SET Monthly Issue October 2009

| October 20, 2009

October 2009


We’re in the thick of earnings season again… so far so good.

This earnings season I’m focusing on top line revenue growth.

Q2 numbers were all about beating analyst estimates through deep cost cutting measures.  That’s all fine and well, but improving earnings by cutting costs can’t last forever.

Revenue growth is the only sustainable way to grow a business and earnings.

It’s encouraging to see some companies growing quarter over quarter sales.  Not surprisingly, the technology stocks are setting the pace.

Don’t forget we’re still in the early stages of recovery.  We’ve just passed the low point in the trough of the business cycle.

The cyclical sectors will continue posting solid gains as investors pour money into economically sensitive stocks.

Expect a few hiccups in the economic data on the path toward recovery.  As long as the overall trend is improving, there’s nothing to worry about.  In fact, a few misses along way will provide good opportunities to pick up our investments at a discount.


Energy demand tumbled when the economy slid into recession.  Oil and gas companies have fallen hard since the boom in ’07 and ’08.  Long gone are the days of Congress considering windfall profit taxes.  (That’s one tax I’ll never understand!)

The downturn forced companies to reevaluate their business plans.

Some projects that were profitable with oil above $100 per barrel aren’t workable with oil at $50, $60, or $70 per barrel.  New projects have been shelved and existing ones are now sitting idle.

It’s no surprise the signs of life in the economy are huge relief for the oil and gas companies.  A rebound in economic activity is just what the doctor ordered to perk up demand.

In fact, the recent rise in oil and gas prices, along with a wave of good economic data, has producers feeling good for the first time in awhile.  One key measure of producers’ expectations is on the upswing lately.

Macro/Economic Trend:  The ‘Rig’ is up

The number of rigs drilling for oil and gas in the US is rising.  The total number of rigs in operation is up 19% from the June low.  Currently 1,040 rigs are in operation across the country.

The increase in the number of rigs tells me producers are expecting demand and prices to move higher from here.

Why else would they be drilling when stockpiles of oil and gas are sitting at or near record highs?

That’s great news for the entire energy sector.  And it’s especially good for the companies specializing in exploration, drilling, and refining.

The companies specializing in these areas are typically much smaller than the giants like Exxon (XOM), Chevron (CVX), and ConocoPhillips (COP).  Their smaller size can lead them to outperform their larger brethren when exploration and drilling activity picks up.

The SPDR S&P Oil & Gas Exploration and Production ETF (XOP) is designed to give us exposure to these very explosive smaller companies.

That’s why we’re adding another energy ETF to the mix.

The energy ETF we already own is the Energy Select Sector SPDR (XLE).  It’s heavily weighted toward the giants of the industry.  And I still expect them to do well. But they’re not the only companies set to profit from a rebound in energy prices.  (Not to mention XLE is up 25% and well past our buy price.)

Fundamentals:  A closer look at XOP

XOP holds 35 companies engaged in the exploration and production of oil and gas.  The companies are evenly weighted with the highest being 3.65% and the lowest 2.64%.

It has a low expense ratio of 0.35% and pays a small dividend on a quarterly basis.

The top five holdings and percentage weights for XOP are –

Company Name Ticker % Weight
Forrest Oil FST 3.65%
Pioneer Natural Resources PXD 3.45%
Holly Corp HOC 3.44%
EXCO Resources XCO 3.27%
EOG Resources EOG 5.30%

A weak dollar is good for oil prices.  The reason’s simple. Commodities like oil are traded in dollars.  When the value of the dollar falls, those commodities become cheaper in other currencies.

So when the dollar goes up, oil prices go down.  When the dollar goes down, oil prices go up.

Right now the value of a dollar has fallen to a 14-month low against other currencies.

The easy money policies and huge deficits the US government is running are eroding the value of the dollar.  At this point, there’s no end in sight.  Unless the policies change (I don’t see that happening anytime soon), the US Dollar will continue to fall. That means oil prices should continue to climb higher as the greenback slumps.

Technicals:  The charts lead the way

The breakout is on… The price for a barrel of crude oil was stuck in a range of $60 to $75 since May.  For five long months, the price for a barrel of crude oil consolidated in an ever-shrinking range.

Chart patterns like this go by many different names.  But they all end in the same way, with a strong and decisive move… otherwise known as a breakout.

The longer the consolidation, the longer and bigger the move is.  The breakout in oil after five months of consolidation has the potential to produce huge profits.  I think we’re just getting started.


The breakout in oil prices has energy stocks moving higher across the board.  But none are more impressive than XOP.  It’s showing great relative strength compared to the entire sector and market in general.

That’s a good sign institutional players are moving money into this industry.  Their interest should keep XOP posting bigger gains as the market marches higher from here.

Trade Alert

Buy:  SPDR S&P Oil & Gas Exploration and Production ETF (XOP) up to $45.00
Recent Price:  $42.75
Price Target:  $56.00
Stop Loss:  $36.00

Remember:  We’re buying XOP on a breakout.  There is considerable momentum behind this trade.  It can cause the ETF’s price to move quickly.  Any pullback should find support at the 10-day moving average, which is currently around $41.


During the last real estate boom, homebuilders went crazy.  The demand for new homes was insatiable.  Builders were pumping out new homes at the fastest rate ever recorded.

Here in Arizona, we were right in the middle of the madness.

I remember a time when new subdivisions would hold drawings for the right to buy one of their properties.  Thousands of people would show up.  Everyone was looking for a chance to get a new lot to build a home on.

Everyone would throw their name in the hat.  If you were lucky enough to be drawn, you signed a purchase contract that day.  A few months later, you were the proud owner of a new home.  It was common for a house to jump in value $100,000 or more between the time you signed the contract and the completion of construction.

The easy money brought in busloads of investors.  Really.  There were literally busloads of investors being shipped (or bussed) in from California.  Real estate investing groups or realtors would sponsor bus trips for people to come to Arizona.

These investors (and I use the term loosely) never planned to live in or rent the home. Their plan was to flip the house and pocket the difference as soon as the house was built.

It’s easy to see why we’re sitting on a huge oversupply of homes.  Many buyers never planned on living in their houses!

Here we are over three years later.  Finally I see a light at the end of the tunnel.  The number of new homes built plummeted over the last few years.  Now were beginning to see homebuilders become less negative about the future.

I think one demographic trend will play a big roll in the rebound in housing and more importantly the homebuilders.

Macro/Economic Trend:  New Households

One of the most important factors in housing demand is the creation of new households.

The problem is the pace of household formation has slipped below the historical average.  The reason’s fairly obvious.  A bad economy and fewer jobs have left more people under the age of 25 unemployed.

They are living with family or roommates instead of forming new households.  One report estimates, if the household formation rate was at the historical norm, we would have already burned through the entire backlog of available homes!

The reality is the rate of new household formations will rebound with the economy. When it does, we’ll see a big spike in the number of households created.  It’s like un-kinking a hose.  We’re going to get an initial burst that will burn through the entire backlog of available homes.

Once the backlog is gone, we could be faced with a shortage of available housing. When the backlog starts falling, homebuilders will once again have pricing power.  That means expanding margins and improving earnings.  And that’s a great situation for the homebuilders.

To be honest, it could take a long time for the market to correct itself.  The economy needs to add a lot of jobs before the number of new households alone can fix the problem.

But don’t worry.  The government’s going to ‘stimulate’ the process.

In fact, they already have.  There’s an $8,000 tax credit for new homebuyers who close on their new home before the end of November.  This credit has brought in enough new buyers to stabilize the market.

However, it’s only temporary.  If the stimulus goes away, the housing market is going to head south again.

Lawmakers in D.C. aren’t going to let that happen.  I expect the tax credit for purchasing a home to be extended and expanded.  And when they do, it’s going to be a boon for the homebuilders.

One ETF I like to profit from this trend is the SPDR S&P Homebuilders ETF (XHB).

Fundamentals:  A closer look at XHB

XHB holds 27 stocks tied to the housing industry.  The weighting of the stocks vary between 3.38% and 5.39%.

The consumer discretionary stocks in the ETF have recently outperformed the homebuilders.  The outperformance of these stocks has increased their weighting in the ETF.  But a rebound in the real estate market will provide a big bump to builders and XHB.

The expense ratio is low at 0.35%.  And dividends are paid quarterly.

The top five holdings and percentage weights for XHB are –

Company Name Ticker % Weight
Tempur-Pedic International TPX 5.39%
Williams Sonoma WSM 4.52%
USG USG 4.39%
Leggett & Platt LEG 4.23%
Sherwin Williams SHW 4.21%

The Q3 earnings season will shed some light on the health of the homebuilders.  I expect to see some very positive signs.

First off, home prices should be stabilizing.  Before the housing market can get better… it has to stop getting worse.

Builders should also be closer to profitability.  Even a modest loss this quarter would be a huge improvement over the last few years.

The last thing I’m looking for is sales growth.  More importantly, what management is forecasting for the rest of this year and 2010.  Positive comments could drive these stocks higher.

Technicals:  The charts lead the way

Take a look at the chart.  You’ll see XHB is consolidating around $15.50 since mid- August.

Then in September, XHB broke out to a new high above $16.  However, it failed to hold above $16 and pulled back to support around $14.

This chart is setting up a bullish continuation pattern.

When XHB does breakout from the current range, the move could be fast and furious. A close above this resistance level should send XHB higher on a strong and decisive breakout after the consolidation.


Trade Alert

Buy:  SPDR S&P Homebuilders ETF (XHB) up to $16.25
Recent Price:  $15.47
Price Target:  $22.00
Stop Loss:  $13.50

Remember:  XHB is consolidating around $15.50.  I’m expecting a breakout above resistance around $16.50 to send the stock rocketing higher.  Improvement in the economic data and the bullish nature of the stock market lately could be enough to get XHB moving higher again.  If not, the announcement of the extension of the homebuyer tax credit will surely provide some fireworks.


Consumer Discretionary (+4.6%)

Our two recommendations from last month, Market Vectors Gaming ETF (BJK) andSPDR S&P Retail ETF (XRT) are off to fast start.

Look for these ETFs to gain momentum heading into the fourth quarter.  I think holiday retail sales are going to be much better than expected.  I don’t know how else to say it… we’re Americans and we like to buy stuff.  I’m expecting consumers to take a break from shedding debt and spend some of their savings.

This month we’re adding the SPDR S&P Homebuilders ETF (XHB) to benefit from continued strength in this sector… see Trade Alert 2 for more details.

Consumer Staples (+4.1%)

Consumer staples are getting a nice bounce from better than expected retail sales numbers.  Investors are hoping consumers will switch back to name brand products as the economy improves.  Many customers traded down from name to store brands to save money over the last year.  It hurt the sales of many traditional safe haven companies.

Any gains for the defensive consumer staples sector will be limited by investors moving into more economically sensitive sectors.

Another factor helping this industry is consumer confidence.  These numbers are starting to move higher.  Watch for more consumer confidence driving this industry higher.

Energy (+10.1%)

Oil finally broke out above resistance at $75 a barrel.  The sharp move higher sent ourEnergy Select Sector SPDR Fund (XLE) up over 25%.  I think this is just the beginning for energy prices.  There’s plenty of room for improvement from here.  We’re adding another energy ETF this month.  It’s the SPDR S&P Oil & Gas Exploration and Production ETF (XOP) see Trade Alert 1 for more details.

Financials (+4.7%)

The bank closures continue to mount.  The FDIC has shuttered the doors of 99 banks so far in ’09.  Unless the bank’s deemed ‘too big to fail’, it’s at risk of failing.  And that’s most banks!  There are just too many bad loans on the books of the regional and community banks.

You can bet the banking lobbyists are putting the full court press on lawmakers to extend the first time homebuyer tax credit.  It’s the only way banks will be able to unload the mountain of foreclosed properties on their books.

Healthcare (+1.1%)

Poor healthcare companies… I feel sorry for you.  The healthcare reform debate is the only story that matters right now.  The entire sector is undervalued based on the status quo.  But the unknown changes leave too many questions unanswered.

Until the debate is settled, we’re staying away.

Industrials (+2.7%)

Our Vanguard Industrials ETF (VIS) is up 15% in just a few months.

The economic data on the manufacturing sector continues to be mixed… Good news one day and bad the next.  The good news is inventory levels continue to dwindle.  As the economy recovery, companies will need to restock.  This should lead to increased orders in the near future.

The bad news is for all its hype, the economic stimulus isn’t getting the job done.  It doesn’t appear to be enough to offset the losses the big construction and engineering firms are suffering in other areas of their business.

With that in mind, we’re going to lock in a 23% gain on PowerShares Dynamic Building & Construction Portfolio (PKB).  Sell this now and take your profits!

Technology (+2.1%)

The technology sector continues to lead the markets higher.  The semiconductor giantIntel (INTC) posted another impressive quarter.  Their numbers are down from a year ago.  But they’re much improved over the previous quarter.

That’s a very good sign the economy is on the mend.

I’m expecting the release of Windows 7 to spark PC sales in the fourth quarter.  IT spending has been almost non-existent over the last year.  Companies have focused on slashing expenses, not revamping there IT.  Many companies are still running XP systems because Vista has more bugs than a rainforest.  Windows 7 could be just the thing to get companies to loosen their purse strings.

Materials (+4.1%)

Basic materials and the companies who own or make them are benefiting from a weak US Dollar.  We’ve seen a big run up in prices over the last few months as the US Dollar’s fallen.

Gold has finally broken through a stubborn resistance level at $1,000 and ounce.  It’s now closing in on $1,070.  Is this the start of a new rally or the end of the line?  It’s hard to say.  In my opinion, as long as the FED keeps pumping dollars into the system, investors will look to gold as a hedge against inflation.  That means gold and most other commodities should go higher from here.

Utilities (+2.6%)

Utilities were pulled higher by the overall market this month.  They’re far from being a leader but they’ve been posting modest gains as the cyclical sectors march higher.

Here’s the bottom line.  There’s much better places to put your money to work for you.  Add in the uncertainty surrounding cap-and-trade legislation and you have a reason to stay away.

I think utilities will continue to lag the rest of the market as the economy recovers.

Portfolio Changes

  • This month we’re buying XOP and XHB…
  • Move MOO and XRT to ‘Hold’ status…
  • Sell PKB for a 23% gain…


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