Just as the International Monetary Fund is urging the Federal Reserve to hold off on increasing interest rates because of a subpar US economy, America's economic data seems to be improving.
The manufacturing sector expanded in May for the 29th straight month, according to the Institute for Supply Management, for example, doing so at an accelerating pace. New orders picked up and are at a strong pace, and employment conditions improved during the month as well, according to ISM.
ISM also said the service sector expanded in May for the 64nd straight month, doing so at a slower, but still very solid, pace than it did in April. The group's new orders and employment sub-indices also weren't quite as strong as they were in April, but they were still very solid.
New claims for unemployment remain at very low levels, having stayed about flat since our last newsletter. They are almost 13% below year-ago levels. Continuing claims, the data for which lag new claims by a week, have moved slightly lower since our last newsletter and are 16% below year-ago levels.
Inflation remains tame, but there are signs that could be changing. The Consumer Price Index rose 0.1% in April, according to the Labor Department. That put it 0.2% behind its year-ago pace. But if you strip out volatile food and energy prices, so-called "core" inflation rose 0.3% in April, and is 1.8% ahead of its year-ago pace. In addition, ISM's prices indices for both the manufacturing and services sectors jumped sharply in May. They are coming off of very low levels, however, and collectively don't paint a picture of major inflation -- yet.
After being flat in March, personal income jumped 0.4% in April, according to the Commerce Department. Real disposable personal income rose 0.3%. Real personal consumption expenditures were flat for the month. More income and flat spending meant that the personal savings rate rose from 5.2% to a very solid 5.6%.
Earnings season is just about done, meanwhile, and the results have been mixed. With all but 6 of the S&P 500 companies having reported, 71% have beaten earnings estimates, according to FactSet. Top-line results have been much weaker, with 45% of firms beating sales estimates. Overall, earnings are up 0.7% for the quarter. That's the lowest since the third quarter of 2012. Energy sector declines amid the oil price plunge were the reason for the weak performance -- excluding energy companies, S&P firms' earnings are up on average by 8.5% in Q1. The results are also better than expected. In late March, analysts had expected S&P earnings to decline at a 4.7% pace in the quarter. Revenues are down 2.9% for the quarter, slightly worse than the late-March estimate of -2.6%.
Gas prices keep rebounding. As of June 2, a gallon of regular unleaded on average cost $2.75, up from $2.61 a month earlier. That's still far below the year-ago level of $3.67, however.
As for the IMF, the group urged the Fed to hold off on raising rates until next year, saying in its annual report on the U.S. economy that "the underpinnings for continued growth and job creation remain in place." But it added that America's "momentum was sapped in recent months by a series of negative shocks" that include a tough winter and an export-sapping strong dollar. It now expects the U.S. economy to grow 2.4% in 2015. That's down from the 3.1% prediction it made in April.
Since our last newsletter, the S&P 500 returned -1.6%, while the Hot List returned -3.5%. So far in 2015, the portfolio has returned 9.1% vs. 1.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 252.8% vs. the S&P's 109.5% gain.
The Rate Hikes Are Coming, The Rate Hikes Are Coming! (Some Day. Honest ... )
While the IMF wants the Federal Reserve to hold off on increasing interest rates until next year, it's still anyone's guess as to what the Fed will do. The consensus seems to be that rate hikes will begin in September, but a lot can happen between now and then. Still, given what we've seen in the economy over the past couple years, and given the language in the Fed's own statements, it seems more likely than not that rates will start to increase sooner rather than later. With that in mind, I spent a lot of time this week researching the impact of interest rates on equities -- after all, the specter of rising rates seems to be one of the main concerns among investors these days.
So, what did I find? Well, I can tell you with certainty that if rates start rising, stocks will go down. That is, unless they go up.
I don't mean to be glib. But the reality is that, while many believe that higher rates in and of themselves are negative for stocks, history has shown that what happens after rate hikes is far from certain.
For example, Robert Johnson, Gerald Jensen and Luis Garcia-Feijoo, authors of the book Invest With the Fed, looked at returns of U.S. stocks and other assets in relation to Federal Reserve rate moves going back to 1966. Earlier this year, The Wall Street Journal's Jason Zweig said that they found that "stocks typically aren't devastated when rates rise. But on average, they show, U.S. stocks barely keep pace with inflation during periods of tightening Fed policy -- and, surprisingly, Treasury bonds outperform stocks during such periods." In restrictive periods -- when the Fed was raising rates -- stocks returned just 0.8% annualized after inflation, according to the research.
That's disconcerting. But according to another researcher, Javier Estrada of the IESE Business School in Barcelona, data shows that there is no consistent historical relationship between interest rates and the stock market, MarketWatch reported in 2013. (Estrada also found that the so-called "Fed Model" -- the idea that equities should command higher P/E ratios when rates are low, and vice versa -- is likely based on coincidence. While the theory has fit in the U.S. over the past few decades, Estrada found that in the 100 years before 1980, it didn't hold up. He also found no consistent relationship between P/Es and interest rates in 19 other countries.)
Further muddying the waters, in any given period involving rising rates, stock returns have varied wildly. In a 2013 piece for Financial Advisor magazine, Rob Brown looked at S&P 500 returns during 12 month periods in economic expansions when interest rates rose the most, going back to the 1920s. As a proxy for interest rates, he used the 10-year Treasury yield. To get an idea of how different the results can be, we need look no further than the three most recent rising-rate periods on his list. In the 12-month stretch ending May 31, 2004, the S&P jumped 18.3%; in the 12 months ending October 31, 1994, the index posted much more moderate gains of 3.9%; and in the 12 months ending May 31, 1984, the results were flat-out poor, with the S&P losing 3.1%.
The lack of consistency in how stocks behave when rates rise is partly because not every rate hike is the same. Investors will certainly view a 1% rate increase differently if the starting point for the increase is 1.5% as opposed to 6%, for example. Then there is the fact that it is extremely hard to isolate the impact of rate increases. Increasing rates may be a drag on stock returns, but if the reason rates are being increased is that the economy is strengthening, investors may see that as a net positive. And that's an incredibly simplistic example. So many factors influence stocks on a day to day and week to week basis that it's nearly impossible to look at stock market performance after a rate increase and say with certainty that the performance is directly attributable first and foremost to the rate changes.
That being said, with regard to today's environment, when rates do rise, they will be rising from historically low levels. That's significant, according to Doug Ramsey of the Leuthold Group. He has studied stock valuations and bond yield data going back to 1878, according to The New York Times, and he's found that while bond yields do impact equity valuations, stocks don't seem to run into big trouble until 10-year Treasury yields hit 6%. At those levels, Ramsey said, bonds "are truly thought of as potential replacements or substitutes for long-term stock returns." Currently, we're nowhere near 6% Treasury yields -- the 10-year is yielding 2.31% (as of June 4).
Ramsey's research intrigued me because it echoed that of Martin Zweig, one of the gurus of whom I base my investment models. In addition to his fundamental stockpicking criteria, Zweig also did extensive research on how interest rate changes impact stocks. Generally, he found that rising rates were a bearish signal, and falling rates were a bullish signal. But when it came to the indicator that he based on the prime rate (the rate banks charge their best clients), Zweig made a distinction: In general, rate increases that occurred when the prime rate was already above 8% were considered more bearish than when the prime rate was below 8%. (Currently, the prime rate is just 3.25%.)
It makes sense that rate hikes have a more negative impact when rates are already high, as Zweig and Ramsey suggest. If Treasurys are yielding, say, 2.5%, and over the course of a year they go up a full percentage point, the new 3.5% yield still doesn't offer stocks much competition. For Corporate America, meanwhile, interest rates are the cost of capital. While corporations would certainly want those costs to be as low as possible, it stands to reason that their businesses would not be devastated by rates rising slightly off of very low levels.
Is that the key, then? Are rate hikes bad for stocks when rates are already high, and not that bad when the starting point is low? For a moment I thought that might really be the key, especially when you consider those three periods I mentioned above from Rob Brown's piece. In that 12-month stretch ending May 31, 2004, when the S&P jumped 18.3% as rates were rising, the starting point was low -- the 10-year Treasury yield was in the 4% range. In the 12 months ending October 31, 1994, when the index posted ho-hum gains of 3.9%, the 10-year Treasury started out in the moderate 6% range; and in the 12 months ending May 31, 1984, when the stock returns were flat-out poor (-3.1%), the rate increases occurred at a time when the 10-year was already yielding double-digits. The theory fits!
Not so fast. If you dig deeper, you'll find plenty of exceptions. In the 12 months ending Jan. 31, 1980, for example, stocks rose more than 20%, even though rates were rising off a double-digit starting point. In the 12 months ending July 31, 1957, meanwhile, stocks returned less than 1% amid rate hikes that brought the effective Federal Funds rate to a still-low 3.25%. And those aren't the only exceptions. So much for the rising-rate silver bullet.
A Bullish Takeaway?
When I started writing this I had hoped to reach some sort of definitive (or close to definitive) conclusion about what interest rate hikes would mean in the current environment. But after looking at a good deal of data, all that seems clear to me is that there is no clarity. (In fact, I haven't even touched on another factor that makes the looming rate hikes hard to figure. That is the fact that rates are usually increased as a way to cool off an overheating economy, but in the current situation, the increases would simply be a normalizing process following a financial crisis.) All of that reinforces my belief that investing systematically and not letting macroeconomic factors sway you is the best way to go. Think about it: Even if there were a clear answer as to how interest rate hikes impact equities, it wouldn't really do us any good as investors. That's because there are so many other factors at work in the market. Interest rates could be giving a clear, unequivocal bullish or bearish signal, and that signal would be one of dozens, perhaps hundreds directing stocks.
So many pundits and strategists seem to talk about interest rate hikes with both fearfulness and certainty that after examining the issue I was a bit taken aback at how inconclusive the data actually is. But the more I think about it, the more I think that's a good thing. The more people talk about how rate increases are going to derail the bull market, the more stable becomes the "Wall of Worry" that keeps equity prices from getting too bloated, which is good for bull markets. I'm not saying the rate-increase fears are "false fears", as Kenneth Fisher would say; when the Fed finally does start increasing rates, it may turn out to be a negative. But history shows that it's far from a slam-dunk case -- and there's certainly not enough evidence for us to alter our long-term approach. We'll stay disciplined, focus on undervalued stocks of solid companies, and leave the rate-hike guessing-game to others.
|Editor-in-Chief: John Reese
As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include:
Lannett Company, Inc. (LCI), Eplus Inc. (PLUS), World Acceptance Corp. (WRLD)
Credit Acceptance Corp. (CACC).
6 stocks remain in the portfolio. They are:
Sanderson Farms, Inc. (SAFM), Jones Lang Lasalle Inc (JLL), Universal Insurance Holdings, Inc. (UVE), Chart Industries, Inc. (GTLS), Amtrust Financial Services Inc (AFSI)
Trueblue Inc (TBI).
We are adding 4 stocks to the portfolio. These include:
Sasol Limited (Adr) (SSL), Silicon Motion Technology Corp. (Adr) (SIMO), Lumber Liquidators Holdings Inc (LL)
Heritage Insurance Holdings Inc (HRTG).
Newcomers to the Validea Hot List
Silicon Motion Technology Corporation (SIMO): Silicon Motion is a fabless semiconductor company that makes high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. Its products include mobile storage, mobile communications, multimedia systems-on-a-chip (SoCs) and other products.
Silicon Motion ($1.2 billion market cap) gets strong interest from my Peter Lynch-based model and high marks from several other strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section.
Sasol Limited (SSL): This South Africa-based firm ($23 billion market cap) is an international integrated energy and chemicals company which has more than 33,000 people working in 37 countries. It develops and commercializes technologies, and builds and operates world-scale facilities to produce a range of product streams, including liquid fuels, high-value chemicals and low-carbon electricity.
Sasol, a former Hot List member, was hit hard by the oil price declines in 2014 and earlier this year, but its strong fundamentals earn it strong interest from my Peter Lynch- and Benjamin Graham-based models. For more on the stock, see the "Detailed Stock Analysis" section below.
Heritage Insurance Holdings, Inc. (HRTG): This property and casualty insurance holding company provides personal residential insurance for single-family homeowners and condominium owners in Florida. Its subsidiary, Heritage Property & Casualty Insurance Company, writes approximately $500 million of personal and commercial residential premium through a large network of agents.
Heritage ($650 million market cap) gets strong interest from my Motley Fool- and Peter Lynch-based models. For more on the stock, see the "Detailed Stock Analysis" section below.
Lumber Liquidators Holdings (LL): It's been a horrible stretch for this Virginia-based hardwood flooring retailer, whose CEO and CFO of both resigned in the wake of allegations that the firm used wood products that had excessive levels of potentially dangerous chemicals in them. Investors have fled the stock in droves. But my models think that investors have done what they often do when scandal or bad news hits: overreact. My Warren Buffett- and Peter Lynch-based models think the stock has sunk to levels that now make it attractive.
Stocks like Lumber Liquidators create a real challenge for quantitative investors. With these sort of greatly maligned firms, just about any investor's first instinct is going to be to avoid the stock like the plague. But history has shown that sticking to the cold, hard numbers and not reacting to headlines and hype is the way to win over the long haul. Vetoing fear-inducing picks that a good strategy recommends is a slippery slope and can often lead to trouble. That is why we are sticking with our approach and adding Lumber Liquidators to the portfolio today.
News about Validea Hot List Stocks
Chart Industries (GTLS): Chart announced that it has entered into a definitive agreement to acquire vaporizer manufacturer Thermax, Inc. in a deal whose terms were not disclosed. Thermax, which will be operated as part of Chart's Distribution & Storage business segment, has annual revenue of approximately $25 million. The firm is a leading provider of cryogenic fluid vaporizers utilized in industrial gas, petro-chemical, and liquefied natural gas applications. Chart expects the acquisition to be accretive to future earnings within the first twelve months.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at my strategies and investment approach. If you have any questions, please feel free to contact us at email@example.com.