October 25, 2017

Although the Dow rose 167 points yesterday or 0.7%, the S&P 500 and the NASDAQ Composite rose a more modest 0.2%. The Dow was sparked by better than expected earnings from both 3M# and Caterpillar. Other earnings reports were generally good, including positive reports from Dow components United Technologies#, McDonald’s# and General Motors#.

Despite the nice gains in the leading averages, there were some cautionary signs. The VIX volatility index rose for the second straight session, unusual in a strong market. 10-year Treasury yields rose above 2.4% as growth and inflation numbers suggested some concern might be warranted. Growth worldwide appears to be improving. Both Japan and Europe should grow well over 2% this quarter. China and India remain strong. Rising commodity prices are putting upward pressure on producer wholesale prices. In a sense, the good news might be a little too good. Over the next week or so, we will hear from both the ECB and the Bank of Japan. Investors will be watching for hints that quantitative easing might be coming to an end a bit faster than anticipated just a few weeks ago, as interest rates creep up and inflation fears percolate just a bit.

But with that said, this is earnings season and that will dominate the news. The flow will increase today and tomorrow. By the end of this week, the trends for the season will be evident and should point to solid and sustained growth. That is the magic that propels bull markets, and unless there is a major change in inflation trajectories or interest rates, there is little reason to suggest the fourth quarter won’t be a positive one for equities. Taxable investors typically like to defer gains until the following year, especially if positive momentum continues. That further reduces selling pressure. The obvious exception is the class of stocks that have fallen either this year or cumulatively over the last several years. Those will continue to be buffeted by tax selling for another 4-6 weeks. But, as I have noted previously, the carnage eventually ends, and as selling pressure dissipates, some bargains will emerge. One doesn’t want to buy stocks of companies in perpetual decline. Sears may never come back, and I am not sure the prospects for coal companies are particularly favorable over the long term. But others will rebound, and Q4 is a great time to go bargain hunting. It may be a bit early to buy enthusiastically, but it isn’t too early to go shopping and start sniffing out tomorrow’s bargains, perhaps even nibbling a bit.

I may be overly simplifying, but one can break down companies into three buckets. One is your classic growth group. These are usually companies within growth segments like technology or health care, or simply companies who have a better formula for success and can persistently gain market share. While valuation always matters, stocks of these companies generally do well, especially in later stages of a bull market when momentum seems to trump valuation. Second are your classic cyclicals. They do well when the economy does well and poorly when the economy contracts. In many cases, companies have multiple divisions that operate on different cycles. In that case, one or more divisions can be strong while others are weak simultaneously. You see this often within the large industrial companies. A year ago, for instance, a company like Caterpillar was beginning to see strength in construction equipment and across certain geographies. But mining equipment and Asian markets were weak at the same time. Today, almost all markets are improving and CAT shares are at record highs. The last group, the one you generally want to avoid, are companies in true secular decline, companies that are being displaced by technological disruption or simply companies being displaced by others doing a better job. In the former case, newspapers would be a good example. In the latter case, think of an old tired restaurant chain fading away. I used the name Sears earlier, a retailer that clearly has lost its mojo.

Sometimes, companies headed for the graveyard can be rescued. Mattel, known for Barbie and other signature toy brands appears lost in a sea of electronic gadgets. It recently hired a new CEO from Google. Can she do the trick and reawaken Barbie and her friends? The answer is a big maybe. The traditional toy industry has been in secular decline for years as kids gravitate to anything with a screen and keyboard at ever younger ages. But, hey, books are making a comeback. This year electronic book sales are down about 4% and real books, the ones you can hold and come with paper pages, are up double digits. Just a few years ago, when Circuit City failed, Best Buy was left for dead. Clearly, this group has a lot of risk. Companies must change to survive. Best Buy matched prices and improved service, for instance. Are there department stores that have bright futures? Will the processed food industry fade away? Are newspapers really going to be replaced by Facebook’s newsfeed? I suspect that in each case, there will be both consolidation and survivors. Some of the survivors will flourish. They won’t succeed by standing still, but there will be diamonds to be found in the rough. As investors, sifting through the rubble is about as easy as finding the proverbial needle in the haystack. But it is interesting to follow. If you want to take a shot and invest in one of the potential survivors I strongly urge you to concentrate your search on best-in-breed companies. Wal-Mart# and McDonald’s are two names that straightened themselves out. Second, recognize that one doesn’t have to throw out the baby with the bath water to succeed. Wal-Mart and McDonald’s both returned to basics and adopted new technology to their core business structures. But Wal-Mart still runs large retail stores and McDonald’s still operates hamburger based restaurants. Tweaks and execution, not jolting change, was the cure. In both cases, the core business model was fine. The execution wasn’t. In 2017’s class of losers there are companies with good bases that need better execution. Find them and you will be a happy camper.

Today Katy Perry is 33.

James M. Meyer, CFA 610-260-2220

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

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