SET Monthly Issue June 2011

| June 21, 2011

June 2011


I’ve got some bad news… The second half recovery isn’t going to happen.  I’ll explain why in a moment.

But first a little background…

First off, Fed Chairman Bernanke is bullish on the US economy.  He’s on record forecasting US economic growth of better than 3% in the second half of 2011.

Many Wall Street analysts are also bullish.  They believe the economy will bounce back quickly from the recent soft patch in the economic data.  They attribute the weak data to Japan’s disaster and high energy prices.

Well, they’re partially right.  The spike in oil prices and Japanese supply disruptions certainly contributed to the pace of the slowdown.

But according to Economic Cycle Research Institute (ECRI), long leading indicators of industrial production had begun moving lower well before Japan’s disaster and surging oil prices.

As ECRI managing director Lakshman Achuthan has said, “The slowdown was baked into the cake.”

What’s he talking about?

He’s referring to ECRI’s indicator of global industrial production peaking in August of 2010. It signaled a slowdown in industrial activity this summer.

And here’s where it really gets scary… The indicator is still falling.

In other words, there’s no sign industrial production will accelerate in the second half of the year.  And without a pickup in industrial production, I don’t see how US GDP grows at more than 1%, much less the 3% mainstream economists are predicting.

As the evidence mounts, economists will have no choice but to slash their predictions for US and Global economic growth.

In fact, we’re already seeing the first wave of downgrades.

According to Reuters, “The International Monetary Fund cut its forecast for US economic growth.”  The IMF is now predicting “US GDP to grow at a tepid 2.5% this year and 2.7% in 2012.”  That’s down from 2.8% and 2.9% just two months ago.

And it’s just the beginning… I believe the economy’s going to get worse before it gets better.

The good news is there’s a silver lining.

I see no evidence of the economy slipping into recession.  This is just a broad based slowdown in growth.  And there’s a big difference between a slowdown and a recession.

What’s more, I think economists will slash their growth predictions too far in the second half.  As usual, they’ll extrapolate on the weak economic data and begin calling for a recession.

When they do, it will offer up some great buying opportunities.  Until then, it’s best to play defense.  And this month’s recommendation pays a fat dividend while we’re waiting for our buying opportunity.


Utility stocks provide stability and income.  The sector is a safe haven for investors when economic storm clouds are on the horizon.

As I pointed out earlier, global industrial production is slowing.  Now, it’s spilling over into the broad economy.

As the economy slows, investors flood into defensive sectors.  And the solid dividend yielding utilities will attract plenty of attention from risk averse investors.

Macro/Economic Trend: Mergers And Acquisitions

The Public Utility Holding Company Act (PUHCA) of 1935 gave the Federal Government the ability to regulate electric utilities.

Under the law, electric utilities operations were limited to a single state or geographic region.  And it also kept them from engaging in both regulated and unregulated business.

In other words, utilities had to follow a strict set of rules.  Their business model was simple and easy to regulate.  And in return for providing an essential service, they were allowed to make a profit.

But on August 8, 2005, President George W. Bush signed the Energy Policy Act of 2005.  And in doing so, he repealed the seventy year old PUHCA.  It put in place a much weaker set of rules called the Public Utility Act of 2005.

The new law allowed utilities to expand beyond a single state or geographic region. And it allowed them to engage in both regulated and unregulated businesses.

In addition, the law was expected to trigger a tidal wave of merger and acquisition (M&A) activity.

However, the process got off to a slow start.  Several of the planned mergers never happened.  And companies held off on investing the time and money to clear the required regulatory hurdles.

As a result, the expected M&A blitz never happened.

Now, some big mergers are finally getting done.  In fact, the recent merger betweenFirst Energy (FE) and Allegheny Energy has prompted more consolidation efforts in the industry.  There are now several merger agreements awaiting regulatory approval.

Completion of these mergers should produce sector wide cost savings.  As costs go down, we should see earnings and dividends push higher.  And that’s a recipe for the Utilities sector to outperform.

One ETF positioned to profit is the Utilities Select Sector SPDR Fund (XLU).

Fundamentals: A closer look at XLU

XLU holds 35 U.S. based utility stocks.

The expense ratio is 0.20%.

And the dividend yield is 3.99%

The top 5 holdings and percentage weight for XLU are –

Company Name Ticker % Weight
Southern SO 8.39%
Dominion Resources D 6.87%
Exelon EXC 6.87%
NextEra Energy NEE 5.91%
Duke Energy DUK 5.73%

Technicals:  The charts lead the way

XLU is one of the best performing sector ETFs over the last 10 and 30 day periods.  In other words XLU’s showing relative strength.  Typically we’ll see sectors show relative strength like this when institutional investors are moving into the sector.

And when big money investors rotate into a sector, we’ll usually see it continue to outperform.

But that’s not all… Take a look at the chart of XLU below.


XLU is in a short term uptrend, and it’s trading above the upward trending 65-day moving average.  These are both bullish signals indicating XLU should continue moving higher in the days and weeks ahead.

Trade Alert

Buy: Utilities Select Sector SPDR Fund (XLU) up to $34.00
Recent Price: $33.16
Price Target: $40.00
Stop Loss: $28.00

Remember: XLU is trading above the 65 day moving average in a solid short-term uptrend.  The defensive sector will provide us with a solid dividend and the potential for growth as mergers drive sector wide cost savings.  Go ahead and grab your shares of XLU now.


Consumer Discretionary (-6.4%)

Retail sales turned lower in May.  It was the first monthly decline since June of last year. The report was headlined by auto sales falling 2.9%.  And spending was weak for other discretionary items like furniture, electronics, and sporting goods. It’s clear higher energy costs are zapping consumers’ ability to spend.

The good news is a global economic slowdown should drive oil prices down.  If consumers are spending less money at the pump, it could boost discretionary spending.

Consumer Staples (-3.0%)

Consumer staples held up well as the markets sold off this month.  And the defensive sector should continue doing well as economic growth cools.  Remember, consumer spending on essentials should remain strong despite the slowdown.

Our Consumer Staples Select Sector SPDR Fund (XLP) is up a bit from our entry point.  However, it’s still trading below our buy price.  Go ahead and buy XLP up to $31.50 if you haven’t already.

Energy (-2.9%)

Energy stocks continue to move lower in lockstep with crude oil prices.

In just the last week, a barrel of crude oil fell from $100 to around $93.  And an even larger correction could come if economic growth continues slowing.

The weak oil market has taken the shine off alternative energy investments.  Investors are worried cheap fossil fuels will slow the need to develop alternative fuel systems.

As a result, our alternative energy ETF, Market Vectors Global Alternative Energy(GEX) is down.  We’re nearing our stop loss at $17.75. If GEX doesn’t hold and move higher from here, we’re going to have to cut our losses and move on.

The good news is… GEX is holding above our stop loss.  But in light of the disappointing performance, I’m moving GEX to a hold.  Sit tight as we wait for bounce.

Financials (-5.6%)

Financial stocks are getting hammered.  The selloff is being led by the large banks. And for good reason…

Right now, banks are facing a horrible environment.

New regulations are destroying old revenue streams.  And so far, banks haven’t shown the ability to replace the lost fee income.

Then you can add the ongoing housing crisis to the mix.  Banks and their regulators were expecting the housing market to begin improving this year.  Now it looks like it won’t begin to stabilize until 2012 at the earliest.

The weak housing market will likely cause loan losses to exceed expectations.  As a result, banks could be forced to set aside even more money for loan loss reserves.

This is a complete reversal from the last few quarters.  Banks were boosting earnings by releasing money set aside to cover losses in previous quarters.  If they have to set more money aside, earnings will take a big hit.

What’s more, the Greek sovereign debt crisis is creating uncertainty.  Nobody knows how much exposure any individual bank has to Greek debt.  If Greece defaults it could cause another credit crisis like we had in 2008.

All in all the risk of investing in financial stocks outweigh the rewards.  I’m steering clear for now…

Our iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) is looking strong.  Demand for apartments continues to outpace new supply.  That’s a good sign residential REITs profitability will increase.  Continue holding REZ for bigger gains ahead.

Healthcare (-3.6%)

Healthcare stocks are down a bit this month.  As expected, this defensive sector is holding up better than cyclical sectors.  And the sectors long term uptrend is still going strong.

One of the best performing segments is insurers.  That’s great news for our iShares Dow Jones US Healthcare Providers (IHF).  Continue holding IHF for bigger gains ahead.

Our two other healthcare ETFs are off to a slow start.  But both have considerable upside potential.  The SPDR S&P Biotech ETF (XBI) and the PowerShares S&P SmallCap Healthcare Portfolio (PSCH) are still below our buy up to price.  Go ahead and pick up your shares if you haven’t already.

Industrials (-5.9%)

Industrials got smoked this month.

We began to sound the alarm about the slowdown in global industrial production a few months ago.  So this shouldn’t have come as a surprise.

Here’s the really scary part…

Up to this point, the recovery has been driven by a revival in industrial activity.  Now the strongest sector of the economy is weakening.  And there’s no indication the sector will begin to strengthen later this year.

Obviously, if industrial production slows it will likely drag down the entire economy.

However, one area of strength is Agribusiness.  Even with a recent pullback in grain prices, farmers are still operating at a sizeable profit margin.  With grain prices this high, we should see farmers spending more money on the products companies in theMarket Vectors Agribusiness ETF (MOO) produce.

The recent pull back in MOO looks like a great buying opportunity.  Go ahead and buy MOO up $53.00 if you don’t already own it.

Technology (-7.6%)

Tech stocks got taken to the woodshed this month.  The sector dropped more than 7% for the month.  That’s never good…

As evidence of an economic slowdown mounts, investors are fleeing highly valued growth stocks.  We’ll typically see growth stocks take a beating when the economy cools.  And it’s no different this time around.

Our PowerShares S&P SmallCap Technology Portfolio (PSCT) got a nice bounce today.  But it looks like a technical bounce from oversold conditions.  I think it’s going to get worse for tech before it gets better.  Let’s take the opportunity to unload PSCT for a small loss.  Sell PSCT now.

Materials (-5.2%)

Materials stocks are down again this month…  However, we’re seeing some strength in the price of the materials themselves.

In fact, there’s a growing divergence between physical metals and mining stocks. Sooner or later something has to give.  Mining stocks are either going to play catch up to the price of metals, or the price of the physical metal is going to fall.

I believe mining stocks are going to play catch up.

Our Market Vectors Gold Miners ETF (GDX) and First Trust ISE Global Platinum Index Fund (PLTM) are down but not out.  If mining stocks start catching up to the physical metals, we’ll look back at this as a great buying opportunity.  If you don’t own GDX or PLTM feel free to buy shares up to $58 and $32.75 respectively.

Utilities (-2.7%)

Utility stocks’ solid dividend yield is an investor’s best friend in these uncertain economic times.  This month I’m recommending the Utilities Select Sector SPDR Fund (XLU)… see page 5 for more details.

Portfolio Changes

  • This month we’re buying XLU.
  • Sell PowerShares S&P SmallCap Technology Portfolio (PSCT)
  • Move Market Vectors Global Alternative Energy (GEX) to hold
  • Move Market Vectors Agribusiness ETF (MOO) to Buy up to $53.00


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