8/8/11: Don’t Panic: Opportunities Abound

After the market closed Friday, credit ratings giant Standard & Poor’s (S&P) announced it had lowered the long-term credit rating for the United States from AAA to AA+. Apparently, S&P announced the move to the US Treasury Dept early in the afternoon, but the public press release was delayed due to the fact that Treasury officials identified a $2 trillion error in the analysis.

Predictably, government officials and some prominent investors and economists, including Warren Buffett, have criticized S&P’s move and rationale for the downgrade.

But all the chatter about the downgrade on the Sunday political talk shows and in the financial news this morning is irrelevant. What matters is that one of the largest bond ratings agencies has downgraded US debt, and the market’s initial reaction is negative. Major US indexes and most European bourses are down 1.5 to 2.5 percent, adding to steep losses last week on both fronts. The only exceptions at this time are Italy and Spain, both led higher by financial shares that are benefiting from the European Central Bank’s (ECB) aggressive purchases of Italian and Spanish government bonds.

Crude oil is also down on the session with West Texas Intermediate (WTI) trading down to $82.80 per barrel (/bbl) and Brent back below $106/bbl this morning; oil prices are reacting once again to fears that a global economic slowdown will crimp global oil demand growth.

Safe haven gold is trading higher to a new record over $1,700 per ounce. The “risk-off” trade–where investors sell assets across the board, raise cash and reduce leverage–is still in play.

Ironically, one asset that apparently hasn’t lost its safe-haven status despite S&P’s action late last week: US government debt. The benchmark US 10-year issue is trading up, pushing the yield down about 6 basis points to just below 2.5 percent, near an all-time low.

There is a natural temptation for all investors to panic and sell out of all of their positions in the face of such a sharp decline in stocks. That’s particularly true since the recent crash brings back painful memories of the steep selloff in the wake of Lehman Brothers’ bankruptcy three years ago. But history shows that’s exactly the wrong response to this market action: The odds suggest that if you sell out amid the panic now, you stand a good chance of exiting the market near its nadir.

I took a look at the past 61 years of market return data for the S&P 500. In particular, I looked at instances where the market declined more than 7.5 percent over a three-week holding period; this represents a statistically improbable downside move. On two-thirds of such occasions, after such a mini market crash, the S&P 500 was trading higher three and six months later. When that was the case, the average gain was 12.65 percent over the ensuing six months.

I also examined the occasions when this crash signal didn’t work out. The list includes two false signals in the middle of the 2007-09 bear market and two during the similarly vicious 1973-74 decline. In almost all instances where this crash signal failed, the bad buy signals occurred in the middle or in the final six months of a bear market decline. One of the only notable exceptions was a false buy signal just ahead of the 1987 market crash. My point: The recent selloff, coming just off a major market high, doesn’t fit the pattern of prior failed signals.

For the record, this mini crash signal was triggered on Friday for the first time this year. The last signal occurred in late May of 2010, just a few weeks before the market bottomed and most energy companies embarked on an impressive rally.

I’m not a fan of blindly following market patterns or seasonal norms. But these statistics do reveal a simple truth: Investors tend to panic and overreact to major news events. That’s why after most major downside moves, the market ultimately recovers as panic recedes and investors once again evaluate conditions rationally.

And what’s true for the market as a whole is magnified for individual stocks. Smaller stocks, in particular, are vulnerable to extreme bouts of selling in sympathy with the broader market. Often these moves are quickly reversed once the market turns.

Fundamentals and Reality

Put all of the media theatre about the US debt ceiling debate and politics aside.  The market is worried about one thing, and only one thing: the risk that the US–and by extension the global economy–could re-enter recession soon. This is a topic I’ve been writing about in The Energy Strategist for months.

In last weekend’s issue of my free e-zine PF Weekly, I offered a detailed analysis of Friday’s far stronger-than-expected July Employment Report and the overall outlook for the US economy. The bottom line: There has been a definite softening of the economic data over the past few months, but it’s still broadly consistent with a slowdown in growth, not another recession. Moreover, the US and most other developed economies have been facing a number of temporary headwinds so far this year and those are all fading. I’m looking for a significant pick-up in growth over the next few months.

This week is a lighter week for economic data than last week. The biggest market-moving events will be the Federal Reserve’s decision on interest rates on Tuesday, initial jobless claims on Thursday and retail sales on Friday. Look for the Fed to take no action on rates but investors will be scouring the statement for any signs the central bank is considering a third round of quantitative easing (QE3). I’ll be watching retails sales closely for signs that the reduction in gasoline prices, since April is beginning to filter through into stronger sales.

The US had already been in recession for more than three quarters when the Lehman bankruptcy unsettled global markets back in 2008. This time around, the US and global economy are hardly booming but are on stronger footing.

Though the timing of the US debt downgrade was a surprise, the fact that the debt was downgraded was not unexpected. This is clear when you consider the orderly and rather unconcerned trading in the US Treasury futures markets this morning despite the downgrade. If investors were really scared about the safety of Treasuries, yields should be spiking not near multi-decade lows.

And though the media has droned on endlessly about the loss of confidence in the US as a result of the debt ceiling debate, the corporate bond market remains extremely strong. The average 10-year corporate bond of an industrial firm rated BBB in the US currently yields just 1.89 percent more than the 10-year US Treasury. That spread is actually down from nearly 2.5 percent last October. Corporates are still paying near record-low rates to borrow money. That’s a far cry from the frozen credit markets and hobbled corporate bond markets that prompted such a severe market selloff in late 2008.

Finally, a statement from ECB President Jean-Claude Trichet over the weekend makes it clear the Europeans intend to buy Italian and Spanish government bonds en masse to shore up these troubled markets. That buying is evident today, with yields on both the Italian and Spanish 10-year bonds declining by a whopping 75 to 80 basis points to around the 5.25 to 5.35 percent range. The Europeans have been reluctant to take this step, and the key will be sustaining these declines in yields. But it appears the ECB is willing to take drastic measures to convince the market it’s serious.

The Italians have also accelerated their austerity plans, coming up with a realistic roadmap to balance their budget by 2013, a year earlier than previously targeted.

Meanwhile, I’ll be watching emerging markets such as China carefully. With inflationary pressures in these countries beginning to ease amid declining commodity prices, the pressure on regional governments to tighten policy to combat inflation and emerging bubbles is lessening. This is likely to lead to a strong rebound in growth in the second half of this year and into 2012, helping support global growth.

Don’t feel pressured into selling at the first whiff of economic weakness. As I explained in PF Weekly, there’s little historic benefit for investors to be the first to call a recession. Meanwhile, there are major risks of selling out of your holdings every time the economy wobbles; for example, last summer’s vicious growth scare was followed by a powerful rally that lasted well into 2011 and took the market to new highs. You don’t want to miss moves of that nature.

While risks have risen somewhat, the news is not all bad, as Friday’s jobs report made clear. The odds are still stacked heavily against those betting on a new economic downturn just as they were a year ago.

How to Play It

Although I can’t tell you exactly when this panicky selloff will stop, I can tell you that moves of this nature and severity are historically short-lived, and the recoveries are typically dramatic. My best guess at this point is that the S&P 500 will find a low somewhere between 1,125 and Friday’s intraday low of 1,170 over the next one to two weeks. Additional signs of significant economic weakness or a runaway credit contagion in Europe would be the only catalysts I can imagine for pushing the S&P 500 below that range.

Macroeconomic events and panics of this nature impact almost all stocks across most sectors. Energy stocks are no exception; in fact, because crude oil prices and energy demand are sensitive to global economic conditions, the group tends to get hit a bit harder than the market as a whole when there are concerns about a recession. The good news: The sector also tends to explode to the upside as the panic subsides, outperforming the broader market on the upside as well.

The recent decline in TES Portfolio Holdings has nothing to do with individual recommendations and everything to do with broader market conditions. I don’t see the fundamental trends and plays within the sector changing much as a result of this growth scare. The same stocks that led earlier this year are likely to lead the recovery from this selloff as well. Examples include Weatherford International (NYSE: WFT) and Schlumberger (NYSE: SLB), two oil services names that posted extremely strong second-quarter results and issued positive guidance for the balance of the year. Also remember that the key global oil benchmark is Brent, and it’s still trading well over $100/bbl, up from less than $80/bbl a year ago. WTI is not a relevant benchmark outside parts of the US.

One of my favorite groups to buy during market-wide downturns of this nature: high-yield “safe-haven” stocks. This list includes names like my recommended master limited partnerships (MLPs) that have little or no exposure to energy prices or broader economic conditions. These companies have locked-in cash flows backed by long-term contracts with major companies that support their yields. While these firms have no significant exposure to prices, the broader market or economy that doesn’t mean that they don’t get hit in broader market declines. Investors are famous for throwing out the proverbial babies with the bathwater.

In the spring and early summer of 2010, many of these high-yield safe havens went on sale, with some, such as Linn Energy LLC (NSDQ: LINE) getting caught up in the early May flash crash, trading sharply lower intraday only to recover all of those losses by the close of trading. Investors who took advantage of these temporary sales often locked in yields of close to 10 percent or more on low-risk names. These high-yield safe havens were also the first to recover from last summer’s selloff.

Here’s a list of stocks in the TES portfolios I consider high-yield safe havens. Consider buying or adding to your positions on any market weakness. Also consider setting a limit order with your broker to buy these stocks roughly 10 to 15 percent below their Friday, Aug. 5, closing prices. This will allow you to buy if any of these stocks are caught up in a temporary flash crash.

Eagle Rock Energy Partners LP (NSDQ: EROC, Yield 7.6%)–MLP with some exposure to natural gas liquids (NGLs) prices but strong distribution growth potential. Buy < 12.

Linn Energy LLC (NSDQ: LINE, 8%)–Upstream (producer) partnership that’s almost fully hedged against oil and gas prices through 2014-2015, recently boosted its payout. I’m looking for 7 to 9 percent annualized growth in distributions over the next three years, among the fastest of any in my coverage universe. Buy < 40. 

Chevron (NYSE: CVX, 3.3%)–Supermajor oil producer. The yield isn’t as exciting as some of the MLPs, but the big oils traditionally fare well during market-wide downturns. Buy < 105.

Enterprise Products Partners LP (NYSE: EPD, 6.4%)–Alongside Kinder Morgan Energy Partners LP, Enterprise is the highest-quality, most defensive and consistent MLP in my coverage universe. It’s boosted its payout for 26 consecutive quarters and tends to outperform on market downturns. But the stock is prone to intraday spikes to the downside that mark excellent opportunities to back up the proverbial truck and buy. Buy < 45. Buy the stock aggressively on any dips to 35 or below.

Kinder Morgan Energy Partners LP (NYSE: KMP, 7%)–Like Enterprise Products Partners Kinder Morgan is heavily fee-based and insensitive to commodity prices. Buy < 70. Load up on this stock if its spikes below 62.

Natural Resource Partners LP (NYSE: NRP, 7.7%)–Some exposure to coal prices but exposure is modest and demand is strong this summer due to hot weather. Buy < 30.

NuStar Energy LP (NYSE: NS, 7.9%)–A combination of a fee-based pipeline company and an asphalt refiner. The recent boost to the quarterly distribution is a sign of management’s confidence in sustainability. The MLP is finally back under my buy price. Buy <  60.

Penn Virginia Resource Partners LP (NYSE: PVR, 8.3%)–A series of recent deals make Penn Virginia less exposed to coal prices and more fee-based. Buy < 29. Get more aggressive on any spikes under 22.

Sunoco Logistics Partners LP (NYSE: SXL, 6%)–A high-quality, rock-solid MLP with no significant exposure to commodity prices or economic conditions. Rates it charges are pre-set and are indexed to inflation. Buy < 85. Use any dips under 77 to get aggressive with this MLP.

Teekay LNG Partners LP (NYSE: TGP, 7.8%)–Teekay LNG’s fleet of liquefied natural gas (LNG) carriers are all booked under long-term, 10- to 20-year contracts, and the firm faces no significant near-term contract expirations. There’s no fundamental reason for the stock’s slide, excerpt investors’ general fear of the shipping and tanker markets. Because Teekay has no exposure to spot rates it’s unaffected. Buy < 41. Buy with both hands if it dips below 30. 

Alliance Holdings GP (NSDQ: AHGP, 5.2%)–Don’t let Alliance Holdings GP’s relatively small yield fool you; distributions are growing at a 15 to 20 percent annualized pace, so the yield you realize will be higher. The MLP has exposure to coal prices but is defensive compared to pure coal-mining names. Buy < 55. Use dips under 42 to get more aggressive.

Knightsbridge Tankers (NSDQ: VLCCF, 11.7%)–Knightsbridge isn’t an MLP and is in an out-of-favor market sector right now, namely tanker shipping firms. That being said, hefty contract coverage means that it has little or no real exposure to spot rates in the near term and is simply guilty by association. A higher-risk play, Knightsbridge is an attractive buy under 27.50.

Seadrill (NSDQ: SDRL, 11.3%)–Seadrill’s fleet of deepwater drilling rigs are all booked under long-term contracts at attractive rates. The stock has been hit partly due to the fact that it experienced trouble with its debt burden back during the 2008 financial crisis. But since then Seadrill has pushed back its debt maturities so that it isn’t exposed to near-term funding risks. In addition, credit markets continue to function this year, so a comparison with 2008 isn’t valid.

Seadrill is one of the best-positioned growth and income names in my coverage universe with its fleet of new highly capable rigs. Buy < 38. Regard any dip under 28 as a gift.

In addition to buying high-yield safe havens, also consider taking on the two short hedge recommendations in my Fresh Money Buys list. First Solar (NSDQ: FSLR) manufactures thin-film solar equipment. While it’s a quality player in the space, solar power is extremely expensive, unreliable and doesn’t work well with current electricity distribution infrastructure. In short, without massive government subsidies, solar is a non-starter and with government spending on the wane, First Solar is headed lower. First Solar now rates a short above 100.

Diamond Offshore (NYSE: DO) is a contract driller, like Seadrill. But unlike Seadrill Diamond has a large fleet of older rigs–known as “mid-water” rigs–that aren’t capable of drilling in the deepest water. The market for these rigs is poor and that’s likely to hurt Diamond over time. Diamond Offshore now rates a short over 55.

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