“In modern business it is not the crook who is to be feared most; it is the honest man who doesn’t know what he is doing.” – William Wordsworth
On the surface, Wall Street seemed very stable this past week. The last three trading sessions all resulted in moves of less than 0.13% for the S&P 500. That’s not much at all, and it’s a welcome change from the 3% or 4% daily swings we saw this time last year. But this September, Wall Street is in a serene mood. The Volatility Index, or VIX, dropped below 14 on Wednesday, which is less than one-third the peak reading of one year ago.
But I’ll warn you, I don’t expect this quiet time to last. Just below the surface, unseen by most investors, the investing terrain is changing, and I think we’re in for an ugly few weeks. Don’t be too alarmed. I expect that after the election in November, Wall Street will be ready for a strong year-end run.
In this week’s CWS Market Review, we’ll look at what has me so concerned, plus I’ll show you the best ways to position your portfolio for the turbulent weeks ahead. I’ll also highlight the recent Buy List earnings reports from Bed Bath & Beyond and Oracle. But first, let’s take a closer look at the quiet before the storm.
The Quiet before the Storm
The mood is quietly shifting on Wall Street as investors are beginning to set their sights on the third-quarter earnings season, which begins in just a few weeks. Analysts currently expect a modest earnings decline of 2.2%. That sounds about right, give or take. Once again, Wall Street will have to survey the damage done to profits thanks to the mess in Europe and the slowdown in China.
A possible preview came this week when FedEx (NYSE:FDX) slashed its full-year earnings forecast. This is noteworthy because FDX’s business is a decent barometer for the larger economy. The company had expected FY 2013 earnings to range between $6.90 and $7.40 per share. Now FedEx expects an earnings range between $6.20 and $6.60 per share.
What’s interesting is that FDX’s customers seem to be turning away from high-cost overnight services in place of slower and lower-cost alternatives. That’s what happens when people need to cut costs. And it’s not just FedEx.
Bank of America (NYSE:BAC) also made headlines this week when it announced plans to lay off 16,000 people before the end of the year. I was also struck when Thursday’s report on initial jobless claims came in worse than expectations.
While the stock market has had an impressive 14% run since the June low, there’s been a nearly unnoticed but ultimately positive development for disciplined investors. Specifically, stock correlations have fallen. By this, I mean the tendency for stocks to move the same way each day. During the summer, it seemed like every stock was joined at the hip to every other. In July, the correlation among the ten S&P 500 sectors was an astonishing 89%.
This is bad news for large institutional traders because they need to prove to their clients that they can stand out from the crowd (and thereby justify their large fees). So when all the fish are swimming together, it’s harder for any single one to be the first up the falls. This is probably why hedge funds are having a terrible year. With our strategy of focusing on high-quality stocks, I’m cheering the decline in correlations. This makes it easier to pick up bargain stocks that have strayed far from the pack. Not only is stock correlation dropping, but the correlation between gold and the S&P 500 fell from 64% in July to 32.6% in August.
What’s causing the decline in correlations? That’s hard to say exactly. My guess is that this “disaggregation” is probably a reflection of the first hints of optimism in Europe. That’s why Draghi’s recent move was so important. When things there look so bleak, it was easy to treat anything that used dollars as the same thing. Well, that’s not the case anymore. Looking back on it, I think the IPO flop of Facebook (NASDAQ:FB) woke up a lot of investors.
The key for investors, as always, is to focus on high-quality stocks such as the members of our Buy List. I want to highlight Ford (NYSE:F) for a moment because this stock has been such a tremendous buying opportunity for us.
I’ve mentioned several times recently how inexpensive it has become. Just last month, I wrote that I didn’t see how Ford could be trading for less than $10, but it was. Now the market has turned and this week, the shares got as high as $10.66. Ford does about one-fourth of its business in Europe, so the numbers in the near-term will be soggy, but that won’t last. Ford is an excellent buy anytime the stock is below $12 per share.
Take Advantage of the Drop in BBBY
On Wednesday, Bed Bath & Beyond (NYSE:BBBY) reported fiscal Q2 earnings of 98 cents per share which was four cents below Wall Street’s estimate. If you recall, when the previous earnings report came out in June, the company warned investors that Q2 earnings would range between 97 cents and $1.03 per share. At the time, Wall Street had been expecting $1.08 per share, so the stock got chopped for a 17% loss the next day.
So Bed Bath & Beyond’s warning was accurate. Interestingly, net income fell by 2.2%, but earnings-per-share increased from 93 cents to 98 cents per share thanks to fewer outstanding shares. BBBY seems to be one the few companies that truly reduces their share base. Total revenue rose 12.05% to $2.593 billion. The key retailing metric, comparable store sales, rose by 3.5%, which is a decent number.
The problem with Bed Bath & Beyond right now is that the company has become overly reliant on discount coupons in order to get people in the door. That’s fine during a recession when there’s a lot of pressure on you to clear out your shelves. But now that the economy isn’t so dire and the housing sector is showing some tentative signs of recovery, they need to have greater pricing power.
Bed Bath & Beyond’s net profit margin dropped from 9.91% for last year’s second quarter to 8.65% for this year’s Q2. Put it this way—a falloff in margins like that turns a sales increase of 14.57% into an increase in profits of 0%. It’s hard to fight against the discounting tide.
But the most important news was the forecast for Q3 and the entire year. Bed Bath & Beyond sees Q3 earnings ranging between 99 cents and $1.04 per share. The Street had been expecting $1.02, so it was still within range. The company kept their full-year guidance the same, between the high single digits and the low double digits. Investors, however, reacted very negatively, and the stock dropped nearly 10% on Thursday.
While I’m concerned about the company’s overuse of coupons, I still like BBBY a lot. They overcame the housing bust, which was much more serious than this. To reflect the selloff, I’m lowering my Buy Below on Bed Bath & Beyond to $67 per share. This is a very good company.
Oracle Is a Good Buy
After the closing bell on Thursday, Oracle (NASDAQ:ORCL) reported fiscal Q1 earnings of 53 cents per share, which matched Wall Street’s forecast. Personally, I was expecting much more. This was a decent increase from last year’s Q1, when Oracle earned 48 cents per share. The trouble spot was on the top line. Oracle’s sales fell by 2% to $8.18 billion, which was $230 million below the Street’s forecast.
Like a lot of companies, Oracle got dinged by currency costs. The strong dollar puts the squeeze on all that money flowing back to the United States. Oracle said that adjusting for currency cost them three cents per share in earnings.
The good news is that Oracle’s licensing revenue rose by 5% last quarter. This is important because it’s probably a good sign of future revenue. Unfortunately, this growth is a slight drop-off from the 7% rate in the previous quarter. Still, Oracle’s CFO said “we’re off to a good start in the new year,” and I have to agree.
On the conference call, Oracle said it expects Q2 earnings ranging between 59 and 63 cents per share and sales growth of flat to 4%. The Street had been expecting 61 cents per share and 4.7% growth. So the outlook was mostly within expectations. I think traders were nervous about this earnings report, as shares of ORCL pulled back on Wednesday and Thursday, but these numbers allay any worries I had. Oracle is a very solid buy up to $35 per share.