Trading / market update Tuesday, August 7, 2012

Sometimes, it is hard to come up with something intelligent to say regarding the market, which is how we felt Sunday night while writing the weekly earnings report, and is the primary reason we left the headline empty.

We continue to think earnings are in the process of bottoming, and will trough in the 3rd calendar quarter of 2012, but we don’t start seeing that earnings data until October 10th or so.

Although we may have no way of taking an intelligent poll of the entire market, my guess is this latest rally has caught a lot of folks off guard, if not outright short, given that we have decoupled from last year’s pattern as of the Friday before the July payroll report and continue to deviate from 2011. That being said, I do think the market is overbought here, and could use a retracement of 5%. However, we are now “comping” against the weakest part of the stock market decline from 2011, which was the USA watchlisting of the AAA credit rating and the Euro mess.

As always, our first look after futures each day and at the market open is how Treasuries are acting, particularly the 10-year Treasury and how the high-yield ETF’s are faring, and thus far the 10-year Treasury yield continues to trek higher after its “outside reversal” week prior to the July payroll report, and the two high yield ETF’s – HYG and JNK – continue to be well bid, but not yet at multi-year highs.

This is what we like to see: US rates rising (faster economic growth) and European sovereign debt rates falling (more confidence in the euro and European banking system).

Moody’s concluded this week in their North American edition of Leveraged Finance that “fundamental credit conditions for Leveraged Finance remain attractive in North America”. Furthermore, low readings on Liquidity and Covenant Stress indices support a benign default rate forecast, per Moody’s.

“Everybody” knows credit is a good place to be today, given global central bank liquidity, not to mention the downside protection credit affords sharply rising rates (i.e. duration risk). Corporate bond fund inflows still exceeding (by far) corporate stock funds. That cant be good. So many retail investors and 401(k) investors are going to be caught off guard when rate do rise – this will be far, far worse than 1994 (for those who remember that experience.)

The high tick for the HYG was $92.85 in the Spring, 2011. The high tick for JNK was $41.32 in Nov, 2010.

So far, despite the high yield or junk bond strength, we havent taken out those multi-year highs.

So why the strong stock market rally ? Well maybe it was thanks to Bill Gross and his “death of equities” call last week, or Harry Dent coming on CNBC yesterday, predicting Dow 3000 (yes as in 10,000 Dow points lower). Bill Gross has made more money in a month than I probably have in my entire career, but I dont understand his equity call. I thought the last paragraph where he said that equities do not perform well in periods of inflation, kind of tipped his hand in terms of the column. We have had 12 years of deflation, and at this point I would think the Fed wants some inflation, and stocks will perform better under an inflationary environment, than a deflationary environment. It is hard to say why he timed his call as he did. It will be interesting what the next few years holds for stock returns.

Listening to the debate over the future and relevance of Microsoft, Hewlett-Packard and Dell today on CNBC, left me reminiscent of what it must have been like to be Apple in the late 1990’s. No one cared about the stock or the company back in the late 1990’s as Steve Jobs was re-engineering one of the greatest turn-around efforts in the history of business (or maybe since IBM).  Microsoft, Intel, Dell and Hewlett-Packard are all value stocks today, dirt cheap on a valuation basis, great dividend yields, unloved, and unwanted. Will they survive ? Sure, Intel and Microsoft will, at least for now. Most people don’t realize that the growth in PC’s correlated with job growth in the 1980’s and 1990’s very closely. Can Apple take over the “enterprise” as Wintel did in the 1990’s ? It is why I think the Microsoft tablet might have a future. (Long Intel, Microsoft, Apple.)

Our big(ger) buy last week was Starbucks (SBUX) which we bought for a bunch of accounts. The stock has declined about 20% – 25% since its $62 high in late April, 2012. There should be very good technical support in the $42 – $43 area for the stock. Whole Foods (WFM) had a monster quarter – the big difference we see between the two great brands is that WFM is primarily USA-based, while SBUX is international. Still SBUX’s China comp’s were still pretty strong, better than we thought they’d be. SBUX should bottom in here shortly, but give it some time. We’ll likely see a rally then another pullback. Expected earnings growth for SBUX is still pretty decent. We’ll have a longer article on the topic shortly. (Long SBUX, WFM)

We continue to think telecom and utilities are a crowded trade, for reasons we detailed in the August 5th corporate earnings update. Very little organic growth, and whole slew of retail investors chasing dividends. Not sure when it ends, but it wont end well. (Sold VZ in March ’12 at $38 – not too bright, but I’d do it again.)

Thanks for checking in.

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager

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