes that momentum is slowing in channel checks. That drop in momentum hurts the company since it has strong valuations and needs continued growth to have valuations stay at elevated levels. Currently, KORS is trading at a future P/E of 23 and current P/E of 33. With any growth stock, the market needs to believe that the future will continue to be better for the company. Any signs of weakness, as have been suggested, can curb enthusiasm. A short-term blip in momentum, though, we believe is an opportunity, not a long-term issue. The company is expected to see over 60% growth in sales this year and over 30% growth next year. Both levels are very solid and we believe that the company has strong penetration potential into a key market that sits in between upper class and middle class.
The segment of society that we are talking about is HENRYs (High Earners Not Rich Yet). KORS offers sleek, stylish clothing that has an appeal to a wealthier class but it is also not luxury spending to shop there. It's for a strong niche of shoppers that want to look well off but do not have significant expendable funding. There are over 21M HENRYs, and they spend money at strong rates. They are usually younger in age, so they are in acquisition phases as well as have fewer expenses for other things like children. We believe that this pocket of spenders is very strong as seen by recent retail sales - consumers are spending money. Avalon Research actually noted they saw very strong channel checks at the end of February.
On top of the solid potential customer, KORS has massive expansion opportunities abroad. KORS only has a dozen stores in China, but Coach (COH) has over 100. The company has the potential to expand to at least that size and even more as China continues to develop. Further, the company has only 17 stores between Spain, France, Germany, and the Netherlands. We expect a lot more growth for this company moving forward.
The best way to play KORS is through a bull put spread that can take advantage of this pullback but also allow for purchasing shares if any other short-term issues do arise.
Trade: KORS, Apr20, 52.50/50 Bull Put Spread
Max Gain: 20%
With the market looking toppy, we may start to see a "risk off" trading environment that we believe will be beneficial to TLT. The bond ETF benefits as investors move from stocks to bonds. With the issue of Cyprus flaring up and strength in the dollar hurting equities, we could see an extended issue for American stocks. If that occurs, bonds will become attractive as a "safe haven" asset. What may be even more beneficial to bonds over anything else will be the FOMC rate decision on Wednesday. If the Fed starts to show some signal of any cut on QE, it will create a lot of demand for bonds. The reason for that is that QE has helped keep bond yields down so that capital will move into equities. If the Fed decides to cut QE early or diminish it, bonds will see increased yield and raise demand. TLT has a lot of potential as it has been down for quite some time, and we believe that TLT has an opportunity if the Fed and Cyprus situations do flare up.
We believe adding a bull put spread in TLT to your portfolio can be a nice hedge to longs. Even if the Fed continues QE and Cyprus blows over, the market is extremely extended right now, and it's a good idea to have this hedge in place. A very solid level of support for TLT has been 114. We can make 18% on Apr20 114/111 bull put spread. That hedge will really help to battle any risk in the market.
Trade: TLT, Apr20, 114/112 Bull Put Spread
Max Gain: 18%
A bearish position we are looking at today is Cliffs Natural Resources. The company has had a rough start to 2013 as it has dropped 47% YTD. The question many are asking is, when does the bleeding stop? To understand that, we need to understand why CLF is dropping. The company has been hurt by declining profits/sales, continued questions over the future of coal in the United States and abroad, and a perceived slowdown in China's infrastructure growth, which will hurt steel demand. The company got a Goldman Sachs (GS) downgrade Tuesday from $24 to $20 due to lower iron ore price forecasting. The lower prices will hurt CLF's top and bottom line. CLF, in general, is being pulled from two sides as coal demand and perception weakens in the USA and iron ore demand weakens in China. The company is being hit on two fronts. Here was the company's outlook for 2013:
In 2013, Cliffs anticipates the end markets for its products to remain healthy, primarily driven by China's continued demand for steelmaking raw materials. Cliffs expects its global iron ore sales to be relatively flat year over year at approximately 40 million tons. While the recent iron ore spot price reached $159 per ton, a new 12-month high, the Company expects pricing for the commodities it sells to remain volatile. Due to this expected volatility and for the purpose of providing a full-year outlook, Cliffs will utilize the year-to-date average 62% Fe seaborne iron ore spot price as of Jan. 31, 2013, which was $150 per ton (C.F.R. China), as a base price assumption for providing its full-year 2013 revenue-per-ton sensitivities for the Company's iron ore business segments. With $150 per ton as a base price assumption for full-year 2013, included in the table below is the expected revenue-per-ton range for the Company's iron ore business segments and the per-ton sensitivity for each $10 per ton variance from the base price assumption.
The issues that we see with this is that China's demand for iron ore appears to be weak, and the spot price of iron ore is expected to drop in the 2H of FY13. The company used a $150 per ton price for assuming most of their goals. The issue with that is that the price is likely too high and is expected to continue to drop as we move forward as more companies come on with supply. As of right now, CLF is cheap. Shares are trading at 0.6 price/sales and 8 future P/E. The problem that we see is, what is the catalyst for CLF? The increased supply is inevitable, and the allure of coal is waning. We believe that CLF has little catalyst to drive shares at this point. At the same time, shares are very cheap. For those holding long, we recommend a bear call spread to hedge your risk. For those looking to get involved for value, we also recommend a bear call spread to buy shares if the stock rebounds strongly. Analysts do not expect a rebound in sales or earnings until 2014, so longs may be waiting some time.
Trade: CLF, Apr20, 24/25 Bear Call Spread
Max Gain: 9%
Wednesday, the market will have all eyes set on the Federal Reserve. The FOMC rate decision will be revealed. While the rate will not move, it will be the language and conversation that will be crucial to the market. Is QE ending? Does the Fed see a better economy? What will they do moving forward? These questions will fuel the market. If any signs of ending QE are released, the market will likely see a fairly strong correction. At the same time, the market could rally a bit on positive news after a few down days. Either way, one should expect a quiet start to the day with a lot of action in the afternoon after the release.
Chart courtesy of finviz.com.