Eye on Commodities: Leading Indicators?

We wanted to highlight two commodity related charts here today. The first is the percent change of price levels of the SP500 versus copper and oil over the last three weeks. The second is the longer trend line for oil.

On the first chart, the last three weeks have seen an important signal from commodities as they outperformed domestic equities, even as the US dollar index has strengthened. This to us is an important early signal--just like semiconductor companies saying that “things are less bad”--that global demand is set to pick up from the lows of Q4 2008 / early Q1 2009. There is likely no better leading indicator than basic commodities like oil and copper, and their clear divergence versus domestic equities over the past three weeks is to be noted.

On the second chart, the point is to highlight that there is serious upside to oil on a breakout. Our quantitative model has oil’s trend resistance at $89.84 per barrel for West Texas Intermediate, which is more than 100% upside from the current price. Obviously oil testing that line is far from a foregone conclusion, but we would highlight a number of incrementally positive fundamental data points:

· OPEC – While this is very difficult to measure, media reports suggest that OPEC compliance with the 4.2MM in production cuts announced since September are now near 80% with the potential to reach 90% by the March 15th OPEC meeting. There are also some rumors that OPEC may cut an additional 500K – 1MM barrels per day at this meeting. According to BP’s most recent statistical abstract, world oil production is at ~81.5 million barrels per day, so a 4 – 5 million barrel cut is very significant.

· U.S. inventory building at a lesser rate – Days supply in the United States has increased for 9 straight weeks from December 19th to the week ending February 20th from 21.8 says supply to 24.9 days supply. In the week ending February 27th, we saw the first abatement of this trend as days supply declined sequentially to 24.8.

· China – On March 9th, Zhang Guobao (head of the Chinese National Energy Administration) said in published reports that China should use part of its nearly $2 trillion in foreign exchange reserves to buy more gold, oil, uranium and other strategic materials. Obviously the Chinese have a lot of buying power. If they were to allocate ~4% of their foreign exchange reserves into buying oil, they could buy 500K barrels, at the current price, every day for the next year. As Tim Russert says, that is BIG!

Modeling the projected supply / demand for the global oil balance is a complex endeavor, but focusing on changes on the margin and major shifts in the model (China buying, OPEC cutting production) are important and can impact the supply / demand balance meaningfully. And as we see in the chart below, there is a serious upside if demand begins outstripping supply, even in the short term.

Daryl G. Jones
Managing Director

Beta Shifting - Up

Today in the Research Edge morning meeting for our clients we said that if the S&P rallied to 711, the next level of resistance would be 754. (We update our model every 90 minutes and the level has changed to an immediate term breakout/breakdown line of 705). Given the massive move we are seeing today, this could happen very quickly.

To gain Alpha in the move to 754, you need to beta shift away from the “safety play.” At the time of writing, the top three performing sectors today are the XLF (Financials), XLE (Energy) and the XLI (Industrials). The corresponding beta on those three sectors are 1.6, 1.2 and 1.04, respectively. The only other sector outperforming the S&P 500 today is the XLY (Consumer Discretionary), with a beta of 1.2. With a beta of 0.52, the XLP (Consumer Staples) is showing a massive negative divergence.

While MCD is not officially in the XLP, it is representative of the issues associated with global consumer product companies that comprise the XLP. Yesterday, MCD reported remarkably strong same-store sales, yet overall sales declined given the currency impact. While most investors like to look through the issues of currency, the strength in the US$ is a big negative for all of these global companies, creating negative year-over-year comparisons. Analysts don’t back out the impact of currency when modeling operating EPS. That being said, from a bottoms up perspective the collective street is modeling 12% operating EPS growth for the XLP; not going to happen given the economic and currency headwinds.

Where to look… The XLE (Energy) double bottom tested on Friday and saw further follow through yesterday and again today. The XLE continues to make sense with oil in positive “Trend” position. The US$ is declining today, therefore higher beta assets like commodities and stocks will “re-flate.” The XLB (Materials) is a major beneficiary of this trade.

We have cited numerous examples over the past week where fundamentally, things are looking less bad in 1Q09 from 4Q08. We continue to like early cycle Technology, Consumer Discretionary and Gaming stocks.

Howard W. Penney
Managing Director


Our consumer and macro team have noted signs of stability in our respective sectors. Things appear to be getting less bad. Is that enough for the stock market? Keith McCullough and our macro team believe so, at least for the near term. They believe we won’t hit resistance until 754 on the SPX, or 6% higher than here. Interesting call particularly if you believe, as we do, that the housing delta will turn positive in Q2. Keep a trade a trade is our motto since we all remain concerned with the quasi socialism that’s being proposed.

In my narrow world, we’ve seen evidence of stability. Today, we got some confirmation in two areas where I would’ve least expected it: lodging and Las Vegas. It wasn’t exactly a “business is booming” call to arms, but Starwood Hotels indicated at an investment conference that “the change in the rate of change has stabilized”. You know it’s a bad stock market environment when a positive 2nd derivative becomes an investable delta. The other surprise of the day was the RevPAR data provided by Sheldon Adelson. February occupancy and rate at their Las Vegas properties were 93% and $225, respectively, much higher than the Street was expecting for Q1. Moreover, March is a stronger seasonal month.

We do acknowledge that these are the first positive data points we’ve garnered on either general lodging or Las Vegas. However, we have been making the case for stability in other areas of leisure. We’ve been highlighting the sequentially improving regional gaming markets (see “REGIONALLY SPEAKING, BUSINESS AIN’T THAT BAD” from 2/18/09). PNK posted terrific earnings and the rest of the regional guys were better than bad. In our 2/26/09 note, “CRUISING TOWARDS STABILITY”, we discussed better Jan/Feb bookings.

In any other market, I probably wouldn’t be highlighting “less bad” as an investable theme. However, given the valuations on leisure stocks, rock bottom expectations, high short interest, and Keith’s near-term positive view on the market, any signs of stability are important.
I personally own shares of PNK

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Where's Shorty? The VIX...

This morning, we are seeing more of the same. Volume accelerating on the stock market’s UP move as volatility (VIX) continues to break down (-9% on the day). These 3 factor (volume, price, and volatility) acting this way in unison are, on the margin, bullish.

The VIX in particular is forming a formidable bearish Trend at the 50.98 line (thick red line), and should accelerate to the downside if/when the VIX breaks the shorter duration Trade line (dotted red line) at 46.53. There is weak support for the VIX down at 43.42, and it should bounce there… but, make no mistake, the VIX is making lower highs (vs. the 2008 peaks) on rallies and strength in the VIX is to be sold.

Be careful on the short side out there. There are some angry bears out there dealing with today’s short squeeze who know this is the right quantitative call.

Keith R. McCullough
CEO & Chief Investment Officer

Eye on China: No Inflation Here...

Chinese inflation Levels continued to contract rapidly in February…

February CPI & PPI data released by the National Bureau of Statistics in China last night showed a continued decline in price inflation with Consumer Prices declining on a year-over-year basis for the first time since 2002.


CPI registered at -1.6% in February, making the specter of deflation a real concern for Beijing. In stark contrast to the pre Olympic period last year, the most recent data shows that collapsing commodity prices has reversed food cost trends, while non-food prices have come in much more modestly (see below).
The dilemma facing the leaders remains how to coax consumers to loosen their purse strings in the face of steady declines at the cash register. Premier Wen Jiabao has recently reiterated the government inflation target of 4% for the year, with expectations that prices will rise as stimulus program projects get under way. Last month we underscored the overlapping cultural and economic incentives for Chinese consumers to save rather than spend in the near term, nothing has changed in this analysis. The middle class have been jolted by factory job losses and the volatility in asset prices globally (a first taste of the negative side of capitalist consumer culture for many). We expect that these more affluent consumers will wait for confirmation that prices have stabilized before re-entering the market for larger purchases.

They may not wait long: As infrastructure projects break ground in central regions, streams of laborers will be drawn into the interior (instead of toward coastal factory towns as in years past) creating new geographical pressures on consumer products that could lead to pockets of regional inflation. Anyone who remembers 7th grade history class will recall the tiny pockets of hyper inflation driven by gold rush prospectors swelling the population in distant outposts. We will be watching for any anecdotal evidence of any regional pressure as construction begins in earnest in the coming months.


The falloff in prices for energy commodities and base metals continued in February, driving PPI to -4.5% Y/Y, its lowest Y/Y levels since March 2002. The breakout in component costs in the NBSC stats still show no signs of the reflationary clues we have been tracking in base metal prices and Australia/China shipping costs.

Coal was the notable divergent component again, increasing by 18.7% Y/Y, up from 12.3% in January. Last month we noted that announced production cutbacks of as much at 20% by generators on the state electricity grid would likely have an impact. It didn’t.

The PPI puzzle remains. If coal cost pressure remains strong and is joined by increased cost in other raw materials in the March data then it can be taken as a reflationary signal showing remerging demand by heavy industry. Until then, the best clues we have are anecdotal reports and price action in the international commodity markets.

Looking Ahead

We have been bullish on China consistently since December of 2009 and remain so – we are long China via the CAF closed end fund. Find us another country with positive mid single digit GDP growth and negative low single digit consumer price inflation, and we’ll show you another country we get bullish on!

China has liquidity and the potential for massive growth in domestic demand; we will remain flexible and will change our stance if the data undermines our conviction, but for now those factors dominate our model.

Andrew Barber

Another Positive UA Nugget

While we'll never hear a retailer outwardy bash UA, the tone on the DKS call supports my view on the health of the brand and near-term success of running launch.
No mention of brands in prepared remarks. But In answer to the first question on Q&A...

a. Not reducing any of the major brands (e.g. NKE, UA, etc.) - it's the other brands that they've scaled back on

b. UA running shoes have done quite well

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