SET Monthly Issue May 2009

| May 19, 2009

May 2009


The S&P 500 rallied 40% from the March low to this month’s high.  But profit taking put the broad markets in pullback mode last week.  You can’t blame anyone for taking profits in this market.

Last week a few data points came up short of expectations.  And investors took that as a cue to sell… seems rational to me.

The two data points I’m talking about are retail sales and initial jobless claims.  They both came in a little worse than expected.  But when you put these in context, I’m not too worried.

A string of better than expected earnings and economic data is driving the market higher.  So missing a forecast shouldn’t be received well.

But going forward, forecasts have changed.

Forecasts had been based upon a deepening recession.  Now they’re gauging the pace of recovery.  That’s a big change in perception.

We’re probably not going to see as many “better than expected” readings.  But the key is that we’re now seeing a recovery.  As long as the economy continues to show improvement, the rally should keep rolling along.


Prices have to go up.  It’s economics equivalent to the law of gravity… but flipped on its head.  Let me give you some background to the current Fed policies.  And why the current low interest rates and increasing money supply will cause higher prices.

First off, in the short term all this government spending and easy money are helpful to the economy.  It counteracts the effects of a sharp fall off in demand.  It artificially holds prices stable.

Why is the government so concerned with stable prices?  I’m glad you asked.

You see, stable or increasing prices are very important to a consumer driven economy. Think of it like this, if it’s going to cost more tomorrow, I’m buying it today.  And that attitude drives consumption and growth.

And that’s what Fed Chairman Ben Bernake is focused on right now.  (I think it’s shortsighted… but more on that later.)  Bernake studied and wrote about the Great Depression extensively prior to his time at the Fed.  In his opinion, price deflation was a main reason it took so long to pull the economy out of the depression.

We’re already seeing the effects of his policies.  GDP is declining and jobs losses are mounting, but prices have stopped falling.  This isn’t natural in a recessionary environment.  Prices should still be falling.

And he’s got no plans to stop increasing the money supply or raise interest rates any time soon.  They’re continuing inflationary policies even though prices have stabilized and the economy has bottomed out.

Big Ben’s willing to err on the side of inflation when it comes to combating deflation.

We’re going to see inflation during a time in the business cycle we should be seeing deflation!

As demand returns to the market, the long term effect is inflation.  Or even the dreaded hyper-inflation.  The good news is, the policies causing inflation can and will be reversed.  That’s why I’m not going into some doom and gloom scenario.

However, the Fed’s going to be faced with tough decisions.  The timing of policy changes will be critical.  Do it too fast and risk falling back into deflation.  Wait too long and risk high inflation.  From everything I’ve been able to gather, they’re going to err on the side of inflation.

To profit from inflation, we want to own companies with the ability to increase prices. One sector I like is the oil and gas companies.  They’ve made their biggest profits when prices are rising.

Macro/Economic Trend:  Supply and Demand

The post-bubble era for oil prices has finally started to settle down, which is good for oil companies.

Speculation and overblown expectations for oil demand drove prices sky high.  The oil companies pocketed huge profits.  But, like any bubble, it deflated in grand fashion. And oil company stock prices have come down with it.

The dramatic swings in oil prices played havoc with these companies.  They’re obviously less profitable with lower oil prices.  And volatility impacts their ability to forecast and plan future business.  What looked like a good idea with oil prices at $145 per barrel is suicide at $50.

The worst is behind the oil companies.  Prices are being determined by supply and demand.  They’re able to implement a strategy that’s profitable at current prices. Higher prices are gravy.

And oil prices have been moving higher, even though the IEA is cutting their demand forecast for the year.  When economists are getting aggressively negative, they’ve usually gone too far.  And the IEA has cut their demand forecast for nine straight months.

I’m expecting them to start revising oil demand numbers higher soon, which will be great news for the oil companies.

Fundamentals:  A closer look at XLE

XLE holds 42 oil and gas company stocks.  The top ten holdings make up 64% of this ETF.  This is to be expected with some of the large cap companies in the sector.

It has a low expense ratio of 0.21%.

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

Company Name Ticker % Weight
Exxon Mobil XOM 20.66%
Chevron CVX 13.34%
ConocoPhillips COP 6.70%
Schlumberger SLB 5.14%
Occidental Petroleum OXY 4.39%

The oil and gas companies have a good history of earnings growth.  They’ve been growing earnings at a rate of 10.57% for the last five years.  And price inflation should boost these growth rates.

Technicals:  The charts lead the way

As you can see, XLE is an upward trend since March.

It’s tested the $52 level three times in the past seven months.  Every test brings us a step closer to breaking through.

Now the 20- and 50-day MA are both in an uptrend, making a breakout above $52 even more likely.


In the last week, XLE moved up to test the 200-day MA and then pulled back to the 20-day moving average.  This price action makes a rebound off the 20-day MA and a breakout above the 200-day MA very likely.

The recent volume on the ETF indicates it’s under accumulation.  And the reading on the MACD confirms recent bullish price action.

Trade Alert

Buy:  Energy Select Sector SPDR Fund (XLE) up to $51.15
Recent Price:  $48.00
Price Target:  $60.00
Stop Loss:  $45.00

Remember:  We’re looking for a breakout above the 200-day MA.  It may take more than one try to overtake this level.  But once it does, there’s clear sailing ahead.  The next level of resistance is our price target of $57.00.


Semiconductors have been one of the strongest industries since early March.  Another example of tech leading the market off the bottom.

The rally comes despite a cloud hanging over industry leaders.  Governments in the US, Europe, and Asia all have antitrust investigations into various companies.  Some of these are finally starting to be resolved.

Recently, Intel (INTC) was slapped with a $1.45 billion fine by the E.U. for anti-competitive business practices.  But it’s not all bad news.  The FTC dismissed a pending antitrust case against Rambus (RMBS) last week too.

I’m not a fan of government intervention.  However, actions like these result in a more competitive industry.

Macro/Economic Trend:  Tech spending on the rebound

Better times for the tech industry are here.  A couple of overriding factors are pointing towards good times.  Business spending (CAPEX) and personal spending are the biggest drivers of demand.  And I see the economic data flashing buy signals.

Goldman Sachs recently released a report on Fortune 1,000 companies planned IT spending.  It indicates the first upward move on new hardware and software spending in the last year.  When businesses start spending money, they’re going to do it with one goal in mind… improving productivity.  They’ll get the most bang for their buck with new technology.

New computers and servers powered with latest semiconductors deliver the goods they’re looking for.

Not only is business spending turning positive but it looks like the consumer is still alive.  Consumer confidence is up and wholesale inventories are down.

PC manufacturers cut back production as the economy nosedived last year.  And it’s left wholesale inventories in need of replenishment.  New orders to rebuild these stock piles will drive sales in the near term.

But I’m even more encouraged by the steadily increasing consumer confidence numbers.  A happy consumer is a great predictor of future spending.  And when you add in the rollout of Windows 7 (expected before year end), it should be the catalyst needed to really fire up sales.

This ultra competitive industry can turn revenues into earnings at an impressive pace. This activity should drive stock prices higher.

Fundamentals:  A closer look at XSD

XSD is composed of 25 companies.  The top ten companies make up 45% of this ETF. It gives us good exposure to both the large and smaller semiconductor manufacturers.

The expense ratio for this ETF is about average at 0.35%.

The top five holdings and percentage weight for XSD are –

Company Name Ticker % Weight
Advanced Micro Devices AMD 5.70%
On Semiconductor ONNN 4.92%
Micron Technologies MU 4.76%
LSI LSI 4.57%
Cypress Semiconductor CY 4.44%

The one area I’m looking at is capacity utilization.  That’s the percentage of production capacity in use compared with what’s available.

This reading might tick higher this quarter.  It’s the first time in a year.  Some estimates have utilization returning to 75% by the third quarter.  A nice recovery after falling all the way to 50% in the first quarter of 2009.

These levels are recovering because of increasing demand and reductions in capacity.

The reduction in capacity was achieved through layoffs and shutting down excess production.  The result is lower costs.  This will allow manufacturers to increase their margins as demand increases.  And we all know what increased margins usually lead to… higher stock prices.

Technical Analysis:  The charts lead the way.

XSD’s rally has shown great strength for the last six months.  The 20- and 50-day moving averages are both in a bullish uptrend.

You can see on the chart that XSD made a solid push higher a few weeks ago.  That push was the first breakout above the 200-day moving average.  But the entire tech sector pulled back a little over a week ago.  The pullback was triggered when the NASDAQ reached its 200-day MA.  It’s typical price action in a bullish trend.  I’m treating it as a buying opportunity.


XSD has pulled back to the 50- and 200-day moving average.  Since we’re already above the 200-day moving average, it should serve as support going forward.

Trade Alert

Buy:  SPDR S&P Semiconductor ETF (XSD) up to $31.25
Recent Price:  $29.37
Price Target:  $39.00
Stop Loss:  $26.50

Remember:  Semiconductors should continue to lead the market higher as long as the economic data continues to show the recession is bottoming.  XSD is just above strong technical support.  The recent high of $33.50 is the only formidable resistance. The next resistance level is at our price target, which is also the low from early 2008.


Consumer Discretionary (-1.7%)

After an unbelievable run last month, this sector is taking a breather.  The market pullback hit this sector hard.  But that’s to be expected.  The April retail sales number wasn’t as good as expected, but it’s still ‘less bad’.

American consumers continue to deleverage their household balance sheets.  I’m expecting consumer spending to continue increasing.  But it’s going to be a bumpy road.  The hangover from a 20 year spending spree doesn’t go away overnight.

Consumer Staples (1.3%)

As investors’ appetite for riskier investments continues to grow, non-cyclical companies will continue to lag the broad market.  This puts pressure on defensive sectors.

I’m expecting consumer staples to continue higher with the rest of the market.  But they’re not going to deliver eye popping gains anytime soon.

Energy (4.8%)

We think energy is the next sector ready to pop.  Oil prices are continuing to march higher and industry profits are set to climb.

We’re recommending the Energy Select Sector SPDR Fund (XLE)… (See Trade Alert 1 for more details.)

Financials (3.8%)

The bank stress tests results were published this month.  And the banks need an additional $65 billion.  Hooray… let the rally begin!  I guess it could have been worse.

This dog of a sector continues to recover from horrible levels, but at a much slower pace than the last few months.

I’m still not sold that all of these banks survive.  But the steep yield curve certainly improves their chances of earning their way out.  They’re paying cheap rates, nearly 0% to borrow, and lending it out longer term at 5% to 8%.  Not bad work if you can get it.

Healthcare (2.4%)

The threat of increased government intervention hangs around the neck of this sector like a scarlet letter.  Nobody wants to be associated with healthcare – fear of the unknown.

Until Obama and his team figure it out, we’re going nowhere.  All the good fundamentals in the world aren’t going to overcome this stigma.  We’ll steer clear of any new recommendations until the cloud of government regulation clears.

Industrials (3.3%)

Government stimulus is flooding into road and bridge improvements.  And the housing industry continues to sell foreclosures and short sales at bargain basement prices.

The PowerShares Dynamic Building & Construction Portfolio ETF (PKB) we recommended last month is off to a great start.  The recent pullback looks to be over. I’m expecting it to move higher from here.

Technology (-0.5%)

We’re adding another industry in this sector this month.  Take a look at SPDR S&P Semiconductor ETF (XSD)… (See Trade Alert 2 for more details.)

Materials (5.6%)

As we predicted, the gold miners have seen a nice rally in the last month.  Gold prices put in a double bottom and have resumed their rally higher.

We see gold continuing higher until it reaches $1,000 per ounce.

Inflation is the driving force.  It looms as the US government continues to print money, pay for stimulus programs, and fight two wars.

Utilities (0.6%)

More government regulation talk…

The threat of new legislation to cap-and-trade greenhouse gases is a big concern for the utilities.  This defacto tax will impact margins and profitability.  It might ultimately put some dividends in jeopardy.

This defensive sector is also out of favor with investors.  Right now everyone’s looking for riskier investments.  So, we’ll stay away for now.

Portfolio Changes

  • This month we’re buying XLE and XSD…
  • IGN and GDX moved past our buy up to price.  They’re now in “Hold” status.



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