SET Monthly Issue August 2010

| August 17, 2010

August 2010


Watch out!  Doom and Gloom are everywhere…

Everyone from Wall Street to Main Street is growing impatient.  The pace of economic recovery isn’t good enough for anyone these days.

I get it.  More than 18% of people are either under- or unemployed.  That’s a lot of unhappy people.  And those lucky enough to have jobs are being worked to the bone.

Everyone wants improvement and they want it now!

Unfortunately, it doesn’t work that way.  These things take time.

The road to recovery isn’t straight.  There are twists and turns, ups and downs, good months and bad ones.

I’m sure you’ll agree that in the age of 24-hour news and the internet, we can lose sight of the big picture.

Single data points are often overblown.  The impact of one economic report or another is turned into an eye-catching headline.

As if that’s not enough, now the Fed is falling into the same trap.

Just look at the most recent Fed meeting. Bernanke drastically changed the Fed’s position.

It was just a few months ago the Fed thought the recovery was strong.  He was talking about unwinding quantitative easing.  And he was beginning to worry about inflation.

Now just a few months later he’s pulled a complete 180… Today he thinks economic growth is weakening.  And the risk of deflation is increasing.

Bernanke is being shortsighted. He’s too worried about volatile month to month fluctuations in economic data.

His knee jerk reaction reinforces all of the negative beliefs investors hold.  It’s a huge policy blunder.  It’s sending the wrong message.

We don’t need more liquidity or lower interest rates.  We need confidence.

Businesses need confidence to spend money.  Confidence to hire new employees. Confidence to place orders.  Confidence to take out a loan.

Confidence is the only thing keeping us from a full blown recovery.

And Bernanke blew it!  He’s undermining confidence.  He’s sending the wrong message at the wrong time.

The result?  Uncertainty and fear continue dominating the market.

Obviously I’m frustrated (maybe even a little angry) by the Fed’s latest move.  But there is a silver lining.  I think the weakness is only temporary.  Even the Fed’s bonehead move can’t derail this train (maybe delay it a little).

It’s actually common for growth to slow at times during a recovery.  During slowdowns, confidence wavers.  Weak hands cut bait and run for cover.

Remember to look at the big picture.  Looking back at where we were a year ago shows us we’re in a slow growth recovery.  Positive trends exist in just about every economic indicator.

Eventually, the recovery will continue.  It will rebound from a slow month or two. Investors who stick to their guns will be handsomely rewarded.

And that leads to this month’s trade…


Forget everything you’ve heard about financial reform.  It’s really not going to hurt the banking industry.

It’s being called many things – Financial Reform Bill, Dodd-Frank Wall Street Reform and
Consumer Protection Act, H.R. 4173…

I call it a bunch of hot air… 2,319 pages of hot air to be exact!

This monstrosity is really more bark than bite.  It creates an enormous government bureaucracy.  However, it does little to address the fundamental problems of the 2008 financial crisis.  But that’s a story for another day.

What’s important is the changes (while still not completely known) aren’t likely to damage bank profitability.  There will be one-time costs to comply with new regulations.  Banking fees will be changed, added, or moved around.

But in the end, it will largely be business as usual.  And that’s a good thing for banks.

To be perfectly honest, the uncertainty surrounding banks is largely their own doing. Banks have protested the proposed reforms.  They said it would hurt profitability.

Bank CEOs have been dragged in front of Congress kicking and screaming.  They’re fighting the new regulations tooth and nail.

But what you haven’t heard is they got their way.  The most damaging parts of the bill were removed.

Obviously it’s in the banks best interest to keep quiet about it.  People are still pretty angry.  Many want to see the banks “get what’s coming to them”.

But it’s just a dog and pony show.

In the end, the banking industry is emerging from the financial crisis in good shape. And the financial reform is just window dressing.  It’s only a matter of time until the curtain of uncertainty is pulled back.

Dig deeper and you’ll find an undervalued industry.  And the Fed is all but ensuring the industry’s profitability through a zero interest rate policy.

Macro/Economic Trend:  Growing Capital and Easing Credit Conditions

Everything is turning up roses for the banking industry.

They’ve managed to avoid the worst of the proposed financial reforms.  Those reforms being passed are watered down.  The banks will still influence the regulators who are crafting and implementing the policies.

And don’t overlook the Fed’s Zero Interest Rate Policy (ZIRP).  Interest rates will be near zero for an extended period.

The impact of this policy on banks’ balance sheets can’t be overstated.  Borrowing at 0% and lending it back to the government risk free at 3% is free money for the banks. (Well it’s actually the taxpayers’ money but it’s free to the banks.)  It’s stabilized and shored up the earnings of the entire industry.

Beyond regulation and ZIRP there are a host of other signs the industry is improving. Specifically, I’m looking for big things out of the large regional banks.

Banks like BB&T (BBT), Fifth Third Bank (FITB), and Bank of New York Mellon(BK) are right in the sweet spot.

They don’t have the same regulatory issues the bigger banks like Citigroup (C),JPMorgan (JPM), or Bank of America (BAC) have.

And they don’t have as much exposure to Commercial Real Estate (CRE) as smaller community banks, at least on a percentage basis.

A downturn in CRE won’t kill them like it will many smaller regional and community banks.  And that’s what really matters.

And there’s more…

In just the last quarter, loan performance is stabilizing.  Nonperforming assets of the large regional banks fell to 4.1% from 4.5% in Q1.  Still not great, but improvement means the worst is behind them.

As a group, regional banks are raising a ton of fresh capital.  They’ve issued common stock, exchanged debt, and decreased the size of their balance sheet.

Now they’re sitting on excess capital.  Large regional banks’ tier 1 capital ratio is 13.9%.  But most of them only need a ratio of 8% to 9%.  And that’s after the new stricter requirements go into place…

This excess capital is fuel for bank profits.  But in order for it to catch fire, their needs be demand for new loans.

That’s why I almost jumped out of my seat when I saw this… The Fed survey of banks shows they are starting to loosen lending standards.

The years of tight credit conditions are ending.  And the modest recovery is creating more credit worthy borrowers.  It’s a combination of events propelling us into the next stage of recovery.

You see, the initial phase of recovery boosted sales for big and small companies alike. It’s allowed them to improve their balance sheets.  Many businesses are better qualified today than they were a year or even six months ago.

The combination of stronger balance sheets and easier credit should spark a new wave of business lending.  That’s great news for the banks and the economy.

In short, this is a significant development on our road to recovery.  And a sign bank profits are on the verge of recovery.

One ETF I like to profit from these trends is the SPDR KBW Bank Index ETF (KBE).

Fundamentals:  A closer look at KBE

KBE is a float-adjusted, modified-market capitalization-weighted index.  It holds 24 of the largest diversified and regional banks.  A full 44% of KBE are the large regional banks in the sweet spot to profit from the recovery.

The expense ratio is 0.35%.

The top five holdings and percentage weight for KBE are –

Company Name Ticker % Weight
Citigroup C 9.06%
JPMorgan Chase JPM 8.47%
Bank of America BAC 8.12%
Wells Fargo WFC 6.74%
US Bancorp USB 5.83%

KBE has a dividend yield of 0.7%.

Earnings per share are estimated to grow at over 8% per year for the next five years. And the Price to Earnings ratio is 13.63.

Technicals:  The charts lead the way

There’s really no nice way to say it.  Banks have taken a beating since April.

KBE has shed more than 21% in the last four months.  Most of the damage was done in May.  Since then, KBE has been consolidating.

It’s been trapped in a trading range between $23 and $25.  It’s only peaked out on either side of this range briefly during the last three months.  And it has reversed sharply each time it did.

There is also a long term support zone just above $22.  It’s the red line on the chart below.


Right now KBE is at the low end of its trading range.  And it’s just above a support zone around $22.

Buyers are stepping in to buy KBE every time it reaches these levels.  It makes this a good low risk entry point.

Trade Alert

Buy:  SPDR KBW Bank ETF (KBE) up to up to $23.50
Recent Price:  $22.83
Price Target:  $27.00
Stop Loss:  $20.00

Remember:  KBE is in a trading range.  It could continue to fluctuate between $23 and $25 for awhile longer.  But as the economy improves and lending picks up, this undervalued industry should rocket higher.


Consumer Discretionary (+2.4%)

Hooray!  Consumer discretionary stocks finally bounced back after three straight down months.

Retail sales are still weak.  Industry bellwethers Wal-Mart (WMT) and Home Depot(HD) reported earnings today.  Revenue fell short of expectations.  But management for both companies sounded optimistic about the future.

The good news is both stocks are up on the reports.  Obviously the bar for success has come down considerably in the last month.

Our position in iShares Dow Jones U.S. Consumer Services Sector Index Fund(IYC) is picking up some momentum.  I think IYC could really pick up steam going forward.

The reinstatement of extended unemployment benefits should spark a flurry of back to school shopping.  And any boost to consumer spending will spark a rally in the sector.

Consumer Staples (+1.1%)

Consumer staples continue down their slow and steady path.  The sector has been holding at this level for the last ten months.  Investors are already putting a premium on staples compared to their historic valuations.

Unfortunately, I just don’t see any catalysts for the sector.  I’m steering clear for now.

Energy (+3.1%)

Oil’s trading in the mid $70s per barrel.  Anytime oil strays too far from $75, it snaps back like it’s tied to a bungee cord.  Are these merely market forces at work?  Or is it a sign of market manipulation?

Our Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ) got off to a good start.  It recently gave back some of its gains as oil prices pulled back.  But IEZ still looks mis-valued to me.  Hold tight for bigger gains ahead.

Financials (-0.4%)

My initial reaction to the financial reform bill was negative to say the least.  I was expecting it to be a major drag on bank profitability.  But upon closer inspection, there’s really not much to those concerns.

Low interest rates, excess capital, and loosening credit conditions should help banks increase profitablilty.

I think banks could make a big run over the next few months.  I’m recommending theSPDR KBW Bank ETF (KBE) this month… see trade alert for more details.

Healthcare (+1.5%)

Healthcare stocks bounced back this month.  Drug and biotech stocks continue to be the bright spot in the sector.  Companies are tapping into developing markets to boost their earnings growth.  That’s great news for our iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE) and First Trust Biotechnology Index Fund(FBT).

However, other areas like medical devices and providers continue to suffer.  The uncertainty over healthcare reform will continue limiting their upside.

Industrials (+4.7%)

Signs of economic expansion are everywhere.  You just have to know where to look…

One of my favorite indicators is railroads.  They’re the backbone of the economy. When railroad traffic is growing, it’s a great indication economic activity is on the upswing.

The Association of American Railroads recently reported the highest traffic levels of 2010.  The number of carloads originated is up 9.4% from this time last year.

As you might imagine, our Dow Jones Transportation Index Fund (IYT) is jumping on the news.  Hold tight for now.

Technology (-0.6%)

Semiconductor industry analysts dropped a bomb last week.

The analysts claim weekly orders for PCs declined sharply.  Weak PC demand spells trouble for chip makers.  They’ll have a hard time meeting revenue and earnings expectations if PC demand falls off.  That’s not good news for our SPDR S&P SEMICONDUCTOR ETF (XSD).

But I’m not ready to throw in the towel just yet…

Remember, one week doesn’t make a trend.  And Wall Street analysts tend to assume too much from single data points like this.  I’m not convinced the PC upgrade cycle has run its course.  But I’m watching the situation closely..

Materials (+4.9%)

China continues to take center stage in the basic materials sector.

In last month’s issue I said, “I think strong Chinese demand will surprise many investors in the second half of the year.  Just this week, Chinese Commerce Ministry spokesman Yao Jian said they will expand their imports of raw materials.”

Then the latest trade balance info was released.  They show China’s imports declining. Not increasing as he suggested they would.  As a result, their trade surplus reached the highest level in 18 months.

Now Mr. Jian is back at it again this week.  He said the trade surplus would shrink in the second half of the year as imports of raw materials grow.

Is this more hype by the Chinese government?  Or a real commitment to narrow the trade surplus?

Either way, it’s sparked a rally in materials stocks.  That’s great news for our Rydex S&P Equal Weight Materials ETF (RTM).  Continue holding RTM for further gains.

Our Market Vectors Junior Gold Miners (GDXJ) is really on a roll right now.  Gold bounced off the support line of the long term uptrend a few weeks ago.  It’s been rocketing higher ever since.  Continue holding GDXJ for further gains.

Utilities (+3.4%)

Utility stocks are building momentum.  One reason is extremely low interest rates.  Low yields on U.S. Treasuries are hurting income investors.  They’re searching for higher yielding investments.

The 4.1% dividend yield on our Utilities Select Sector SPDR Fund (XLU) looks mighty attractive.  Continue holding XLU for the next leg higher.

Portfolio Changes

  • This month we’re buying KBE…
  • Move GDXJ to hold
  • Move IEZ to buy up to $41.50


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