8/23/11: Strategy Session
Although the S&P 500 clawed its way back above 1,200 last Monday, this strength proved short-lived. Stocks on Tuesday shrugged off a stronger-than-expected estimate of July industrial production and drifted lower through midweek.
The selloff accelerated on Thursday and Friday, reflecting a disappointing reading from the Federal Reserve Bank of Philadelphia’s August 2011 Business Outlook Survey. The widely watched indicator plummeted to negative 30.7 from 3.2 in July. Analysts’ consensus estimate had called for a reading of 2.0, making for one of the largest shortfalls in the index’s history.
Several subscribers have asked if this changes our outlook for the US economy over the next few quarters. We still expect the US to skirt a recession over the next six to 12 months, though the likelihood of an economic contraction has increased in recent months to a one-in-three chance.
The huge decline in business sentiment reported by the Philadelphia Fed’s survey may have surprised analysts, but this data point continued a trend that’s been in play for several weeks. Recent survey data, which gauge outlooks and expectations rather than actual activity, have fallen short of Wall Street’s estimates, while hard data has surprised to the upside.
That’s not to discount the importance of soft economic data such as the Philadelphia Fed’s Business Outlook Survey or the Institute for Supply Management’s Purchasing Managers Index (PMI). These reports are important leading indicators of US economic activity.
But the Philadelphia Fed’s latest measure of regional business sentiment appears to overstate the weakness in the US economy.
The August survey took place between Aug. 8 and Aug. 16, a time when confidence was in short supply. Over this period, business leaders were buffeted by a number of unsettling developments, from a substantial decline in the S&P 500 to Standard & Poor’s downgrade of the US government’s credit rating and ongoing worries about the EU’s sovereign-debt crisis.
Moreover, although the Federal Reserve Bank of New York’s Empire State Manufacturing Survey (released on Aug. 15) also fell short of analysts’ consensus estimates, the magnitude of this deviation paled in comparison to the Philadelphia Fed’s Business Outlook Survey.
Nevertheless, if we take the big drop in business sentiment reported by the Philadelphia Fed’s at face value, the reading implies that the August Manufacturing PMI could come in as low as 44 or 45. Such a reading would be consistent with a US recession.
The Philadelphia Fed’s regional survey has often been wrong in the past; this data looks like an outlier. We’ll also scrutinize the Federal Reserve Bank of Richmond’s Fifth District Survey of Manufacturing Activity when it comes out on Aug. 23.
To complicate matters, hard economic data continue to suggest that the US economy has extricated itself from the soft patch in which it’s been mired.
Industrial production numbers released last week almost doubled analysts’ consensus expectations. The automobile industry led the way, reflecting a welcome recovery from the supply-chain disruptions that had plagued the group since the Tohoku earthquake in March.
Meanwhile, the latest retail sales data suggests that falling energy prices have coaxed US investors to open their pocketbooks. The US Census Bureau estimates that retail sales increase by 0.5 percent in July (in line with analysts’ consensus expectations) and revised its June number higher to reflect a 0.3 percent monthly increase.
Initial jobless claims, though a bit higher than expected last week, have declined steadily in recent weeks, and the widely watched four-week moving average of unemployment claims continues to fall.
All eyes will be on the Census Bureau’s advance estimate of July durable goods orders, which is slated for release of Aug. 24.
The divergence between sentiment and economic activity has put investors on edge. At a certain point, the prevailing outlook can become a self-fulfilling prophecy. Shocked into submission by a stream of negative headlines and doomsday scenarios, consumers could rein in spending and businesses curtail hiring. In that event, a recession is a possibility.
That being said, sentiment can turn on a dime–particularly if economic data continue to improve.
Oil and Some Positives
As we’ve explained in recent issues of The Energy Strategist, West Texas Intermediate (WTI) crude oil has traded at a substantial discount to Brent crude oil and other major international benchmarks.
WTI generally commands a slight premium to Brent crude oil, but that relationship has reversed over the past 12 months. Local supply conditions at the physical delivery point in Cushing, Okla., are the culprit: Rising US imports of Canadian oil, higher domestic output from shale oil fields and an uptick in ethanol production have prompted pipeline operators to add new lines or reverse the flow of existing lines to carry crude south to Cushing and other refinery centers.
This shift has not only glutted storage facilities at Cushing, but the reversed pipelines have limited flows out of the hub. When an influx of crude oil overwhelms refining capacity, stockpiles build, and the price of WTI declines. This logistical logjam can only be resolved by the construction of new pipelines to move crude oil from Cushing to the Gulf Coast.
Investors instead should monitor the price of Brent crude oil, an important international benchmark that currently goes for $109 per barrel. This price is well off its 2011 high of almost $130 per barrel but well above the $80 per barrel it commanded a year ago. Rest assured that oil companies are basing their strategic direction and capital expenditures on Brent crude oil.
Thus far in August, Brent crude oil has traded as low as $103 per barrel. A tight supply-demand balance in the global oil market should prevent prices from sinking further, which explains why retail gasoline prices haven’t declined to the extent one might expect.
But the price of Brent crude oil receded slightly yesterday after Libyan rebels declared Muammar Qaddafi’s rule had come to an end. Investors shouldn’t expect Libya’s oil industry to return to normal once the civil war ends–it will take at least a year to restore production to pre-conflict levels. Meanwhile, rebel leaders have cautioned that there are still pro-Qadaffi strongholds in Tripoli and other Libyan cities. The conflict could drag on for some time.
Nevertheless, several producers have indicated that they hope to bring production online soon–a possibility in some parts of eastern Libya that the rebels control by strength of arms and historic allegiance. Investors should remember that the war has damaged Libya’s energy infrastructure significantly.
The history or previous war-torn countries suggests that it will take far longer to restore oil production than optimistic projections suppose. Remember all the talk a few years ago about Iraqi oil production flooding the global market? Libya’s oil exports will recover gradually.
Investors should also pay close attention to Federal Reserve Chairman Ben Bernanke’s upcoming speech in Jackson Hole, Wyo., on Aug. 26. At last year’s event, Bernanke revealed that the central bank would initiate a second round of quantitative easing, an announcement that boosted the stock market in September.
Some speculate that the Fed chairman on Friday will announce or at least hint at the possibility of a third round of quantitative easing. Other commentators suggest that Bernanke will unveil plans to reinvest interest and principal repayments from the central bank’s current holdings into longer-dated US Treasury bonds.
Regardless of how you feel about these policies, any of these options would support stock prices.
Predicting recessions is tricky. Economists have innumerable forward indicators to consult, though each generates its fair share of false alarms. For example, history indicates that the S&P 500 tends to peak about six months before the start of a recession and bottom roughly six or seven months into the recession. A simple model that looks at major six-month changes in the S&P 500 predicted all eight recessions dating backs to the 1960s, as well as nine other downturns that never came to fruition.
Early indicators of a recession tend to give the most false signals. Slower-moving indicators–including my favorite, the year-over-year change in the Conference Board’s Index of Leading Economic Indicators–yield fewer incorrect forecasts but lags earlier indicators.
Over the weekend, I put together a probability model that considers a number of indicators that have proved their worth in the past. At present, this model indicates there’s a roughly one-in-three chance that the US economy will slide into recession over the next six months. If the probability of a contraction spikes to more than 50-50, we will adjust our strategy accordingly.
What to Do Now
1. Buy Yield
As my colleague Roger Conrad observed in The S&P Downgrade, Dividend Payers and Low-Cost Capital, the yield on 10-year US Treasury bonds recently slipped under 2 percent. Although the yields on lower- grade “junk” bonds have risen, the yield spread between high-grade corporate debt and Treasury bonds of similar duration remains near record lows. Income-oriented investors won’t find much to like in the corporate bond market, either.
Investments that offer favorable yields and the potential to generate steady income over time will remain in high demand. For most of the 20th century, dividends accounted for at least half the total return investors could expect from the stock market. Income investing fell out of favor in the late 1990s, but dividend-paying equities will also be essential to outperforming developed markets in this century.
Fortunately, the recent market rout offers periodic opportunities to scoop up our favorite high-yielders at a discount. Many of our top picks have limited exposure to economic conditions or commodity prices; their dividends should remain intact, regardless of broader conditions. These periodic selloffs reflect spillover from a weak market, as opposed to company-specific problems. This gives you the opportunity to lock in high-yields that will sustain your returns through any downturn.
For a shopping list, consult the list of dividend-paying, safe-haven stocks outlined in the Aug. 8, 2011, Flash Alert, “Don’t Panic: Opportunities Abound.”
In this week’s issue of The Energy Strategist, we’ll take a closer look at other safe-haven bets, including the Super Oils. Big oil companies such as current Portfolio holdings Chevron Corp (NYSE: CVX) and Eni (Milan: ENI, NYSE: E) limit their exposure to energy prices through hedging and boast bulletproof balance sheets. As these stocks have pulled back with the broader market, now marks a good opportunity to invest in integrated oil and gas companies that pay sustainable dividends.
2. Buy Long-Term Growth on the Cheap
Shares of coal mining firms and oil-services outfits tend to endure bigger price swings than the broader market.
For example, the Philadelphia Stock Exchange’s Oil Services Index has exhibited a beta of 1.40 over the past five years; the S&P 500 Energy Index, on the other hand, has a beta of 1.07 over the same period. A beta of 1.0 indicates that a particular sector tends to move at about the same speed and in the same direction as the S&P 500 as a whole. Betas of greater than 1.0 imply more volatility and less than 1.0 suggest less volatility.
Some subscribers have asked me why shares of oil-services giant Schlumberger (NYSE: SLB) and coal producer Peabody Energy Corp (NYSE: BTU) have pulled back more than the broader market.
The answer has nothing to do with stock-specific factors–both stocks reported strong quarterly results and improving outlooks–but is a simple function of investor conditioning. When the outlook for global growth dims, investors sell oil services and other higher-beta names first. It’s just the accepted playbook.
In the short term, these stocks could pull back further or trade sideways. If the S&P 500 breaches its technical support near 1,100 or 1,120, expect services and international coal names to give up more ground. Nevertheless, you should regard weakness in these stocks as an opportunity to buy long-term growth on the cheap.
With the US economy expected to grow at a subpar rate over the next few years and Europe’s political elite sorting out the EU’s sovereign-debt travails, the emerging markets have become infinitely more attractive to investors.
Investors had worried that governments in emerging markets would tighten monetary policy to rein in inflation; the developed world’s troubles reduce the likelihood of tightening. Meanwhile, rising demand from emerging markets will continue to buoy the price of Brent crude oil.
Multinational oil-services firms Schlumberger and Weatherford International (NYSE: WFT) should continue to benefit from robust spending on exploration and production. The potential Libya’s oil industry to begin its slow, painful recovery could be a meaningful tailwind for Weatherford International.
Growth stocks may be out of favor right now, but fundamentals in international coal and oil-services markets don’t justify the recent flight to safety. Six to 12 months out, current prices for these names will look like steals. We’ll also list the top bargains among our growth-oriented plays in the next issue of The Energy Strategist.
3. Hedges
The most direct way to profit from the current downdraft in global equity markets and protect your portfolio against future volatility is to short stocks that are disadvantaged in the current environment. A few exchange-traded funds (ETF) also enable investors to bet effectively against certain sectors or commodities.
This is not a new strategy in The Energy Strategist. In fact, the Fresh Money Buys list has contained two short plays for almost a year: First Solar (NSDQ: FSLR), which is up 31.7 percent through Aug. 22, and Diamond Offshore Drilling (NYSE: DO), which is up 9 percent. Both stocks have underperformed the S&P 500 Energy Index handily since we added them to the model Portfolio. Holding these shorts as the market tanks has offered ballast for your portfolio.
Investors looking to hedge their portfolios should sell First Solar short above 80; the stock could decline to as low as 50 as cuts to government subsidies erode the company’s revenue.
Diamond Offshore Drilling’s fleet of older, “midwater” rigs is vulnerable to any cutback in exploration and production spending. Sell Diamond Offshore Drilling short above 55. If things get ugly, the stock could revisit its 2009 low of less than 45.
We will examine additional hedges in this week’s issue of The Energy Strategist. In particular, North American natural gas producers look particularly vulnerable in this environment. The group has benefited from extremely hot weather across the US and Canada in July, which drove unusually strong demand for gas and held down natural gas inventories.
In addition, Hurricane Irene’s approach serves as a reminder that the Atlantic hurricane season is just entering its most deadly and destructive stretch. Fears of a major storm hitting the Gulf Coast and disrupting production tend to hold up natural gas prices in the August and early September.
But the short-term outlook for US gas prices is bearish. US drilling activity remains robust, production continues to grow, and demand will slacken as summer heating season ebbs. There’s still a glut of gas in the US market, and it’s only going to get worse if the economy slows further or, contrary to my expectations, enters recession.
Please note that my outlook for North American gas prices differs substantially from the outlook for liquefied natural gas in international markets.
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