October 24, 2024

The Fed Is Cutting Interest Rates. So Why Are They Rising Again?

October hasn’t been accompanied by the type of stock selling we’ve witnessed the last two years, when U.S. markets fell sharply in October and reached a second-half-of-the-year bottom both times. Instead, this October has wrought a more subtle disappointment: rising interest rates.

Indeed, despite the Fed’s 50-basis point cut to the federal funds rate in mid-September ringing in a new era of rate slashing, 10-year Treasury yields have risen steadily since the calendar flipped to October, going from 3.80% to 4.24% – their highest level since July. In fact, Treasury yields are up 15% since September 18, the day the Fed cut rates for the first time in four and a half years.

Why is this happening? Why are interest rates (and, by relative proxy, mortgage rates, up a quarter-point in the last two weeks to reach 6.4% for a 30-year loan) doing the exact opposite of what the Fed intended? Because the economic data has improved, prompting many traders to scale back their expectations for exactly how fast the Fed will cut rates.

It started on October 4, when the September jobs report came in much better than the previous two months, with 254,000 jobs added and a drop to a 4.1% unemployment rate. The 254,000 number obliterated economists’ expectation of a mere 140,000 jobs and was a far cry from the 159,000 added in August and 144,000 added in July – numbers that had sparked fears that the U.S. economy might be slipping toward a long-feared recession – and that the Fed had waited too long to cut rates.

The other development is that inflation continues to fall, with the September CPI (Consumer Price Index) number falling to 2.4% – its lowest reading since February 2021. That number was reported on October 10. The way-better-than-expected jobs number combined with inflation dipping to a three-and-a-half-year low has made for a sturdier, more settled economic environment. And that’s a good thing! But it might convince the Fed to go slower in what appeared to be a very aggressive rate-cutting program when it was initiated last month.

A month ago, CMEGroup’s trust FedWatch Tool showed that a majority of industry experts – 53% of them – expected the Fed to slash rates by another 50 basis points, to a 4.25-450% range, in November. The remaining 47% expected the Fed to cut rates by just 25 basis points next month. Not one person thought the Fed wouldn’t cut rates at all next month.

Now, with U.S. economic data much improved in the last month, expectations are far more modest: 91% of traders think the Fed will cut rates by 25 basis points next month, 9% think there will be no cut. Not one person thinks there will be a 50-basis point cut after a majority of the crowd thought that would be the case a month ago.

Taking it a step further, there is also now zero expectation that the Fed will cut rates by more than 50 basis points the rest of the year (including their December meeting), down from 76.6% of traders thinking they’d cut by either 75 or 100 basis points a month ago. So, the expected pace of rate cuts has totally changed this month, and that’s due mostly to the recent evidence that the U.S. economy is more resilient than thought in September and August.

Again, this is all good news. And in reality, it hasn’t done much to slow the market as a whole – all three major indexes are up in October and are hovering near all-time highs. But certain pockets of the market have felt the brunt of rising interest rates, and that includes homebuilders, which are down 3.6% in the last month and have really taken on water in the last week as interest rates have spiked to three-month highs. It’s why our Toll Brothers (TOL) position, which was off to a very good start after we added it to the Cabot Value Investor portfolio in early September, has come back to earth of late.

It won’t last. Whether they slash rates by 25 basis points or 100 in the next couple months, the fact is the Fed is cutting rates and will be doing so for much, if not all, of 2025. And when the federal funds rate falls, so will interest rates and mortgage rates. Even if it takes a little longer than it seemed like it might a month ago.

Thus, Toll Brothers remains one of our highest-conviction “Buys” over the long term. And if you haven’t yet bought the stock, you can get it for cheaper now than you could have a week ago.

Note to new subscribers: You can find additional commentary on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Value Investor on the Cabot website.

Send questions and comments to chris@cabotwealth.com.

Also, please join me and my colleague Brad Simmerman on our weekly investment podcast, Cabot Street Check. You can find it wherever you get your podcasts, or you can watch us on the Cabot Wealth Network YouTube channel.

This Week’s Portfolio Changes
None

Last Week’s Portfolio Changes
United Airlines (UAL) – Moved from Buy to Sell Half, Hold the Rest (reached price target!)

Upcoming Earnings Reports
Thursday, October 24 – ADT, Inc. (ADT), Capital One Financial (COF)

Wednesday, October 30 – Gates Industrial (GTES)

Growth & Income Portfolio

Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.

Capital One Financial (COF) is a diversified bank that provides banking services to consumers and businesses, as well as auto loans. Though it is probably best known for its credit cards – if you watch any TV, you’re probably familiar with its “What’s in your wallet?” tagline. It’s the fourth largest credit card company in the U.S., with $272.6 billion in purchase volume in the first half of 2023 alone. And it’s on the cusp of getting even bigger: Capital One is in the process of acquiring fellow credit card giant Discover Financial (DFS) for $35 billion. If approved, the deal could be completed either later this year or early next year and would make Capital One the largest credit card issuer in the U.S. and the sixth-largest U.S. bank by assets.

Even absent the Discover buyout, Capital One is growing just fine on its own. Its revenues have expanded from $28.5 billion in 2020 to $36.8 billion in 2023; this year, they’re expected to swell another 5%, to $38.7 billion, with another 5% uptick estimated in 2025.

And yet the stock is cheap, trading at 11.2x forward earnings estimates and 1.59x sales. The share price peaked at 177 a little over three years ago, in August 2021; it currently trades at 155.

The bank has caught Warren Buffett’s attention. In May 2023, Berkshire Hathaway disclosed that it had taken out a nearly $1 billion stake in Capital One. With earnings per share expected to rise more than 25% by the end of 2025, and with Discover Financial possibly adding an even greater windfall should the deal gain approval, it’s easy to see why the Oracle of Omaha likes it.

Capital One Financial reports earnings today (Thursday, October 24), after time of publication. Shares were down 1.5% this past week ahead of earnings. Expectations are modest: 7.2% revenue growth, with a 15.7% decline in EPS. The company has fallen short of bottom-line estimates in each of the last three quarters, so perhaps the low EPS estimates this time around are a tad pessimistic. We’ll see.

Regardless, a strong third quarter from Discover Financial – reported last week, highlighted by a 41% improvement in net income – bodes well for Capital One’s pending acquisition of it. Company executives have maintained that they believe the deal will close either later this year, or early next, but we’ll see if they have an update on that forecast during today’s earnings call. BUY

Dick’s Sporting Goods (DKS) has been growing steadily for years.

From 2016 to 2023, the sporting goods chain’s revenues have improved 64%, from just under $8 billion to just under $13 billion. This year, the top line is on track to top $13 billion for the first time. It should top $13.5 billion next year.

Dick’s, in fact, has grown sales in each of the last seven years – including in 2020 and 2021, when most other retailers saw sales nosedive due to Covid restrictions. But Dick’s all-weather ability to keep growing no matter what’s happening in the world or the economy speaks to its versatility. Since Covid ended, however, Dick’s sales have entered another stratosphere. As youth sports returned in 2021, Dick’s revenues jumped from $9.58 billion to $12.29 billion. They’ve been rising steadily each year since and are expected to do so again this year.

But Dick’s isn’t purely a growth stock—it’s also undervalued. DKS shares currently trade at just 14.6x forward earnings estimates and at 1.33x sales. To be sure, it’s not the cheapest stock in our portfolio. But it is one of the fastest growing – and pays a solid dividend to boot.

There’s been no company-specific news for Dick’s of late. The stock was down nearly 2% but is comfortably above the 200 level it dipped to in early October. It’s still well shy of its late-August, post-earnings highs just under 240. But the bounce off 200 support was encouraging.

There’s been no real reason for the drop-off, and the company is coming off a strong second quarter in which adjusted earnings per share improved 55% year over year and net sales rose 7.8%, both higher than analyst estimates. Those results initially gave DKS shares a big boost, but one that has completely evaporated since.

With no reason for the decline, there’s no reason to believe DKS shares won’t bounce right back. The stock has 20% upside to our 250 price target. BUY

Honda Motor Co. (HMC) – After years of declining sales, Honda was rejuvenated in 2023 thanks to hybrids. The Japanese automaker sold 1.3 million cars last year, up 33% from 2022; a quarter of the cars it sold were hybrids, led by its popular CR-V sport utility vehicle (SUV) and Accord mid-size sedan. The CR-V was the best-selling hybrid in the U.S. last year, with 197,317 units sold. The Accord wasn’t far behind, with 96,323 sold. All told, Honda’s hybrid sales nearly tripled in 2023, to 294,000 units.

So, Honda is making the full pivot to hybrids, with the Civic soon to become the latest addition to its hybrid fleet. Investors have started gravitating more to the companies that sell them. Invariably, those are well-established, big-name car companies made famous by many decades of selling internal combustion engine vehicles; most aren’t ready to fully abandon their roots but want to tap into the surging national (and global) appetite for electric, so they instead are turning to hybrids as a compromise. As a result, these once-stodgy car companies are tapping into new revenue streams, and their share prices are surging accordingly.

Among the hybrid-rejuvenated, brand-name automakers, Honda offers the best value.

Another week, another recall for Honda. The automaker is recalling more than 700,000 Accords and Civics due to cracks in the high-pressure fuel pumps, raising the risk of the cars catching on fire should they leak. That comes on the heels of a 1.7 million-car recall due to a steering issue earlier this month. Not surprisingly, HMC shares have tumbled from 32 to 30 in the last few weeks.

As I wrote a couple weeks ago, one recall is no big deal – every car company has them. Two in this short a span is at least a yellow flag. Is Honda trying to churn out cars so fast to meet (or exceed) production benchmarks that it’s forsaking quality, at least in some cases? Perhaps. It’s a trend worth watching. In the immediate term, the more important thing to watch will be the company’s upcoming earnings, which will be released on November 6.

HMC has been our most frustrating stock, routinely ignored (or sold off) by investors despite a strong combination of growth (3.8% EPS growth expected in its current year, fiscal 2025) and value (it trades at a mere 6.4X forward earnings estimates, 0.35x sales and at just 53% of book value). I still think a big rally is coming, like we saw with United Airlines (see below). If the company can get out of its own way.

Honda has 47% upside to our 45 price target. BUY

Toll Brothers (TOL) – Historically, when the Fed cuts interest rates, homebuilder stocks are among the first to benefit. Indeed, in 2019 and early 2020 (before Covid hit), during which the Fed cut rates from 2.5% to 1.5%, homebuilder stocks were up 64%, more than double the 30% bump in the S&P 500. Now, with the Fed finally cutting rates for the first time in four and a half years, the homebuilders are undervalued, trading at 13x forward earnings. Toll Brothers is even cheaper, trading at 10.8x estimates – and growing faster than the average bear. In fiscal 2024, analysts anticipate 18.4% EPS growth on 7.1% revenue growth, both of which would easily top 2023 results (13.6% EPS growth on a 2.7% downturn in revenues).

Toll Brothers isn’t the biggest homebuilder in the U.S. – its $10 billion in revenue last year paled in comparison to the likes of D.R. Horton’s ($35 billion), PulteGroup’s ($16 billion), or Berkshire Hathaway holding Lennar’s ($34 billion). But it’s cheaper and growing faster than all of them.

As I mentioned in the opening, it’s been a rough week for TOL stock, with shares down nearly 7%. But the company is doing just fine. And keep in mind that the pullback in the share price comes after TOL was hitting new all-time highs above 158 a week ago. It’s all about interest rates being on the rise again, and that’s not going to last. As soon as they start to decline again – perhaps when the Fed presumably cuts rates again early next month – TOL shares will get back in gear. We already have a nice gain on the stock in just over a month and a half, so in the grand scheme, one bad, interest rate-fueled week is nothing to fret.

TOL shares have 22% upside to our 180 price target. BUY

United Airlines (UAL) – People are flying in planes again in Covid’s aftermath, and no major airline is taking advantage of it quite like United.

United Airlines is the fastest-growing major U.S. airline. The third-largest airline carrier in the world by revenues behind Delta (DAL) and American (AAL), United is expected to grow sales by 5.9% in 2024 – more than its two larger competitors – and that’s with revenues already topping a record $50 billion in 2023 – 19.6% higher than in 2022, which was also a record year. For United, business has not only returned to pre-pandemic levels; it’s better.

Meanwhile, the stock is super cheap. It trades at a scant 6x forward earnings estimates, with a price-to-sales ratio of just 0.44 and a price-to-book value of 2.13. The stock peaked at 96 a share in November 2018; it currently trades at 73.

A company that’s making more money than ever before (gross profits reached a record $15.2 billion last year, though earnings were still second to 2019 levels on a per-share basis), and yet its stock trades at barely more than half its peak from five and a half years ago. A true growth-at-value-prices opportunity.

United Airlines shares just keep rising! A week after reaching our price target, UAL shares were up another 3% as they continued to gain strength in the wake of last week’s earnings report.

On October 15, the airline reported adjusted EPS of $3.33, down from a year ago but well ahead of the $3.13 consensus estimate. Meanwhile, sales of $14.84 billion came in ahead of the $14.77 billion estimate and did mark a 2.5% year-over-year uptick. On top of it all, United’s board authorized a $1.5 billion share buyback – its first repurchase plan since the company suspended its last one due to Covid, in 2020. Having enough cash to spend more than a billion dollars on a stock buyback is perhaps the surest sign yet that airlines – and United in particular – are back.

Having reached our 70 price target a week ago, I made the decision to Sell Half our position at a 42% return in five and a half months and Hold the rest. The reason I didn’t sell the whole thing was because of the momentum coming off such a strong quarter and the fact that UAL stock is still quite cheap, trading at 6x earnings, just 0.44x sales, and still well below its pre-Covid peak of 96. Let’s keep hanging in there with our remaining half-stake. HOLD A HALF

Buy Low Opportunities Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risk than our Growth & Income stocks yet also offer more potential upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

ADT Inc. (ADT) – ADT is literally a household name.

It’s a 150-year-old home security company whose octagon-shaped blue signs with white lettering that say “Secured by ADT” are ever-present in neighborhoods across the country. ADT provides security to millions of American homes and businesses, with products ranging from security cameras, alarms and smoke & CO detectors, to door/window/glass break sensors and more, all of which can alert one of ADT’s industry-best six 24/7 monitoring centers if any one of those security systems is breached.

Business has been fairly stable, with annual revenues hovering in the $5 billion range for four of the last five years (2021 was an exception, with a dip down to $4.2 billion during Covid) and is on track to do it again both this year and next. But where the century-and-a-half-old company has really improved of late is profitability. The last two years marked the first time the company has been in the black in consecutive years, with earnings per share going from 15 cents in 2022 to 51 cents in 2023; this year, EPS is expected to improve another 33%, to 68 cents, and then to 83 cents (+22%) in 2025.

All of that EPS growth makes the share price look quite cheap. ADT shares currently trade at 9.5x earnings estimates and at just 1.25x sales. A solid dividend (3.1%) adds to the appeal of this mid-cap stock.

Like Capital One Financial, ADT reports earnings today (Thursday, October 24), after time of publication. Top-line expectations are modest, with sales estimated to come in flat year over year, but earnings per share are expected to nearly double, to 17 cents from 8 cents last year. We’ll see how the reality compares to the estimates. ADT shares haven’t budged much since we added the stock to the portfolio earlier this month. Let’s see if today’s earnings report can awaken them – and hopefully get them moving in the direction of our 10 price target (45% upside). BUY

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. While activist investor Cevian Capital has closed out its previous 5.2% stake, highly regarded value investor Dodge & Cox now holds a 5.0% stake, providing a valuable imprimatur and as well as ongoing pressure on the company to maintain shareholder-friendly actions.

There was no company-specific news for Aviva this week. Shares were down about 2% and are flirting with October lows in the mid-12s. The stock has been in a bit of a malaise – down 3.5% in the last three months – but the overall trend is still up, with shares up 13.5% YTD.

Aviva remains one of the most reliable stocks in our portfolio and is coming off a strong first half of the year in which it reported operating profits of £875 million, up 14% from the first half of 2023 and ahead of analyst estimates. Insurance premiums increased 15%, which helped, as did a 49% boost in its protections business thanks in large part to the company’s acquisition of AIG Life earlier this year. And yet, the stock remains cheap, trading at 10.5x earnings estimates and at a mere 0.33x sales, with a microscopic 0.06 enterprise value/revenue ratio. The 6.9% dividend yield adds to our total return.

The stock has 12% upside to our 14 price target. BUY

CNH Industrial (CNH) – This company is a major producer of agriculture (80% of sales) and construction (20% of sales) equipment and is the #2 ag equipment producer in North America (behind Deere). Its shares have slid from their peak and now trade essentially unchanged over the past 20 years. While investors see an average cyclical company at the cusp of a downturn, with a complicated history and share structure, we see a high-quality and financially strong company that is improving its business prospects and is simplifying itself yet whose shares are trading at a highly discounted price.

There’s been no news for CNH since it was added to the S&P MidCap 400 index last month, which seems to have been a shot in the arm for the share price. While the stock is up only modestly in the past few weeks, it’s up 17% since early August, with the index upgrade being the only news. The next big news will likely come on November 8, when the company reports third-quarter earnings.

CNH shares remain dirt-cheap, trading at 7.8x forward earnings estimates and 0.62x sales. We upgraded the stock back to Buy recently and will maintain our price target of 15, which is 35% higher than the current price. BUY

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018. Following several sell-downs, Blackstone has a 27% stake today.

There was no news for Gates this week, though there will be soon: The company will report earnings next Wednesday, October 30. Shares were up another 1.5% and briefly touched new 52-week highs before pulling back some on Wednesday.

GTES shares are up more than 70% since they were added to the Cabot Value Investor portfolio – our best-performing position. Yet, trading at 11.8x forward earnings, they still have 8% upside to our 20 price target. BUY

Note for stock table: For stocks rated Sell, the current price is the sell date price.

Current price is yesterday’s mid-day price.

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