SET Monthly Issue July 2009

| July 21, 2009

July 2009


I’ve got a confession to make.  My usual optimism has taken a beating lately.  Have I misjudged how the business cycle will look during recovery?  Should we sell everything and run for the hills?

Well, not exactly.  Let me explain.

What we have here is, “A failure to communicate.”

In order for President Obama to sell his stimulus package, he made one hell of a sales pitch.

We heard him tell Congress to pass his $787 billion stimulus bill or else… unemployment will spiral out of control, financial markets will continue to meltdown, and the recession could turn into a depression.

This ‘hard sell’ approach got results and the bill passed.  But it also set unrealistic expectations.

Everyone expected the recession to end quickly.

These lofty expectations triggered the March rally where we witnessed the S&P 500 rocket up 43% over 14 weeks.  But when the “V” shaped recovery started looking more like an “L”, the market flattened out and pulled back from the highs.

Here’s the thing, we’re actually on track.  What wasn’t clear from the outset was the timing.

The stimulus spending up to this point is designed to stop the fall and cushion the landing.

It’s working.  Catastrophe has been averted by funneling billions of dollars into the states for unemployment, Social Security, and Medicare benefits.  As well as lowering payroll tax withholding, bailing out the financial and auto industries, and foreclosure prevention.

Now it’s time for real stimulus money.

The portion of the stimulus plan actually designed to stimulate the economy is just getting started.  This second wave of stimulus spending is designed to create jobs and business opportunities.

Will this stimulus be quick and effective?  That’s still open for debate.  I think the billions of dollars in government spending will spur new growth starting as early as the third quarter.

So the bottom line is I’m optimistic about the economic recovery.  For one thing, businesses are starting to once again give upbeat and clear guidance about the future.  Whether or not they are taking the stimulus money into consideration is unclear.  But their confidence is exactly what the market needs to move higher.


Tech continues to lead the market higher.  And software developers are on the cutting edge of economic recovery.

In fact, the tech industry has held up better than expected during the recession. They’ve been buoyed by cost cutting and operational efficiency as spending slumped over the last year.

The good news is business conditions have been steadily improving.  This should prompt business to open up their wallets over the next couple of quarters.  And when they do, they’ll be spending big money on the technology upgrades they put off over the last year.

Macro/Economic Trend:  Tech dependent society

Technology is being interwoven into the fabric of society more every day.  Take a look around.  Computers, smart phones, and home entertainment systems are almost necessities of modern life.

And software makes the technology come alive.

Whether it’s a social networking website, a video game, or business app, it’s the software making it possible.

New applications and upgrades to existing products keep customers coming back for more.  Even though it seems technology is already saturating developed markets, there’s still plenty of room for growth.

But the real growth opportunities are in the developing countries.  They’re just beginning to come online.  Take China for example.  The number of people using the internet shot up 42% to 298 million at the end of last year (that’s a lot of new software to sell).

As modern life becomes more interconnected, technology takes center stage.  We’ve uncovered an ETF focused on the software companies that should benefit from the expanding roll tech plays in everyone’s lives.  It’s the iShares S&P North American Technology – Software Index Fund (IGV).

Fundamentals:  A closer look at IGV

IGV holds 42 software company stocks.  The companies range from business software developer Oracle to video game makers Activision Blizzard and Electronic Arts.

It has an expense ratio of 0.48% which is about average.

IGV holds a variety of software companies ranging from business to personal use.  The companies also vary from large to small-cap giving this ETF good diversification, while still having great growth opportunities.

The top five holdings and percentage weight for IGV are –

Company Name Ticker % Weight
Microsoft MSFT 9.33%
Oracle ORCL 8.76%
Symantec SYMC 8.56%
Adobe ADBE 8.45%
Intuit INTU 6.00%

Technicals:  The charts lead the way

Take a look at the chart of IGV.  You’ll see it just broke out above its June high.  This a positive sign the uptrend since March will continue.  Breakouts above a recent high means the buyers (bulls) have overpowered the sellers (bears).


IGV is showing strength relative to the S&P 500 and the NASDAQ over the last week, which means its gains are outpacing the rest of the market.  This is a good sign that the big institutional investors are moving into this sector.  And when the big boys move into a sector, they can make it move quickly.

Trade Alert

Buy:  iShares S&P North American Technology – Software Index Fund (IGV) up to $41
Recent Price:  $39.50
Price Target:  $50.50
Stop Loss:  $36

Remember:  IGV just broke out above resistance of the June high.  This eliminates a lot of selling pressure from people who bought at the previous high.  The positive earnings so far this quarter should create enough momentum to keep IGV moving higher.  But we’ll need positive readings on the economic data along the way to get us to our price target.


The financial crisis of 2008 was ugly.  Institutions with bad investments brought the economy to its knees.  The crisis brought into existence the term ‘too big to fail’ and ushered in an unprecedented era of government intervention.  The government is providing funding through TARP to ensure “systemically significant” firms don’t fail.

To put it bluntly, I don’t like the policy.  But that doesn’t mean I’m going to ignore a sector when the deck is stacked in its favor.

The ‘too big to fail policy’ didn’t stop every bank from failing.  Huge banks like Wachovia and Washington Mutual were merged with others deemed too big to fail.

It’s consolidating the banking industry into a few major players’ hands.  The result is a great business environment.  Competition is limited and the government’s “got your back” if things take a turn for the worse.

The bottom line is it’s providing investors with a great opportunity to own a sector with limited downside and great upside potential.

We’re seeing banks cash in with their investment banking operations.  And a low cost of money is allowing these firms to earn their way out this crisis.

Macro/Economic Trend:  Steep Yield Curve

There’s an economic indicator with a great track record of predicting economic growth.  Right now it’s flashing “green”.  It’s telling us economic growth is just around the corner.  (And it’s also a catalyst for bank profits.)

What’s the indicator?  The yield curve.

What exactly is a yield curve?  It’s simply a relationship between interest rates and time.

The most watched yield curve is for the US Dollar.  The US government regularly sells US treasuries for different lengths of time.  Some are very short term (1 month), others are long (30 years), and the rest fall somewhere in the middle.

The interest rate will vary depending on the maturity date.  Typically, the shorter term interest rates are lower and the longer term are higher.  If you plot the numbers on a graph, you have a yield curve.

Right now the yield curve is steep.

The typical spread between the 20 year and the 3 month US treasury is around 2%.Right now the spread is 4.15%.  When we’ve seen spreads get this wide in the past, a period of robust economic growth is usually close at hand.

How does this indicator help the banks?

Interest rates are how banks make most of their money.  They borrow money on a short term basis and lend it for a longer period of time.  A steep yield curve allows them to borrow money very cheaply and lend it out at much higher rates.  They are able to capture a large spread (difference between borrowing and lending rate) which increases their profit margin on existing and new loans.

The largest banks are in position to rake in revenue.  The amounts are so big the banks are going to be able to offset the losses on bad loans.  Even if the amounts of bad loans increase to record levels, the banks will be able to absorb the losses with their earnings.  This will allow banks to earn their way out of this crisis.

The best way to profit from the steep yield curve is buying the SPDR KBW Bank ETF(KBE).

Fundamentals:  A closer look at KBE

KBE holds 24 large cap bank stocks.

The expense ratio is only 0.35%.

The top five holdings and percentage weight for KBE are –

Company Name Ticker % Weight
Bank of America BAC 9.18%
JP Morgan Chase JPM 7.94%
Wells Fargo WFC 7.78%
US Bancorp USB 6.74%
Bank of New York Mellon BK 5.64%

We’re already seeing signs of big profits for banks.  Bank of America (BAC), Citigroup (C), and JP Morgan (JPM) recently beat quarterly estimates.  A trend we expect to continue.

Technical Analysis:  The charts lead the way

You can see the huge rally KBE went on in March and April on the chart below.  The rally in financials sparked a broader market rally.

Now the banks and market have been flat over the past few months.  KBE is consolidating at $18.15.  This level marks an inflection point.

The 200-day moving average and the inflection point are rapidly converging.  A breakout above this level should set the stage for another rally.


Trade Alert

Buy:  SPDR KBW Bank ETF (KBE) up to $19
Recent Price:  $18.42
Price Target:  $23.50
Stop Loss:  $16.25

Remember:  Financial stocks were the catalyst of the March rally.  I think they’ll be a big part of the next one.  KBE needs to break through resistance of the 200-day moving average.  It may take a couple of tries in order for it to do so.  But once is does, a big rally in financials should play a big role in the market rally.


Consumer Discretionary (-0.38%)

The ability of American consumers to spend money is a central theme in the recovery debate.  And for good reason, consumer spending accounts for two-thirds of US GDP.
Consumers continue to choose to save more and spend less.  The most recent reading has the savings rate up to 6.9% from 5.4% in the previous month.  If this trend continues, it will impact how quickly the economy can recover.

Consumer Staples (1.74%)

The relative safety of this defensive sector made the staples a good place to be last month.

Investor confidence was shaken by economic data showing little improvement over the last month.  However, the quarterly earnings have given investors confidence that recovery is close at hand.

This will send investors back into the riskier cyclical stock, which isn’t good news for the defensive sectors like Consumer Staples.

Energy (-9.46%)

Oil prices reversed course and headed lower earlier this month, much like the overall market.  The fear is slow economic recovery will keep oil demand depressed for the foreseeable future.

Now the positive quarterly earnings surprises have improved the outlook for economic recovery.  And oil prices have recovered to around $63 per barrel.

It looks like oil prices will be determined by the expectations of future demand, which is really a reflection of economic sentiment.

Financials (-2.80%)

It’s a good news bad news situation for the financials.

Delinquencies and bad debt continue to climb as unemployment continues to rise.  But banks have a steep yield curve driving revenue higher.  This is going to allow them to earn their way out of this credit crisis.

We’re recommending the SPDR KBW Bank ETF (KBE) this month… See Trade Alert 2 for details.

Healthcare (3.51%)

Interest in healthcare stocks picked up this month as investors moved out of more economically sensitive stocks.  However, a cloud of uncertainty hangs around this sector.  The impact of government reforms is a major barrier for any improvement in this sector.

We’re going to continue to avoid this sector for now.  In fact, we’re going to cut our exposure to this sector altogether.  Go ahead and close out any open positions in SPDR S&P Biotech ETF (XBI) at current market prices.

Industrials (-5.00%)

The industrials struggled this month in the face of stagnating economic data.  This cyclical sector’s health is dependent upon economic recovery.  Luckily, the stimulus package should swing into high gear in the second half of 2009.

If the stimulus package is able to deliver as promised, it will be a boon for the industrials.

Technology (3.37%)

Technology continues to lead the markets higher.

Comments from Intel (INTC) in their quarterly earnings announcement have reignited the stalled market rally.  Not only did Intel beat analysts’ estimates, they also gave positive guidance about the future indicating the worst is behind for the chip maker.

We’re adding another piece of the tech industry this month… See Trade Alert 1 for more details.

Materials (-5.03%)

It’s been a wild ride for the materials sector this month.  The four month rally came to an end and prices retreated quickly.  But the 200-day moving average held as a support level.

Now, renewed hope for recovery has the sector moving higher once again.

Utilities (-0.56%)

The defensive nature of the utilities will leave them on the outside looking in as investors continue to move into more economically sensitive sectors.

On the upside, the sector is paying out nice dividends.  This makes the industry a nice choice for investors looking to generate income.  But capital appreciation will be next to nothing for this sector over the rest of 2009.

Portfolio Changes

  • This month were buying IGV and KBE…
  • Sell SPDR S&P Biotech ETF (XBI)


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