Weekly Research from June 2008

June 30, 2008

Basics, utilities and industrials score highest while healthcare, services and financials are weakest. The ratio compares the average score by sector to the average score across our entire universe and helps you stay focused on sectors creating the greatest alpha.

The S&P 500 has dropped 8.7% in June – the biggest fall since September ’02. In June, the SPY’s average daily volume has run 44% higher than during the April & May rally. The VIX remains too complacent, suggesting the market has further to fall. Both the January and March bottoms occurred on +30 VIX readings. The DJIA is on track for its worst June since 1930 and has now undercut its 2008 lows.

Arch Coal (ACI) believes U.S. coal exports will rise to 100mn short tons in 2010, well above the 80mn tons expected by analysts in 08. U.S. coal production is 1.1bn short tons, about 1/6th of global production. In the next decade, seaborne coal demand will rise over 20%. Newcastle Australia thermal coal prices hit yet another record, closing at $172.10 on Friday. China continues to wrestle with tight coal supplies at power plants. Energy shortages this summer will increase coal and diesel imports. Buy coalmining and mining equipment on down days.

Qatar is holding the line on oil production despite Saudi’s pledge to increase production. Oil hit another record, trading above $142 on the 27th. Money continues to flow into the USO with June’s average daily volumes nearly triple the average daily volume in Q1. Active gas rigs in the U.S. rose to record 1530 last week, sparked in part by rising use of costly horizontal drilling. Nat Gas production is set to rise 3.6% in 09 as a result of the pickup in drilling. If so, it will mark the biggest production gain since ’94. Total U.S. oil and gas active rigs are at a 22 year high. High crude and nat gas benefit day rates of expensive next gen equipment –supporting earnings at energy services companies.

Corn hit a record $7.99 a bushel last week, rising 4.2% on the week and near 30% this month. Corn is up 73% this year and remains well below its inflation adjusted high of $14+. Soybeans hit a 3-month high at $15.79 a bushel, gaining over 3% on the week. Flooding swept away nutrient enriched topsoil and will prompt additional fertilizer in the coming years. Meanwhile, lower grain production from the Midwest supports prices and will spark a surge in corn acreage next year. Agrium predicts U.S. corn acreage will surge to 95mn acres in 09, the highest since ’44. Buy down days in agriculture supply.

Gold rallied last week hitting a 1-month high. We wrote in last week’s report of the strong seasonality for gold in Q3. Last week, gold rallied over 3% while the market dropped. The inflation adjusted record high for gold is above $2000 an oz. Last week, average daily volumes in gold (GLD) rose 23% versus the first half of June and were 42% higher than in May. Buy gold

Financials declined for the 4th consecutive week as Goldman warned writedowns may continue into 09. MBIA hit a 20 year low last week, strained by payments and credit collateral calls on over 7 bn in debt. JPM, the creator of CDS’s and widely exposed to the instrument, fell 7.4% this month and is trading at October 05 prices. Financials risk remains too high on QSPE balance sheet migration. Sell on up days.

June 16 2008

Basics, utilities and industrials remain strongest, all posting scores above the average score across our 1800 stock universe. Financials and healthcare remain weakest.

Earnings clarity remains your best bet for excess return in 2008. Investors are punished for taking risk. Q3 is notoriously weak. Focus on leading baskets and stocks in our best list. Our Q1, 2008 Focus picks have returned 22% year-to-date. Use our weekly picks to outperform. The average return of the SPY in Q3 this decade is –2.57% (see table in our paragraph on gold). During 01, the SPY fell 14.49% in Q3. In 02, it fell -16.90% in Q3. The average return of the GLD in Q3 this decade is 8.17%.

Average daily volumes in the SPY are 45% higher in June than in May. The SPY has fallen 6.2% this month. The EFA has fallen 7.7% this month as contagion fear spreads. 24 of the DJIA are trading below the 200dma. The last time the DJIA was at this level the VIX was 32. On Friday, it closed at a lackluster 23. The risk to the market remains.

Energy uncorked? On June 3rd we wrote “Global fuel price subsidies and controls may be coming to an end as Malaysia blinks and India discusses lifting fuel price ceilings. At some point, likely post-Olympics, China will be forced to acquiesce”. China has now joined its Asian counterparts in easing the cork up the refined product bottleneck. The supply pressure will ease and Chinese refiners will import more crude. If not, China will be forced to increase ceilings again. The Sichuan disaster diverted scarce diesel and gas from neighboring provinces, straining supply and causing empty diesel pumps. Easing price ceilings will allow China’s refiners to increase capacity. Did China’s last fuel hikes in November curb demand? In May, China’s oil imports were up 25% YoY. The 2 largest months of crude imports in China’s history have occurred this year. One beneficiary? VLCC operators. Following last November’s fuel price increase, supertanker day rates rose for 2-months at the fastest pace in 16 years. A rise in African shipments to Asia will also boost voyage lengths.

U.S. crude inventories are at the low boundary for this time of year. The surge in prices has stoked talk over increasing domestic drilling acreage. Brazil’s heady deepwater E&P plans are already taxing offshore equipment supply, supporting day rates. Asia Pacific deployed rigs are at a 16-year high. Global investment in boosting capacity supports energy service profits. Sunday’s Saudi summit will likely bring little more than press releases. India’s inflation hit a 13-year high as price caps for fuels were raised. On June 4th, India eliminated import taxes on crude. India imports 70% of its crude and will continue to actively source imports. Saudi says work on its Khurais oil field will boost production by 1.2mn bbls/day by mid 09. RDSA declared force majeure for June and July at its Bongo field following a militant attack that impacted 184k bbl/day scheduled July production. Strike risk for Nigerian workers at CVX continues to rise as workers plan to go on strike on the 23rd. CVX produces 350k bbls/day in Nigeria.


Natural gas inventory is now 16.2% last year and 2.6% below the 5-year average.

Corn and soybean prices have marched steadily higher in June as investors digest the impact of Mid West flooding on future USDA production revisions. Up to 20% of Iowan farms were impacted. River flooding spread into farmland throughout the Mississippi. In ’93, the USDA had to reduce its corn production forecast 31% and its soybean forecast by 17%. Global stockpiles are too small and support prices. Prices are driving acreage conversion from pastureland to farmland. Increased acreage will drive future seed, fertilizer and equipment demand. “In today's dollars a bushel of corn would have to sell for $14.60 in order to be worth the same as corn in 1974.” (source: www.inflationdata.com). Buy ag supply on down days.

Will “clean coal” replace ethanol as the catchphrase of this election year cycle? It appears so with swing states and 44% of electoral votes in top coal producing states. The global reality is electricity capacity will grow dramatically in the next 20 years and with it, the demand for coal and nat gas. McCain’s energy plan benefits engineering companies and the makers of power generation equipment. In China, policy instituting price ceilings for thermal coal will boost capacity into summer, when expected power shortfalls are expected to be greatest. The unintended consequence? Discouraging coal production, increasing black market exports and reigniting export quotas. In short, China’s coal price caps will prove inefficient and will prop global prices.

The woes for financials continue and shareholder dilution risk remains. There is little incentive given “valuation” arguments are eroded by falling earnings estimates. QSPE’s will continue to migrate to balance sheets and pressure leverage. C traded below $20 Friday after increasing forecasts for writedowns. MER rumors sent the stock lower on Friday as investors grow increasingly concerned over level 3 valuations and QSPE risk. Financials have scored poorly all year. Sell them on up days. CDS’s hit 2-month highs as investors fear rate cuts from agencies. JPM developed CDS’s in the 90’s and is the largest buyer and seller of CDS’s in the market. AIG is also at substantial risk, having written down $9bn in CDS value in early May on top of $11bn in 07. JPM has swaps betting on future credit quality of $7.9 tn in debt (OCC). C has $3.2 tn in CDSs. GS & MS are the largest swap counterparties. 40% of CDS protection worldwide is on co’s rated below investment grade (Fitch, July, 2007) up from 8% in 2002. High yield debt defaults will rise fourfold to 6.1% by Feb 07 (Moody’s). A year ago, BAC reported hedge funds had sold 31% of all CDS protection. JPM, in its Feb Annual Report, disclosed $22 bn of credit swap counterparty risk unprotected by collateral entering 08.

European co’s borrowed more through bond offerings in Q2 than any Q2 on record, agreeing to pay the highest interest on the borrowings in 10 years.

Copper rose by the most since March. Sichuan rebuilding and So. American strikes help prop prices despite lower demand in the U.S. India, the fastest growing copper consumer, accounts for only 3% of global copper market. Any rally in aluminum will decrease substitution. Own FCX. Inflation adjusted gold prices peaked at $2145 (Sept 07 Dollars) in 1980 (www.inflationdata.com). In the past 3 years, the GLD returned 7.5% in Q3, 2005, -2.8% in Q3, 2006 and 14.3% in Q3, 07. Buy gold.

EU electricity prices have risen 50% in the past year. Eskom won a 27% rate increase. Global electricity rates will rise. Higher input costs are removing weak, low-cost competition from U.S. markets. Expect higher rates and capacity investment. Own utilities.

LNG imports begin for the first time in Brazil in July. W. Australia is diverting Asian diesel supplies as it deals with APA’s nat gas plant shutdown. Nat gas seasonality has now shifted to stock-by-stock. Own highest scoring.


June 16, 2008

The basics, utilities and industrials sectors all score highest in our work. Financials and healthcare are weakest. High scoring sectors benefit from earnings clarity while services, financials and healthcare all face spending, dilution and political risk respectively.

The SPX fell for its 2nd consecutive week, the first back-to-back drop since March. 2-year Treasury yields rose 65bps while the dollar also rallied last week. Both the 20- year (TLT) and TIP are broken.

The SPY volumes have risen markedly in the past 10 days as investors react to continued risk in financials and a failure of the broader market to hold critical 200dma support. End of quarter redemption activity and window dressing risk is building.

Growing concern over U.S. economic contagion knocked the EFA from at high of $78.77 in May to $72.48 on Friday.

In November 1993 the USDA cut its corn crop production forecast by 31% and its soybean production forecast by 16%, marking decade low forecast to production levels. From October ‘93 to April of ‘94, corn prices rose ~50%. The flooding in the Midwest is once again center stage with rivers throughout the grain belt at record levels and flooding in Iowa cities. Across the grain belt, 25% of planted acreage is at risk of yield loss. The USDA will continue to cut production forecasts in 08, helping support corn. The December corn contract rose 13% last week. Soybeans hit a 3-month high Friday. India and China continue to incent food imports to contain food inflation. Argentinean farmers continue to strike in protest of grain export taxes. The volumes in ag supply are beginning to trend higher in response to the rapid jump in grain prices/volumes. Own fertilizer, seed and equipment stocks.

Asian nations have already begun loosening price caps on oil and refined product. The Group of 8 are urging developing nations to abandon subsidies. Crude prices have gained 697% since 2001. US crude inventories are at the low boundary of average range for this time of year. China’s crude imports rose 25% last month and its refined imports are up 17% in the first 5 months. The Sichuan Province crisis, spring planting, power shortages and economic growth continue to propel import demand. Own energy service.

Natural gas seasonality shifts stock-by-stock this month. Natural gas in storage remains 15.4% below last year. Focus on leaders. Coal demand continues to support global prices – buy down days.

India has raised export taxes this week on iron ore and steel bars in an effort to help curb inflation, which is hitting its highest since 2001. Central banks in India, Russia, Brazil and China recently raised interest rates.

LEH was forced to dilute shareholders, selling $6bn in common and preferred, to bolster its balance sheet amid $2.8 bn in losses. Financials stocks took out prior lows. 5-day average volumes in the RKH are 62% higher than their 20-day average daily volumes. XLF 5-day volumes are 52% higher than their 20-day volumes. Dilution risk continues to force institutional liquidation.

Seasonal tailwinds for tech related industries fade by mid July. The NASDAQ, which has held up better than other broad market indexes, faces increased pressure into seasonally unfavorable Q3.

Biotech seasonality shifts positive in Q3, use weakness in leaders to build positions.

June 9, 2008

Basics and industrials remain our highest scoring sectors across our entire universe. Financials and healthcare are weakest. Large cap scores are under pressure while mid cap stocks have outperformed in Q2. The Russell 2k closed above its 200dma on Thursday and traded back below on Friday. The R2K has traded above average daily volumes for 7 consecutive days. The DJIA remains under pressure. Investors have embraced earnings clarity in 08, rewarding baskets benefiting from exports. Financials, which have scored poorly in ’08, remain a source of cash on dilution risk.

The above chart shows our sector score trends since March. Basics and industrials have remained strongest through Q2. Services have flattened, in line with historical seasonality, after peaking into Q4 EPS. Technology has steadily improved relative to other sectors since April. Healthcare is starting to move higher.

On June 6th, the S&P 500 declined 3.09%, marking only the 53rd trading day (of 14,70 trading days) where the S&P has fallen 3% or more. The 3.09% is the 41st worst returning day since 1950. Since 2007, we've had three negative 3% + days. The first occurred on February 27, 2007 (the SPX was up 2.85% in the 30 days following the February sell-off). The second was February 5th, 2008 (the SPX fell -2.86% in the 30 days following). Volatility is back with the VIX moving back above 20 last week. In 2002, there were 7 plus or minus 3% days.

Seasonal strength for natural gas fades by mid-June and becomes “stock-by-stock”. Focus on top scoring stocks in the basket and watch weekly best & worst lists for shifts.

The chart below shows the average score of our farm related universe versus the average score of our entire 1800 stock universe. The DBA, which has been basing since March, has moved back above its 50dma and is approaching the top of its Q2 range. Volumes of major ag supply stocks are returning. Buy ag supply on down days.

Vietnam, in a bid to control food inflation, is taxing urea and rice exports. Urea export taxes may run as high as 40%. U.S. fertilizer prices continue to reach new highs with DAP selling for $1050 a ton and urea costing $650 a ton. 70% of dry urea is imported, and the import market is shrinking as developing nations increase tariffs. The dollar weakening and rising freight costs further boost prices. Corn surged to a new record last week on concerns over crop emergence rates. Soybeans also broke out of its recent range and hit a 3-month high. Wheat is attempting to create a saucer bottom on Australian drought risk.

Crude oil surged on Thursday and Friday as global central banks hiked rates, pressuring the Dollar. The average daily volumes in the USO are driving volatility. Gasoline topped $4 a gallon over the weekend. Oil prices support E&P in hard-to-reach, pricey deepwater and support tertiary field recovery. Gas shales including Bakken and Haynesville continue to attract attention for potential size and scope. Energy service day rates benefit from demand for expensive next-gen extraction technologies. Nigerian strike risk to Chevron production impacts 350k bbls/day of crude and 14mn cu ft of natural gas. Buy down days in energy service.

Coal prices are rising steadily for Eastern coal. Powder River Basin coal remains flat, however will trend higher. On April 25th, Appalachian coal was trading 6.67x Powder River. Currently, its trading 7.68x Powder River. If Appalachian stays at this level and the Powder River spread moves back to 6.67, it would equal a price of $16.25 per short ton – a 15% move from its price on the 30th. Eastern coal production is down –1.1% YoY while Western is up 1.3%. According to GlobalCOAL’s index, Australian coal prices hit another record above $159 a mt on Friday. China’s largest coal producer, Shenhua, has upped coal production 17% YoY yet China’s coal stockpiles at utilities are 23% lower YoY. Buy coalmining and mining equipment stocks.

AIG hit a 10-year low on reports regulators will scrutinize its CDS bond valuations. AIG will continue to dilute. LEH counter party risk forced it to new multi-year lows. MER is next.

Rising input costs will produce higher electricity prices as small players exit utility markets. In the U.K., household energy bills rose 15% in Q1. UK electricity is 69% more expensive than 2003. Electricity futures for next winter are trading 2x last year. Utility seasonality is bullish beginning July. Buy utility stocks.

South African gold production fell 17% YoY due to power shortages.

Tech seasonality fades in 4-6 weeks.

Biotech seasonality is bullish in Q3. Use June and early July to build positions.

The Baltic Dry Index consolidated recent gains and will move higher as vessel supply remains tight. China imports will rise in the wake of the Sichuan earthquake. Own dry shipping and shipping tied to crude and refined product delivery as China’s appetite for diesel continues and Asian product price ceilings are increased.


June 2, 2008

In the month of May, coal, semiconductor, energy service, commodity and technology ETF’s performed best. In all, 13 of the ETF’s we watch rose more than 5% this month. 3 fell more than 5%: financials, regional banks and homebuilders. The winners were stocks with earnings clarity. The losers were those facing shareholder dilution.

In keeping with historical seasonality, mid and small cap stocks outperformed the S&P 500 and the DJIA in May. Typically, June is similar with NASDAQ and the Russell 2k outpacing the DJIA.

Volumes in the DBA (Corn, Wheat, Soybeans & Sugar) peaked in Q1. Only 2 days since April have traded above average daily volumes. The DBA is basing above $35 and the 200dma is converging on this level. A close below $34 would signal trouble for ag suppliers, while a close above $38 will reignite another up wave. Corn had its first monthly drop since August. The Int’l Grain Council increased their forecast for June 09 ending grain stockpiles by 1.6%, citing greater wheat production. Argentinean negotiations on grain export taxes continue with farmers rejecting recent offers for caps to variable tax rates. Global demand for ag supply remains high as acreage is converted from pasture land to farm land. China’s fertilizer export restrictions bolster prices. Vietnam, the 13th most populous nation and 2nd largest rice exporter, saw fertilizer imports jumped 40% in the first 5 months of 08. Last year, fertilizer imports rose 21%. Buy ag supply and equipment into weakness.

Technology stocks, in line with historical seasonality, performed nicely in May. However, volumes remain absent with the XLK average trading volume declining for the third consecutive month. QQQQ volumes, despite a 5% move in May are running well below Q1. Internet, high-tech and computer basket seasonality historically ends in 6 weeks. Watch volumes carefully on technology baskets and remain focused on the highest scoring names in our Best and Worst lists.

Metals were under pressure last week as the dollar found footing and the DBB broke down, setting a new closing low for Q2 (aluminum, zinc & copper). Keep a close eye on copper & aluminum producers. India’s ministry upped the limit on overseas borrowing for domestic spending to $100mn from$20mn to help prop up GDP growth while fighting inflation. India is also removing its export tax on steel and instituting a new export tax on iron ore of 15%. Rio Tinto believes global minerals demand will double by 2022. China will refocus attention on metal imports to support Sichuan and battle inflation given prices have fallen off highs. Own iron ore and mining equipment.

The 20 Year bond (TLT) broke down this week, putting in a new Q2 low. The TIP bounced off its 200dma on Friday. We saw rotation last week into month end. However, lackluster equity volumes raise questions as to gamesmanship versus sustainable rotation.

While personal spending and income rose, both gained less than in March. The trend of rising jobless claims continues to rein inflation and dampen GDP.

Oil inventories are average for this time of year. Gasoline and Diesel supplies remain within their historical ranges, albeit on the low end. Global investment in deepwater supports energy service dayrates. Buy energy service into weakness. Nat gas, which rose 6.5% in May, sees broad-basket seasonal support fade by mid June, becoming stock-by-stock. Plan portfolios accordingly around leaders. Nat gas inventories are 0.5% below the 5-year average and 15.9% below last year. Inventories in the west remain worst, 11% below the 5-year average. Own leaders.

The coal ETF (KOL) rose 22% in May as China’s utility coal stockpiles declined and Eskom, South Africa’s power company, failed to build adequate coal stockpiles into winter. Newcastle, Australia thermal coal prices hit a record above $151 a ton up from $56 a ton YoY. Vietnam, the largest coal exporter to China, is cutting coal exports 30% and expects to become a net coal importer by 2012. Richard’s Bay coal also hit a record, trading at $122.95 a ton. U.S. export demand is shrinking U.S. utility stockpiles, supporting rising prices for Appalachian coal. We’ve been advocating coal plays since spring 07 and clients continue to be rewarded. Use any short term profit-taking to boost weightings.

Industrials continue to score high in our work, supported by export demand and international GDP expansion. In Sichuan Province, rebuilding and repair of infrastructure, both industrial and farming, further supports industrial export demand, particularly for engineering and building-related stocks. Overall, 15mn people were displaced and 14,207 industrial companies were affected.

Seasonality embraces Utility stocks from July through January. At the same time, rising input costs are providing opportunities for utilities to raise prices for residential and industrial electricity and natural gas customers. Rising rates will support infrastructure investment and bolster utility margins. Overseas, Germany’s 09 electricity prices have risen 20% year-to-date. Use June and July to build utility weightings.

The Baltic Dry Index tested prior highs and digested gains last week. Global energy and commodity demand continues to pressure vessel availability and support prices while VLCC retirements offset newbuilds. China’s diesel and gasoline import demands will continue through 08, supporting dayrates. Own seaborne shippers.

Biotech seasonality kicks off a Q3 bull run in July. Use June and July to build positions in the highest scoring biotech stocks and watch best and worst lists carefully for those improving.