SET Monthly Issue July 2010

| July 20, 2010

July 2010


Investors continue looking at the markets with a skeptical eye.  And for good reason… There’s a lot of uncertainty right now.

It’s left investors wondering if the recent pullback is merely a market correction or the beginning of a new bear market.

Even record setting earnings by semiconductor giant Intel (INTC) last quarter didn’t get investors excited.

The problem is earnings look back at what the company’s already done.  And more and more investors think last quarter could be a peak in corporate profitability.

Instead of celebrating a return to profitability, investors are looking to the future.

And right now they don’t like what they see…

Forward looking economic reports are showing signs the world economy is slowing.

Just last week, two important economic reports show growth in the U.S. manufacturing industry is slowing.  And more importantly, new orders are down from last month.  (If manufacturing contracts, the economy is in for a world of hurt.)

To add fuel to the fire, the Fed recently cut its outlook for economic growth putting investors on edge.  The Fed had projected the U.S. GDP to grow between 3.2% and 3.7% this year.  Now they’re expecting GDP growth between 3% and 3.5%.  (Any way you slice it, this revision isn’t good!)

And when you add in uncertainty surrounding financial and health care reform… it’s enough to send a lot of investment dollars to the sidelines.

Clearly, the fear of further losses outweighs the fear of missing profits.

However, I’m not ready to throw in the towel.  Despite the recent decline in stocks, we haven’t entered into a new bear market.

It’s fair to say the bull market since March 2009 is over.  But it’s too early to say a new bear market has emerged.

More than likely we’re entering into a period of consolidation.  We’re likely to see stocks chop around without much conviction from either the bears or the bulls.

The way I see it is the initial growth spurt following the recession is over.  This period is fueled by cost cutting, inventory restocking, and government stimulus.

Now we’re entering into the next phase of recovery.

Investors are likely to remain skeptical until economic data shows us the economy can continue growing without government support.  That means the markets will continue to be choppy and volatile.

In the end, I think this period of transition from initial recovery to sustained recovery will be a great buying opportunity.  But until we get confirmation from the economic data, we’ll have to ride out the ups and downs.


Pharmaceutical companies are cash generating machines.  And their profits are relatively stable.

The demand for life saving medications isn’t dependent on an economic growth cycle. Boom or bust, people need their medications.

It makes this industry a great way to generate profits in times of economic uncertainty.

Drug prices are holding steady, new products are coming to market, and massive cost saving efforts are steadily driving sales and earnings higher.  And in the big picture, more earnings almost always lead to higher stock prices.

Macro/Economic Trend:  Fat Margins and Growing Exports

For the big pharmaceutical companies, growth is driven by a few key elements.

In developed markets, the key to generating huge sums of cash in the drug business is margins.  And the major drug companies have it down to a science.

Over the last year, the major drug companies have nearly a 70% gross profit margin. And their net profit margin is more than 15%.  With margins this fat, it makes the drug business one of the most profitable industries in the world.

But margins alone don’t make this industry a good investment.  For that we need growth too.

In order for U.S. based drug makers to drive earnings growth, they’re going international.  Drug sales in developing countries are where all the excitement’s at. Emerging markets are playing bigger roles in growing sales and earnings.

And some recent statistics show the big pharmaceutical companies have the wind at their backs.

In an effort to pull the U.S. economy out of recession, President Obama made increasing U.S. exports one his highest priorities.  In his State of the Union address in March, he announced the National Export Initiative (NEI).  The goal is to double exports over the next five years.

And so far it’s off to a good start.  In the first four months of the year, exports grew nearly 17% from last year.

I think the combination of fat margins and growing exports will continue to drive sales and earnings growth.  One ETF I like to profit from this trend is the iShare Dow Jones U.S. Pharmaceuticals Index Fund (IHE).

Fundamentals:  A closer look at IHE

IHE is a market cap weighted index.  It holds 36 of the largest name brand and generic drug makers.

The expense ratio is 0.48%.  And the dividend yield is 1.4%.

The top five holdings and percentage weight for IHE are –

Company Name Ticker % Weight
Johnson & Johnson JNJ 9.69%
Merck MRK 8.44%
Pfizer PFE 8.41%
Abbott Laboratories ABT 7.11%
Bristol-Myers Squibb BMY 5.92%

Technicals:  The charts lead the way

IHE is holding up well in a down market.  In other words, it’s showing relative strength to the S&P 500.

IHE is down about 10% from the high it set earlier this year.  But the S&P 500 has been down as low as 17% from its high.

And earlier this month, the S&P 500 fell below the lows it set in May and June.  But IHE was able to hold above its recent lows.

There’s clearly a strong floor of support for IHE around $54.

Take a look at the chart below… You can clearly see buyers stepping in every time IHE sinks to $54.


The strong floor of support just below its current price gives us a good low risk entry point to buy IHE.

Trade Alert

Buy:  iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE) up to up to $56.50
Recent Price:  $55.54
Price Target:  $64.50
Stop Loss:  $50.00

Remember:  IHE is trading just above support around $54.  This level should keep IHE from moving much lower even if the broad markets take another leg down.  The drug companies’ steady sales and earnings growth should lead to higher stock prices.  And their huge stockpiles of cash and a solid dividend will attract investment dollars in just about any market.


On April 20th, 2010, an explosion rocked the Deepwater Horizon drilling rig.  The explosion claimed the lives of eleven crew members.

After burning for 36 hours, the rig sank. In the process, the riser running from the wellhead on the ocean floor to the rig was destroyed.

The ensuing oil spill in the Gulf of Mexico sparked a wave of panic.  Investors began dumping oil equipment and service provider stocks left and right.

There’s no denying the economic and environmental disaster will cause untold problems in the area for years to come.  But it’s also caused an entire industry to be “mis-valued”.

Macro/Economic Trend:  Supply Keeping Pace With Demand

Oil equipment & service providers play an important role in the energy sector.  They do everything from drilling wells to providing information on oilfields.  As well as many other services supporting field operations.

And demand for their services is growing.  It’s being fueled by the major oil and gas producers.

The reality is there isn’t much spare capacity to meet an ever growing global demand for oil.

In order to meet demand, producers are continually trying to boost their supply.  And worsening decline rates at existing wells force producers to bring new wells online on a regular basis.

It’s just a fact of life for oil producers.  Existing wells produce less oil as the reservoir is depleted.  Eventually the well goes dry and new wells must be drilled to replace them.

The constant search for new supply is the life blood of the oil equipment & service industry.

And recent forecasts by the IEA (International Energy Agency) and other energy industry groups should keep producers in search of new supply because they’re predicting oil prices to remain in the mid $70s per barrel.

With oil prices projected to remain stable, producers are likely to increase their efforts to develop new supply.  That means demand for the oil equipment & services industry is likely to increase.

Despite the strong fundamentals, the industry has taken a beating in the aftermath of the Deepwater Horizon oil spill.

Investors are wary of increased regulation and the six month moratorium on deep water offshore drilling.  I think the recent selloff in the industry has been overdone.  I think investors have cut too deeply and the industry is now “mis-valued”.

As fear fades, a return to the fundamental value in the industry should lead to higher stock prices.  The ETF I like to profit from this “mis-valuation” is iShares Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ).

Fundamentals:  A closer look at IEZ

IEZ is a market cap weighted oil equipment & services fund.  It holds 43 stocks ranging from specialized contract drillers to more diversified players.

The expense ratio is 0.47%.

Right now the top five holdings and percentage weight for IEZ are –

Company Name Ticker % Weight
Schlumberger SLB 7.69%
Halliburton HAL 5.25%
Baker Hughes BHI 4.32%
National Oilwell Varco NOV 3.83%
Smith International SII 3.17%

Technicals:  The charts lead the way

IEZ took a big hit recently.  From its April high to the low on June 1st, IEZ lost almost 30%.

But since the sharp six week decline, IEZ is actually showing a bit of strength relative to the S&P 500.

Take a look at the chart.  You’ll see IEZ held above the June low when the S&P 500 was setting new year-to-date lows in early July.


And over the last week as the markets pulled back, IEZ has held up better than other sectors.  It’s a clear sign of relative strength in IEZ.

Remember, industries showing relative strength often continue to outperform.

Trade Alert

Buy:  iShares Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ) up to $41.50
Recent Price:  $40.24
Price Target:  $50.00
Stop Loss:  $35.00

Remember:  IEZ has been “mis-valued” by investors in the wake of the Deepwater Horizon oil spill.  But uncertainty surrounding the impact of increased regulation in the industry could keep the investors at bay for awhile.  So we could see some volatility in the short term. B ut recent relative strength indicates investors may be on the verge of pouring back into the industry.


Consumer Discretionary (-6.9%)

Weak retail sales and waning consumer confidence have spelled trouble for consumer discretionary stocks recently.  Until the job market starts to improve, the sector could have difficulty gaining much ground.

Our position in iShares Dow Jones U.S. Consumer Services Sector Index Fund(IYC) has gotten off to a slow start.  I was expecting low analyst earnings estimates to lower the hurdle for some companies to deliver better than expected earnings.  So far it hasn’t materialized.  But there are plenty of companies reporting in the next few weeks.  Hold tight for now.

Our SPDR S&P Homebuilders ETF (XHB) has fallen out of favor with investors because of the expired home buyer tax credit.  XHB could still make another run but negative news is creating strong headwinds.  I think we’re better off selling XHB and looking for better opportunities.

Consumer Staples (+0.2%)

Consumer staples are one of the few sectors posting a gain since our last issue.  But the sector faces a host of issues likely to keep any gains to a minimum.

The major obstacle in the sector is lack of pricing power.  Consumers remain very price sensitive and competition between the major players is fierce.  It’s almost impossible for companies to expand margins and increase profitability in the current environment.

Energy (-4.8%)

Oil’s trading in the mid $70s per barrel.  This is smack dab in the middle of the trading range.  The big news is BP (BP) finally capped the Deepwater Horizon well.  But the environmental impact from the oil spill will likely be felt for decades to come.

The uncertainty the oil spill created for the industry caused investors to hit the sell button first and ask questions later.  I think it’s caused investors to “mis-value” an entire industry.  This month I’m recommending the Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ)… see Trade Alert 2 for more details.

Financials (-2.6%)

The financial reform bill was signed into the law this month.  While it’s a step in the right direction, it doesn’t do enough to curb excess risk taking in my opinion.

The most immediate impact will be felt by the banks.  The reforms eliminate a number of highly profitable income streams.  Without them, banks are bound to be less profitable.  But they won’t give up their profitability without a fight.

In order to make up for the loss of revenue, banks are starting to charge fees for services they previously offered for free.  Things like free checking and free online bill pay are quickly disappearing.  It’s still unclear if banks will be able to generate enough revenue from alternative sources to return to historical profit levels.

Uncertainty will continue to cloud the future of the financial industry for awhile longer.

Healthcare (-8.5%)

Healthcare stocks as a whole have continued to struggle.  But we’re starting to see certain industries within healthcare perform better than others.  Most notable are the big drug companies.  I’m recommending the iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE) this month… see Trade Alert 1 for more details.

Industrials (-3.8%)

The industrials are a mixed bag right now.  Investors continue to grapple with strong earnings and weakening economic data.  Over the last week, a few economic reports have pointed toward slowing growth in the manufacturing industry.  The Empire State Manufacturing Survey and the Philly Fed Survey both came in well below economist forecasts.

If slowing growth turns into contraction, the economy could be in for a world of hurt.

Technology (-1.7%)

The semiconductor industry got some great news from industry giant Intel (INTC). They posted their most profitable quarter ever!  But the rally it sparked was short lived.

Investors continue to be cautious.  They’re worried growth driven by PC replacements and server upgrades may run out of steam.  I think the upgrade cycle for both personal and business use is just getting started.

It should continue to drive revenue and earnings growth for the chip makers for at least another year.  That bodes well for our SPDR S&P SEMICONDUCTOR ETF (XSD).

Materials (-2.7%)

Basic materials have leveled off after taking some big losses a few months back.
China continues to be center stage in the materials sector.  They can’t produce enough raw materials to feed their economy.  Imports of raw materials were the driving force behind a 2009 rebound in materials stocks.  But as fears of slowing growth in China sprouted, the entire sector has struggled to hold onto those gains.

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.

Our Market Vectors Junior Gold Miners (GDXJ) lost some ground along with gold prices this month.  But the long term uptrend in gold is still intact.  Once gold begins moving higher, GDXJ should rocket higher once again.

Utilities (+1.6%)

Utilities are one of the few bright spots in the stock market.  The sector posted a 1.6% gain since the last issue of Sector ETF Trader.

Our Utilities Select Sector SPDR Fund (XLU) continues to trade in a range between $28 and $31.  And it’s paying a nice dividend as well.  The recent strength in Utilities stems from increased demand.  Hotter than normal temperatures are forcing people to run their AC units more than ever.  In fact, 2010 is the hottest year on record worldwide.  If temperatures remain higher than normal, it should drive profits as people continue to crank up the AC to stay cool.

Portfolio Changes

  • This month we’re buying IHE and IEZ…
  • Sell SPDR S&P Homebuilders ETF (XHB)…


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