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Today's Market WrapUp 04.29.2008 Mon Tue Wed Thu Fri Barbera Archive Eternal Constants
and the Eye of the Storm Over the last 12 months, we have tried on occasion to highlight various stock market sectors which may be overlooked and unloved at key moments in time. Our approach is always a combination of fundamental analysis and technical analysis, using fundamental analysis to decide where good values can be found, and technical analysis to decide when to make such purchases. In recent weeks, we featured a segment on emerging small micro cap healthcare stocks which have moved, by and large, steadily higher ever since, and in October of last year, we invested some time in highlighting the action of Junior Oil and Gas Companies. These companies, in many cases, have now become THE market leaders surging well ahead of the price performance seen in large cap energy and even Oil Service. We featured that update back in our FSO Commentary entitled, “Halloween Scariness in the Financial Sector” and we stated, “It’s that “Back to the 70’s Show” all over again, courtesy of Uncle Ben. In this vein, we note that during today’s stock market sell off, some of the Energy names were hit especially hard with money rotating “out of energy” and into “technology.” Bad move from our viewpoint, as Technology has already started showing major cracks in the CAPEX damn. And have a good look at those PEG Ratio’s why don’t you; nothing really cheap in the Tech Sector. In fact, Tech Sector investing and recession simply don’t mix, but Energy, especially in the world of Putin, Chavez and Ahmadinejad, Energy Stocks, well, are in many cases, still plenty cheap and thus ripe for potentially bigger gains ahead. As a final note to those willing to do some hunting, we throw out the following bone relative to the Energy Sector. Consider the Energy Majors which have moved to new highs and which have largely enjoyed a huge advance. As in many areas of the Natural Resource world, most of these larger companies need to continue to grow reserves, and to that end, in today’s world growth through acquisition, even with nice takeover premiums is still far cheaper than originating homegrown organic growth. As a result, we perceive an industry trend that will continue on the path to greater consolidation wherein smaller and mid-sized companies probably sport the best EPS leverage around. In the chart below, we show our basket of secondary Oil Stocks (about 30 names) visa vie the large cap dominated XOI. You can see that on the very bottom clip, Small Cap Energy is down in the basement and appears to be trying to turn the corner. Bargain Hunter’s – let loose your best truffle sniffing hogs, as there is much fertile ground in this corner of the world -- a corner far, far removed from all that weeping and gnashing of teeth taking place in the dark recessed ugliness of the financial space.” In the chart below, we show the snapshot of the Small Cap Energy sector as it was 6 months ago and as it appeared in our FSO Update, followed by the same snapshot taken today. Amazing what six months can mean for your investment horizon as most of these stocks, names like XTO Energy (XTO), Range Resources (RRC), Denbury Resources (DNR), Cimarex Energy (XEC), Whiting Petroleum (WLL), Newfield Exploration (NFX), Comstock Resources (CRK) are up 50% or more. THEN,
NOW,
As it happens, we still like the Mid-Cap E&P segment for the long haul. However, with the stocks as far advanced as they are at the present time, we would not be surprised to start seeing some “backing and filling” price action, the kind of thing that suggests a consolidation for a period of time. Within the stock market, sector rotation is one of the few eternal constants with money managers given the job of figuring out, perhaps where the rotation will go next. To this end, as noted last week, we still do not see the kind of very overbought technical conditions which would herald an end to the bear market counter-trend rally now underway. Yes, it may end up that the rally may be of low quality, and may run into a decaying orbit at any time. The S&P could even dip down toward the 1300 level over a period of a few weeks and in the larger scheme of things, nothing would change. Overall, the market is in a trading range, a non-trending mode, and it does not appear as though we will face the prospect of new lows in the S&P until sometime after July/August. Thus, a relative period of stability should prevail allowing the stock market to stay afloat into the summer months, with July and/or August often recording important peaks. As we have hopefully communicated our thoughts that this is a bear market rally, an important question then becomes, what sectors could end up doing relatively better in the next down market phase. To this end, among several ideas we like, the concept of being Long/Short as this looks like a good road to relatively conservative profits. In our update for March 18th, only a few weeks back, we pointed out two approaches to the Long/Short strategy. In both cases, we are looking at the recession scenario, which we very much continue to believe is still powering ahead. As we see it, the Fed is caught between the Dollar and the Banking System and as a result, a weakening economy will force the Federal Reserve to keep interest rates low for an extended period of time. Now, we realize, that at the moment, many market participants are working up a lather concerning tomorrow’s Fed announcement. Is it the end of Fed rate cuts? Will the Fed go on hold? In our view, the answer to that one is plainly no, at least not for an extended period of time. * Keep in mind that only a few short weeks ago, the Financial System was on the verge of a major melt down. * Keep in mind that the US System is extremely over-leveraged in every sense. * Keep in mind, that even as this luxurious lull in the storm has wafted over the markets, collateral values for Real Estate continue to decline. This will translate into still more loan-losses ahead for the major banks. * Keep in mind that even as we ply the calm seas of the hurricane’s eye, rising food and energy prices continue to force a steep income squeeze amongst many a household balance sheet. *Keep in mind, that the US is exporting recession to the rest of the world, which is experiencing dollar based inflation and that such inflation continues to push foreign capital away from holding dollar currency. More then anything, the Fed is committed to aiding the banking system, which is now overrun with bad debts. In order to maintain the “I.V.” of intensive care ward ‘life support,’ the yield curve must be maintained with a steeply rising slope. The carry trade must be allowed to work its healing magic over a period of many months, and to this end, there is no way the Fed will alter policy course in a dramatic fashion. Could they go on a temporary pause for a month? Perhaps. But over time, rates are likely to remain low and move lower on the short end of the curve as the banking and financial system remains over-leveraged and badly crippled. As a result of the Fed being forced to keep rates low for an extended period of time, we continue to believe that near term rallies notwithstanding, the US Dollar will remain weak during the balance of 2008 and beyond. This is an important point because there are many approaches one can use to benefit from a falling dollar. Of course, there are the obvious beneficiaries, Gold and other precious metals, which having now had a sizeable correction are moving into a good posture to ‘decouple’ later on. Another approach, is the Long-Short strategy, taking advantage of the fact that US exporters will be greatly aided by a weak greenback, while European and to a lesser degree, Asian exporters will be impaired. In our article entitled “Central Bankers At Work,” I wrote about the possibility of a market recovery which could allow shorting the Vanguard European ETF and going long a basket of US consumer staples. As things have taken shape, it is striking to see how the modest recovery in stock prices has moved money back into ‘growth’ type stocks while virtually ignoring the more conservative consumer staples. This ‘knee-jerk’ response which appears hopeful that the ‘worst is over’ has allowed European Large Cap stocks to recover substantially at the very time when we fear the worst news still lies directly ahead. It has also depressed and left virtually unchanged from the lows, any number of large cap US exporters which have been uniquely shunned during this advance. Just catch an eye full of the charts of Clorox, Procter and Gamble, Budweiser and Pepsico, and you’ll have a small sampling of what has taken place.
For the Relative Strength Ratio of US Consumer Staples (primarily exporters aided by the weak Dollar) versus Large Cap Europe (Primarily exporters hurt by the strong Euro/weak Dollar), we see that the last few weeks have brought about a very dramatic slide in the Ratio back to the rising 200 day moving average.
Above: top clip: Europe Large Caps, Middle: US Consumer Staples, Lower: Ratio Staples to European Large Caps.
Above: Top Clip: Relative Strength Ratio of US Consumer Staples (Exporters) versus European Large Cap. Bottom Clip: Medium Term RSI (momentum) indicator, now oversold. As we can see in the chart above, the slide in the Ratio of US Consumer Staples versus Large Cap European Exporters has moved the medium term RSI down to fully oversold values. Could this mean that the brief period of Dollar strength is coming to an end? One thing is for certain; at the moment, most US staples are selling at still very depressed price levels meaning we could be looking at relative bargains. For those investors who like ETF’s, the last few years have been very kind with any number of listings. To trade large cap Europe, there is VGK, VEU and FEZ to name a few. While I may be crazy, to me the price action in the Euro Top 100 and the Dow Jones Euro Stoxx 50 Indices sure look a lot like potentially massive topping patterns with the recent rally producing ‘right shoulder’ action. Clearly, the only answer to this question of, “are these markets topping?” will be in the fullness of time, as we see price action begin to break down in the months ahead, a likely slow process to be sure. While we still cannot rule out a further modest price advance, overall volume and momentum levels look weak, with prices snapping back toward a 200 day moving average that is now declining, and this is often a major tell.
Yet another approach for those looking to trade the recession using this period of intervening confidence as a potential entry point, we also like the idea of being long Consumer Staples versus Short Consumer Discretionary. Here again there are ETF’s that can be of aid, with IYK and XLP both tracking consumer non-cyclical stocks, while XLY is the Spyder ETF for Consumer Discretionary. So far, this later ETF has not done a great job at tracking discretionary names, and if we look at the Holdings, it is not that well constructed. Yet in screening any number of stocks, we see many issues which have had huge moves to the upside recently, representing truly extended multiples, and truly discretionary spending where the market darling phenomena is at work.
For those looking for other ideas, Technology related ETF’s would probably also work well as (a) Tech is extremely cyclical and won’t do well in a recession, (b) tech tends to be quite vulnerable in bear markets, and (c) relative to decaying CAPEX spending, Tech multiples are currently still a long way from cheap. On the Consumer Staple side of the trade, the key component as we see it, Staples have emerged into a new relative strength uptrend over the last few months. This is important because they had been lagging the market for most of the 2003 to 2006 bull market cycle and could therefore be overdue for several years of relative out-performance.
Above: the GST Consumer Staples Index (30 stocks) and lower clip: Relative Strength Ratio of Consumer Staples versus the S&P 500. Trend change underway? In tracking the Consumer Staples sector, our own index uses 30 names which include all the familiar components such as Procter and Gamble, Coca-Cola, Clorox, Colgate etc. However, the A/D Line for our index does an even better job of showing just how depressed this sector is at the current time as the A/D Line hovers near the former lows. Ditto the cumulative volume gauge which has also experienced virtually no bounce and currently appears overdue for a trend change.
For the benefit of those readers who like to do there own homework, and may not be fully satisfied using an ETF, we decided to go a bit further and perform a full evaluation of the Consumer Staples (export oriented) producers. We categorized product makers as either a 1, 2, or 3, with all the one’s being ‘Weak Dollar’ beneficiaries, the 2’s as either slightly less ‘staple’ oriented, or less ‘weak dollar’ oriented, while the 3’s were either a lot less ‘Weak Dollar’ oriented or a lot more ‘discretionary.’ A little bit arbitrary on our part, but we tried to get this right. The table below ranks the sector in descending order by category and by market capitalization.
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