SET Monthly Issue May 2012

| May 15, 2012

May 2012

TURBULENT TIMES ARE GREAT
BUYING OPPORTUNITIES

Stocks’ steady climb higher since last October has hit a bump in the road.  In fact, it has hit a washboard full of bumps…

First off, Europe’s sovereign debt crisis has reared its ugly head again.

This thing is like Jason from Friday the 13th horror movies.  Just when you think you’ve got away, there it is again.  It just won’t die!  And the prospect of Greece leaving the Euro is even scarier than a hockey-mask-wearing ax-wielding maniac for many investors.

In addition to that, a bad derivatives trade at JPMorgan Chase (JPM) resulted in an unexpected $2 billion loss.  In an instant, all of the ugly memories from the 2008 financial crisis came rushing back.

Weren’t new regulations supposed to prevent systemically significant banks from putting the entire financial system at risk?  But here we are five years later and too-big-to-fail banks are still taking huge risks.

It’s put doubt in investors’ minds about the stability of our entire financial system.

And that’s not all…

Cisco Systems (CSCO) CEO, John Chambers, sucker punched tech stocks in CSCO’s quarterly earnings report.

The long serving CEO issued a weak forecast for business IT spending.  He claimed CSCO would see revenue fall 3% or 4% as businesses dialed back spending.

In my opinion, this is a CEO who’s grasping at straws. He missed the boat on the cloud computing revolution.  Now he’s trying to head off future failures by blaming it on an industry-wide slowdown instead of facing the reality of CSCO’s shortcomings.

But nevertheless, the damage was done.  And the red hot tech sector has fallen out of favor with investors.

Here’s the bottom line…

These bumps in the road have shaken investor confidence.  They’re afraid an unexpected shock to the market is going to derail growth or create havoc in the financial markets.

But as Warren Buffett likes to say, “Be fearful when others are greedy and greedy when others are fearful”.  And with fear the dominant emotion in the market today, it’s time to be greedy.

TRADE ALERT 1:  AIRLINE PROFITS ARE TAKING FLIGHT

Competing in the ultra-competitive commercial airline industry isn’t for the faint of heart.  And it’s even more difficult to be a long term investor.

The industry has been plagued with a long list of failures and bankruptcies.  But air travel is an essential part of modern life.  The massive industry supports more than 56 million jobs and $2.2 trillion of economic activity worldwide.

And every so often everything comes together to create an opportunity to catch the industry on the upswing.  Right now is one of those times…

Macro/Economic Trend:  Growing Demand And Falling Oil Prices

Here’s the deal…

The International Air Transport Association (IATA) reported total passenger demand is growing at better than 7% per year.  But airlines are only increasing capacity at 4.4% per year.

It’s simple economics… When demand is growing faster than supply, prices go up.

Obviously, when airlines are carrying more passengers and charging higher prices, revenue is going to increase.

But here’s the problem… Expenses were growing even faster than revenue.

Stubbornly high oil prices are eating up a big chunk of the airlines profits.  In the first quarter alone, jet fuel prices shot up 8%.  And according to the IATA, fuel now accounts for 34% of average operating costs.

As a result, headwinds from high oil prices have more than offset the bullish trends in passenger demand.

But as you know, oil prices are falling.  The price for a barrel of Brent crude oil has fallen more than 13% from a recent high of $128.40 in March to around $111 today. And there’s no end in sight to oil’s recent declines.

The bottom line is falling oil prices are removing the final roadblock to a resurgence in airline profitability.  And that’s great news for the industry.

The way I see it, airlines have amazing upside in this environment.  The Guggenheim Airline ETF (FAA) gives a pure play on the upside in the airline industry.

Fundamentals:  A closer look at FAA

FAA holds stock in 26 airline companies worldwide.

The expense ratio is 0.65%.

The top five holdings and percentage weight for FAA are –

Company Name Ticker % Weight
Delta Airlines DAL 17.14%
United Continental UAL 16.80%
Southwest Airlines LUV 13.30%
US Airways LCC 4.79%
Allegiant Travel ALGT 3.93%

FAA has a P/E of 12.6x… which is significantly lower than the S&P 500 whose P/E stands at 14x.  And the average market capitalization of the holdings is $5.1 billion.

Technicals:  The charts lead the way

FAA is in a solid uptrend off the December low.  As you can see, it’s steadily climbing higher along the upward trending support line.

faa051512

What’s more, it’s solidly outperforming the S&P 500 over the last 45 trading days.  Over that time, FAA is up more than 5% while the S&P slumped to a 2% loss.

In other words, FAA is outperforming the broad market by 7%.

As you know, relative outperformance by an industry often indicates investors are rotating money into a sector.  And as more money pours into a sector, it will likely continue to outperform in the weeks and months ahead.

Trade Alert

Buy:  Guggenheim Airline ETF (FAA) up to $31.25
Recent Price:  $30.28
Price Target:  $38.00
Stop Loss:  $27.00

Remember:  FAA is ready to take flight as passenger demand surges and oil prices fall. Let’s grab our shares of FAA today as it climbs to cruising altitude.

TRADE ALERT 2:  THE COMEBACK KID

While the stock markets are getting battered around by issues in Greece and Europe, one asset is making a move to the upside.  And it’s been a while in the making.

Right now, natural gas is bouncing hard off a 10-year low.  After trading under $2 for about a week in April, natural gas spot prices have turned higher and haven’t looked back.  Right now the spot price of natural gas is just under $2.50 per MMBtu.

That’s a gain of over 30% in just a month’s time!

What’s more, natural gas remains oversold.  If you weren’t aware, the average price for the previous six years was at $5.45.  Even after all that natural gas prices have lost, it may be a while before we see a 5-handle on this energy source.  But there’s a very real chance we’ll see the spot price back above $3.00 before the year is over.

The bottom line is higher natural gas prices will lead to improved profitability for natural gas producers.

Macro/Economic Trend:  Low prices and oversupply created a selloff

The selloff happened not just in natural gas prices, but also in the stock prices of natural gas producers.  You see, a perfect storm hit the energy markets this past year.

It was an unprecedented four-pronged attack

First off, the natural gas fracking process created massive new US supplies.Located in various locations around the US are shale formations filled with natural gas deposits.  But they’re unreachable by normal vertical drilling methods.  That’s where fracking comes in.

I’m sure you’ve heard of a couple of these major finds… The Bakken region and the Marcellus Shale region are probably the most well known.  These are massive areas that hold an enormous amount of potential natural gas reserves.

And as soon as production came online, the added supply virtually filled current storage capacity causing prices to start plummeting.

Second, as supply grew, prices continued falling.  Unfortunately, prices fell so much that it has become unprofitable for even the largest multi-resource companies to continue drilling for natural gas.  The pure cost of drilling for natural gas is in the range somewhere near $5 per MMBtu.

However, the largest companies that pulled both liquids and natural gas out of the earth were able to continue drilling down near the $3 range.  So supplies remained elevated well below the $5 level.

Third, the much anticipated increase in demand for natural gas never materialized.  And the natural gas industry has the current government to thank for that.

You see, many companies made huge investments in new natural gas sites as it was virtually certain that our nation’s leaders would want to free the US from foreign oil dependence… and natural gas is the obvious answer.  This would mean natural gas demand would surge on a major scale once conversion subsidies were put in place, etc…

Sadly, it seems there’s too much political infighting for The President and Congress to get a bill passed… even as it was handed to them on a silver platter by one T. Boone Pickens.

Finally, the winter of 2011-2012 is one of the warmest winters recorded in US history. That great weather caused a drop in demand for heating needs in the colder parts of the country.

The one, two, three, four punch that hit natural gas all but leveled prices to unsustainable levels.  And now, as a result of overly low prices, more and more natural gas producers simply shut down production.

According to the US Energy Information Administration, natural gas rig counts as of May 4th have fallen to just 606.  That represents a 31.9% drop from last year!

This drop in rig count is part of the reason we’re seeing natural gas prices get a boost here.  In addition, the US finally authorized the export of Liquid Natural Gas (LNG) to start in the next few years.

It’s pretty clear we’re going to see natural gas prices rise as supply dwindles from lower production.  Along with that, we’ll see US gas producers also get a boost.  As natural gas prices have fallen, so have the stocks of natural gas producing companies.

As natural gas prices continue to rally off a 10-year low and natural gas producers are able to put production back on line, let’s buy First Trust ISE-Revere Natural Gas Index Fund (FCG) in order to profit.

Fundamentals:  A closer look at FCG

FCG seeks investment results that correspond to the price and yield of an equity index called the ISE-REVER Natural Gas Index.  The fund invests at least 90% of its assets in common stocks of natural gas producing companies.

As of May 11th, FCG holds 29 natural gas producing companies.

The expense ratio for this ETF is 0.60%.

The top five holdings and percentage weights for FCG are-

Company Name Ticker % Weight
Comstock Resources CRK 4.77%
EXCO Resources XCO 4.38%
EnCana EAC 4.29%
Range Resources RRC 4.25%
Cabot Oil & Gas COG 4.09%

Technicals:  The charts lead the way

FCG has sold off in the wake of the drop in gas prices.  As the index is nearing support, now is a great time to buy this ETF.

fcg051612

You may notice, FCG has not moved higher in recent weeks with natural gas prices. Issues with one of the holding, Chesapeake Energy (CHK), have caused an unrelated disturbance to the fundamentals of natural gas… and natural gas producers.

Simply put, this gives us an even better entry point on this ETF.

Trade Alert

Buy:  First Trust ISE-Revere Natural Gas Index Fund (FCG) up to $16.50.
Recent Price:  $15.58
Price Target:  $23.00
Stop Loss:  $11.50

Remember:  FCG finds a strong support level just below the current price of $15.58. After a fast and aggressive over-reaction, FCG is set to rally from higher natural gas prices.

SECTOR SNAPSHOTS

Consumer Discretionary (-0.3%)

American consumers are feeling outright optimistic these days.  In fact, the Michigan Consumer Sentiment index hit the highest level since December 2007.  And as a result, they’ve been willing to use credit to pay for more big ticket items.

Our SPDR S&P Retail Fund (XRT) is off to shaky start.  It’s fallen in line with the broad market’s pullback recently.  But the positive trends in spending, credit, and sentiment should fuel further gains for retailers after this bout of fear passes.

The SPDR S&P Homebuilder ETF (XHB) has held up better than the retailers.  Builder sentiment is on the upswing once again as buyer traffic and sales picked up in April. That’s good news for XHB…

Consumer Staples (+0.8%)

Consumer staple stocks are benefiting from the market’s recent pullback.  Fearful investors have dumped their riskier stocks in favor of the relative safety consumer staples.

Our PowerShares Dynamic Food & Beverage (PBJ) ETF rose to a new high of $20.06 and a peak gain of 5.5%.  Continue holding for bigger gains.

Energy (-1.3%)

Energy stocks can’t catch a break.  They followed up last month’s steep decline with another 1.3% loss this month.  They’re now down more than 10% in the last few months.

As usual, falling oil prices are to blame for the recent slide.  Oil prices are falling as investors fear a global slowdown will hurt demand.

On the bright side, natural gas prices in the US have finally risen off their lows.  In fact, we think this could be a great buying opportunity.  We’re recommending the First Trust ISE Revere Natural Gas Index Fund (FCG) this month… see Trade Alert 2 for more details.

Financials (-2.8%)

Financial stocks took another beating this month.  Uncertainty about the fate of Greece in the Euro Zone and JPM’s $2 billion loss on a bad trade have turned investor sentiment toward financials from bad to worse.

Our iShares FTSE NAREIT Residential Plus Capped Index Fund (REZ) hit a new high of $48.27 this month.  And we’re fast approaching our $50 price target.  Continue holding REZ…

And despite the recent turmoil, our SPDR S&P Insurance ETF (KIE) is holding up well. In fact, it attempted to break out above resistance at $42.50 earlier this month.  But it failed to hold above this key level.  If KIE can clear $42.50, it should have smooth sailing up to our $48 price target.  Continue holding KIE…

Healthcare (+1.1%)

Healthcare stocks gained some attention from investors this month.  The sector joined other defensive sectors, consumer staples and utilities, as the best sectors.  Clearly, investors are moving money out of riskier sectors and into defensive ones.

Our PowerShares S&P SmallCap HealthCare Portfolio (PSCH) trade is off to a solid start.  But it’s still below our buy up to price.  Grab your shares of PSCH up to $34.25 if you haven’t already.

Industrials (-2.1%)

Industrial stocks continued to slide this month.  Investors are weighing the impact of a recession in parts of Europe and slow growth in China.  And they don’t like what they’re seeing…

Clearly, this isn’t good news for our Industrials Select Sector SPDR ETF (XLI). Let’s sell XLI now to conserve capital.

But we’re not down on the entire industrial sector…

Airlines are one industry in this massive sector that are actually benefiting from current economic environment.  We’re recommending the Guggenheim Airline ETF (FAA) as a better way to profit… see Trade Alert 1 for more details.

Technology (-2.1%)

Technology stocks took another step backward this month.

As I said earlier, CSCO’s proclamation that businesses are dialing back on IT spending was a sucker punch to the entire industry.  However, I think CSCO’s shortcomings are more self-inflicted than they’re letting on.

Our iShares S&P NA Technology-Software Index Fund (IGV) pulled back following the CSCO dire assessment of business tech spending.  But don’t forget, cloud computing is still in a secular bull market.  And any weakness is likely to be short lived. Continue holding IGV…

Materials (-3.4%)

Materials stocks led the stock market lower this month.  The industry is a punching bag for investors who see slowing economic growth cutting into demand for raw materials.

And to make matter worse, the US Dollar is rising in value.  As you know, a stronger dollar makes raw materials more expensive in other currencies.  And all else being equal, commodity prices go down when the dollar goes up.

Put simply, falling commodity prices are bad for materials stocks.

The impact of the strong dollar is on full display in the gold market.  The US Dollar and gold prices have had a nearly perfect inverse relationship in 2012… when one rises, the other falls.  And right now the US Dollar is on the upswing.

Needless to say, we’re steering clear of materials stocks.

Utilities (+3.7%)

Utilities were the best performing sector this month… an indication investors have become much more risk averse recently.

Our Utilities Select Sector SPDR Fund (XLU) is testing the December highs.  If it breaks out above $37, we could finally see XLU reach our $40 price target.  But until then, we’re happy to sit back and collect our 4% dividend.  Continue holding XLU…

Portfolio Changes

  • This month we’re buying FAA and FCG
  • Sell Industrials Select Sector SPDR ETF (XLI)

 

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