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Economic data has been mixed since our last newsletter, making it difficult to get a solid read on the state of the economy. The market also appears to be having a difficult time making up its mind, given that the S&P 500 has been essentially drifting sideways over the past two weeks, signaling the summer market doldrums are in full swing.
Retail and food service sales were much weaker than consensus estimates for the month of July. July retail sales was virtually unchanged from the June reading, which was revised upward from +0.6% to +0.8%, according to the latest report from the Census Bureau. Compared to the year-ago period, retail and food service sales were up 2.3%.
Industrial production increased 0.7% in July, according to a new Federal Reserve report. The advance in July was the largest for the index since November 2014 and follows a 0.4% increase in June. Manufacturing output, the largest component of the industrial sector, increased 0.5%, its largest gain since July 2015. The index for utilities rose 2.1% as a result of warmer-than-usual weather in July boosting demand for air condition. Mining output also increased, rising 0.7%. The index has increased modestly, on net, over the past three months after having fallen about 17% between December 2014 and April 2016, according to the Federal Reserve.
Inflation eased in July, as the Consumer Price Index was unchanged, according to the latest report from the Department of Labor. This comes after a 0.2% increase in June. The core Consumer Price Index (which strips out volatile food and energy prices) increased just 0.1% in July, after an increase of 0.2% increase in June. Compared to a year ago, prices are just 0.8% higher, a smaller increase than the 1% rise for the twelve months ending in June. Core prices are 2.2% higher, below the 2.3% year-over-year increase in June.
The housing sector expanded sharply in July, as New Home Sales increased 12.4% in July, according to the Census Bureau. The figure, 654,000, is the strongest pace of new home sales since October 2007 and is up 31.3% where they were a year ago. Median sales prices fell 0.5% to $294,600, which is essentially unchanged from a year ago.
Oil prices have increased, rising to as high as $49 a barrel after a reading two weeks earlier at about $44 a barrel. As of this writing, on August 25th, the price had come off the recent highs and was at roughly $47 a barrel. Regarding gas prices, a gallon of regular unleaded gas, on average, cost $2.20 on August 25, up from $2.16 a month earlier, according to AAA. That's about 15.1% below where it was a year ago.
Since our last newsletter, the S&P 500 returned -0.6%, while the Hot List returned 1.2%. So far in 2016, the portfolio has returned 10.1% vs. 6.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 210.2% vs. the S&P's 117.2% gain.
The Fed - Will They or Won't They Raise Rates, And What It Means for Investors
The debate rages on...will the Federal Reserve raise interest rates again before the end of the year? Since the publication of the last Hot List Newsletter, the Federal Reserve released the minutes of its July 26-27 Federal Open Market Committee meeting, during which the committee voted to leave the fed funds rate unchanged. The minutes offered no definitive answer to the "rate-debate," as they noted officials lacked a strong consensus opinion regarding interest rate policy. Specifically, "the Committee would likely have ample time to react if inflation rose more quickly than they currently anticipated, and they preferred to defer another increase in the federal funds rate until they were more confident that inflation was moving close to 2% on a sustained basis."
Looking at various economic data reports in recent weeks provides little firm guidance as to the rate-debate. Employment data implies a near term rate hike is in the cards, as job growth was strong in both June and July, with nonfarm payrolls increasing far above consensus estimates in both months. Other data releases, though, muddy the waters, indicating an economy on less-than-solid footing. For example, retail sales was unchanged for the month of July, warning that the consumer, the key driver of the U.S. economy, has cooled discretionary spending, calling into question whether a rate increase is warranted. A better read on the situation could be provided as of the date of this publication, as Federal Reserve Chairwoman Janet Yellen is set to deliver a speech at the Kansas City Fed's Economic Symposium in Jackson Hole.
However, a firm answer to the question "Will the Fed raise rates or won't they?" may not be provided for weeks, or perhaps months, down the road, as the Fed is scheduled to meet three more times this year -- in September, November and December. And as these future meetings approach, the debate among investors and the news media regarding the next actions of the Fed will likely persist on nearly a daily basis, as long as the U.S. is in the midst of a rate increase cycle.
With this debate comes the discussion of what another interest rate hike, the second in the current rate increase cycle which began in December 2015, would mean for the equity market. Will the 6+ year-long bull market begin to show signs of struggle, or will it continue to rage on? These are questions that have been asked during the early stages of rate increase cycles time and time again. For this piece, I examined research regarding the impact of rising interest rates on the equity market. And, most importantly, address the bottom line: what should an investor do, if anything, in anticipation of additional interest rate increases in the months ahead.
Regarding interest rate hikes and the ensuing performance of the market, I found that no simple answer exists, despite the generalized belief that rising interest rates is a negative event for stocks. In fact, according to a piece published in Forbes in May 2015 by one of the gurus on which I base my investment models, Kenneth Fisher, the Fed raising interest rates is not a problem. In his piece, "Five Market Trends You Can Bank On," he states definitively on interest rate increases, "First, you read so much about it -- so it's largely priced in already. No surprise there. Second, we have a very long history of initial Fed interest rate hikes, and they say simply nothing about future stock returns statistically looking out 30, 90, 180, 360, 1,080 or 1,800 days." With the initial rate hike in the current cycle occurring on December 16, 2015, we are about 250 days in. Thus, according to Fisher's research, no solid conclusions can be drawn regarding what the current rate hike cycle should mean for stock in the coming months, or years, for that matter.
Another piece which discusses the impact of interest rates on the market was published by Ritholtz Wealth Management in July 2014. In it, they examine periods in which there were interest rate changes in either direction and the impact of those changes on the S&P 500. Since we are currently in a rising rate environment, the findings of two of the scenarios are detailed below:
1. Rising stocks, rising rates. According to the piece, their "most significant finding was that when rates were rising, the most prevalent condition for stocks was that share prices were rising too. During a year in which rates rose, 73.9 percent of the time - 34 out of 46 instances - equity prices also moved higher. This combination of events - stocks and rates rising in concert - occurred 39.5 percent of the time." When they examined the environment surrounding periods of rising rates and stocks, Ritholtz Management found "that the average 10-year bond yield was 5.11 percent, the P/E ratio of the S&P 500 averaged about 15, and inflation as measured by the Consumer Price Index (CPI) was over 4 percent. The average S&P 500 increase during these periods was almost 21 percent."
2. Rising rates, falling stocks. "In the dozen instances when rates rose and stocks fell, the S&P 500 lost almost 16 percent on average. At the same time, the 10-year bond yield averaged over 6 percent, the P/E ratio for stocks was a historically low 12.57, but inflation was high, averaging 6.8 percent during these periods. This combination of high rates, hot inflation, and cheap (and getting cheaper) stocks typically implies a recessionary environment."
Their conclusion from this study: "When inflation is high, and rates are going up from already high levels, we see a very negative impact on stocks. When inflation is subdued, and rates start increasing from low or very low levels, the impact on stocks is positive." The current climate is clearly one of rates rising from historically low levels amid a subdued inflationary environment, while the forward 12-month P/E ratio for the S&P 500 is 17.1 (according to FactSet as of the August 18th close). Thus, one may conclude that additional increases in interest rates should not represent a death blow for the current bull market, given the current environment.
A similar conclusion was reached in a study by TIAA-CREF published in the Fall of 2015, in that the impact of rising interest rates depends largely on market circumstances. The study looked at past rate tightening cycles and along with variables similar to those in the Ritholtz piece -- interest rates, inflation rates, rate trends and valuations.
The study notes that "in general, hikes aimed at slowing high or rising inflation tended to hurt stocks. Hikes that rose at a measured pace-or reflected improving economic growth-tended to be more positive. Thus, today's environment of firming growth and modest inflation would tend to be relatively supportive of equities. Although history shows that stocks often stall three months into the cycle, a series of rapid and sustained rate hikes is usually a prerequisite for derailing equity performance."
The market environment in which a rate hike is taking place was also a key factor the investment methodology of another guru on whom I base my investment models, Martin Zweig. Zweig's book, "Winning on Wall Street," published in 1986, includes a chapter entitled "Monetary Indicators -- Don't Fight the Fed." Zweig performed extensive research on the stock market and interest rates and, in the process, developed the Prime Rate Indicator. The prime rate is the rate banks charge their best customers and, according to Zweig, "the beauty of using the prime rate as a stock market indicator is that it does not change every day as do other interest rates." He also favored its tendency to lag behind other interest rates. In "Winning on Wall Street" Zweig states, "An interest rate that moves a little behind other interest rates can often mark just that point when stocks finally begin to respond to the changes in interest rates."
In general, Zweig's work found that rising rates tended to be bearish for stocks and falling rates bullish. But, there was a qualifier: the level of the prime rate. A prime rate above 8% was considered to be relatively high, and below 8% is relatively low. Zweig notes "minor increases in rates at levels above the 'high' 8% zone are enough to give bearish signals for stocks. But at levels below 8%, somewhat larger increases in rates are needed to give bearish signals." At present the prime rate is 3.5%. Thus, rising rates in the current market environment would not have called for an immediate sell signal according to Zweig's Prime Rate Indicator. However, I should go on further to note that if the prime rate is below 8%, Zweig's system does call for a sell signal on the second of two hikes in the rate or on a full 1% jump. Thus, another rate hike by the Fed in the coming months would likely call for a sell signal using Zweig's methodology.
So despite the conclusion from the two aforementioned studies that the level of interest rates matters in a rake hike tightening cycle, all is not cut and dry when it comes to rising rates and the performance, or expected performance, of the equity market. Zweig's research showed that the second rate increase even in a low rate environment is enough to trigger a sell signal, while other research indicates a slow and steady increase in an effort to normalize the level of interest rates, rather than cool off an overheated economy and tame inflation, leaves room for further gains in the current bull market, calling for remaining invested.
If I had dug further into analysis available on the market and changes in interest rates, I'm sure I could have found dozens of other theories and disciplines to offer in this newsletter as potential outcomes to a cycle of rising interest rates, some supporting conventional wisdom that rising rates are bad for stocks. Period.
So, the all-important question that begs answering remains: "What action should investors take in the current stage of the rising rate cycle, particularly if another increase in rates is on the horizon for 2016?" Clearly offering a sweeping suggestion regarding stock allocation would be misplaced, given my longer-term approach of seeking out undervalued stocks of solid companies, regardless of economic conditions or, more specifically, the actions of the Federal Reserve and what that might mean for the market. What I can suggest, though, is study the fundamentals and stay with those companies that offer exceptional value. Abandoning your discipline and adopting a "sell everything" mindset in fear of what may be coming down the pike in regard to interest rates could cause you to miss out on many excellent investment opportunities that appreciate in value irrespective interest rate policy.
As we rebalance the Validea Hot List, 7 stocks leave our portfolio. These include: Nic Inc. (EGOV), Natural Health Trends Corp. (NHTC), Insteel Industries Inc (IIIN), Cal-maine Foods Inc (CALM), Hawaiian Holdings, Inc. (HA), Paycom Software Inc (PAYC) and Anika Therapeutics Inc (ANIK).
3 stocks remain in the portfolio. They are: Valero Energy Corporation (VLO), Banco Macro Sa (Adr) (BMA) and Lgi Homes Inc (LGIH).
The New Additions
We are adding 7 stocks to the portfolio. These include: John B. Sanfilippo & Son, Inc. (JBSS), Polaris Industries Inc. (PII), Supreme Industries, Inc. (STS), Trex Company, Inc. (TREX), Grupo Financiero Galicia S.a. (Adr) (GGAL), Amtrust Financial Services Inc (AFSI) and Banc Of California Inc (BANC).
Newcomers to the Validea Hot List
Amtrust Financial Services Inc. (AFSI): Amtrust Financial Services, Inc. (AmTrust) is an insurance holding company. The Company, through its subsidiaries, provides specialty property and casualty insurance focusing on workers' compensation and commercial package coverage for small business, specialty risk and extended warranty coverage, and property and casualty coverage for middle market business. Its segments include Small Commercial Business, Specialty Risk and Extended Warranty, and Specialty Program. The Small Commercial Business segment is engaged in providing workers' compensation, commercial package and other commercial insurance lines produced by wholesale agents, retail agents and brokers in the United States. The Specialty Risk and Extended Warranty segment is engaged in providing coverage for consumer and commercial goods and custom designed coverages. The Specialty Program segment is engaged in writing commercial insurance for defined classes of insureds through general and other wholesale agents.
AmTrust ($4.393 billion market cap) has taken in more than $5.1 billion in sales over the past year. My Peter Lynch-, Warren Buffett-, and Martin Zweig-inspired models are high on its shares. For details about its fundamentals, see the "Detailed Stock Analysis" section.
Banc of California, Inc. (BANC): Banc of California, Inc. is a financial holding company. The Company is the parent of Banc of California, National Association (the Bank) and The Palisades Group, LLC (The Palisades Group). The Company operates through Commercial Banking; Mortgage Banking; Financial Advisory, and Corporate/Other segments. The business of the Commercial Banking segment consists of attracting deposits and investing these funds primarily in commercial, consumer and real estate secured loans. The business of the Mortgage Banking segment is originating conforming single-family residential (SFR) loans and selling these loans in the secondary market. The business of the Financial Advisory segment is operated by The Palisades Group and provides services of purchase, sale and management of SFR mortgage loans. The Corporate/Other segment includes the holding company. The Corporate/Other segment engages in business activities through the sale of other real estate owned and loans held at the holding company.
Banc of California ($1.106 billion market cap) gets an 89% score from my Validea Momentum Investor model and receives high marks from my Peter Lynch- and Motley Fool-based models. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.
Grupo Financiero Galicia S.A. (ADR) (GGAL): Grupo Financiero Galicia S.A. (Grupo Financiero Galicia) is a financial services holding company. The Company's segments include Banking, Regional Credit Cards, CFA, Insurance and Other Grupo Galicia Businesses. Banco de Galicia y Buenos Aires S.A. (Banco Galicia) is a subsidiary of the Company. Its banking business segment represents Banco Galicia consolidated line by line with Banco Galicia Uruguay S.A. (Galicia Uruguay). It operates the regional credit cards segment through Tarjetas Regionales S.A. and its subsidiaries. Its CFA business segment extends unsecured personal loans to low and middle-income segments of the Argentine population. The Company operates the insurance segment through Sudamericana Holding S.A. and its subsidiaries. Its Other Grupo Galicia Businesses segment includes the results of Galicia Warrants S.A., Galicia Administradora de Fondos S.A. Sociedad Gerente de Fondos Comunes de Inversion and Net Investment S.A.
Grupo Financiero Galicia S.A. ($3.115 billion market cap) gets a 100% score from my James O'Shaughnessy-based model and also earns high marks from my Peter Lynch- and David Dreman-based models. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.
John B. Sanfilippo & Son, Inc. (JBSS): John B. Sanfilippo & Son, Inc. is a processor and distributor of peanuts, pecans, cashews, walnuts, almonds and other nuts. The Company offers nuts under a range of private brands and under the Fisher, Orchard Valley Harvest, Fisher Nut Exactly and Sunshine Country brand names. The Company also markets and distributes a diverse product line of food and snack products, including snack mixes, salad toppings, snacks, snack bites, trail mixes, dried fruit, and chocolate and yogurt coated products under private brands and brand names. The Company's principal products are raw and processed nuts. The Company's nut product line includes black walnuts, English walnuts, macadamia nuts, pistachios, pine nuts, Brazil nuts and filberts. The Company's products are sold through various distribution channels to buyers of nuts, including food retailers, commercial ingredient users, contract packaging customers and international customers.
John B. Sanfilippo & Son, Inc. ($508 million market cap) has a Price/Earnings/Growth Ratio of 0.46, which is considered very favorable and helps the company earn a high mark from my Peter Lynch-inspired model. My Kenneth Fisher-based model is also high on its shares. For details about its fundamentals, see the "Detailed Stock Analysis" section.
Supreme Industries, Inc. (STS): Supreme Industries, Inc. (Supreme) is a manufacturer of specialized vehicles, including truck bodies, trolleys and specialty vehicles. The Company operates through two segments, which include specialized commercial vehicles and fiberglass products. The Company manufactures specialized commercial vehicles that are attached to a truck chassis. The Company's truck bodies are offered in aluminum, FiberPanel PW, FiberPanel HC, or SignaturePlate. The Company's products include Signature van bodies, Iner-City cutaway van bodies, Spartan service bodies, Spartan cargo vans, Kold King insulated van bodies, stake bodies, armored sport utility vehicles (SUVs), armored trucks and specialty vehicles, and trolleys. Its products are attached to light-duty truck chassis and medium-duty truck chassis. Supreme integrates a range of options into its truck bodies, including liftgates, cargo-handling equipment, customized doors, special bumpers, ladder racks and refrigeration equipment.
Supreme Industries, Inc. ($273 million market cap) scores highly in my Peter Lynch-based model and also earns a high score in my Validea Momentum Investor model, which likes STS's increasing relative strength trend. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.
Trex Company, Inc. (TREX): Trex Company, Inc. is a manufacturer of wood-alternative decking and railing products. The Company markets its products under the brand name Trex. The Company offers a set of outdoor living products in the decking, railing, porch, fencing, trim, steel deck framing and outdoor lighting categories. Its decking products include Trex Transcend, Trex Enhance and Trex Select. The Company's railing products include Trex Transcend Railing, Trex Select Railing and Trex Reveal aluminum railing. It offers Trex Transcend Porch Flooring and Railing System, a porch product, and a fencing product called Trex Seclusions. The Company offers TrexTrim product, which is a cellular polyvinyl chloride residential exterior trim product. It offers a triple-coated steel deck framing system called Trex Elevations. The Company offers outdoor lighting systems, including Trex DeckLighting and Trex Landscape Lighting. It also offers Trex Hideaway, which a hidden fastening system for grooved boards.
Trex Company ($1,821 billion market cap) scores highly in my Validea Momentum Investor model as well as in my Motley Fool-based model. The Motley Fool-based model likes the company's profit margin and its relative strength reading of 90. For details about its fundamentals, see the "Detailed Stock Analysis" section.
Polaris Industries, Inc. (PII): Polaris Industries Inc. (Polaris) designs, engineers and manufactures off-road vehicles (ORV), including all-terrain vehicles (ATV) and side-by-side vehicles for recreational and utility use, snowmobiles, motorcycles and global adjacent markets vehicles, together with the related parts, garments and accessories. The Company's segments are ORV/Snowmobiles, Motorcycles and Global Adjacent Markets. These products are sold through dealers and distributors located in the United States, Canada, Western Europe, Australia and Mexico. Its ORVs include Sportsman ATVs, Polaris ACE, RANGER, RZR and Polaris GENERAL side-by-side vehicles. It produces snowmobiles, ranging from youth models to utility and economy models to performance and competition models. Its Motorcycles segment consists of Victory, Indian motorcycles and the moto-roadster, Slingshot. It offers products in the light-duty hauling, people mover and urban/suburban commuting sub-sectors of the Work and Transportation industry.
Polaris Industries Inc. (5.874 billion market cap) earns a score of 100 from my Warren Buffett-inspired investment model. The company is also favored highly by my Peter Lynch-based model. The company's EPS growth rate of 20.5% is considered very good. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Banco Macro SA (ADR) (BMA): BMA reported second quarter profit of $127 million on August 9th. The Buenos Aires, Argentina-based bank said it had earnings of $2.17 per share. The financial holding company posted revenue of $318.8 million in the period.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will take an in-depth look at my investment strategies. If you have any questions, please feel free to contact us at email@example.com.
The top scoring stocks not currently in the Hot List portfolio.
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