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The Trader: Earning Season Over, Stocks Quietly Subside -- Barron's

19 May 2018 10:00 am
By Vito J. Racanelli 

If you didn't watch closely, you might have missed the stock market's downdraft last week. It was that quiet. Shares pulled back about 0.5% in slow, summer-level trading levels.

Admittedly, there was a dearth of market-moving economic data releases. But not even an uptick in political rhetoric from North Korea was enough to push the market out of tight daily trading ranges. A rise in 10-year Treasury yields to as high as 3.12%, at one point from below 3% last week, was the main bearish impetus for equity traders. The yield settled at 3.07%.

The Dow Jones Industrial Average dropped 116 points, or 0.5%, to 24,715.09. The Standard & Poor's 500 index also lost 0.5%, or 15 points, to 2712.97. The index kept to a 10- to 20-point daily trading range, much tighter than in prior weeks. The Nasdaq Composite gave up 0.7% to finish at 7354.34.

With the first-quarter earnings cycle out of the way, there isn't much new for equity investors to focus on beside yields, says John Leo Manley, a Wells Fargo investment strategist. This Wednesday sees the release of minutes from the last Federal Open Market Committee meeting. The market, he says, is looking for another rate hike in June.

A generally bullish Jeremy Klein, chief market strategist at FBN Securities, adds that as long as rates "move up in an orderly way, not in a sprint," the strong equity-market fundamentals will allow stocks to move higher.

Despite increasing concerns about interest rates, small- capitalization stocks, as measured by the Russell 2000 index, hit a record last week, at 1626.63. Some bulls take that to be a harbinger of better things to come from large-caps. Maybe it is, and maybe it isn't. We'll get to that in a moment.

Energy stocks, up 1.5% last week, continued to rally on stronger oil prices. Meanwhile, consumer staples remain, among strategists, the most hated group in the universe. Valuations remain high and earnings growth low. Staples is one of just two sectors where estimates are dropping for both 2018 and 2019 earnings growth, the other being telecoms. As bond proxies, both are suffering as interest rates go up. Staples are down 14% in 2018, telecoms are off 13%.

Bulls claim that last week's rise in small caps will herald a rise in the rest of the market. It's a sign of "risk on" for the whole stock market. But that isn't supported by the technical data, says Doug Ramsey, chief investment officer of the Leuthold Group, who measures the relative strength of the Russell 2000 index compared to the S&P 500. Since 1979, when this ratio is above its 40-week moving average, as it is now, the S&P 500's return is an annualized 4.2%. That's one-third of the 12.9% return when the ratio is below the moving average.

Moreover, as recoveries go, this one since the Feb. 8, 2018 low is getting long in the tooth. As of Friday, says Ramsey, "we are 69 trading days from the low" without recovering to a new high. For stock market drops of 7% to 12% since 1950 -- the 2018 correction was 10% -- the median time to recover is 33 days.

What's taking so long? Fundamentals are strong, right? Our guess is that a good portion of those improvements -- such as supercharged earnings growth -- was anticipated and baked into to the high reached Jan. 26. Maybe the market wants something else.

Fixing Up Lowe's

Lowe's (ticker: LOW) got hammered following its fourth-quarter earnings report. Will its first-quarter release, due on Wednesday, bring more of the same?

Let's hope not. When Lowe's reported fourth-quarter results on Feb. 28, its shares fell 6.5%, as its earnings missed forecasts, and guidance fell short of expectations -- Lowe's largest one-day decline since 2012.

Investors might be in a more comfortable position this time around. With shares of Lowe's off 7.1% this year, expectations low, and big changes on the way, the stock probably has limited downside in case of a miss -- and major upside if it delivers the goods.

Let's be honest: There's a decent chance that won't happen. For evidence, look no further than, Home Depot (HD), which released its own results on Tuesday. Lowe's competitor reported a profit of $2.08 a share -- ahead of forecasts for $2.05 -- which might seem good enough, except that its sales at pre-existing stores rose by just 4.2%, more than a full percentage point below what analysts had expected. Home Depot's stock tumbled 1.6% after the report.

Lowe's is expected to report a profit of $1.22 a share on sales of $17.46 billion, while its same-stores sales are expected to be up by 3.2%. But even some bulls deem these numbers a reach. Credit Suisse analyst Seth Sigman, who has an Outperform rating on Lowe's, expects first-quarter earnings of just $1.17 a share, and predicts that the same-store sales gain could come in at just 0.9%.

That sounds ugly. Why is Sigman bullish? Part of it comes down to valuation. Lowe's trades at 15.7 times consensus 2018 earnings forecasts of $5.45, a gap of nearly four points to Home Depot's 19.6 times, near the widest level. If Lowe's disappoints, its valuation could fall to 15 times, Sigman says, or around $80 a share, based on his estimates, a 7% drop from Friday's close of $86.31. And if Lowe's offers a positive surprise? Sigman says its valuation could jump to 17 or 18 times 2018 earnings, putting shares in the low-to-mid $90s, a 7% to 13% rise.

But for long-term investors, what matters is turning Lowe's around. Lowe's has, after all, trailed Home Depot in most important metrics, including same-store sales and profit margins. The addition of three new board members was a step in the right direction, as was CEO Robert Niblock's decision to retire after a new boss is found, says Wells Fargo analyst Zachary Fadem. In fact, the announcement of that new chief could provide a big boost for Lowe's stock.

"We view a coming CEO announcement as a major catalyst, which we believe to be likely in several months," Fadem says. And until then? Lowe's could get a "hall pass" for its disappointments, he says.

Lowe's just might need it.

--

Ben Levisohn

Drones Hit Turbulence

Those sputtering sounds overhead last week were shares of military-drone makers AeroVironment and Kratos Defense & Security Solutions. We've written before about how drone hype carried the two companies' stocks to valuations out of sync with larger defense rivals. Last week, the shares hit air pockets.

AeroVironment (AVAV) started losing altitude Monday, sinking from about 60 to 50 bucks by Thursday, when the reason became clear: A whistleblower suit had been filed in a California state court alleging that an AeroVironment employee took an explosive drone in his carry-on luggage on a 2015 commercial airline flight. The whistleblower says he was dismissed as a result. The company told us the suit's legal claims are baseless.

Over at Kratos (KTOS), first-quarter sales reported on May 10 were disappointing, especially after backing out a boost from an accounting change.

Both drone stocks have come under criticism by Ben Axler, an activist New York fund manager who tells the world why he's short a stock with presentations he posts on the website of his Spruce Point Capital Management (sprucepointcap.com). In June of last year, Axler warned that the robotic vacuum cleaners sold by iRobot (IRBT) were about to meet savage competition. They did, when appliance leader SharkNinja entered the market, and iRobot's expensively valued shares fell from $101 to $63.

The wrongful-termination lawsuit against AeroVironment alleges the producer of hand-launched drones sacked Mark Anderson in retaliation for his blowing the whistle on the company's dangerous conduct. The April 18, 2018 complaint says Anderson worked for AeroVironment for 10 years, running security and top-secret operations, like the Switchblade program to produce an explosive-bearing drone weighing just 5.5 pounds and measuring two feet across. In April 2015, he alleges, AeroVironment employees took one or more drones packed with live explosives on a commercial Delta commuter flight from Salt Lake City to Los Angeles with about 230 civilian passengers aboard.

Anderson's lawsuit says he reported the incident to the government about six months later, concerned the company hadn't yet reported what he believed a violation of state and federal laws. The employee who had brought the explosive drone on the Delta flight resigned. But the company, the suit says, then demoted Anderson and removed him from Top Secret programs like Switchblade. CEO Wahid Nawabi reprimanded him. Eventually, Anderson was fired. He alleges his firing was part of an effort to cover up the security breaches that Anderson had reported to the government.

AeroVironment told us Anderson's claims are without merit. Once it's served with the complaint, said a spokesman, the company will defend itself "consistent with its continuing commitment to conducting its business with the highest standards of ethics, safety, and integrity." AeroVironment shares closed Friday at $56.09. They compose 10% of the holdings of the ETFMG Drone Economy Strategy ETF (IFLY).

Kratos makes jet-powered drones the military uses for target practice. Excitement about its plans to produce battlefield-attack drones has tripled its stock in recent years to the vicinity of $11, where it trades at 30-times cash flow. But if you happen to care about free cash flow, which includes capital expenditures, Kratos has very little.

In a research report last week, Axler notes that Kratos is padding its 2018 cash-flow guidance by including $7 million in cash it got from selling a subsidiary. "That's a one-time event," Axler told us.

Backing out that nonrecurring piece, Axler concludes Kratos's 2018 guidance of $40 million in cash flow from operations will be closer to $30 million. Subtract another $24 million in expected capital spending, and Axler figures Kratos free cash flow could be less than $10 million this year.

(MORE TO FOLLOW) Dow Jones Newswires

May 19, 2018 06:00 ET (10:00 GMT)

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