July 14, 2017

Stocks edged higher, continuing Wednesday’s rally after Fed Chair Janet Yellin testified before Congress that she expected the Fed to take a gradual approach relative to future interest rate increases.

Over the last several sessions the leading tech stocks have staged solid rebounds recovering much of their recent losses. But with one or two exceptions, they have failed to break out to new highs. They could do so today. But until they do, they remain in a trading range. While the tech names were consolidating sharp gains from earlier in the year, money over the past month has begun to rotate into value stocks. Yesterday, after Target reported that recent same store sales exceeded previous expectations, its stock moved sharply higher and took the entire retail sector along for a ride. Given how badly retail stocks have done recently, it isn’t all that surprising that they would bounce sharply on the slightest piece of good news.

The retailers aren’t the only out-of-favor group that has started to come to life over the past week or two. No group has performed worse this year than the energy stocks. In a market where leading averages are up close to 10% for the year to date, energy stocks are down an equivalent amount. That shouldn’t be a shock given the weakness in oil prices over the past several months, amid swollen inventories and rising U.S. production. But rig counts have now started to fall, and oil prices have put in at least a temporary bottom around $42 WTI.

Despite the fact that auto sales have peaked, shares of leading companies like Ford and General Motors have started to rebound. That may relate strictly to value. Both pay above average dividends, and both appear to be more innovative than they have been over the past decade.

In the stock market, rotation is generally considered a good thing. Tech stocks rocketed higher in the first half of the year, but when the notoriously cyclical and capital intensive semiconductor group sports leadership companies selling at multiples of 30 or more times prospective earnings, valuations become stretched. We are buying stocks, not companies. In the tech world, there are a lot of great companies but there may not be a lot of cheap stocks. One has to wonder whether perfection is now priced into many of these shares.

Growth stocks have outperformed value stocks for a number of years. That won’t go on indefinitely. One buys stocks in the belief that the underlying company can grow earnings, cash flow and dividends over time. Growth companies grow faster and, as a result, are priced accordingly, with P/E ratios greater than market averages while value stocks, almost by definition sell at lower than average P/Es. However, today cyclical companies are expected to achieve faster earnings growth and sell at discounts of 40% or more versus their growth brethren. Valuation matters.

But with that said, stock performance is all about how companies do relative to expectations. High growth stocks have to match or exceed lofty expectations to move higher. In some cases, they do just that. All you have to do is look back on the recent history of names like Amazon, Facebook#, or Apple# as proof. But value stocks can also perform very well. They simply have to beat lower expectations. Sometimes they do. But sometimes they don’t. The latter deserve their label as value traps. If a company is expected to earn $5 per share next year and is priced at $50, its P/E ratio of 10 is almost half that of the overall market. It looks cheap on the surface. But if it only earns $2.50, it won’t prove to be cheap at all.

With that as a backdrop, let’s take a closer view at a few sectors. I’ll start with autos. Ford and GM are deep value stocks. Their outlook is tarnished by a rather tepid outlook for the entire auto group. But that doesn’t mean all auto stocks are bad. Just look at Tesla which today sells at a greater market cap than Ford, even though it is only a tiny fraction of Ford’s size. Will Tesla be the dominant auto company in a decade? Bulls may think so. But the economics of electric versus gas powered cars probably plays in favor of traditional autos for many years to come. Both Ford and GM have shown signs of being more innovative than in the past. If that proves to be the case, they just might be cheaper stocks and have better earnings prospects than a high flyer like Tesla. But if the flashes of innovation we see from the two auto giants are just that, flashes, then we are headed for flat-to-down sales and earnings, and these stocks will go nowhere.

Today everyone is assuming every retailer is going to be beaten to a pulp by Amazon. That is probably not true. Amazon will likely continue to grow, but at no time in history has one company reached and maintained a market share far over 20% in any broad retail sector. Amazon may be the biggest online retailer, but it isn’t the only one. However, with that said, traditional retailers have been unbelievably slow adapting to a changing world where online and in-store retailing have to be integrated efficiently. Virtually every traditional retailer loses money today on its Internet business. To compound the misery, the U.S. is horribly overstored. Achieving the right balance will take many years. By the time the process ends and the right balance is achieved, the dollars spent in stores will be less than today, while Internet sales will double or triple. The retail group may have short term bounces as they did yesterday, but the transformation of this sector is only in its early innings. For traditional retailers, there remains a lot more pain ahead.

The situation for oil isn’t nearly as bleak. Demand continues to grow worldwide and the cost to produce a barrel of oil is declining sharply. Big veins of oil and gas lie in easy to reach places within shale rock in the U.S., and there are companies poised to take advantage. With that said, oil is probably going to trade within a fairly wide range for a long time. It appears $40 is a reasonable floor that will only be violated on the downside for brief periods. Below that price, too much drilling will cease, quickly creating shortages. On the other hand, prices above $55-60 will bring a surge in production that will collapse upon itself. One can trade oil buying when prices are near $40 and selling when they exceed $55. But it will be hard to find many real long term investments here. And if you want to find an energy sector with an outlook as bleak as conventional retailing, look at the offshore drillers. At today’s prices, there is absolutely no incentive to start drilling deep wells offshore.

The moral of this tale is that value stocks sell at muted P/E ratios for a reason; they have lesser growth prospects than the average company. But there are cycles of surprising strength that can lift all boats. A good example of the moment is housing, which after many dull years, seems to be on a sustainable path upward. Another example could be banks. While loan growth has been anemic and trading profits are both volatile and hard to predict, banks will benefit from rising interest rates, an upward sloping yield curve, and much less regulation. Bank stocks rallied sharply after the Trump victory but paused as economic growth came up short in Q1. But with growth now stable and rates slowly moving higher, they have the wind at their backs. We will get earnings reports from several big banks today. Finally, look at capital spending. In a slow growing economy, companies have to become more productive. That means investing and modernizing. Companies that play into that theme will flourish.

Today is Bastille Day. It is also a summertime Friday. The big news story of the day will be the earnings from a trio of large banks. They could spark some trading activity this morning, but it should fade as the day wears on. Republicans introduced their latest iteration of healthcare reform yesterday. Two Republicans, Rand Paul and Susan Collins, have already said they would vote no. To get the bill passed, every other Senator has to vote yes. Most of those previously against the bill will wait for several days to see how the CBO scores the bill. They will also allow time for constituents to chime in. No other Republican wants to be the one who votes no and leaves the final tally 51-49 against. Either a group will vote no in addition to Paul and Collins or the bill will pass. This is politics. For seven years, Republicans have screamed “repeal and replace.” This is put up or shut up time. Next week will be key. While the bill, if passed, will affect millions, it is unlikely to have a significant overall economic impact in the short run.

Today actress Jane Lynch is 57.

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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