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Weekly issue: Downside Protection Critical Amid These Uncertain Conditions

Weekly issue: Downside Protection Critical Amid These Uncertain Conditions

Key points inside this issue

  • Ahead of the Fed’s latest dot blot, 2019 GDP expectations move lower.
  • With uncertainties again on the rise, we reiterate our Buy rating on the ProShares Short S&P 500 ETF (SH) ahead of the upcoming March quarter earnings season.

 

Weakening GDP Expectations for the Remainder of 2019

Looking back over the last few weekly issues, it would be fair to say they were a little wordy. What can I say, between the economic data and earnings season, plus thematic data points, there was a lot to share over the last few weeks. Today, however, I’m going to cut to the point with my comments, largely because all investor eyes and ears are waiting to see and hear what Fed Chair Jerome Powell has to say about the speed of the US economy as they look for signs over what is coming next out of the Fed.

We’ve talked quite a bit about the slowing speed of the global economy, and even though there have been some individual bright spots across the aggregated hard and soft economic data from both government and third-party sources, the slowing speed is hard to ignore. Based on the published data, domestic GDP hit 3.1% last year, and as we’ve shared recently we’ve started to see the expectations for 2019 move lower in recent weeks. Per the March CNBC Fed Survey of 43 economists and Fed watcher findings, GDP for 2019 is now expected to clock in around 2.3% — not quite cut in half compared to 2018, but dramatically lower and significantly lower than folks were looking for in the back half of 2018.

When the Fed issues its post FOMC meeting statement today, the focus will more than likely not be on the interest rate decision – almost no one expects a hike. Instead, rapt attention will be paid to the Fed’s updated economic dot plot, which will reveal how it sees the US economy shaping up. Let’s remember that one unofficial aspect of the Fed’s job is to be a cheerleader for the economy, so it becomes a question of “if they are cutting their GDP forecast” how deep of a cut could we really see?

Culprits of the slowing economy and these cuts include aspects of our Middle-Class Squeeze investing theme as consumers in the US grapple with debt levels that have risen precipitously over the last several years. The consumer spending tailwind associated with our Living the Life investing theme appears to be slowing some given the rising debt levels of Chinese consumers. Governments have also run up debt in recent years as the current business cycle has grown longer in the tooth. And of course, there is the impact of currency as well as political and trade uncertainties, including the pushout of US-China trade talks to June.

 

Downside Protection is Key Under These Circumstances

In a little over 10 days, we will be exiting March, entering the second quarter and beginning the earnings season dance all over again. My concern is that given the above and the several unknowns therein, we are poised to see another earnings season during which aggregate expectations will be adjusted lower. Case in point, with the  US-China trade agreement timetable slipping and slipping, it becomes rather difficult for a company to factor any resolution into its guidance, especially when the terms of the agreement are unknown.

Despite all of the above, the domestic stock market has continued to chug higher, once again approaching overbought levels, even though 2019 EPS cuts for the S&P 500 have made the market even more expensive than it was as we exited 2018.

The potential poster child for this is FedEx (FDX), which saw its shares take a fall last night after the company cut its annual profit forecast for the second time in three months due to slowing global growth, rising costs from a 2016 acquisition in Europe and questions over its ability to withstand U.S.-China trade tensions and uncertainty over the U.K.’s exit from the European Union.

Not to go all Groundhog Day on you, but this looks increasingly like the situation we saw in December when I added the ProShares Short S&P 500 ETF (SH) to the Select List. If we didn’t have those shares to offer some downside protection for what lies ahead, I would be adding them today. If you don’t have any of those shares in your holdings, my advice would be to add some. Much like insurance, you may not know exactly when you’ll need it, but you’ll be happy to have it when something goes bad.

  • With uncertainties again on the rise, we reiterate our Buy rating on the ProShares Short S&P 500 ETF (SH) ahead of the upcoming March quarter earnings season.

 

 

Apple’s negative pre-announcement serves as a reminder to the number of risks that have accumulated

Apple’s negative pre-announcement serves as a reminder to the number of risks that have accumulated

 

We are “breaking in” to share my thoughts with you on the implications of Apple’s (AAPL) downside December quarter earnings news last night. Quickly this is exactly of what I was concerned about in early December, but rather than take a victory lap, let’s discuss what it means and what we’re going to do. 

Last night we received a negative December quarter earnings preannouncement from Apple (AAPL), which is weighing on both AAPL shares as well as the overall market. It serves as a reminder to the number of risks that have accumulated during the December quarter – the slowing global economy, including here at home; the US-China trade war; Brexit and other geopolitical uncertainty in the eurozone; the strong dollar; shrinking liquidity and a Fed that looks to remain on its rate hike path while also unwinding its balance sheet. Lenore Hawkins and I talked about these at length on the Dec. 21 podcast, which you can listen to here.

In short, a growing list of worries that are fueling uncertainty in the market and in corporate boardrooms. When the outlook is less than clear, companies tend to issue conservative guidance which may conflict with Wall Street consensus expectations. In the past when that has happened, it’s led to a re-think in growth prospects for both the economy, corporate profits and earnings, the mother’s milk for stock prices.

These factors and what they are likely to mean when companies begin issuing their December quarter results and 2019 outlooks in the coming weeks, were one of the primary reasons we added the ProShares Short S&P 500 (SH) shares to our holdings in just under a month ago. While the market fell considerably during December, our SH shares rose 5% offering some respite from the market pain. As expectations get reset, and odds are they will, we will continue to focus on the thematic tailwinds and thematic signals that have been and will remain our North Star for the Thematic Leaders and the larger Select List.

 

What did Apple have to say?

In a letter to shareholders last night, Apple CEO Tim Cook shared that revenue for the quarter would come in near $84 billion for the quarter vs. the consensus estimate of $91.5 billion and $88.3 billion, primarily due to weaker than expected iPhone sales. In the letter, which can be read here, while Apple cited several known headwinds for the quarter that it baked into its forecast such as iPhone launch timing, the dollar, supply constraints, and growing global economic weakness, it fingered stronger than expected declines in the emerging markets and China in particular.

Per the letter, most of the “revenue shortfall to our guidance, and over 100 percent of our year-over-year worldwide revenue decline occurred in Greater China across iPhone, Mac, and iPad.”

Cook went on to acknowledge the slowing China economy, which we saw evidence of in yesterday’s December Markit data for China. Per that report,

“The Caixin China General Manufacturing PMI dipped to 49.7 in December, the first time since May 2017 that the reading has been below 50, the mark that separates expansion from contraction. The sub-index for new orders slid below the breakeven point of 50 for the first time since June 2016, reflecting decreasing demand in the manufacturing sector.”

In our view here at Tematica, that fall in orders likely means China’s economy will be starting off 2019 in contraction mode. This will weigh on corporate management teams as they formulate their formal guidance to be issued during the soon to be upon us December quarter earnings season.

Also, in his letter, Cook called out the “rising trade tensions with the United States”  and the impact on iPhone demand in particular.

In typical Apple fashion, it discussed the long-term opportunities, including those in China, and other positives, citing that Services, Mac, iPad, Wearables/Home/Accessories) combined to grow almost 19% year-over-year during the quarter with records being set in a number of other countries. While this along with the $130 billion in cash that Apple has on its balance sheet exiting the December quarter, bode well for the long-term as well as its burgeoning efforts in healthcare and streaming entertainment, Apple shares came under pressure last night and today.

 

Odds are there will more negative earnings report to come

In light of the widespread holding of Apple shares across investor portfolios, both institutional and individual, as well as its percentage in the major market indices, we’re in for some renewed market pressure. There is also the reality that Apple’s decision to call out the impact of U.S.-China trade will create a major ripple effect that will lead to investors’ renewed focus on the potential trade-related downside to many companies and on the negative effect of China’s slowing economy.

In recent months we’ve heard other companies ranging from General Motors (GM) to FedEx (FDX) express concerns over the trade impact, but Apple’s clearly calling out its impact will have reverberations on companies that serve markets tied to both the smartphone and China-related demand. Overnight we saw key smartphone suppliers ranging from Skyworks Solutions (SWKS) and Qorvo (QRVO) come under pressure, and the same can be said for luxury goods companies as well. We’d note that Skyworks and Qorvo are key customers for Select List resident AXT Inc (AXTI, which means if we follow the Apple revenue cut through the supply chain, it will land on AXT and its substrate business.

All of the issues discussed above more than likely mean Apple will not be the only company to issues conservative guidance. Buckle up, it’s going to be a volatile few weeks ahead.

 

Positives to watch for in the coming weeks and months

While the near-term earnings season will likely mean additional pain, there are drivers that could lift shares higher from current levels in the coming months. These include a trade deal with China that has boasts a headline win for the US, but more importantly contains positive progress on key issues such as R&D technology theft, cybercrimes and the like – in other words, some of the meaty issues. There is also the Federal Reserve and expected monetary policy path that currently calls for two rate hikes this year. If the Fed is data dependent, then it likely knows of the negative wealth effect to be had following the drop in the stock market over the last few months.

Per Moody’s economist Mark Zandi, if stocks remained where there were as of last night’s close, it would equate to a $6 trillion drop in household wealth over the last 12-15 months. Per Zani, that would trim roughly 0.5% to 2019 GDP – again if the stock market stayed at last night’s close for the coming weeks and months. As we’re seeing today, and given my comments about the upcoming earnings season, odds are that 2019 GDP cut will be somewhat larger. That would likely be an impetus for the Fed to “slow its roll” on interest rates or at least offer dovish comments when discussing the economy.

Complicating matters is the current government shutdown, which has both the Census Bureau and Bureau of Economic Analysis closed. Even though there will be some data to be had, such as tomorrow’s December 2018 Employment Report from the Labor Department, it means the usual steady flow of economic data will not be had until the government re-opens. No data makes it rather difficult to judge the speed of the economy from all of us, including the Fed.

Given all of the above, we’ll continue to keep our more defensive positions companies like McCormick & Co. (MKC), Costco Wholesale (COST), and the ProShares Short S&P 500 shares intact. We’ll continue to watch input costs and what they mean for corporate profits at the margin – case in point is Del Frisco’s (DFRG), which is benefitting from not only falling protein costs but has been approached by an activist investor that could put the company in play. With Apple, Dycom Industries (DY), and AXT, we will see 5G networks lit this year here in the US, which will soon be followed by other such networks across the globe in the coming years. Samsung, Lenovo/Motorola and others have announced 5G smartphones will be shipping by mid-2019, and we expect Apple to once again ride that tipping point in 2020. That along with its growing Services business and other efforts to increase the stickiness of iPhone (medical, health, streaming, payments services), keeps us long-term bulls on AAPL shares.

When not if but when, the stock market finds its footing, which likely won’t be until after the December quarter earnings season at the soonest, we will look to strategically scale into a number of positions for the Thematic Leaders and the Select List.

 

Weekly Issue: Investor anxiety continues

Weekly Issue: Investor anxiety continues

Key points inside this issue

  • As the investors grapple with anxiety over trade as well as the speed of economic and earnings growth, we’ll continue to hold ProShares Short S&P 500 (SH) shares.
  • Our price target on the shares of Guilty Pleasure Thematic Leader Del Frisco’s Restaurant Group (DFRG) remains $14.
  • Our price target on Middle-Class Squeeze Thematic Leader Costco Wholesale (COST) shares remains $250.
  • Our price target on Amazon (AMZN) shares remains $2,250

 

The stock market experienced another painful set of days in last week as it digested the latest set of economic data, and what it all means for the speed of the domestic and global economy. Investors also grappled with determining where the U.S. is with regard to the China trade war as well as the prospects for a deal by the end of March that would prevent the next round of tariffs on China from escalating.

There remain a number of unresolved issues between the U.S. and China, some of which have been long-standing in nature, which suggests a fix in the next 100+ days is somewhat questionable. This combination induced a fresh round of anxiety in the market, leading it to ultimately finish the week lower as the major indices sagged further quarter to date. In turn, that pushed all the major market indices into the red as of Friday’s close, most notably the small-cap heavy Russell 2000, which finished Friday down 5.7% year to date. For those keeping score, that equates to the Russell 2000 falling just under 15% quarter to date.

Last week we added downside protection to our holdings in the form of ProShares Short S&P 500 (SH) shares, and we’ll continue to hold them until signs of more stable footing for the overall market emerge. As we do this, I’ll continue to evaluate not only the thematic signals that are in and around us day-in, day-out, but also examine the potential opportunities on a risk to reward basis the market pain is creating.

 

Shares of Del Frisco’s get some activist attention

Late last week, our shares of Guilty Pleasure Thematic Leader Del Frisco’s Restaurant Group (DFRG) bucked the overall move lower in the domestic stock market following the revelation that activist hedge fund Engaged Capital has acquired a nearly 10% in the company with a plan to push the company to sell itself according to The Wall Street Journal. Given the sharp drop in DFRG shares thus far in 2018, down 52%, it’s not surprising to see this happen, and when we added the shares to our holdings, we shared the view that at some point it could be a takeout candidate as the restaurant industry continues to consolidate. In particular, Del Frisco’s presence in the higher end dining category and its efforts over the last few months to become a more focused company help explain the interest by Engaged.

In response, Del Frisco’s issued the following statement:

“Del Frisco’s is committed to maximizing long-term value for all shareholders. While we do not agree with certain characterizations of events or of our business and operations contained in the letter that we received from Engaged Capital, the Company values constructive input toward the goal of enhancing shareholder value. “

Compared to other Board responses this one is rather tame and suggests Del Frisco’s will indeed have a dialog with Engaged. Given the year to date performance in DFRG shares, odds are there are several on the Board that are frustrated either with the rate of change in the business or how that change is being viewed in the marketplace.

In terms of who might be interested in Del Frisco’s, we’ve seen a number of going private transactions in recent years led by private equity investors that re-tool a company’s strategy and execution or combine it with other entities. We’ve also seen several restaurant M&A transactions as well. Let’s remember too how on Del Frisco’s September quarter earnings conference call, the management team went out of its way to explain how the business performed during the last recession. That better than industry performance may add to the desirability of Del Frisco’s inside a platform, multi-branded restaurant company.

As much as we may agree with the logic behind Del Frisco’s being taken out, we’d remind subscribers that buying a company on takeout speculation can be dicey. In the case of Del Frisco’s, we continue to see a solid fundamental story. We are seeing deflation in food prices that bode well for Del Frisco’s margins and bottom line EPS. Over the last quarter we’ve seen prices in the protein complex – beef, pork, and chicken – move lower across the board. According to the United Nation’s Food and Agriculture Organisation’s (FAO) food price index, world food prices declined during the month of November to their lowest level in more than two years. We’re also seeing favorable restaurant spending per recent monthly Retail Sales reports, which should only improve amid year-end holiday dinners eaten by corporate diners and individuals.

We’ll continue to hold DFRG for the fundamentals, but we won’t fight any smart, strategic transaction that may emerge.

  • Our price target on the shares of Del Frisco’s Restaurant Group (DFRG) remains $14.

 

What to watch in the week ahead

As we move into the second week of the last month of the quarter, I’ll continue to examine the oncoming data to determine the vector and velocity of the domestic as well as global economy. Following Friday’s November Employment Report that saw weaker than expected job creation for the month, but year over year wage gains of 3.1% the Atlanta Fed continued to reduce its GDP forecast for the current quarter. That forecast now sits at 2.4%, down from 3.0% at the end of October.

With the sharp drove in oil prices has consumers feeling a little holiday cheer at the gas pump, odds are next week’s November inflation reports will be tame. The fact that world food prices per the Food and Agriculture Organization’s (FAO) food price index hit the lowest level since May 2016 also bodes well for a benign set of inflation data this week. Later in the week, we’ll get the November Retail Sales report, which should be very confirming for our holiday facing positions – Amazon (AMZN), United Parcel Service (UPS), McCormick & Co. (MKC) and Costco Wholesale (COST) – that given the kickoff of “seasons eatings” with Thanksgiving and the start of the holiday shopping season that clearly shifted to digital shopping.

That report will once again provide context for this shift as well as more than likely confirm yet again that Costco Wholesale (COST) continues to take consumer wallet share. Speaking of Costco, the company will report its quarterly results this  Thursday. Quarter to date, the company’s monthly same store sales reports are firm evidence it is winning consumer wallet share, and we expect it did so again in November, especially with its growing fresh foods business that keeps luring club members back. Aside from its top and bottom line results, I’ll be focused once again on its pace of new warehouse openings, a harbinger of the crucial membership fee income to be had in coming quarters.

  • Our price target on Middle-Class Squeeze Thematic Leader Costco Wholesale (COST) shares remains $250.

We’ll end the economic data stream this week with the November Industrial Production report. Given the sharp fall in heavy truck orders in November, I’ll be digging into this report with a particular eye for what it says about the domestic manufacturing economy.

As discussed above, this week Costco will report its results and joining it in that activity will be several other retailers such as Ascena Retail (ASNA), DWS (DWS), American Eagle (AEO) and Vera Bradley (VRA). Inside their comments and guidance, which will include the holiday shopping season, I’ll be assessing the degree to which they are embracing our Digital Lifestyle investing theme. We’ll also see Adobe Systems (ADBE) report its quarterly result and I’ll be digesting what it has to say about cloud adoption, pricing and prospects for 2019. As we know, that is a core driver of Amazon Web Services, one of the key profit and cash flow drivers at Amazon (AMZN).

  • Our price target on Amazon (AMZN) shares remains $2,250