Market Review May 27: The Consolidation Phase

by: Eddy Elfenbein

In the March 4th issue of CWS Market Review, I told investors to expect a range-bound for much of this spring and that’s largely what we’ve seen. Every rally seems to fizzle out after a few days, and every sell-off is soon met with buying pressure.

Consider this: Over the last two months, the S&P 500 has closed between 1,305.14 and 1,348.65 over 86% of the time. That’s a range of just 3.33%. Even going back to February 4th, we’ve still remained in that narrow range nearly 80% of the time. The Dow hasn’t had a single four-day losing streak since last August.

Let me caution you not to get frustrated by sideways markets. This is how markets typically work. After impressive rallies, investors who got in early like to cash out their chips. This is known as a consolidation phase. Although the market may seem to be spinning its wheels, there’s a lot of action going on just below the surface.

This week, I want to take a closer look at some of these hidden currents. As I’ve discussed before, the market is rapidly changing its leadership away from cyclical stocks. In fact, the ratio of the Morgan Stanley Cyclical Index (^CYC) to the S&P 500 nearly broke through 0.8 this week for the first time in six months. Cyclicals have underperformed the broader market for nine of the last 12 trading sessions, and most of the worst-performing sectors this month are cyclical sectors. This trend will only intensify.

The other important change is that the bond market has turned around, and it’s been much stronger than a lot of people expected. After the Fed announced its QE2 plans last August, bond yields started to rise, especially for the middle part of the year curve (around five to 10 years). Beginning late last year, the yield on the five-year Treasury more than doubled in just a few weeks. This was part of a larger shift as investors moved out of safe assets and into riskier asset classes. I’d like to say that I saw this coming, but I merely followed the path laid out for us by the Federal Reserve.

Now bonds are hot again. The yield on the five-year treasury is at its lowest level of the year. The 10-year yield is close to breaking below 3% again. This week’s auction of seven-year notes had the highest bid-to-cover ratio since 2009. What’s happening is that investors are growing more skeptical of the U.S. economy and they’re seeking safer ground. Also, the fear of inflation is subsiding. In April, the inflation premium on the 10-year Treasury hit 2.67% which was its highest in three years. Today, the inflation premium is down to 2.26%.

Many investors are also worried that the European sovereign debt crisis is getting worse. I think that’s correct. What you need to understand is that the shift back into Treasuries compliments the move out of cyclicals stocks. The common thread is a desire for less risk. This current is perfectly understandable and it helps our Buy List since most of our stocks are non-cyclical.

For us, the takeaway is that the stock market will eventually break out of its trading range but it will be a more cautious and risk-averse rally. That’s good for us. Please don’t get frustrated by a churning market. It will come to an end before you know it. Until then, make sure your portfolio has plenty of high-quality defensive and non-cyclicals stocks such as the ones on our Buy List.

Speaking of the Buy List, we had one earnings report this past week and it was a slight disappointment. Medtronic (MDT) reported earnings-per-share of 90 cents for its fiscal fourth quarter which was three cents below Wall Street’s consensus. That’s not good news, but honestly, it’s not too bad.

Over the last several months, Medtronic has repeatedly lowered its earnings forecast. As I like to say, these lower earnings revisions tend to be like cockroaches — there are a few more hiding for every one you see. But last August, Medtronic dropped below $32 which made it an outstanding buy. Since then, MDT has put on a nice rally that only broke down recently.

With this past earnings report, Medtronic gave us a full-year earnings guidance range of $3.43 to $3.50 per share (their fiscal year ends in April). Wall Street had been expecting $3.62 per share. My take: I think the company has grown tired of lowering its forecasts so they decided to give us a low ball to start the year. Even so, let’s put this into proper perspective: Medtronic is currently going for 11.78 times the low-end of their forecast. That’s pretty cheap.

With other companies, the lowered guidance would get to me, but Medtronic isn’t like most stocks. Some time in the next few weeks you can expect Medtronic to raise its dividend as it has every year for the past 34 years. That’s a very impressive record. Medtronic is a solid buy below $45 per share.

The next Buy List earnings report will be from Jos. A Banks Clothiers (JOSB). Three months ago, I said that Joey Banks looked like it was ready break out. How right I was. The shares are up over 20% since then. For the year, JOSB is up 37.52% for us and it’s our top-performing stock.

The company hasn’t said when they’ll report yet, but they’ve historically released their Q1 report shortly after Memorial Day. I have to explain that JOSB’s annual earnings are heavily tilted towards their Q4 (November, December, January). About 40% of their profits for the year come during that quarter while the other 60% is divided up during the other three quarters. As a result, the upcoming earnings report isn’t nearly as crucial as the report from two months ago.

For the coming earnings report, Wall Street’s consensus is for 65 cents per share which is probably a bit too high. JOSB’s earnings are hard to predict so a little leeway should be expected. For example, the earnings “miss” from six month ago clearly hasn’t hurt the stock. Joey B has a very compelling business model and this will very likely be their 20th straight quarter of higher earnings.

I still think JOSB is a great stock, but if you don’t own, I urge you not to chase it. Chasing stocks is simply bad investing; good investors are disciplined about price. If you want to buy JOSB, wait until it falls below $50 per share. Patience, my friend. Patience.

Some other Buy List stocks that look good right now include Deluxe (DLX) which is a good buy up to $26. I love that 4% yield! The folks at Motley Fool have a good article explaining why DLX’s earnings are so strong. Fiserv (FISV) is also looking strong. I rate it a good buy any time the shares are less than $65. Their board just approved a share repurchase of up to 5% of the outstanding shares. Lastly, I think AFLAC (AFL) is a great buy below $50 per share. AFL is going for less than eight times my estimate for this year’s earnings.

That’s all for now. The market will be closed on Monday for Memorial Day. I hope everyone has a great long weekend.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Disclosure: Author has AFLAC, DLX, FISV, JOSB and MDT in his portfolio.