John Dessauer Investments, Inc.

Transcription

1 John Dessauer Investments, Inc. John Dessauer s market review and update as of Wednesday August 6, 2014 Our sanctions against Russia may be a bad idea. Plus, are government number crunchers the reason for the U.S. economic rollercoaster? And, second quarter corporate profits are generally better than expected and up nicely from last year. Remember the 1970s? The U.S. economy was thrown into a cycle of inflation and recession by rising oil prices. At the moment, there is plenty of oil, and prices are stable. But that could change. Imagine ISIS influencing similar minded radicals in Saudi Arabia. Oil production is already down in Libya and Iraq. We are not prepared for a 1970s like repeat, if oil from the Middle East is withheld or disrupted. We are complacent because of the huge amounts of oil being produced in the United States and elsewhere in North America. However, the jump in energy production is due to new technologies, especially fracking. Rather than celebrating the breakthrough in energy production, many Americans are fighting to prevent fracking. And, our government is reluctant to encourage oil exploration. We carry on as if there is no threat to our economy from turmoil in the Middle East or sanctions against Russia. In Siberia there is one of the largest known reserves of oil and gas. Developing that energy resource would not only add to available supplies - it would be a counter balance to potential losses in the Middle East. Efforts to hurt Russia s economy through sanctions carry the risk of stopping the development of Siberian energy. The reason is that Russia needs help, especially when it comes to fracking. The United States is the

2 leader in fracking technologies. Sanctions will stop American companies from helping in Siberia. That won t do much to hurt Russia s economy right now, but if oil prices were to spike, the U.S. economy could be pushed down into another inflation/recession cycle. At the same time Russia would benefit from rising prices on its current energy exports. Europe s political leaders seem to grasp the challenge better than our Washington based leaders. Europe has been reluctant to impose sanctions on Russia because of the economic consequences at home. Europe is dependent on oil and gas from Russia. Punishing Russia s energy production will have an immediate and painful reaction among Europe s economies. France, Europe s second largest economy, has just crushed its domestic real estate market by enacting populist legislation limiting rents. Construction in France has collapsed. The last thing Europe needs is an energy shortage. The United States is not dependent on Russian oil or gas. We are in a much stronger position when it comes to current supplies of oil and gas. However, we are sensitive to oil prices. Rising oil prices would take a toll on U.S. economic growth. In addition, rising oil prices would further enrich Middle Eastern oil producers. Radicals need money to buy weapons and launch attacks. Oil is the major source of money in the Middle East, where most of the dangerous radicals originate. Keeping oil prices low should be priority number one for our Homeland Security. Sanctions against Russia should be very carefully crafted to be sure the economic damage is confined to Russia. And, we should announce new initiatives to develop oil and gas on federal lands in the United States. That would let Europe and the rest of the world know we understand the risks and will open our country to more aggressive oil and gas exploration.

3 Taking steps to keep oil prices low would hurt Russia, but help Europe and ourselves. Imposing sanctions designed to punish Russia by hurting its energy exploration and production is a bad idea. Meanwhile do not be seduced by the siren songs about stocks like BP, NYSE, BP, $48.85, and Halliburton, NYSE, HAL, $ Both will be affected by current sanctions on Russia. But neither will see major damage done to their growth opportunities. Halliburton is benefiting from growth in North America. How much future growth will be lost if sanctions on Russia are not lifted for years? That is difficult to say. However, Halliburton s management has proven adept at searching out opportunities around the world and is also adept at developing new technologies for energy exploration. BP s Russian deal is not currently a major source of cash flow. I am sure BP s management would not like to lose that deal permanently, but will be able to meet all its obligations, pay the generous dividend and grow earnings without a contribution from the Russian energy deal. Remember: if poorly crafted sanctions on Russia end up pushing oil prices higher, both BP and Halliburton would benefit. The BEA (Bureau of Economic Analysis) says the U.S. economy grew at a 4% annual rate in the second quarter. The BEA said the economy grew at a 4.1% annual rate in the third quarter of last year. From plus 4% to minus 2% and back in three quarters is an economic rollercoaster. However, the BEA s numbers seem unrealistic. After the BEA s announcement, during a CNBC interview, Aetna s CEO said: It sure doesn t feel like a 4% economy. Wal-Mart s CEO expressed similar feelings when discussing second quarter results. Recently both Kraft and Whole Foods reported second

4 quarter sales that were below expectations. Sales and earnings data from the private sector do not support the BEA s 4% growth rate. Likewise, private sector data say the BEA s first quarter minus 2.1% was unrealistic. Corporate profits grew nicely in the first quarter. That is not consistent with an economy in contraction. The best conclusion is that we should ignore quarter to quarter fluctuations in GDP growth rates. If we look back four quarters, the BEA s data say the growth rate is 2.1%. That is consistent with corporate profit data and consumer and business behavior. Economists hope the rate will improve somewhat in the coming quarters. The second quarter BEA data are not much help. Housing is stabilizing. Car sales are volatile. Business investment is hardly growing. Our banks are still struggling with the aftermath of the real estate crash, and now have a new burden of confusing regulations. The fact that the U.S. economy is growing at all under these circumstances is testimony to its core underlying strength. The Jobs report for July was good, but not great. Overall the U.S. economy added 209,000 jobs, but the unemployment rate ticked up to 6.2%. The private sector added 198,000 jobs in July; while good, that was far less than the 270,000 private sector jobs added in June. The July job figures, like so much other data, say the economy is growing, but at a rate far below previous recoveries. So far there is no indication of acceleration in the rate of growth and therefore no reason for investors to fear a dramatic rise in interest rates. The U.S. stock market was not impressed by the BEA s second quarter report. A broad list of stocks fell sharply, and the major averages like the Dow Jones Industrial Average wiped out the previous gains to end July in the red.

5 One stock in particular Aetna, NYSE, AET, $78.55 was severely punished after reporting strong second quarter results and increasing full year guidance. Following the very good earnings news, the stock fell more than 10%. Second quarter earnings, excluding items, were $1.69 a share, well above the $1.60 expected. For the full year 2014, management now expects earnings of $6.45-$6.60 a share. That is up from earlier guidance of $6.35-$6.55 a share. Aetna is doing an excellent job negotiating through the turbulent times in health care insurance following the enactment of the Affordable Care Act (ACA), also known as Obamacare. The stock s plunge was due to unwarranted fears about the future under the ACA. Following the earnings announcement, during the interview with CNBC, Aetna s CEO Mark Bertolini described the issues with the ACA, including higher utilization rates and lower margins for some types of policies. He also explained that Aetna has priced in the higher utilization rates and included the lower margin policies in the increased 2014 earnings guidance. I listened to the interview twice and carefully read the earnings releases. I could not find any reason to warrant the stock s plunge. S&P Capital has a strong buy rating on Aetna, with a $98 stock price target. I agree. During the CNBC interview, Bertolini also talked about the problem of high medical costs in the United States. He said the ACA does nothing to control underlying medical care costs. In his view the only practical way to deal with medical costs is to empower consumers. He talked about situations where insured consumers have a choice. They always look at costs and make sensible decisions because they feel they are spending their own money. When asked about why approved medical procedures vary from state to state even with the ACA, he said that is because of varying licensing

6 regulations. He added something I have long thought necessary - a national standard for licensing and medical insurance provisions, so there can be competition from state to state. My takeaway from his interview is that there are opportunities to amend the ACA and other legislation so we can move closer to a more affordable health care system. Hopefully, political leaders in Washington and the States will seize the chance to improve our health care system. The stock market s decline The underlying fundamentals that have been supporting corporate profits - and therefore stock prices - remain solid. We now have second quarter results from 361 of the 500 companies in the S&P 500 stock index. Excluding banks and other financial companies, earnings are up 11.5% from last year s second quarter. Revenues are up 5.8%. With the financial sector companies included, earnings are still up a healthy 8.9% from last year on revenue growth of 5%. What is most remarkable about the second quarter is that the results to date show more growth in both earnings and revenues than seen this late in past recoveries. Earnings estimates for the S&P 500 stocks are $117 for this year and $125-$130 for Given the second quarter s strength, these estimates are likely to be raised. The S&P 500 Index at 1,930 trades at 16.5 times the 2014 estimate and just over 15 times the midpoint of the current 2015 estimates. At these valuation levels, stocks generally are no longer bargains, but neither are they overvalued. There is no reason to fear a stock market plunge. The best strategy is to hold on to stocks, enjoy the dividends, and look forward to modest, 6%-8%, capital gains.

7 I will have the next market review and update for you one week from today on Wednesday, August 13, All the best, John Dessauer August 2014