An Interesting Week Ahead: Viewpoints from Mohamed A. El-Arian, CEO and co-CIO of PIMCO
This coming week will be an interesting one. I am not just thinking of Tuesday’s FOMC meeting in Washington that will shed light on whether the Federal Reserve revises down its economic growth projections (it should and, I suspect, will) and expands non-conventional policies (it will, but probably not at this meeting).
I am also thinking of two other issues, which were left to simmer quietly over the last few months when most of the focus was on America’s "recovery summer" — or, to be more exact, the lack thereof.
The first pertains to Europe. Solvency concerns are again on the rise there. Last week’s catalyst was Ireland where banking issues are a serious worry. But the underlying problems are deeper and more complex. Market measures of risk for peripheral European countries (Greece, Ireland, Portugal and Spain) are at or near danger levels… despite exceptional support from the ECB, EU and IMF, and despite the implementation of adjustment measures on the part of some.
The failure to reduce risk spreads means that the public sector bailout is not working. Rather than provide assurances of better times ahead and, thus, encourage new investments, ECB/EU/IMF support funding is being used by existing investors to exit their exposures to the most vulnerable peripheral European countries.
This situation cannot be sustained forever. It undermines any chance that the most vulnerable countries (e.g., Greece) have of limiting the collapse in their GDP and maintaining social cohesion; it contaminates the balance sheet of the ECB; it exposes the revolving nature of IMF resources to considerable risk; and it raises the risk of renewed contagion.
The second issue is even more complex. It pertains to the global configuration of currencies. Last week, Japan intervened massively to stop its currency from appreciating. It did so in a unilateral fashion and, immediately faced criticisms from Europe and the U.S.
Meanwhile, in a sharply-worded testimony to Congress, Treasury Secretary Geithner provided lots of data to those who feel that the U.S should have already labeled China a currency manipulator. And while China has recently accelerated the rate of its managed appreciation — 1% in the last week compared to just 1.6% since the country declared great "flexibility" back in June — this is proving insufficient to counter growing currency tensions.
These latest foreign exchange developments bring to the fore an inconvenient reality. While not all industrial countries wish to make it explicit, they are happy (indeed eager) to see their currencies depreciate. They see this as helping them address the extremely difficult challenges associated with a protracted period of low growth, high unemployment, and limited policy effectiveness.
The list of industrial countries wishing to depreciate their currencies is not matched by a list of emerging economies happy to let their currencies appreciate significantly. As a result, foreign exchange tensions are mounting, and the price of gold has been driven to a new record level.
This week will shed light on whether policymakers can do anything to deal with these two issues. If they continue to stumble and hesitate, what has been simmering may well come to a full boil in the next few months.
Investment Strategy from Jeffrey Saut, Senior vice president and chief economist at Raymond James
"Change of a long-term or secular nature is usually gradual enough that it is obscured by the noise caused by short-term volatility. By the time secular trends are even acknowledged by the majority they are generally obvious and mature. In the early stages of a new secular paradigm, therefore, most are conditioned to hear only the short-term noise they have been conditioned to respond to by the prior existing secular condition. Moreover, in a shift of secular or long-term significance, the markets will be adapting to a new set of rules while most market participants will still be playing by the old rules.” —Bob Farrell
Over the years I have quoted Bob Farrell, sage ex-strategist of Merrill Lynch, in my missives because his insights have proven timeless. The aforementioned quote is no exception. To be sure, I have often spoken of secular changes before they were widely acknowledged. One of my better observations was the secular change that China was joining the World Trade Organization in the 4Q of 2001, which was going to cause per capita incomes in China to rise. History shows that when per capita incomes rise people consume more “stuff” (oil, gas, coal, cement, timber, agriculture, precious/base metals, etc.). Accordingly, we have ridden that profitable insight ever since. More recently, I have talked about cloud computing and its ability to potentially shake the business models of existing hardware and software companies to their very foundations. I have also discussed smartphones’ potential impact on personal computing (PC) companies since the smartphone market is growing ~5 times faster than the PC market. This morning, however, I want to revisit my long-standing bullish views on coal.
I was reminded of the bullish potential for coal while listening to arguably the best energy portfolio manager on the planet, namely BlackRock’s Dan Rice. To paraphrase his comments, Dan suggested that with 2% world GDP growth the price of crude oil would average $80 – 85 per barrel. That should allow oil stocks to rise by some 40% over the next few years. He also stated that we are living hand-to-mouth on many commodities like oil, copper, and coal. The comments that really struck me were about coal, which he said would rise from a price of $60 – 65 per ton to $85 per ton with a concurrent 300% “hop” in the aggregate share price of many coal stocks.
Piqued by Dan’s comments I reflected on a presentation by Peabody Energy’s (BTU/$47.00/Outperform) CEO, Gregory Boyce, and his belief regarding the “long-term supercycle for coal.” In said presentation Mr. Boyce observed that coal has been the world’s fastest-growing fuel over the past decade, with demand surging by nearly twice the rate of natural gas, and four times faster than global crude oil consumption. “It’s stunning,” he said, “that any mature commodity could expand some 50% in a decade.” He went on to say, “coal (usage) is expected to grow faster than other fuels in the coming decade.” Indeed, in 2010 more than 94 gigawatts of new coal-fired electric generation facilities are slated to come on line, representing roughly 375 million more tonnes of coal consumption. This comes at a time when the burgeoning middle-class of emerging countries is demanding more electricity, as well as more steel, both of which compound the demand for coal! Peabody estimates the demand for coal will increase by ~1 billion tonnes over the next four to five years. Currently, Peabody is exporting 6 – 7 million tonnes of coal per year, but intends to ramp that production to 20 million tonnes over the next few years.
While there are many favorably rated coal stocks in our research universe, there is only one Strong Buy-rated name, Alpha Natural Resources (ANR/$39.35). Conveniently, Alpha had an Analyst Day last week, causing our analyst, Jim Rollyson, to pen the following research note: “On Tuesday, we attended Alpha's Analyst Day in Pittsburgh. Overall, there weren't any earth shattering revelations. We did, however, come away with several takeaways. The recent Foundation Coal merger is working out better than planned. The balance sheet remains in a strong position with Alpha's net debt position continuing to slide. At the end of 2Q, net debt stood at $159 million (including nearly $662 million in cash and marketable securities). The good news is this exceptional balance sheet leaves Alpha with many opportunities to invest in organic growth projects and/or M&A potential.”
“M&A moves are a matter of when, not if. Alpha has made it known it is looking at acquisition opportunities both domestically and abroad. Additionally, several organic growth projects are in the works. Alpha highlighted several new mine projects under development, or in the permitting stage, anticipated to at least replace production over the next several years and in certain cases enhance it. Finally, valuation remains attractive, especially for a larger cap, diversified coal producer. Touting a cheap valuation has become a normal character trait for Analyst Days, but in this case we have to agree. After successfully completing the Foundation merger, putting up decent results for several quarters (even through the global recession) and continuing to improve the balance sheet, ANR trades not only below the larger, diversified peers it compares itself to, but at a discount to the overall group as well. Our model suggests ANR trades for ~4.5x 2011 EBITDA as compared to 5.6x for the larger peers, which if normalized would drive ANR share price into the low $50s. Note that this excludes any separate value for ANR’s natural gas assets, which we believe could offer another $5-10/share of future potential upside.”
I revisit the coal theme this morning because the La Niña weather pattern, combined with numerous volcanic eruptions that put large amounts of ash into the atmosphere, have allowed the Tropic of Cancer and the Tropic of Capricorn to expand. The result has brought increased hurricane activity, soaring temperatures, Asian floods, droughts (Russia has lost 30% of its wheat crop), and the list goes on. While the current focus is on the unusually warm weather, don’t expect this to continue as the Northern Hemisphere faces an upcoming VERY cold winter due to massive amounts of volcanic ash in the atmosphere. Energy stocks, therefore, should be over-weighted in portfolios with the biggest “bang” going to the Exploration & Production stocks (E&P), as well as coal stocks (70% of China’s energy consumption is coal, while 20% is oil). My favorite E&P name remains Clayton Williams (CWEI/$48.68/Outperform).
The call for this week: According to Dow Theory, the primary trend of the stock market is “up.” That upward trend would be reconfirmed if the D-J Industrial Average (INDU/10607.85), and the D-J Transportation Average (TRAN/4433.66), break above their respective August 9th closing highs of 10698.75 and 4516.35. Such action would also suggest a run toward the Dow’s April 26th closing high of 11205.03. Last week, however, stocks stalled around their August recovery highs. For readers of these comments that should come as no surprise given my very short-term concerns that with 75.8% of the S&P 500’s stocks above their 50-day moving averages (DMAs) we are currently pretty overbought. Then too, we are at the top of the Bollinger Bands that have contained all rallies for the past year, as can be seen in the nearby chart. Still, as repeatedly stated, I don’t think any selling will gain much downside traction, leading to a re-rally that will carry the major averages above their August highs. Reinforcing that view is my proprietary intermediate-term trading indicator, which is trying to turn “green” after being in a cautionary “red” mode since the first week of last May. Interestingly, despite last week’s wimpy trading pattern, the Telecommunication Services Sector, and the Consumer Discretionary Sector, both broke out to the upside in the charts (read: no double-dip). And don’t look now, but also breaking out to the upside in the charts was our long-standing bullish positions in the precious metals complex despite China’s currency, the renminbi, trading to new all-time highs versus the U.S. Dollar. Indeed, curiouser and curiouser . . .
of TrimTabs Weekly Liquidity Review
We Turn Neutral (0% Long) from Cautiously Bullish (50% Long) on U.S. Equities;
We Turn More Pessimistic as New Offering Calendar Ramps Up, Insider Buying Plunges, Retail Sentiment Turns Much More Bullish, and U.S. Economy Stagnates.
We are turning neutral (0% long) from cautiously bullish (50% long) on U.S. equities. This week’s market call was tougher than usual, but we elected to play it safe. Not only have U.S. equities come a long way in a short time—the S&P 500 is up 7.5% from its interim low on Thursday, August 26—but some of our supply indicators are turning less favorable:
The float of shares has diminished every month this year, but the float has only shrunk $2.4 billion in September, and corporate selling (new offerings + net insider selling) of $5.8 billion was slightly higher than announced corporate buying (new cash takeovers + new stock buybacks) of $5.5 billion in the past week. Also, new offerings are reviving. They hit a six-week high of $4.6 billion in the past week, and they are set to reach $20 billion this week due mostly to a record secondary offering from Brazilian oil giant Petrobras (we estimate that $15 billion of this offering will be sold to U.S. investors).
Corporate insiders have dramatically reduced their purchases of equities. Insider buying in September has amounted to a scant $120 million, putting this month’s amount on track to be the lowest this year. While insiders have been committing a fair amount of corporate cash to buy shares, they are putting less of their own cash to work.
Even some of our demand-side indicators have deteriorated a bit:
The TrimTabs Demand Index, which uses 21 flow and sentiment variables for market timing, fell to 81.6 on Thursday, September 16. While this level is above the neutrality line of 50, it is almost 11 points below the interim peak of 92.4 on Monday, August 30.
While U.S. equity funds have lost an estimated $6.9 billion (0.2% of assets) in September, retail sentiment has brightened dramatically. The American Association of Individual Investors (AAII) reports that 50.9% of the respondents to its sentiment survey are bullish, while only 24.2% are bearish. The shift in AAII sentiment in the past four weeks from bearish to bullish was the most dramatic since early 2004, and it is worrisome from a contrarian perspective.
Leveraged long U.S. equity exchange-traded funds are still posting outflows, which is bullish from a contrarian perspective, but the outflows are not quite as large as they were in the previous week. In the past week, leveraged long U.S. equity ETFs redeemed 4.6% of assets, while leveraged short U.S. equity ETFs issued 4.6% of assets.
Finally, we are comfortable being neutral because the U.S. economy does not seem to be improving much. Due to a mid-month calendar quirk, we will not be able to comment on the latest trend of growth in income tax withholdings until Tuesday, but growth in withholdings in recent weeks indicates wages and salaries are flat to somewhat lower sequentially. Also, key indicators suggest demand for labor is pretty weak. Until our real-time indicators show the economy is turning around, we are unlikely to be any more than cautiously bullish on U.S. equities
Summary of Industry Update (Banks) from Keefe, Bruyette & Woods
Six Bank Failures—The FDIC announced 6 additional bank closings on Friday, Sept. 17, located in the states of Georgia, Ohio, New Jersey and Wisconsin. This weekend’s 6 failures brings the total number year-to-date to 125 and cycle-to-date to 293 institutions including 140, 25, and 3 in 2009, 2008 & 2007, respectively In total, last weekend’s failed banks held $1.3 billion in assets and $1.2 billion in deposits. The estimated losses to the FDIC totaled $348 million or 26% compared to the 2009 loss rate of 21% ($36.4 billion in losses on $171.9 billion in assets).
Concentration of Failed Assets & Deposits—Relative to the industry, last week’s failed banks had a higher concentration in commercial real estate loans at 45% of total loans, compared to an average of 35% for the industry (Exhibit 8). On the liability side this week’s failed banks relied more heavily on time deposits at 74% versus the overall industry at 69%.
Roll-Up Group—We continue to believe that our roll-up group, those banks with capable and willing management, sufficient capital, above average credit quality and regional opportunities, are likely to benefit by rolling up failed banks.
Performance of Roll-Up Group—In terms of performance, the roll-up group has produced a cumulative return (since we introduced the group on July 6, 2009) of 5.4%, which is below the BKX’s return of 14% and below the KRX’s return of 10.9%.
Potential Opportunities—We attempt to map out potential opportunities for the roll-up group to gain market share by identifying banks, by region, with Texas ratios in excess of 100%. After incorporating this week’s failures, our potential opportunities table currently has 458 institutions with a Texas ratio over 100% with total assets of $236 billion. This compares to the FDIC “Problem List” of 829 banks with assets of $403 billion.
Location of Potential Opportunities—The majority of the assets we have identified in our potential opportunities list are located in the Southeast and Midwest with 28.5% and 23.2%, respectively, followed by the West with 18.6%. The Mid-Atlantic is not far behind offering 17.5% of total assets and the Southwest currently holds 11.4%. Additionally, the Northeast region presents the fewest opportunities with less than 1%.
Sept. 20: The Housing Market Index, from The National Association of Home Builders
Sept. 21: ICSC-Goldman Store Sales, published by the International Council of Shopping Centers; a measure of comparable store sales at major retail chains.
Sept. 22: EIA Petroleum Status Report. Reprot from the Energy Information Administration providing weekly information on petroleum inventories in the U.S., whether produced here or abroad.
Sept 23: Jobless claims, from the U.S. Department of Labor
Sept 24: Durable Goods Orders, from U.S. Dept of Commerce
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