Weekly Commentary & Outlook
McIntyre, Freedman & Flynn
By Tom McIntyre
October 24, 2011
Stocks continued to advance as stellar earnings reports continue to overshadow the macro worries. These include the European crisis as well as many of our domestic problems such as the protests in the streets,
And the confusion caused by President Obama starting his reelection campaign so early. This has created total grid lock in Washington DC.
As the charts above illustrate, the Dow Jones Industrial Average gained 1.4% last week while the NASDAQ Composite fell slightly due to confusion around
Apple Computer’s earnings release.
I doubt the disappointment for Apple will prove to last for long.
The Markets & Economy
As we predicted (and hoped) the arrival of another solid quarterly earnings parade has erased for now the daily obsession with sovereign debt concerns from Europe or with the impending fiscal crises here in the United States. These problems have not gone away, and in Europe’s case the process of creating a policy response has reached the point where European heads of state are publicly challenging each other and even making disparaging remarks about one another in public.
The European circus act is not over. Another summit meeting is planned for Wednesday, and I am quite certain more will follow. Just understand this, you cannot have a society whereby you are paid to do nothing and expect fewer and fewer people to continue to support that arrangement. The promises and choices made by the European leaders of both the left and right for the past 50 years have created this mess and the solution will have to be painful - otherwise it will not be a solution.
Here in the United States, the government is becoming increasingly distracted with political histrionics and not able to govern. This starts with the President, who as our leader is talking about government inaction as if he were running for President, and not having been President for nearly three years. I do not expect any positive news to emerge from the so-called super committee whose report is due in one month. Look for this to loom larger and larger on the markets as we approach that date.
Finally, the concern over the economy here has lessened over the past several weeks. While the Economic Cycle Research Institute continues to confidently predict a recession in 2012 (see chart below) they do not know if it will be deep.
Based upon corporate leaders and their outlooks, I would simply say that since we never took off after the last recession we will find it hard to fall far in the future. Thus the perceived inequality between the corporate sector and its financial performance is likely to continue to confound and give ammunition to those class warriors such as our President and his billionaire friends. The irony of course is without the strong corporate sector our society’s problems would be much worse.
Don’t mistake me though, the economic background is dismal, but stock prices are determined by the level of earnings, interest rates and sentiment. Today these are all very positive. The last point is counter intuitive, but when most investors are down on stocks - that is the time to buy, and frankly that is true for most asset classes.
What to Expect This Week
The Europeans will summit again this Wednesday and should attract coverage. I sure would not want to own European banks or sovereign bonds over there. Closer to home the earnings season will be in full gear, but stocks have enjoyed a substantial rally so perhaps a breather is in store.
Finally, the Federal Reserve is due to announce some sort of plan to perhaps start to buy up mortgages in a form of new quantitative easing. This will be announced in conjunction with President Obama’s plan to allow refinancing even for those with no equity. Yet another mistaken attempt to prop up the price of an asset for which the market thinks is not worth it. This will simply delay the day and price point at which the market must fall in order to establish the floor level for which true economic buyers will emerge.
In essence this kind of tinkering just extends the misery of all those involved: The owner of underwater houses as well as those who loaned the money at inflated valuations.
Verizon reported better than expected third quarter earnings last week as the Company gained twice as many new subscribers as its main rival AT&T. The Company earned $0.56 per share, which was a penny better than consensus estimates, as revenues grew to nearly $28 billion. Management also reiterated their guidance: they expect earnings growth between five and eight percent throughout the remainder of this year.
The Company added 882,000 wireless subscribers during the quarter and there is solid demand for recently launched new products. Management indicated that they have a robust backlog for the new iPhone 4S, which should lead to a very strong fourth quarter. The wireless division also had their highest profit margins in Company history this quarter, and we expect margins can continue to expand as consumers continue to migrate to smart phones.
Verizon is still very conservatively valued and we believe this Company will be a core holding for the foreseeable future. The shares currently yield 5.3 percent and we believe the growth opportunities are being underestimated on Wall Street. We believe the shares will trade up to $45 within the next 12 months.
Despite labor issues, Freeport McMoRan reported better than expected third-quarter earnings results last week, and expressed optimism about the current business environment. The Company earned $1.10 per share, as revenues were slightly higher than last year. The price of copper has been extremely volatile in the last several months, but the Company expects demand to remain strong for the next several quarters.
Management was able to minimize the effects from work stoppages at its Indonesian mine leading to the upside earnings surprise. Operations remain extremely efficient at the Company and Freeport remains the lowest cost producer of copper in the world. We look for management to resolve the current labor issues by the end of this year, which will remove the overhang on the share price.
Shares of Freeport have been very volatile over the last six weeks, but their business remains strong. We believe that China is still the main growth driver in the copper business and look for demand to accelerate in the fourth quarter. We believe that shares of Freeport are dirt-cheap at these levels, and this stock is our top pick in the commodity space. We believe the shares will move back to $50 within the next six months.
Flextronics reported solid second quarter earnings results, which caused a 10 percent spike in the shares on Friday. Sales grew by 8 percent to $8.0 billion, as earnings per share remained flat from last year at $0.22. These results topped estimates, so fears of a slowdown in technology spending seem to be overblown.
The Company experienced growth in all of its product lines, and indicated demand remains strong in this business environment. Also, management has done a terrific job at improved profitability during the financial crisis. They were able to generate $176 million in free cash flow and continued to buy back shares aggressively.
We are encouraged by these results and the positive response by shareholders to this report. Flextronics will always be a cheap stock given its low margin business, but we believe the business cycle will drive their margins higher over the next year. We expect the shares to reach $9 within the next 12 months.
(c) McIntyre, Freedman & Flynn