When Asia Sneezes
For close to seven months, global equity markets have been locked in a steady, nearly uninterrupted uptrend. That benign environment came to at least a temporary halt last week as Asian markets led a sudden, sharp selloff that spread quickly to infect just about every sector and industry subgroup the world over.
The good news: Energy stocks came through last week’s bloodbath in relatively good shape. That’s not to say the group was unaffected; but energy didn’t lead downturn as it did last year’s May/June selloff. The Philadelphia Oil Services Index (OSX) declined a touch more than 3 percent last week against a 4.4 percent decline in the S&P 500 and a 5.8 percent decline in the Nasdaq Composite.
Other energy subgroups performed even better, particularly my favorite income-oriented group, the master limited partnerships (MLPs). The Alerian MLP Total Return Index actually eked out a 0.7 percent gain on the week; the index is up 8.5 percent so far in 2007.
The MLPs are a high-yielding, extraordinarily defensive group that should continue to perform well regardless of what happens to the rest of the market. My income-oriented Proven Reserves Portfolio is particularly heavy in MLPs; this Portfolio is actually up about 2 percent for the past two weeks, bucking the trend in the broader markets.
I have two groups I’m watching carefully right now as possible additions to the Portfolios: refiners and general partner (GP) stocks. “Crack” spreads–a measure of profitability for refiners–have been expanding lately and should continue to rise during the next few months as we head into the summer driving season.
GPs are companies that manage the assets within MLPs; the MLP actually pays them a fee for managing these assets. Bottom line: GPs offer nice yields and distribution growth as high as 40 percent annualized in the next three years.
But I’m unwilling to introduce these important new themes in this issue in light of the recent selloff. I prefer to focus on defending gains in current recommendations; I’ll look to introduce these important new themes in an upcoming issue.
This global pullback is playing out differently for the energy patch than the move we had last May. Last year, the oil- and gas-related stocks had been the market’s star performers in the months leading up to the May/June selloff. It’s hardly surprising that the group pulled back violently as traders took big gains off the table; high-momentum groups typically perform poorly when the market takes a dive.
To make matters worse, the fundamentals in the US natural gas market had clearly started to deteriorate by the middle of l2006. Gas inventories had been building up for months and remained far above average, and the North American drilling slowdown I wrote about in the most-recent issue of The Energy Strategist, All Eyes On Gas, was just starting to unfold at that time. The threat of hurricanes kept a bid under gas prices all summer, but that quickly faded into a sharp selloff in September.
This year, oil- and gas-related stocks have been trading sideways for months. The fundamental picture remains mixed: As I pointed out in the last issue of TES, the market remains concerned about a further dampening in North American drilling activity, while foreign drilling markets remain red-hot.
But gas inventories are starting to moderate as a result of continued bouts of colder weather in the Northeast and upper Midwest; fundamentals are slowly but steadily improving. In any event, the oil and gas group certainly hasn’t been the market’s star performer in recent weeks. There’s less momentum money in this group than there was last May.
I suspect this accounts for the relative quietness in the energy patch during last week’s tempest. In addition, the worst news is already priced into many gas-related stocks; sentiment on natural gas is actually bearish right now.
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I don’t see much downside left for these stocks, as they’ve already been heavily sold. Many traders are even betting against these stocks by selling shares short. The short interest ratios—ratio of short shares outstanding to average trading volume—for many of the land drillers and North America-focused services names I follow are approaching six-month highs. That’s hardly a sign of investors’ bullishness on the group.
Analysts have already slashed their earnings estimates for any company with exposure to North American gas markets, so the bar of expectations remains ultra-low. I continue to look for an opportunity to play North American gas names more aggressively this spring.
I’m also of the belief that the outlook for the global economy really hasn’t deteriorated significantly during the past few weeks. Asian markets have been the epicenter of the recent pullback, and Asia’s economic picture remains key to the market’s future.
Asia is also absolutely crucial to the energy story. Asian demand has been a primary force in the rally in oil and gas prices during the past few years. And the continent also remains a major driver for the renaissance of nuclear power, agriculture and biofuels.
This is why I’ve asked our in-house Asia expert, Yiannis Mostrous, editor of The Silk Road Investor to contribute a piece for today’s issue explaining the outlook for the Asian markets and economy. His detailed analysis can be found at the end of today’s issue. I couldn’t agree more with his basic outlook.
That said, although energy’s relatively solid showing is encouraging, it’s not enough; we can’t be content with simply losing money less quickly than the market as a whole. Globally synchronized selloffs of the sort witnessed in the past week and a half have a nasty habit of spilling over into all markets.
Specifically, when traders decide to liquidate stocks and raise cash positions, all groups in all countries see selling. Fundamentals and industry prospects go out the window in such environments as investors all race for the exits at the same time.
This isn’t the end of the bull market in energy, and Asian economies aren’t imploding. However, I’d be surprised if the recent bout of weakness doesn’t persist for at least another four to six weeks. The speed and severity of the move is simply too sharp to be ignored, and there are many investors looking for any rally to bail out.
It’s high time we take steps to evaluate the model Portfolios’ current positioning, defend gains in big winners and protect capital. That capital will be sorely needed for when this bout of selling ends, and it’s time to start putting money to work aggressively again.
I suggest a three-part approach to this selloff. First, continue to focus on risk management for existing positions by adhering to stop-loss recommendations and using options hedges to protect gains.
Second, in last year’s decline, MLPs continued to rally even during the worst weeks of the move; any dips in this defensive group constitute a buying opportunity.
And finally, I outline the case for some direct index hedges in this week’s issue.
I’ve made several recommendations to protect your portfolio in the last issue, as well as the two succeeding flash alerts. Here I update you on such recommendations, as well as what’s going on in my uranium and biofuels bets. See Stops And Options.
I’m normally not a fan of exchange traded funds, but with in current global selloff, they may not be a bad investment tool to use as protection against major losses. I’m adding one to the Gushers Portfolio for the time being. See Index Hedges.
I also hold several MLPs in my Portfolios as defensive plays. These investment products offer significant benefits within this current market, which I highlight here. See Playing Defense.
In his article, Yiannis explains that, for a country such as China that has experienced such significant and quick growth, this selloff was not only inevitable but necessary. He also details his opinions on the effects in other Asian markets. See Unnerving.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
Stops And Options
In the most-recent issue of TES, I highlighted two options strategies as a useful means of hedging your big winners against downside risk: put insurance and call replacement. I went on to offer specific strategies for hedging six of the biggest winners in the TES Portfolios.
If you took those recommendations, you’d have significantly softened the pain of last week’s move. Take another look at that section of the issue, and consider implementing some of the strategies outlined there if you haven’t done so already.
Some of these stocks are down since that recommendation, and the options outlined are now more expensive. However, I continue to see these options hedges as useful strategic tools in this environment.
The key is that all investors, no matter how seasoned, tend to get frightened by sharp moves lower such as witnessed last week and so far this week. Put insurance will protect your downside no matter how sharply your stocks decline; I find that holding such hedges helps to stem any panic during declines.
In addition to last week’s recommendations, here are two additional put hedge recommendations for stocks not covered in that issue:
Of course, not all of the stocks I recommend trade options or offer liquid options contracts. Therefore, this strategy can’t be our only means of managing risk.
I recommend two further means of managing risk on existing positions. First, I set recommended stop positions on most recommendations in the three model Portfolios. Stop orders are nothing more than an automatic order you leave with your broker to sell you out of a position once a pre-determined “stop” price is hit.
For example, assume you buy a stock at $100 and set a stop at $90. As soon as that stock trades at $90, you will be automatically sold out of all your shares. Therefore, your downside risk is limited to roughly $10, or 10 percent, on the investment.
I also recommend using what’s known as a trailing stop. Basically, I’ll periodically adjust stops on Portfolio recommendations to lock in incremental gains. For example, if I recommend a stock at $50 and it rises to $70, I may recommend raising your stop to $55 to lock in a minimum $5 gain. By periodically raising—known as trailing—the stop higher as the stock rises, we can lock in incremental gains over time.
In the flash alert sent out earlier this week, The Selloff, I recommended raising stops in several Portfolio recommendations. Those recommendations are all updated on the Portfolio tables.
Bottom line: If you took any of my options hedge recommendations in this week’s or last week’s flash alerts, you can cancel outstanding stop orders on these stocks. Otherwise, I recommend that all subscribers consider setting stop orders to protect gains and guard against downside.
Also in the flash alert this week, I recommended taking partial gains on a number of key Portfolio picks, including several names in the biofuels and uranium field bets. Again, these sales aren’t a sign that I’m cooling on either story; I still see uranium and nuclear power as my top growth idea for the next three to five years at a minimum. And biofuels, too, should continue to see growth led by political pressure for years to come.
But I recognize that subscribers who got into my uranium field bet recommendations last summer when I first initiated the play are now up, on average, more than 100 percent on these picks. That’s in spite of the recent pullback in the group.
Therefore, for these subscribers, the uranium field bet has grown from a small portfolio holding into some of their biggest positions. Even those who jumped into the uranium names at the beginning of 2007 are showing some nice gains despite the sharp pullback of the past two weeks. I summarize the performance of this play in the table below.
Source: The Energy Strategist
Although I expect all these names to take out their 2007 highs later this year, there could be another 10 to 20 percent downside in the context of a continued global selloff. This is nothing new: Check out the chart of Paladin Resources below for a closer look.
Source: StockCharts.com
Paladin has seen two corrections of roughly 35 percent since its initial public offering in 2005. Although the stock is up close to sevenfold during this period, those pullbacks seemed vicious at the time.
On average, in prior pullbacks, Paladin remained weak for eight to 12 weeks before resuming its uptrend. I expect the stock to act in broadly similar fashion this time around; I expect new highs later this year, but we could be in for choppier, back-and-forth trading for the near term. I’ll be monitoring the stock and plan to send a flash alert out recommending adding to your position once the stock stabilizes.
Of course, this is nothing unique to Paladin. It’s not at all unusual for stocks in strong multi-year uptrends to see corrections of that magnitude–all of the other uranium field bet plays show similar patterns.
I’ve spoken or conversed via e-mail with several new subscribers who’ve not yet jumped into the uranium field bet because the stocks have been too extended to buy. I’ve spoken to a few others who got in later and are watching gains since the beginning of February disappearing in this selloff. I caution all new subscribers not to forget the basic premise of the field bet.
To play these stocks, I don’t recommend putting a huge amount of money to work in each name. Therefore, if you normally put $10,000 into each TES recommendation, only put $2,000 into each field bet play.
The idea of the field bet is to give us diversified exposure to a number of promising stocks in a volatile subgroup of the energy markets. As I’ve said before, I don’t recommend betting the farm on some or all of these names. If you start by buying relatively small stakes, then this volatility won’t be as much of a concern.
And if you’re not yet into the uranium stocks, consider taking a small position in all field bet picks and then adding more on any further 10 to 20 percent declines. I see this selloff as an outstanding opportunity for those who believe the uranium story–which I outlined in the July 26, 2006, issue, The Nuclear Option, and updated and reviewed in the Dec. 20, 2006, issue, Oil And Gas–to jump into the field bet recommendations at attractive prices.
My basic recommendation on the field bet is as follows. For those with big gains, consider selling off a third of your position in the stocks I outlined in the March 5 flash alert to book profits and reduce your exposure to the uranium space. Although I still like the story, triple-digit gains in these stocks during the past quarter have resulted in a portfolio that’s far too overweight the group.
I’ll be looking to put that cash back to work in my favorite uranium names once this selloff cools down in a few weeks. Look for recommendations via flash alert or in an upcoming issue when it’s a good time to add more exposure to the group.
If you’ve jumped in only recently, remember to ensure that you’re not taking on too much risk. It’s imperative to follow my field bet strategy of only putting a small amount of cash to work in each name.
For those not yet in, consider taking half your intended position at current levels and look to add to that exposure on a further 10 to 20 percent decline in the group. Such a decline would be roughly equivalent to prior declines we’ve seen in this sector during the past two years.
The situation for the biofuels field bet is similar. Because agriculture is seen as a defensive sector, these stocks aren’t down as sharply as the uranium names I recommend.
I also highlighted options hedge plays on four of my favorite agriculture/biofuels recommendations in the last issue of TES; I gave options insurance strategies for Bunge, Potash Corp, Mosaic and Syngenta. If you haven’t yet taken out those insurance policies, it’s not too late to do so now.
If you’re unwilling to play the options market, consider taking a third of your position in Syngenta, Potash Corp, Mosaic and Bunge off the table to lock in some impressive profits and reduce what’s now an overweight position in the group. Continue holding on to the other stocks recommended in the biofuels field bet.
Source: The Energy Strategist
Also note that I’m cutting my recommendation in Earth Biofuels to a hold from a buy. This is the only stock in either field bet to be showing a loss.
I identified this stock as by far the riskiest when I originally recommended it in September. But recommendation clearly hasn’t worked out as intended, and I’m concerned by the insider selling I’m seeing.
Earth Biofuels is a highly volatile name that tends to see some big runs from time to time. Rather than sell out of the stock now, I’ll be looking to recommend getting out on any strength later this spring. If you’ve kept your position very small, as recommended, this loser hasn’t hurt performance a great deal.
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Index Hedges
One final means of hedging the model Portfolios is to use a broad index hedge. Last May, I recommended using put options on the Oil Service HOLDRS (OIH) as a hedge against further downside in the group. But thanks to the advent of a series of new exchange traded funds (ETFs), it’s now possible to hedge out risk more simply and without trading options or shorting any index.
Long-time readers are aware that I’m not a huge fan of ETFs. I generally believe that the average investor can do far better selecting individual stocks than playing market indexes.
In addition, ETFs don’t grant access to all of the best plays out there. This is particularly true of the oil and gas space, where most ETFs are dominated by holdings in a handful of mega cap names.
But there are a few exceptions. One is the Deutsche Bank Agriculture iShares I recommend in the biofuels field bet. I recommend these iShares because they allow investors access to the commodity markets–a market that few stock investors had access to prior to the launch of this ETF.
I also see the attraction of a series of short ETFs launched in the past few months. First, it’s useful to explain the concept of shorting stocks.
Selling short, or shorting, is a way to profit from declines in a stock. The best way to illustrate is with an example. Say you want to short an imaginary stock, “ABC,” trading near $50 per share. Assuming you want to short 200 shares of the stock, the value of the transaction would be $10,000.
To short the stock, you first need to borrow shares from your broker. Your broker loans you 200 shares of ABC stock; you immediately sell this stock on the open market for $50 per share, receiving $10,000 for that sale.
But because you borrowed 200 shares of ABC, you still owe this to your broker and will need to return the shares at some point in the future to pay off your debt. In other words, you’re short the stock. Assume a few weeks pass and you’re ready to close out your short, a process known as buying to cover. At this time, two basic scenarios are possible:
As you can see from this example, short selling is a way of profiting from the decline in a stock. And although I’ve outlined the mechanics of the process in the example above, all of that is totally seamless and behind-the-scenes.
With most online discount brokers, there’s an option on your trading screen that says “Sell Short” or simply “Short.” Another option labeled “Buy To Cover” allows you to close out a short. The broker handles all of the lending of shares automatically.
Although shorting has become progressively cheaper and easier to do in recent years, many traders are either prohibited from shorting (such as within IRA accounts) or uncomfortable with the strategy. Enter the short ETF.
Basically, when you buy these ETFs, they give you exposure to the short side of the underlying index. If you purchase the Short QQQ Fund (AMEX: PSQ), you’re effectively shorting the Nasdaq 100 index.
If you buy the UltraShort QQQ (AMEX: QID), you’re effectively double shorting the Nasdaq. If the Nasdaq 100 falls 10 percent, the UltraShort QQQ ETF could be expected to rise in value by roughly 20 percent.
There’s a short ETF that tracks the inverse of the Dow Jones OIL & Gas Sector, a basket of the largest oil- and gas-related stocks in the US market. The UltraShort Oil & Gas (AMEX: DUG) will tend to rise by double the percentage that the Dow Jones Oil & Gas Index falls.
If the Oil & Gas Index falls by 15 percent, you can look for the ETF to rise by 30 percent. This ETF allows investors the opportunity to dispense with shorting entirely and play the downside in indexes by actually buying these ETFs.
ETFs trade on the major exchanges just like stocks. They’re simple to buy and sell. Your broker should charge you no more to buy these ETFs than to purchase any other stock.
By purchasing UltraShort Oil & Gas, we can partially hedge our long-side exposure to the industry. Specifically, I’m looking for the stocks in my three model Portfolios to broadly outperform the industry as a whole. But if this bout of selling continues for a few more weeks, even the fundamentally attractive names I recommend will get pulled lower.
Remember, as I said earlier, fundamentals go out the window during global selloffs of this nature. Exposure to this UltraShort ETF will guard against such an eventuality.
I’m adding the UltraShort OIL & Gas ETF to the aggressive Gushers Portfolio as a hedge. I’ve placed a stop loss order on this hedge just as with any other position.
I’ll look to hold on to this hedge until I see signs of a stabilization in global markets; this could be four to six weeks away. When it’s time to sell out of the hedge, I will send out a flash alert or announce it in the newsletter.
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Playing Defense
Finally, I strongly suggest that those looking to put new money to work focus their attention on my MLP recommendations. I have several of these recommended across the three model Portfolios; I’ve listed all of them in the table below.
Source: The Energy Strategist
The story behind MLPs was outlined at great length in the Nov. 22, 2006, issue of TES, Leading Income. I won’t repeat that analysis here.
Suffice it to say that I see the bullish story for MLPs resting on several key pillars:
I see the MLP group as an absolutely key piece of the TES Portfolios. I recommend that all subscribers look to buy into the story. And, if these stocks see any reaction to the recent selloff, use that as an opportunity to add to your positions in the group.
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Unnerving
By Yiannis G. Mostrous
Editor, The Silk Road Investor
FALLS CHURCH, Va.–Markets move in mysterious ways. Late in February, I wrote that the near-total absence of bearish voices was reason for investors to be cautious.
Those comments were made while Asian markets were making new highs, and I hoped to highlight the danger this reality was creating in a risk-seeking environment. And last Tuesday the Chinese market gave its first scare in more than six months by dropping 9 percent in a single day. The rest of Asia followed suit.
The US also declined substantially as investors tried to adjust their market positions by taking profits off the table. And given the market’s run since July 2006, there are a lot of profits to be taken.
The S&P 500 Index was up almost 18 percent from its low last summer, and even after the recent selloff, it’s still up double digits. It seems that the desire to reduce risk hits all investors at the same time.
As a result, we experienced an overnight transformation in the global investing environment, a move from extreme greed to alarming levels of fear.
But for a market–China–that enjoyed a 50 percent rise in three months, a correction like this shouldn’t merely have been expected; it was also necessary. Chinese authorities have made it clear that they’re trying to cool down not only certain parts of the economy but also the stock market.
The latest warning came toward the end of 2006 when Cheng Siwei, vice chairman of the Standing Committee of the National People’s Congress, warned investors against “blind optimism” in relatively underdeveloped local capital markets.
The People’s Bank of China (PBoC), in its quarterly Monetary Policy Execution Report released in early February, acknowledged the fact that its measures to slow loan growth and improve loan structure–a particularly worrisome part of the Chinese economy–have started to work.
I look favorably on responsible government actions–such as those we’ve seen India and, increasingly, in China–to rein in exuberance. Although the results aren’t guaranteed, and may cause short-term pain, the long-term effects are unquestionably bullish for the region’s economies and markets.
When it comes to the Chinese market, I’ve been quite negative overall. As I noted earlier this year:
These are the stocks that suffered the biggest declines off recent highs, ending the day anywhere between 10 percent and 25 percent from those levels.
Profit-Taking
What we saw Tuesday was profit-taking, rather than a reaction to poor global economic data or market fundamentals.
As I noted in January:
As for the global economy, I maintain the view I expressed last month:
The US economy will slow to a sub-2 percent annualized growth rate during the first half of the year.
A look at the Organization for Economic Cooperation and Development (OECD) leading indicators shows that growth rates in developed economies should start strengthening around the middle of 2007. Keep in mind that OECD leading indicators are constructed to anticipate industrial production growth cycles by six months.
The OECD leading indicators for the G-7 economies seem to be bottoming, although some near-term weakness should be expected.
Source: Bloomberg, The Silk Road Investor
The above data is consistent with the signal from the OECD leading indicators for the US, which appear to have bottomed around October.
Source: Bloomberg, The Silk Road Investor
At the same time, inflation expectations in the US continue to drift lower. The following chart is the Economic Cycle Research Institute’s (ECRI) future inflation gauge for the US. It continues to roll over, indicating that inflation may prove to be less of a threat to the markets than is commonly believed.
Source: Bloomberg, The Silk Road Investor
Although a total economic collapse that pushes the global economy into a deep recession (that could endure through 2008) can’t be ruled out, my view remains more benign–though not quite upbeat–on the economy’s health for 2007.
The good news: Energy stocks came through last week’s bloodbath in relatively good shape. That’s not to say the group was unaffected; but energy didn’t lead downturn as it did last year’s May/June selloff. The Philadelphia Oil Services Index (OSX) declined a touch more than 3 percent last week against a 4.4 percent decline in the S&P 500 and a 5.8 percent decline in the Nasdaq Composite.
Other energy subgroups performed even better, particularly my favorite income-oriented group, the master limited partnerships (MLPs). The Alerian MLP Total Return Index actually eked out a 0.7 percent gain on the week; the index is up 8.5 percent so far in 2007.
The MLPs are a high-yielding, extraordinarily defensive group that should continue to perform well regardless of what happens to the rest of the market. My income-oriented Proven Reserves Portfolio is particularly heavy in MLPs; this Portfolio is actually up about 2 percent for the past two weeks, bucking the trend in the broader markets.
I have two groups I’m watching carefully right now as possible additions to the Portfolios: refiners and general partner (GP) stocks. “Crack” spreads–a measure of profitability for refiners–have been expanding lately and should continue to rise during the next few months as we head into the summer driving season.
GPs are companies that manage the assets within MLPs; the MLP actually pays them a fee for managing these assets. Bottom line: GPs offer nice yields and distribution growth as high as 40 percent annualized in the next three years.
But I’m unwilling to introduce these important new themes in this issue in light of the recent selloff. I prefer to focus on defending gains in current recommendations; I’ll look to introduce these important new themes in an upcoming issue.
This global pullback is playing out differently for the energy patch than the move we had last May. Last year, the oil- and gas-related stocks had been the market’s star performers in the months leading up to the May/June selloff. It’s hardly surprising that the group pulled back violently as traders took big gains off the table; high-momentum groups typically perform poorly when the market takes a dive.
To make matters worse, the fundamentals in the US natural gas market had clearly started to deteriorate by the middle of l2006. Gas inventories had been building up for months and remained far above average, and the North American drilling slowdown I wrote about in the most-recent issue of The Energy Strategist, All Eyes On Gas, was just starting to unfold at that time. The threat of hurricanes kept a bid under gas prices all summer, but that quickly faded into a sharp selloff in September.
This year, oil- and gas-related stocks have been trading sideways for months. The fundamental picture remains mixed: As I pointed out in the last issue of TES, the market remains concerned about a further dampening in North American drilling activity, while foreign drilling markets remain red-hot.
But gas inventories are starting to moderate as a result of continued bouts of colder weather in the Northeast and upper Midwest; fundamentals are slowly but steadily improving. In any event, the oil and gas group certainly hasn’t been the market’s star performer in recent weeks. There’s less momentum money in this group than there was last May.
I suspect this accounts for the relative quietness in the energy patch during last week’s tempest. In addition, the worst news is already priced into many gas-related stocks; sentiment on natural gas is actually bearish right now.
In This Issue
I don’t see much downside left for these stocks, as they’ve already been heavily sold. Many traders are even betting against these stocks by selling shares short. The short interest ratios—ratio of short shares outstanding to average trading volume—for many of the land drillers and North America-focused services names I follow are approaching six-month highs. That’s hardly a sign of investors’ bullishness on the group.
Analysts have already slashed their earnings estimates for any company with exposure to North American gas markets, so the bar of expectations remains ultra-low. I continue to look for an opportunity to play North American gas names more aggressively this spring.
I’m also of the belief that the outlook for the global economy really hasn’t deteriorated significantly during the past few weeks. Asian markets have been the epicenter of the recent pullback, and Asia’s economic picture remains key to the market’s future.
Asia is also absolutely crucial to the energy story. Asian demand has been a primary force in the rally in oil and gas prices during the past few years. And the continent also remains a major driver for the renaissance of nuclear power, agriculture and biofuels.
This is why I’ve asked our in-house Asia expert, Yiannis Mostrous, editor of The Silk Road Investor to contribute a piece for today’s issue explaining the outlook for the Asian markets and economy. His detailed analysis can be found at the end of today’s issue. I couldn’t agree more with his basic outlook.
That said, although energy’s relatively solid showing is encouraging, it’s not enough; we can’t be content with simply losing money less quickly than the market as a whole. Globally synchronized selloffs of the sort witnessed in the past week and a half have a nasty habit of spilling over into all markets.
Specifically, when traders decide to liquidate stocks and raise cash positions, all groups in all countries see selling. Fundamentals and industry prospects go out the window in such environments as investors all race for the exits at the same time.
This isn’t the end of the bull market in energy, and Asian economies aren’t imploding. However, I’d be surprised if the recent bout of weakness doesn’t persist for at least another four to six weeks. The speed and severity of the move is simply too sharp to be ignored, and there are many investors looking for any rally to bail out.
It’s high time we take steps to evaluate the model Portfolios’ current positioning, defend gains in big winners and protect capital. That capital will be sorely needed for when this bout of selling ends, and it’s time to start putting money to work aggressively again.
I suggest a three-part approach to this selloff. First, continue to focus on risk management for existing positions by adhering to stop-loss recommendations and using options hedges to protect gains.
Second, in last year’s decline, MLPs continued to rally even during the worst weeks of the move; any dips in this defensive group constitute a buying opportunity.
And finally, I outline the case for some direct index hedges in this week’s issue.
I’ve made several recommendations to protect your portfolio in the last issue, as well as the two succeeding flash alerts. Here I update you on such recommendations, as well as what’s going on in my uranium and biofuels bets. See Stops And Options.
I’m normally not a fan of exchange traded funds, but with in current global selloff, they may not be a bad investment tool to use as protection against major losses. I’m adding one to the Gushers Portfolio for the time being. See Index Hedges.
I also hold several MLPs in my Portfolios as defensive plays. These investment products offer significant benefits within this current market, which I highlight here. See Playing Defense.
In his article, Yiannis explains that, for a country such as China that has experienced such significant and quick growth, this selloff was not only inevitable but necessary. He also details his opinions on the effects in other Asian markets. See Unnerving.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- Biofuels Field Bet
- Dresser-Rand (NYSE: DRC)
- Duncan Energy Partners (NYSE: DEP)
- Enterprise Products Partners (NYSE: EPD)
- Eagle Rock Energy Partners (NYSE: EROC)
- Linn Energy (NSDQ: LINE)
- Natural Resource LP (NYSE: NRP)
- Penn Virginia (NYSE: PVR)
- Sunoco Logistics (NYSE: SXL)
- Teekay LNG (NYSE: TGP)
- Tortoise Energy Infrastructure Corp (NYSE: TYG)
- Valero LP (NYSE: VLI)
- Williams LP (NYSE: WPZ)
- Uranium Field Bet
- UltraShort Oil & Gas (AMEX: DUG)
Stops And Options
In the most-recent issue of TES, I highlighted two options strategies as a useful means of hedging your big winners against downside risk: put insurance and call replacement. I went on to offer specific strategies for hedging six of the biggest winners in the TES Portfolios.
If you took those recommendations, you’d have significantly softened the pain of last week’s move. Take another look at that section of the issue, and consider implementing some of the strategies outlined there if you haven’t done so already.
Some of these stocks are down since that recommendation, and the options outlined are now more expensive. However, I continue to see these options hedges as useful strategic tools in this environment.
The key is that all investors, no matter how seasoned, tend to get frightened by sharp moves lower such as witnessed last week and so far this week. Put insurance will protect your downside no matter how sharply your stocks decline; I find that holding such hedges helps to stem any panic during declines.
In addition to last week’s recommendations, here are two additional put hedge recommendations for stocks not covered in that issue:
- ExxonMobil (16.2 Percent Gain)–Buy one July 70 Put (XOM SN, $2.90) per 100 shares owned.
- Cameco (100 Percent Gain)–Buy one September 35 Put (CCJ UG, $2.90) for every 100 shares owned.
Of course, not all of the stocks I recommend trade options or offer liquid options contracts. Therefore, this strategy can’t be our only means of managing risk.
I recommend two further means of managing risk on existing positions. First, I set recommended stop positions on most recommendations in the three model Portfolios. Stop orders are nothing more than an automatic order you leave with your broker to sell you out of a position once a pre-determined “stop” price is hit.
For example, assume you buy a stock at $100 and set a stop at $90. As soon as that stock trades at $90, you will be automatically sold out of all your shares. Therefore, your downside risk is limited to roughly $10, or 10 percent, on the investment.
I also recommend using what’s known as a trailing stop. Basically, I’ll periodically adjust stops on Portfolio recommendations to lock in incremental gains. For example, if I recommend a stock at $50 and it rises to $70, I may recommend raising your stop to $55 to lock in a minimum $5 gain. By periodically raising—known as trailing—the stop higher as the stock rises, we can lock in incremental gains over time.
In the flash alert sent out earlier this week, The Selloff, I recommended raising stops in several Portfolio recommendations. Those recommendations are all updated on the Portfolio tables.
Bottom line: If you took any of my options hedge recommendations in this week’s or last week’s flash alerts, you can cancel outstanding stop orders on these stocks. Otherwise, I recommend that all subscribers consider setting stop orders to protect gains and guard against downside.
Also in the flash alert this week, I recommended taking partial gains on a number of key Portfolio picks, including several names in the biofuels and uranium field bets. Again, these sales aren’t a sign that I’m cooling on either story; I still see uranium and nuclear power as my top growth idea for the next three to five years at a minimum. And biofuels, too, should continue to see growth led by political pressure for years to come.
But I recognize that subscribers who got into my uranium field bet recommendations last summer when I first initiated the play are now up, on average, more than 100 percent on these picks. That’s in spite of the recent pullback in the group.
Therefore, for these subscribers, the uranium field bet has grown from a small portfolio holding into some of their biggest positions. Even those who jumped into the uranium names at the beginning of 2007 are showing some nice gains despite the sharp pullback of the past two weeks. I summarize the performance of this play in the table below.
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Uranium Field Bet
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Company Name (Exchange: Symbol)
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Change From Recommendation (%)
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Change From January 1 (%)
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Change From February 1 (%)
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Current Advice
|
| Paladin Resources (Australia: PDN, Toronto: PDN, OTC: PALAF) | 110.6 | -1.8 | -2.7 | Buy |
| SXR Uranium One (Toronto: SXR; OTC: SXRFF) | 68.5 | -1.5 | 1.8 | Buy (note flash alert) |
| Energy Metals (Toronto: EMC, NYSE: EMU) | 98.3 | 15.5 | 11.2 | Buy |
| Pitchstone Exp. (Toronto V: PXP, OTC: PEXPF) | 104.4 | 40.7 | 20.9 | Buy (note flash alert) |
| UEX Corp (Toronto: UEX) | 86.4 | -1.8 | 16.2 | Buy (note flash alert) |
| UNOR (Toronto V: UNI, OTC: ONOFF) | 5.6 | -5.0 | -10.9 | Buy |
| Uranium Part. (Toronto: U, OTC: URPTF) | 68.0 | 14.6 | 5.7 | Buy (note flash alert) |
| Uranium Resources (OTC: URRE) | 26.3 | 7.8 | 9.7 | Buy |
Source: The Energy Strategist
Although I expect all these names to take out their 2007 highs later this year, there could be another 10 to 20 percent downside in the context of a continued global selloff. This is nothing new: Check out the chart of Paladin Resources below for a closer look.
Source: StockCharts.com
Paladin has seen two corrections of roughly 35 percent since its initial public offering in 2005. Although the stock is up close to sevenfold during this period, those pullbacks seemed vicious at the time.
On average, in prior pullbacks, Paladin remained weak for eight to 12 weeks before resuming its uptrend. I expect the stock to act in broadly similar fashion this time around; I expect new highs later this year, but we could be in for choppier, back-and-forth trading for the near term. I’ll be monitoring the stock and plan to send a flash alert out recommending adding to your position once the stock stabilizes.
Of course, this is nothing unique to Paladin. It’s not at all unusual for stocks in strong multi-year uptrends to see corrections of that magnitude–all of the other uranium field bet plays show similar patterns.
I’ve spoken or conversed via e-mail with several new subscribers who’ve not yet jumped into the uranium field bet because the stocks have been too extended to buy. I’ve spoken to a few others who got in later and are watching gains since the beginning of February disappearing in this selloff. I caution all new subscribers not to forget the basic premise of the field bet.
To play these stocks, I don’t recommend putting a huge amount of money to work in each name. Therefore, if you normally put $10,000 into each TES recommendation, only put $2,000 into each field bet play.
The idea of the field bet is to give us diversified exposure to a number of promising stocks in a volatile subgroup of the energy markets. As I’ve said before, I don’t recommend betting the farm on some or all of these names. If you start by buying relatively small stakes, then this volatility won’t be as much of a concern.
And if you’re not yet into the uranium stocks, consider taking a small position in all field bet picks and then adding more on any further 10 to 20 percent declines. I see this selloff as an outstanding opportunity for those who believe the uranium story–which I outlined in the July 26, 2006, issue, The Nuclear Option, and updated and reviewed in the Dec. 20, 2006, issue, Oil And Gas–to jump into the field bet recommendations at attractive prices.
My basic recommendation on the field bet is as follows. For those with big gains, consider selling off a third of your position in the stocks I outlined in the March 5 flash alert to book profits and reduce your exposure to the uranium space. Although I still like the story, triple-digit gains in these stocks during the past quarter have resulted in a portfolio that’s far too overweight the group.
I’ll be looking to put that cash back to work in my favorite uranium names once this selloff cools down in a few weeks. Look for recommendations via flash alert or in an upcoming issue when it’s a good time to add more exposure to the group.
If you’ve jumped in only recently, remember to ensure that you’re not taking on too much risk. It’s imperative to follow my field bet strategy of only putting a small amount of cash to work in each name.
For those not yet in, consider taking half your intended position at current levels and look to add to that exposure on a further 10 to 20 percent decline in the group. Such a decline would be roughly equivalent to prior declines we’ve seen in this sector during the past two years.
The situation for the biofuels field bet is similar. Because agriculture is seen as a defensive sector, these stocks aren’t down as sharply as the uranium names I recommend.
I also highlighted options hedge plays on four of my favorite agriculture/biofuels recommendations in the last issue of TES; I gave options insurance strategies for Bunge, Potash Corp, Mosaic and Syngenta. If you haven’t yet taken out those insurance policies, it’s not too late to do so now.
If you’re unwilling to play the options market, consider taking a third of your position in Syngenta, Potash Corp, Mosaic and Bunge off the table to lock in some impressive profits and reduce what’s now an overweight position in the group. Continue holding on to the other stocks recommended in the biofuels field bet.
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Biofuels Field Bet
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Company Name (Exchange: Symbol)
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Change From Recommendation (%)
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Change From January 1 (%)
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Advice
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| Potash Corp (NYSE: POT) | 50.1 | 5.1 | Buy (note hedge) |
| Mosaic (NYSE: MOS) | 52.9 | 19.3 | Buy (note hedge) |
| Syngenta (NYSE: SYT) | 20.4 | -4.7 | Buy (note hedge) |
| MP Evans (London: MPE) | 4.7 | -2.8 | Buy |
| Anglo-Eastern Pl. (London: AEP) | 8.6 | 4.1 | Buy |
| Monsanto (NYSE: MON) | 12.3 | 0.5 | Buy |
| Sipef (Belgium: SIP) | 24.0 | -4.9 | Buy |
| Earth Biofuels (OTC: EBOF) | -80.7 | -51.1 | Hold |
| PowerShares DB Agriculture (AMEX: DBA) | 9.2 | 5.8 | Buy |
Source: The Energy Strategist
Also note that I’m cutting my recommendation in Earth Biofuels to a hold from a buy. This is the only stock in either field bet to be showing a loss.
I identified this stock as by far the riskiest when I originally recommended it in September. But recommendation clearly hasn’t worked out as intended, and I’m concerned by the insider selling I’m seeing.
Earth Biofuels is a highly volatile name that tends to see some big runs from time to time. Rather than sell out of the stock now, I’ll be looking to recommend getting out on any strength later this spring. If you’ve kept your position very small, as recommended, this loser hasn’t hurt performance a great deal.
Back To In This Issue
Index Hedges
One final means of hedging the model Portfolios is to use a broad index hedge. Last May, I recommended using put options on the Oil Service HOLDRS (OIH) as a hedge against further downside in the group. But thanks to the advent of a series of new exchange traded funds (ETFs), it’s now possible to hedge out risk more simply and without trading options or shorting any index.
Long-time readers are aware that I’m not a huge fan of ETFs. I generally believe that the average investor can do far better selecting individual stocks than playing market indexes.
In addition, ETFs don’t grant access to all of the best plays out there. This is particularly true of the oil and gas space, where most ETFs are dominated by holdings in a handful of mega cap names.
But there are a few exceptions. One is the Deutsche Bank Agriculture iShares I recommend in the biofuels field bet. I recommend these iShares because they allow investors access to the commodity markets–a market that few stock investors had access to prior to the launch of this ETF.
I also see the attraction of a series of short ETFs launched in the past few months. First, it’s useful to explain the concept of shorting stocks.
Selling short, or shorting, is a way to profit from declines in a stock. The best way to illustrate is with an example. Say you want to short an imaginary stock, “ABC,” trading near $50 per share. Assuming you want to short 200 shares of the stock, the value of the transaction would be $10,000.
To short the stock, you first need to borrow shares from your broker. Your broker loans you 200 shares of ABC stock; you immediately sell this stock on the open market for $50 per share, receiving $10,000 for that sale.
But because you borrowed 200 shares of ABC, you still owe this to your broker and will need to return the shares at some point in the future to pay off your debt. In other words, you’re short the stock. Assume a few weeks pass and you’re ready to close out your short, a process known as buying to cover. At this time, two basic scenarios are possible:
- ABC falls in value. If ABC is trading at $35, for example, you can go out into the open market and buy 200 shares for just $7,000. You can then turn around and use the 200 shares purchased to satisfy the loan from your broker. Since you sold the shares for $10,000 and then bought them back for $7,000, you realize a profit of $3,000 minus commissions.
- ABC rises in value. If the stock rises to $60, for example, you’ll need to pay $12,000 to buy back the 200 shares. Therefore, you’ll have lost 2,000.
As you can see from this example, short selling is a way of profiting from the decline in a stock. And although I’ve outlined the mechanics of the process in the example above, all of that is totally seamless and behind-the-scenes.
With most online discount brokers, there’s an option on your trading screen that says “Sell Short” or simply “Short.” Another option labeled “Buy To Cover” allows you to close out a short. The broker handles all of the lending of shares automatically.
Although shorting has become progressively cheaper and easier to do in recent years, many traders are either prohibited from shorting (such as within IRA accounts) or uncomfortable with the strategy. Enter the short ETF.
Basically, when you buy these ETFs, they give you exposure to the short side of the underlying index. If you purchase the Short QQQ Fund (AMEX: PSQ), you’re effectively shorting the Nasdaq 100 index.
If you buy the UltraShort QQQ (AMEX: QID), you’re effectively double shorting the Nasdaq. If the Nasdaq 100 falls 10 percent, the UltraShort QQQ ETF could be expected to rise in value by roughly 20 percent.
There’s a short ETF that tracks the inverse of the Dow Jones OIL & Gas Sector, a basket of the largest oil- and gas-related stocks in the US market. The UltraShort Oil & Gas (AMEX: DUG) will tend to rise by double the percentage that the Dow Jones Oil & Gas Index falls.
If the Oil & Gas Index falls by 15 percent, you can look for the ETF to rise by 30 percent. This ETF allows investors the opportunity to dispense with shorting entirely and play the downside in indexes by actually buying these ETFs.
ETFs trade on the major exchanges just like stocks. They’re simple to buy and sell. Your broker should charge you no more to buy these ETFs than to purchase any other stock.
By purchasing UltraShort Oil & Gas, we can partially hedge our long-side exposure to the industry. Specifically, I’m looking for the stocks in my three model Portfolios to broadly outperform the industry as a whole. But if this bout of selling continues for a few more weeks, even the fundamentally attractive names I recommend will get pulled lower.
Remember, as I said earlier, fundamentals go out the window during global selloffs of this nature. Exposure to this UltraShort ETF will guard against such an eventuality.
I’m adding the UltraShort OIL & Gas ETF to the aggressive Gushers Portfolio as a hedge. I’ve placed a stop loss order on this hedge just as with any other position.
I’ll look to hold on to this hedge until I see signs of a stabilization in global markets; this could be four to six weeks away. When it’s time to sell out of the hedge, I will send out a flash alert or announce it in the newsletter.
Back To In This Issue
Playing Defense
Finally, I strongly suggest that those looking to put new money to work focus their attention on my MLP recommendations. I have several of these recommended across the three model Portfolios; I’ve listed all of them in the table below.
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TES MLPs
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Company Name (Exchange: Symbol)
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Change From November 22 issue (%)
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Indicated Yield (%)
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Portfolio
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| Duncan Energy Part. (NYSE: DEP) | 13.1 | 6.8 | Proven Reserves |
| Enterprise Products Partners (NYSE: EPD) | 9.4 | 6.2 | Proven Reserves |
| Natural Resource Partners (NYSE: NRP) | 25.5 | 5.5 | Proven Reserves |
| Penn Virginia (NYSE: PVR) | 3.9 | 6.2 | Proven Reserves |
| Teekay LNG (NYSE: TGP) | 20.9 | 5.1 | Proven Reserves |
| Tortoise Energy Infrastructure (NYSE: TYG) | 4.7 | 6.0 | Proven Reserves |
| Valero LP (NYSE: VLI) | 16.9 | 5.8 | Proven Reserves |
| Eagle Rock Energy Partners (NSDQ: EROC) | 4.5 | 7.2 | Wildcatters |
| Sunoco Logistics (NYSE: SXL) | 19.0 | 5.7 | Wildcatters |
| Williams LP (NYSE: WPZ) | 15.7 | 4.2 | Wildcatters |
| Linn Energy (NSDQ: LINE) | 29.7 | 6.3 | Wildcatters |
Source: The Energy Strategist
The story behind MLPs was outlined at great length in the Nov. 22, 2006, issue of TES, Leading Income. I won’t repeat that analysis here.
Suffice it to say that I see the bullish story for MLPs resting on several key pillars:
- Desire For Income–A growing cadre of investors is looking for high-quality, income-oriented plays. Obviously, bonds and money market funds yielding in the 5 percent range aren’t offering much income relative to historical norms. And after a giant run-up in the past four-plus years, most real estate investment trusts (REITs) and utilities—the traditional mainstays of income portfolios—just aren’t offering overly attractive yields. REITs in particular are now yielding around 3 percent down from closer to 7 percent in 2000-01.
MLPs are one exception to this rule. Most currently yield close to 6 percent and are posting annual distribution growth in the 8-to-15-percent range. There are no other major groups I can find that are seeing distribution growth at anything close to that pace. I see the best MLPs out there offering average annualized gains in the 10 to 15 percent range in the next few years when you factor in dividends and dividend growth. - Tax Advantages–Distributions from MLPs aren’t normal dividends. Instead, typically the IRS will classify 80 to 95 percent of the distributions you receive as a return of capital. Return of capital payments aren’t taxed immediately. Instead, return of capital payments serve to reduce your cost basis in the MLP: You won’t owe tax on these distributions until you sell the MLP or your overall cost basis drops to $0. Therefore, MLPs offer useful tax deferral.
- Changes In US Tax Laws–The American Job Creation Act of 2004 changed the laws governing MLPs to allow institutional investors to buy into the group. Before that change, institutions were severely limited as to how much of an MLP they were allowed to purchase. The effect of this is that the shareholder base for MLPs is widening; hedge funds, closed-end funds an even some mutual funds are jumping into the group. MLPs have traditionally been a retail-investors only story. With more institutional money now flowing into the group, valuations are finally on the rise.
- Lack Of Commodity Sensitivity–Although all the MLPs I follow are involved in the oil and gas business, most aren’t overly exposed to commodity pricing. For example, Teekay LNG Partners transports liquefied natural gas (LNG) in its tanker ships. But fees charged are governed by long-term contracts; the company essentially receives a fixed fee for transporting gas. That fee isn’t based on the value of the gas transported. Therefore, MLPs tend to be less volatile that other energy-related sectors and the S&P 500 in general.
I see the MLP group as an absolutely key piece of the TES Portfolios. I recommend that all subscribers look to buy into the story. And, if these stocks see any reaction to the recent selloff, use that as an opportunity to add to your positions in the group.
Back To In This Issue
Unnerving
By Yiannis G. Mostrous
Editor, The Silk Road Investor
FALLS CHURCH, Va.–Markets move in mysterious ways. Late in February, I wrote that the near-total absence of bearish voices was reason for investors to be cautious.
Those comments were made while Asian markets were making new highs, and I hoped to highlight the danger this reality was creating in a risk-seeking environment. And last Tuesday the Chinese market gave its first scare in more than six months by dropping 9 percent in a single day. The rest of Asia followed suit.
The US also declined substantially as investors tried to adjust their market positions by taking profits off the table. And given the market’s run since July 2006, there are a lot of profits to be taken.
The S&P 500 Index was up almost 18 percent from its low last summer, and even after the recent selloff, it’s still up double digits. It seems that the desire to reduce risk hits all investors at the same time.
As a result, we experienced an overnight transformation in the global investing environment, a move from extreme greed to alarming levels of fear.
But for a market–China–that enjoyed a 50 percent rise in three months, a correction like this shouldn’t merely have been expected; it was also necessary. Chinese authorities have made it clear that they’re trying to cool down not only certain parts of the economy but also the stock market.
The latest warning came toward the end of 2006 when Cheng Siwei, vice chairman of the Standing Committee of the National People’s Congress, warned investors against “blind optimism” in relatively underdeveloped local capital markets.
The People’s Bank of China (PBoC), in its quarterly Monetary Policy Execution Report released in early February, acknowledged the fact that its measures to slow loan growth and improve loan structure–a particularly worrisome part of the Chinese economy–have started to work.
I look favorably on responsible government actions–such as those we’ve seen India and, increasingly, in China–to rein in exuberance. Although the results aren’t guaranteed, and may cause short-term pain, the long-term effects are unquestionably bullish for the region’s economies and markets.
When it comes to the Chinese market, I’ve been quite negative overall. As I noted earlier this year:
The China [bearish] argument remains a more-convincing one. It’s well known that that excess supply of capital–a problem afflicting China–leads to bad investment choices and, eventually, a readjustment period.
I don’t know when this adjustment will take place, but I’m well aware of investors’ seemingly insatiable appetite for Chinese exposure. My advice is to avoid financial stocks (banks, insurance, etc.) in China.
These are the stocks that suffered the biggest declines off recent highs, ending the day anywhere between 10 percent and 25 percent from those levels.
Profit-Taking
What we saw Tuesday was profit-taking, rather than a reaction to poor global economic data or market fundamentals.
As I noted in January:
Although the view may be beautiful from the rooftop, the fact of the matter is that Asia will once again be at the center of liquidation activity when investors decide–or are forced–to take profits.
Tactically, this is the reason why time was spent here during the last four weeks booking profits, either through outright stock selling or through simple profit-taking (i.e., leaving the initial investment intact).
As for the global economy, I maintain the view I expressed last month:
I still expect a global economic slowdown to happen this year, but there’s no conviction of a US-led global recession outcome. The latter is mentioned because there’s been talk–from serious analysts–that 2007 will be the year that a real estate-based recession will take place in the US eventually affecting the global economy and markets.
The US economy will slow to a sub-2 percent annualized growth rate during the first half of the year.
A look at the Organization for Economic Cooperation and Development (OECD) leading indicators shows that growth rates in developed economies should start strengthening around the middle of 2007. Keep in mind that OECD leading indicators are constructed to anticipate industrial production growth cycles by six months.
The OECD leading indicators for the G-7 economies seem to be bottoming, although some near-term weakness should be expected.
Source: Bloomberg, The Silk Road Investor
The above data is consistent with the signal from the OECD leading indicators for the US, which appear to have bottomed around October.
Source: Bloomberg, The Silk Road Investor
At the same time, inflation expectations in the US continue to drift lower. The following chart is the Economic Cycle Research Institute’s (ECRI) future inflation gauge for the US. It continues to roll over, indicating that inflation may prove to be less of a threat to the markets than is commonly believed.
Source: Bloomberg, The Silk Road Investor
Although a total economic collapse that pushes the global economy into a deep recession (that could endure through 2008) can’t be ruled out, my view remains more benign–though not quite upbeat–on the economy’s health for 2007.
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