Sorting Through the News: What's Next?

Judy Garland and Frank Morgan in The Wizard of Oz

Last week, Federal Reserve Chairman Ben Bernanke made some comments that the market interpreted to mean that no additional monetary stimulus would be imminent (that is, no further Quantitative Easing in the form of "QE3"). The market apparently didn't like this, just as a crack cocaine addict wouldn't like news that his supply has been cut off. The silver lining here, which the market initially overlooked, is that the Fed may view the economy now as being able to function without training wheels: to say that monetary stimulus is not needed is to affirm some strength in the economy. Then, when the equity markets were closed for Good Friday, the employment numbers were released (as they always are on the first Friday of the month), but the growth in jobs was well below what the market expected. The down-tick in the unemployment rate was attributed to people just dropping out of the labor force by ending their job searches (if you have ceased looking for work, you are no longer counted as unemployed). When the equity markets got around to opening on Monday morning, investors were treated to another sell-off, this one focused on worries about economic weakness. When markets respond the same way to contradictory pieces of news, there's a good chance that some other influences are at work. In this case I think the market was just looking for an excuse to correct after a stunning first quarter.

As has been the tradition for many years, earnings reporting season kicked off officially this week with the report after-hours Tuesday from Alcoa (AA, $10). AA surprised Wall Street by posting a quarterly profit instead of the expected loss, with revenues also coming in ahead of forecasts. While I do not follow AA as a prospective investment, I do pay close attention to what they have to say each quarter, because their comments offer valuable insight about the overall economy. The company noted strength in two of its end markets, automotive and aerospace, while acknowledging continuing weakness in construction. Overall the company's report was not only encouraging for AA itself, but also served to assuage some fears about the state of the economy. The stock market reacted favorably to the news when trading opened on Wednesday, and the release of the Fed's Beige Book that afternoon seemed to confirm an economy that was continuing to grow, albeit at a pace that was "modest and moderate" instead of robust. Then, on Thursday morning we learned that initial unemployment claims had increased to 380,000 versus the decline to 355,000 that economists had expected.

What do we get when we put all of this together? I certainly hope I am wrong about this, but the economy seems to be following the playbook of our "Tale of Two Cities" investment thesis. Economists are saying that growth is not strong enough to bring the unemployment rate down meaningfully, and I think that is true to some extent. However, that assessment focuses on the traditional cyclical factors that we associate with an economic recovery, while the challenge for job growth involves structural considerations as well. We'll take a more in-depth look at this issue in upcoming posts, but for more insight on the topic I suggest this article from The Wall Street Journal: http://online.wsj.com/article/SB10001424052702304587704577335944226268750.html
I think that even if the pace of economic growth picked up to something closer to 4%, we would still be disappointed with an unemployment rate that stubbornly refuses to return to the 5% range, the level 
we have seen in past recoveries. Some sectors in the economy will thrive, but we're not seeing the wage growth that leads to broad-based prosperity.

The reality is that stocks can do quite well in this environment. Companies cut costs dramatically and became more efficient during the recession, so as business picks up we are seeing top-line revenue gains translating into bottom-line profitability gains. As earnings reporting season unfolds, we'll want to keep a close eye on whether earnings are attributable to strong sales growth or just to improving margins. Companies cannot cost-cut their way to sustainable prosperity, so the true growth stocks are going to be the ones that can both grow revenues and take those gains to the bottom line. We can expect the field of companies reporting truly outstanding results to narrow as year-over-year quarterly comparisons get tougher. That is actually not bad news, because it means that we are in a true stock-picking environment, and I expect the stocks we're monitoring on our Radar Screen to be among the cream of the crop.

 Monitoring the Radar Screen

For more on our concerns about the bond market, please check out this article from The Wall Street Journal:
http://online.wsj.com/article/SB10001424052702304450004577279754275393064.html

Chipotle Mexican Grill (CMG, $433): Argus Research raised their price target to $480 from $420, citing strong same store sales growth and unit growth, plus moderating food costs. Argus also raised their price target on Yum! Brands (YUM, $70) to $79 from $74. Bernstein raised their price targets on the following: CMG to $500 from $475; YUM to $85 from $78; Starbucks (SBUX, $60) to $72 from $63.

Lululemon Athletica (LULU, $73) was added to the Most Preferred List at UBS.

Intuitive Surgical (ISRG, $553) was lowered to neutral from buy at Lazard based on valuation, but ThinkEquity raised their price target to $620 from $550.

QUALCOMM (QCOM, $68): Credit Suisse raised their price target to $80 from $70; Oppenheimer raised their price target to $75 from $70, citing accelerating LTE adoption.

 Apple (AAPL, $623): Credit Suisse upped their target price to $750 from $700.

We'll see a flood of earnings announcements over the next several weeks, so stay tuned!

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of CMG, YUM, SBUX, LULU, ISRG, QCOM, and AAPL. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.