TODAY’S S&P 500 SET-UP – June 10, 2013

As we look at today's setup for the S&P 500, the range is 45 points or 1.18% downside to 1624 and 1.56% upside to 1669.     










  • YIELD CURVE: 1.87 from 1.87
  • VIX closed at 15.14 1 day percent change of -8.96%

MACRO DATA POINTS (Bloomberg Estimates):

  • 9:50am: Fed’s Bullard speaks in Montreal
  • 11:00am: Fed to purchase $1b-$1.5b notes in 2017-2043 sector
  • 11:30am: U.S. to sell $30b 3M bills, $25b 6M bills
  • U.S. Rates Weekly Agenda


    • President Obama speaks on Equal Pay Act’s 50th anniv.
    • Jeff Chiesa, R-N.J., is sworn in as U.S. Senator
    • House, Senate in session
    • Senate Commerce Cmte votes on nominations of Penny Pritzker for Commerce Sec., Anthony Foxx for Transportation Sec.
    • Senate to vote on Leahy amendment to farm bill, S. 954, followed by final passage, 5:30pm
    • Fed issues interim rule on how to treat American branches of foreign banks for a section of Dodd-Frank that prevents bailouts of swaps dealers


  • Google said to be buying Waze for $1.1b for social maps
  • Apple holds Worldwide Developers Conf.; to unveil new iOS
  • Elan board rejects raised $6.7b Royalty Pharma offer
  • AstraZeneca to buy Pearl Therapeutics for up to $1.15b
  • SoftBank’s clearance for Sprint deal confirmed by officials
  • China May industrial output rose 9.2% vs est. 9.4%
  • Marchionne says Fiat may acquire Chrysler stake before IPO
  • JBS said to agree to buy Seara food assets from Marfrig
  • Exide files for Chapter 11 bankruptcy after losing Wal-Mart
  • McDonald’s May global comp. sales seen gaining 1.9%
  • GE CFO Sherin said to take over finance arm as soon as summer
  • CBS said nearing $2.7b in upfront advertising commitments
  • Hawke horror film “The Purge” outsells Vaughn/Wilson duo
  • Japan revises growth to annual 4.1% in boost for Abe
  • Obama tells Xi that China must act against cybertheft
  • Pentagon’s cybersecurity plan calls for $23b through 2018
  • U.S. Weekly Agendas: Finance, Industrials, Energy, Health, Consumer, Tech, Media/Ent, Real Estate, Transports
  • North American M&A Agenda
  • Canada Weekly Agendas: Energy, Mining
  • Retail sales probably rose in May: U.S. Weekly Eco Preview
  • U.S. Retail Sales, BOJ, Iran, U.S. Open: Wk Ahead June 10-15


    • Navistar International (NAV) 4pm, $(1.20)
    • Lululemon Athletica (LULU) 4pm, $0.30
    • Diamond Foods (DMND) 4:01pm, (-$0.19)
    • Annie’s (BNNY) 4:06pm, $0.28
    • Pep Boys (PBY) 4:41pm, $0.09


  • WTI Trades Near Two-Week High on Economy; Sudan Oil Threatened
  • Gold Bull Bets Reach Seven-Week High Before Retreat: Commodities
  • China Approves Gold-Backed ETPs as Domestic Buyers Chase Bullion
  • Gold Declines to Two-Week Low in London on U.S. Stimulus Outlook
  • Corn Drops With Soybeans as Dry Weather May Aid Crop Conditions
  • Freeport May Declare Force Majeure If Grasberg Shutdown Extends
  • JBS Becomes Largest Chicken Producer With Marfrig Deal
  • Rupee Slump Set to Boost Costs for India Bullion Importers
  • Palm Oil Falls From Two-Month High on Concern India May Buy Less
  • Allana in Ethiopia Snubs Potash Supply Concern: Corporate Canada
  • Sudan Threatens to Shut South Sudan Oil Over Rebel Support
  • San Onofre Seen as Latest Setback for U.S. Nuclear Power: Energy
  • Bullion Bear Market Seen Extending to $1,303: Technical Analysis
  • Deutsche Bank Starts Singapore Gold Vault With 200 Ton Capacity






















The Hedgeye Macro Team












Bullish Places

“Books can lie, but places never do.”

-Jack Weatherford


I love that quote. Jack Weatherford uses it in the Introduction to this epic book I am still reading – Genghis Kahn and The Making of The Modern World.  Politicians and market pundits can lie too, but markets are always scoring the truth.


Some will disagree and say that markets are often wrong. Agreed – if the market goes your way on the timeline that you outlined prior to taking your position, that is. Being positioned for what the market currently accepts as truth is the name of the game.


If you could be right every day, you would be. Very few will disagree with me on that.


Back to the Global Macro Grind


Last week’s employment data continued to drive home a very simple, but trending, score in 2013 – US employment and consumption growth is accelerating. This shouldn’t have been a surprise by the time you saw the sequential improvement in the payroll data on Friday. Our preferred leading indicator (non-seasonally adjusted rolling jobless claims) has been trending bullish for 6 months.


Every 3 months, we update our Top 3 Global Macro Themes @Hedgeye. This quarter I was definitely nervous about one of them. Making a call that US growth could go from stabilizing to accelerating was more of a question to us than it was a definitive answer. Throughout Q213 however, US employment, housing, and consumption data has improved, impressively.


To review - our Macro Themes for Q2 2013 are:


1.       US #GrowthAccelerating

2.       #StrongDollar

3.       #EmergingOutflows


Since the fulcrum factor in our trending themes remains the US Dollar, last week’s abrupt selloff in the US Dollar versus the Japanese Yen definitely mattered. An immediate-term TRADE does not an intermediate-term TREND make though, so this morning’s -1.25% reversal in that move to #StrongDollar’s benefit has me smiling again.


Alongside a big bounce in #StrongDollar versus Burning Yen, this is what you get pre-open:

  1. Gold and Silver down another -0.5-1.3%, respectively
  2. Copper and Corn down another -1.1-1.3% respectively
  3. US Equity Futures up another 6 handles, following Friday’s +1.3% bullish breakout back above 1624 SPX

If you are betting on growth, you’ve recognized that the market’s version of the truth is currently paying people who have embraced the non-consensus bullish case that #StrongDollar is a pro-growth signal. You can see that in the following trending correlations:

  1. USD vs SP500 (on our intermediate-term TREND duration) has a positive correlation of +0.81
  2. USD vs Gold (on our intermediate-term TREND duration) has a negative correlation of -0.72

Moreover, if you want to dig into the multi-factor, multi-duration update, these correlations have actually strengthened across multiple factors in the last month. In addition to rising US Treasury yields, here are some more pro-growth signals to consider:

  1. US Financial Stocks (XLF) are +4.2% in the last month vs slow growth Utility Stocks (XLU) at -4.5%
  2. Low Dividend Yield stocks (i.e. higher growth stocks) = +20.9% YTD
  3. High Short Interest stocks (i.e. the ones that squeeze hedgies shorting them on “valuation”) = +19.1% YTD

Again, the score in the book may very well feel like a lie to people who are still bearish on growth, but where this market has scored the game for 2013 YTD isn’t. I’m not a fan of investing alongside what people are “feeling” anyway.


Another score that is developing quickly here is that a #StrongDollar eventually drives underperformance in Emerging Markets.  We call this Theme #EmergingOutflows and it’s worth scoring this morning as well:

  1. MSCI Emerging Markets Index = down another -2.4% last week and -6.6% for 2013 YTD
  2. China’s Shanghai Composite Index = down another -3.9% last week and -2% for 2013 YTD
  3. Brazil’s Bovespa Index = down another -3.6% last week and -15% YTD

Investors we speak with on #EmergingOutflows fall into 1 of 3 camps:

  1. Bearish on everything (we aren’t) – so they think Copper and China going down is bearish for US stocks
  2. Bullish on Global Growth (we aren’t) – so they think they should buy Emerging Markets because they “look cheap”
  3. Bullish on US #GrowthAccelerating and #StrongDollar – so they are bearish on Emerging Markets tied to commodities

We’re obviously in the 3rd camp. Looking at this week’s contra-indicator camps (weekly futures and options contracts in the CFTC data) we’re still seeing Camp 1 A) buy Gold (weekly net long position +19% wk-over-wk) and B) short SPY (there’s still a net short position in SPY right now of -3,061 non-commercial contracts).


I’m not saying we’re going to nail the macro call in perpetuity. All I’m saying is that last week was one of the top 6 times in the last 6 months that you’ve had to re-load on the long side where it’s actually working. Bullish Places are as bullish does.  And, globally, they are getting harder and harder to find.


Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST10yr Yield, VIX, and the SP500 are now $1, $100.27-105.25, $81.31-82.96, 96.05-99.98, 2.07-2.22%, 13.77-15.87, and 1, respectively.


Best of luck out there this week,



Keith R. McCullough
Chief Executive Officer


Bullish Places - Chart of the Day


Bullish Places - Virtual Portfolio

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Takeaway: The XLF continues to rise in the face of broad deterioration in company and sovereign credit swaps. High Yield, meanwhile, blasts off.

Key Takeaways:


High Yield – High Yield rates rose 36.5 bps last week, ending the week at 6.11% versus 5.75% the prior week. This is disconcerting, as we've historically observed fairly tight correlations between U.S. Financials, particularly large caps, and junk yields. The current divergence is an outlier vs. history.


* European Financial CDS - European financials swaps widened considerably, increasing by a median of 18 bps. The U.K., Spanish and Italian banks widened sharply. Italian banks, in particular, were materially wider.


American Financial CDS -  Morgan Stanley was a significant outlier last week, widening by 15 bps to 133 bps. The rest of the large caps were narrowly tighter or slightly wider. It was another week of spreads backing up for mortgage insurers and bond guarantors.


XLF Macro Quantitative Setup – More risk than reward in the short-term. Our Macro team’s quantitative setup in the XLF shows 1.8% upside to TRADE resistance and 3.0% downside to TRADE support.


Financial Risk Monitor Summary

 • Short-term(WoW): Negative / 2 of 13 improved / 6 out of 13 worsened / 5 of 13 unchanged

 • Intermediate-term(WoW): Negative / 3 of 13 improved / 6 out of 13 worsened / 4 of 13 unchanged

 • Long-term(WoW): Positive / 4 of 13 improved / 2 out of 13 worsened / 7 of 13 unchanged




1. American Financial CDS -  Morgan Stanley was a significant outlier last week, widening by 15 bps to 133 bps. The rest of the large caps were narrowly tighter or slightly wider. It was another week of spreads backing up for mortgage insurers and bond guarantors.


Tightened the most WoW: MET, C, JPM

Widened the most WoW: RDN, TRV, MS

Tightened the most WoW: MBI, AGO, UNM

Widened the most MoM: SLM, AXP, RDN




2. European Financial CDS - European financials swaps widened considerably, increasing by a median of 18 bps. The U.K., Spanish and Italian banks widened sharply. Italian banks, in particular, were materially wider.




3. Asian Financial CDS - Indian banks were notably wider last week, with State Bank of India widening by 17 bps and IDB Bank of India wider by 20 bps. Chinese banks were also wider, by an average of 7 bps. In Japan, swaps were mixed, with three advancers, two decliners and one unchanged.




4. Sovereign CDS – Sovereign swaps were wider around the globe with the sole exception of Germany, which tightened 3 bps to 24 bps., and now trades inside the U.S. by 4 bps. The biggest movers were Portugal, Spain and Ireland at +16, +12 and +8 bps, respectively. 








5. High Yield (YTM) Monitor – High Yield rates rose 36.5 bps last week, ending the week at 6.11% versus 5.75% the prior week.




6. Leveraged Loan Index Monitor – The Leveraged Loan Index fell -6.3 points last week, ending at 1793.16.




7. TED Spread Monitor – The TED spread fell 1.5 basis points last week, ending the week at 23.2 bps this week versus last week’s print of 24.7 bps.




8. Journal of Commerce Commodity Price Index – The JOC index rose 0.4 points, ending the week at 3.6 versus 3.2 the prior week.




9. Euribor-OIS Spread – The Euribor-OIS spread tightened by 1 bps to 12 bps. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. 




10. ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB.  Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system.  An increase in this metric shows that banks are borrowing from the ECB.  In other words, the deposit facility measures one element of the ECB response to the crisis.  




11. Markit MCDX Index Monitor – Last week spreads widened 9 bps, ending the week at 75.5 bps versus 66.3 bps the prior week. The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 16-V1.



12. Chinese Steel – Steel prices in China fell 1.4% last week, or 47 yuan/ton, to 3422 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity, and, by extension, the health of the Chinese economy.




13. 2-10 Spread – Last week the 2-10 spread tightened to 185 bps, -3 bps tighter than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.




14. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF shows 1.8% upside to TRADE resistance and 3.0% downside to TRADE support.




Joshua Steiner, CFA


Jonathan Casteleyn, CFA, CMT


The Economic Data calendar for the week of the 10th of June through the 14th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.




Takeaway: Current Investing Ideas DRI, FDX, HCA, HOLX, MPEL, NSM, WWW

(Editor’s note: We added HCA and NSM as new Investing Ideas, and we will issue full Stock Reports on those two companies next week. Additionally, we have removed CAG from the Investing Ideas list.)

Investing Ideas Updates:

  • DRI: Restaurants sector head Howard Penney writes “Strong price action in the casual dining stocks is being confirmed by sequentially stronger Blackbox Intelligence data,” a restaurant industry databank.  Penney says the May data “is giving us added confidence” being long the casual dining group, which has outperformed the S&P 500 by 16% year to date.  Darden Restaurants has come along for the ride, rising from the mid-40’s in January to the mid-50s this week.  Sales trends continued to improve last month and companies look set to meet analyst expectations without difficulty.  This means DRI can continue to track above the market averages – always with the possible kicker of an activist stepping in.  Penney likes the combination: DRI’s management is weak enough to make it a potential takeover target, but its above-average performance shows it actually has fundamentals going in its favor. (Please click  here to see the latest Stock Report on DRI.)


  • FDX: This week, FedEx Express announced an accelerated retirement schedule for high cost, older aircraft.  Industrials sector head Jay Van Sciver calls this “a meaningful positive,” even though “the announcement didn’t seem to attract much interest.”  This could just be more of the same in a company that much of Wall Street still sees as not in the running with its Big Brown competitor.  But Van Sciver continues to prefer FDX, calling the Express restructuring “a meaningful inflection point in FDX’s operating history.”  He expects the FedEx Express restructuring “to expand margins towards peer levels, driving higher share price.  Sooner is better.” (Please click here to see the latest Stock Report on FDX.)


  • HCA: Health Care sector head Tom Tobin says HCA Holdings, a major provider of health care through its network of over 160 hospitals nationwide, is uniquely positioned to benefit from converging demographic and economic trends.  As highlighted in last week’s Sector Spotlight, Tobin’s economic work points to an extended positive cycle for health care providers.  The three biggest points are: Increased physician utilization (“doctor visits”), an upturn in the birth rate, and the flow of payments from the Affordable Care Act.  Any one of these would boost HCA’s revenues.  The trifecta makes for a strong outlook for HCA’s revenues, while long term consolidation will help on the cost side with more favorable pricing and purchasing terms.  Having three significant reasons to be bullish means future revenues should be somewhat insulated from the effect of momentary or seasonal downturns in any one revenue stream. (We will issue a full Stock Report on HCA next week.)


  • HOLX: Health Care sector head Tom Tobin sees continued acceleration in consumption by the working age demographic and expects traffic at doctors’ offices to continue to grow, with accompanying steady growth in the consumption of medical services.  Tobin sees this as confirming evidence of his forecast for growth focusing around increased birth rates, household formation, improving employment picture – notably among women of child-bearing age entering the work force.  This trend should be positive for Hologic’s diagnostics division.  At the same time, the FDA has just released its Mammography Quality Standards Act data (a monthly review of standards and practices at US mammography facilities) showing sharply increased use for May, and annual growth at its highest level in five years.  Tobin says demographic trends should combine with stimulus from the Affordable Care Act to continue to lift HOLX’ business prospects and with them, its stock price, noting for example a new contract this week between HOLX and Qwest Diagnostics. (Please click here to see the latest Stock Report on HOLX.)


  • MPEL: Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016.  Meanwhile, across the globe, Macau gaming revenues for the month of May grew 13.5% year-over-year, despite losing two days to flooding caused by the heaviest rainfall in thirty years.  Infrastructure improvements are expected to continue to boost traffic to Macau in the coming years, and Jordan expects MPEL will benefit from new rail links bringing more people from northern China to the gaming tables of Macau – where they will be more focused than ever before on the games, since by then it looks like smoking will be totally banned in all Macau casinos.  (Please click here to see the latest Stock Report on MPEL.)


  • NSM: Financials sector head Josh Steiner is the Street’s head bull on residential mortgage originator/servicer Nationstar, projecting $9 in earnings for the company in 2014.  This is well above the company’s own guidance range, which tops out at around $7.50.  NSM had a successful start to the year as it won servicing bids on substantial mortgage portfolios.  They also reported significant increases in their profit margins on those portfolios, and double-digit increases in their own originations.  Housing prices are ramping significantly higher, as Steiner predicted, as demand continues to exceed supply in both new and existing homes.  Steiner says this quality mortgage company could ride the crest of a sustained wave of sector improvement.   (We will issue a full Stock Report on NSM next week.)



Macro Theme of the Week: Unemployment for Dummies

            “Say hello to the people, Stupid.”

            “Hello to the people, Stupid!”

      - Edgar Bergen and Charlie McCarthy

Washington policy makers have perfected the ability to speak out of both sides of their mouth simultaneously.  Like the best practitioners, they constantly wear a broad smile which effectively masks any movement, with the result that no one can tell who is actually doing the talking.


As we pointed out two weeks ago here the Fed “manages” interest rates using two primary tools: by buying and selling Treasury bonds – and now a whole lot of other stuff – in the open market, or by just talking about when they might buy or sell some Treasury bonds (or sketchier instruments).  One might argue that, once the first dollar has been spent in open market operations (or more accurately, the first trillion dollars, but who’s counting…?) (Who, indeed…) it is just as effective to threaten to buy Treasury bonds as to actually purchase them.  And it’s a lot cheaper.


As we have observed in the past, markets cannot go up in an environment of uncertainty.  If we didn’t know better, we would assume the government purposely destabilizes the markets by putting out contradictory and confusing data, presumably as a way from keeping the brakes on to prevent asset bubbles from proliferating out of hand.


Of course, it might be that we attribute too much stealth and connivance to our government.  Or too much intelligence.


The Fed is an outstanding practitioner of auto-ventriloquy, but they are hardly alone.  Our Financials sector head Josh Steiner highlights the ongoing push-pull in government data with his read on this week’s Initial Unemployment Claims numbers.


For ordinary mortals such as we, it is confusing enough that the government reports both Em-ployment and Un-employment.  Steiner says this week’s unemployment data continue an optical illusion that has governed perceptions of the economy for three years. 


As we have mentioned in earlier notes, Steiner tracks the weekly Non Seasonally Adjusted initial jobless claims data (NSA) which he says give an accurate picture of how many people are actually filing claims.  The Bureau of Labor Statistics (BLS) puts out Seasonally Adjusted (SA) claims figures to smooth for the effect of collecting data monthly. To the likes of you and me, this might seem perfectly logical – which means we likely qualify to work for the government.


Like any metric that cuts off at month end and restarts the following day, there is an artificiality to the data underlying the SA figure.  It’s a bit unavoidable – portfolio managers and mutual funds are judged on annual performance, as are most business metrics in any industry.  And everyone celebrates their birthday, which is otherwise no different from the day before or after.  Steiner argues that the economic convention of tracking SA data has created the illusion of stagnation.


After showing steady improvement (a decline in the rate of new unemployment claims) from August of last year through February, the SA data is all but flat from March up to now.  Steiner says this leveling “is expected as it is following the same trend over the past three years, owing to faulty seasonal adjustment factors in the government’s model.”  In fairness to the government policy makers (we never thought we’d hear ourselves say that) statistical modeling is difficult, and it’s really hard to get seasonal factors right for exactly equal comparisons over time.  Of course, this is precisely why Steiner relies on the NSA figures, which is the actual number of people filing initial unemployment claims.


“The market still cues off the SA data,” says Steiner, “so to the market’s eye, the data is beginning to stagnate.”  Charting the SA data shows roughly parallel annual trends in 2009-2012, with the decline in unemployment reversing around March of every year and an increasingly dismal labor picture emerging through August.  To any observer this labor market stagnation is an indicator of economic decline – just when things were starting to look better!


Unemployment plays a significant role in investors’ perceptions of the economy, and the recent stagnation in the SA labor numbers have to be a big part of what’s leaning on stock prices right now.  Looking at the NSA numbers though, Steiner sees a marked drop in unemployment and a robust pattern emerging.  For the first time since 2010, the rate of year-over-year change in the NSA figures clearly form a downward slope, compared with rising or rising-to-flat trends in the prior three years.  In other words, the rate of improvement is accelerating.


Steiner would urge patient investors to be poised to buy market dips, to the extent they are triggered by fading confidence in the labor market recovering.  The headwind from the SA figures will culminate around August and will switch back to a tailwind beginning in September, accelerating through February 2014.  This could be the catalyst for a late-summer (read: election season) rally.  As with every call that is based on knowing something the rest of the market doesn’t, you have to be willing to live with volatility until your vision pans out.


This brings us full circle to the notion of the Fed “jawboning” stock prices this way and that without so much as lifting a finger – or a measly $85 billion – to influence the market.  And to other branches of government maintaining completely conflicting parallel stories.  In other words, government auto-ventriloquy is not some exotic form of speech impediment.  It turns out to be an important policy tool.   


Another way to look at this is that the government is merely the government, and who are they to say which is the best way to look at the data?  By putting out myriad data series all tracking essentially the same thing, the BLS and other government agencies create the perfect environment for crowd-sourcing answers to complex problems. 


Some folks say the stock market is the ultimate example of the Wisdom of Crowds.  Could it be that the policy ventriloquists down in Washington are no dummies?


Sector Spotlight: “Peak”-A-Boo in the Energy Market

Remember “Peak Oil”?  The notion was making the rounds a few years ago that the world had run out of its readily-producible supply of oil, and that Life As We Know It would soon grind to a halt, predicated as it has been since WWII on an unending supply of cheap oil. 


Oil is already no longer cheap – the US Department of Energy says that, in constant 2011 dollars, the price of gasoline rose from under $1.50 a gallon on the eve of the Arab Oil Embargo of 1974, to over $3.50 by the end of 2011.  Peak Oil says oil is also no longer plentiful, because we have drilled the world down to a diminishing petroleum reserve. 


Books and articles proliferated – because not many people can make money trading markets, but a whole lot of folks can make money writing about how to trade markets – predicting how dire our lives were about to turn, and how soon.


Now “Peak Oil” has not only peaked.  It has flipped.  Now, when folks use the term, they mean that demand for oil has peaked and the combination of fracking and newly-discovered US gas reserves will make our energy woes a thing of the past.  We have no idea who will be proved right, but we again observe that it pays to speak in superlatives and paint extreme scenarios if you want to sell books about investing.


Energy prices have long been a key driver of inflation, and significant moves in energy prices tend to ripple across markets.  Many portfolio managers still assume that a move in the price of oil is sufficient to move the equities markets, generally in the opposite direction.  Oil Up = Inflation = Stock Market Down. 


Inflation used to mean higher interest rates.  In Modern Portfolio Theory (MPT) this used to be expressed in the interest rate paid on US Treasury Bonds (the “riskless asset,” perhaps another outmoded concept).  Interest rate increases naturally flowed through to stock price declines, and vice versa.  It is axiomatic to MPT that investors seek a higher rate of return in exchange for taking on more risk.


In 1996, the 2-year Treasury had a nominal yield of around 6.25%, while the 10-year yielded over 7.5%.  There was the same arbitrage opportunity then as there is now: borrow short, and lend long and capture the spread.  But who needed to finagle to get 1.25%, when you could just buy the darned things and have Uncle Sam pay you over 6% to sit?


In order to take on the added risk of being in equities, said MPT, the average investor would need to obtain a return at least 1 ½ times that of the Riskless Investment.  With 2-year Treasurys yielding over 6%, this means stock market investors were looking for a return of between 9%-10% annually. 


Nowadays these relationships are all out of whack.  Two-year bonds yield next to nothing, and investors are looking not for equity appreciation, but for yield replacement.  Meanwhile, the global central bank cabal is driving asset prices (stock markets) to further enrich the wealthy – those who do not rely on interest income to fund their meager retirements.


The yield panic is driven by a number of forces, among them pension fund managers who are required to produce a minimum target return every year (there’s that semi-artificial unit of measurement again) and who long relied on fixed income to do their heavy lifting.


Another side is individual savers who can no longer afford to retire because they live on a fixed income and need every extra smidgeon of yield.  Your average corporate lawyer or Wall Street professional used to be able to sock their bonus away in muni bonds and retire in just a few years.  At 5% annual interest, $2 million will get you $100,000 a year in tax-free income.  No longer.


Welcome to the “New Normal.”  With the Riskless Asset no longer a viable investment option – it is neither an Asset, nor Riskless – MPT theory has to do some fancy footwork to adjust.  Managers hunting for yield have given rise to a range of market distortions such as the recent run-up in the distressed debt market (“junk” bonds) which got bid up so far in price, they were trading more like low-range investment grade paper until the recent rush for the exits.  And now investment banks are offering exactly the same instruments that are blamed for the collapse of the global financial markets (see for example Financial Times, 6 June, “Frankenstein CDOs Twitch Back To Life”).


Getting Energized: Into this morass treads our intrepid Energy sector senior analyst Kevin Kaiser.  Kaiser has managed to get a whole lot of folks riled up in recent weeks over his coverage of Linn Energy.


Kaiser has taken LINN’s financials apart and, despite loads of criticism, disdain and some good old-fashioned name-calling – from Wall Street analysts who are bullish on the stock, from money managers who own lots of it, and from the company’s own management – Kaiser keeps coming back to the conclusion that LINN is using accounting methods that may be legal, but that don’t represent the company’s financial picture in a manner consistent with the expectations of shareholders.


LINN is what’s called an “upstream oil & gas MLP.”  An MLP – Master Limited Partnership – is a tax-advantaged investment vehicle that distributes its income to its shareholders, and also trades like a stock, offering constant liquidity.  It is “upstream” because it focuses on acquiring oil and gas producing properties, thus getting paid at the wellhead. 


Upstream MLPs got a bad rap in the 1980s when many of them borrowed heavily and bought into producing properties with short remaining life spans.  Energy price volatility banged up against declining inventory, and the hedging markets in the 1980s were nowhere near as deep or complex as they are today.  Upstream MLPs fell out of favor and were replaced by Midstream MLPs that piped oil and gas from the producer to distributors and users.  This middleman position was seen as far safer and held sway for many years.


Now the upstream business has come back into vogue.  The greater risks associated with exploration and production (E&P) are offset by higher payouts to unit-holders.


But wait, you say – if there’s more risk, how can you be sure you’ll always be able to make those bigger payments?


How, indeed.


One of Kaiser’s major criticisms of LINN is its method of accounting for its hedging book, where it seems to be crediting itself for amounts it spends to buy swaps and options.  Just this week, in response to what appears to be pressure from the SEC, LINN has disclosed the actual cash outlays to acquire put options used in their hedging program.  Says Kaiser, “in the most recent quarter, 29% of Distributable Cash Flow was generated by LINN’s unique put options accounting method.”  This means that, far from generating cash flow from the production of oil and gas, the company appears to be raising money by offering its partnership units in the equities market and buying hedges on its production portfolio with the proceeds – then redistributing that same cash back to unitholders. 


The most conservative way to account for this would be to book the cost of acquiring the options as an expense, and to treat the resale of those options as a return of capital, which would leave the financial picture essentially flat, with the only difference being any profits from the sale of the options.


Instead, LINN’s accounting method makes these payments look almost like revenues.  In the beginning of 2012 this accounted for 16% of DCF.  Now it is up to 29% and counting.  To the uninitiated – which certainly includes the majority of individual investors who have long been buyers of these MLPs for the yield and the perceived safety – this is starting to look like the company is increasingly in the business of recycling money, rather than producing oil and gas.


To make matters worse, Kaiser’s comparison of LINN’s operating properties with those of competitors working the same areas indicates wide discrepancies between the price LINN says they will get for their production, and the value of that production implied by comparable transactions in the same markets. 


The big question for us is not even LINN.  It’s the valuation of producing properties across the whole sector and the likelihood that the upstream MLP business may again fail.  Because of the higher yields from upstream MLPs, they have been favorites of individual investors, especially those primarily driven by yield.  This group includes largely retired people and, increasingly, the elderly.  As both energy prices and the upstream MLP well reserves decline, where will the MLPs find the quarterly cash flow to continue to make payments at the same levels?


As long as MLP unitholders receive the same steady return month after month, they will not be motivated to ask questions about the companies’ operations or the health of the business model.  Not even the most obvious ones – like, given fluctuations in production levels and in the price of oil and gas, how do you manage to make exactly the same payment every quarter?  If that doesn’t make your antennae go up, nothing will.


Kaiser’s work points to what might be a troubled corner of the Energy sector.  MLPs that continue to make high payments to unit holders should be scrutinized closely.  Investors desperate for yield may to be ignoring the risks associated with robbing Peter to pay Paul.


Looking for an acceptable rate of interest on a safe fixed-income investment that you can hold for the long term?  Sorry, looks like your retirement plan just peaked.


Investing Term of the Week: Correction

It kind of makes no sense: the stock market retreats from an uptrend and you lose money.  Why is that “Correct”?


The difference between a Crash and a Correction may be very small, at least initially, but they tend to have diametrically opposite after-effects.  A correction is defined as a pullback of general price levels of 10% or less, generally in a relatively short period of time, and often leading to higher prices in the future.  If all those qualifiers bother you, welcome to the world of economic analysis, where events can only be clearly identified when they are already in the rear-view mirror.  And as in real life, so in the markets: objects in the mirror may be larger than they appear.


A market crash is defined as a drop of between 10%-20% that usually happens relatively quickly – sometimes famously in a single day.  Various protective measures have been implemented by regulators to hold the line against crashes.  These include “circuit breakers” such as Trading Curbs in the stock markets, where trading in a stock may be suspended for a period of time and then re-started on the same day, and price-move limits and position-size limits in the futures markets. 

Market economists generally say that corrections are inevitable – which works in favor of using a positive-sounding name for them – and that they do not create lasting negative effects.  Crashes, on the other hand, are associated with recessions and with permanent wealth destruction – and in the most extreme cases, societal disruption.


One way to understand this is to say that excessive enthusiasm causes stocks to “get ahead of themselves.”  You may remember Alan Greenspan’s famous locution “irrational exuberance.”  If stocks in a sector tend to trade at a 15 price / earnings multiple, and one stock has gotten to a 25 P/E, then perhaps that stock needs to be “corrected.” 


There are traders who buy on Momentum – which can look a lot like emotion.  When a stock has advanced a certain percentage in price, these traders hop on board to capture the last X% of the price move.  And there are also investors who panic.  They see a stock that has risen 20% in a few days and, terrified that they have missed the boat, they pile in and their buying lifts the stock another 3%.  Irrational Exuberance at work. 


And then the momentum traders sell.


Which knocks the price down a quick 5%.


And then the emotion buyers panic and sell too.  Next thing you know, the stock has retreated 10% from its recent high.  The momentum buyers are out of it, and the emotional buyers are out, leaving only those who “should” own the stock.  This includes long-term holders, value investors, fundamental or special situation investors, and those forlorn souls who can never make a decision one way or the other.


So the theory of a Correction, simply put, is that it shakes out those who “shouldn’t” own the stock now and forces the buying action to consolidate.  In a bull market, these consolidations build a more stable platform for the stock to launch to a higher level.  Think of it as a pit stop for a race car, an elite runner slowing a bit to take a sip of water.


Or, if you are like lots of other people, just panic next time the stocks you own go down in price, sell everything and take your losses – then react in fury when those same stocks are 10% higher three months later.


You won’t be alone.

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