Stocks Pull Back On Thursday

Amid this strong earnings season, the stock market had a rare decline on Thursday as the S&P 500 fell 0.4% and the Nasdaq fell 0.37%. The Nasdaq will likely increase on Friday because of Microsoft’s great earnings report which I will review later in this article. The Russell 2000 was up 0.56% as the small caps outperformed the large caps by about one percent. The financials led the decline on Thursday as the big banks gave back some of their winnings in the past few days. Bank of America stock was down 1.56% and Morgan Stanley was down 0.4%. I don’t believe the financials will get back to their high seen in January because the economy is about to decelerate, and the yield curve will invert soon. The bank profits look great in 2018, but they won’t look as good in 2019 if default rates pick up, which they might. The only sectors that were up were utilities and real estate. They were up 0.94% and 1.01% because treasuries rallied.

No More Volatility

The theme for July is still a slow grind higher despite the modest decline on Thursday. This rally has sucked the volatility out of the stock market. The volatility in bonds and currencies has also gone away this summer. As you can see, in the chart below, the S&P 500 hasn’t moved more than 1% in July yet. There were only 2 days with 1% moves in June and 3 days in May. Even though the correction is still technically ongoing because the S&P 500 hasn’t broken the January record, the volatility has dried up. I expected 2018 to be more volatile than 2017. That forecast came true in from February to April, but now we are revisiting the type of market we saw in 2017. This was a normal correction in terms of size, but it has lasted longer than most. You can almost call it a sideways correction.

The chart below shows the front month contracts of the VIX. The title of the chart is perfect. The volatility in the past 2.5 months has fallen near the levels seen after the November 2016 presidential election. Even though growth is expected to slow in the second half, that might not be enough to bring back volatility.

Big Rally In Treasuries

The chart with a box around the recent action in the 10 year bond yield, adding the point that it might break out higher, was proven to be exactly wrong on Thursday as the 10 year yield fell about 5 basis points. I will reiterate that I think the 10 year yield will stay below the May high and probably below 3%. Bond investors don’t believe in inflation accelerating much further and they think the GDP growth rate will likely peak in Q2. Plus, the curve needs to flatten to price in the fact that the Fed is almost done with its rate hikes. I think the Fed will only hike rates 3 more times this cycle. The 2 year yield fell about 2 basis points on Thursday which means the curve flattened further. The latest difference between them is near the cycle low as it is about 25 basis points.

Microsoft’s Blockbuster Q4 Earnings

Microsoft beat EPS estimates by 5 cents as earnings were $1.13 per share. Revenue was $30.09 billion which beat estimates for $29.21 billion. The chart below shows year over year revenue growth was 17.5% which is 2% higher than last quarter. That marks at least 4 straight quarters of accelerated revenue growth. Q1 revenue guidance was a range between $27.35 to 28.05 billion which beat estimates for $27.38 billion. This helped the stock move up 3.26% after hours. The stock is up 40.66% in the past year, so any earnings report which pushes the stock up further must be fabulous.

Operating margins were 34.5% which is the highest in at least 2 years. The intelligent cloud’s margins of 40.6% were the highest in at least 2 years; this brought the overall total up. Another reason margins increased is because the intelligent cloud grew quicker than the other businesses. It made up 31.9% of revenues, which is the highest in at least 2 years, while personal computing’s 35.9% is the lowest in at least two years. The productivity and business processes unit made up 32.1% of revenues in Q4.

The chart below shows the product/services growth rates. Azure is the star of the company as it grew at an 89% pace. Credit Suisse projected it would grow 84% and Raymond James and Stifel expected it would grow 80%. The overall commercial cloud division grew 80% which was slower than last quarter’s growth of 93%. Azure is about a $9 billion business which means it is quickly taking over the other segments of the company. Microsoft appears to have done a great job with the LinkedIn acquisition as its revenues grew 37%. This helped the productivity and business category grow 13% to $9.37 billion, which missed estimates by $10 million. Gaming revenue grew 39% to $2.29 billion. Xbox’s software and services revenue growth of 36% was driven by strength in third party titles.

I feel that Microsoft’s Surface product is finally resonating with consumers as it has great battery life, design, power, and portability. The touch screen allows it to be a tablet and a laptop. Sales growth backs up the anecdotal evidence as it was 25%. The commercial cloud business houses some of the firm’s fastest growing products and services. They include Dynamic 365, which grew 61% and Azure. This business grew 53% as it pulled in $6.9 billion in revenue. That is down from 58% last quarter, but beat the 46% estimate from KeyBank. As you can see, the fastest growing segments all grew a bit faster than expectations. After years of floundering during CEO Steve Ballmer’s tenure, the company looks ready to outperform in the next decade as it has momentum which was unthinkable 6 years ago.