Equities Edition
Week of June 22-26, 2009

CAPITAL MARKETS COMMENT | EQUITY FEATURE TRADE 1: TREASURIES SPREAD | EQUITY FEATURE TRADE 2: UTILITIES SPREAD | PREVIOUS TRADE RECAP/UPDATE | SUBSCRIBE via RSS | DISCLAIMER

CAPITAL MARKETS COMMENT

Plain and simple. Equity markets started the week of June 15-19 on the wrong foot as the European Central Bank confirmed Monday the view I posited in last week’s BHBGroupTrader Market Spread Report, namely that central bankers are not buying the green shoot theories of recovery. In its bi-annual Financial Stability Review, the ECB suggested that euro-zone banks will need to write down an additional $283 billion by the end of next year and warned that risks to euro-zone financial stability “remain high”. Among the central bank’s worries were sharper-than-anticipated falls in U.S. house prices, further winnowing of euro-zone banks’ capital buffers and the possibility that economic upheavals across Central and Eastern Europe — where some euro-zone banks have big investments — could intensify. Other sources of concern include rising corporate-default rates, falling property prices in some euro-zone countries, and the potential for the bloc’s recession to be worse than expected.
Here in Canada, data released this week showed the economy contracted at a 5.4 percent annual rate in the first quarter, the fastest pace since 1991. In May, employment fell by 41,800 jobs, sending the unemployment rate to an 11-year high of 8.4 percent. A second report showed Canadian retail sales unexpectedly declined 0.8 percent in April, as mounting job losses prompted consumers to check spending. Tuesday’s wholesale trade report showed Canadian wholesale sales fell in April for a seventh straight month and to the lowest level since 2005, led by a 2.9% month-over-month drop in building material sales, and a 1.2% month-over-month drop in machinery and electronic equipment sales. On Thursday, a Statistics Canada report of leading economic indicators showed a decline for the ninth straight month, led by a 12 percent plunge in new manufacturing orders and a 1 percent fall in furniture and appliance sales.

Economic data in the US fared no better. On Monday, a Federal Reserve Bank of New York report – one which is widely believed by economists to provide the earliest indication of US factory conditions — showed that the New York state factory sector shrank at a more severe rate in June than during the previous month, and much worse than even the most pessimistic estimates. On Tuesday, a report from the Federal Reserve showed that industrial production and capacity utilization both fell more than expected, with industrial production — a key measure of cyclical growth — falling at its fastest rate since 1946 and capacity utilization – a key measure of demand — falling to the lowest level since the data began being kept in 1967. On Wednesday, the US Commerce Department said the current account trade deficit – the broadest measure of trade because it covers not only goods and services but also investment flows between countries — dropped to $101.5 billion in the first quarter, much worse than economists’ median estimates of $85 billion.

To be fair (and also so that our readers cannot simply dismiss us as chronic doom-and-gloomers) there was one bright spot as far as economic data was concerned: housing starts in the US were up a staggering 13% month-over-month. Yes that is good news until you think about it a little and realize an increase in the supply of homes isn’t exactly what the housing market needs for recovery.

Global equity markets responded to the barrage of horrendous data in a way it had not done for several weeks: they actually sold off, with the broad market S&P 500 equity index and the TSX Composite Index closing the week 2.6% and 3.3% lower, respectively.

On the S&P 500 we can see a new trading range that has developed. The range is 880-945 and we have to look at these areas for the next move for the markets. It looks like a test of 875-880 is coming now and we will need to judge the price and volume to determine the reaction from the area mentioned. One point that is important to realize is that volume on the rallies is still declining versus a rise in volume on sell-offs.

What made this past week different? During the past three months, economic data has been awful and yet equity markets have managed to shrug off the dismal data to work their way substantially higher. Why the sudden change in market behavior?

There are several possible explanations. First, bear market rallies typically last around 3 months (this one has exceeded the median time frame by about two weeks). Second, investors wanted to see some follow through in terms of positive economic data. That they got the opposite – worse than expected news – is a setback to say the least. Third, and in our opinion, the most plausible explanation, is the one put forward by our favorite capital markets commentator Karl Denninger. According to Mr. Denninger, the fall in equity prices last week has to do with market pricing in the intentional drain of liquidity from the financial system by the US central bank. In examining the open market operations of the Federal Reserve, Denninger noted that on Thursday just over $101 billion of Term Auction Facility (TAF) paper sloshing in banking system matured, and only $48 billion of it was rolled (reinvested back into the system ) – meaning that there was a drain of $53 billion of liquidity from the banking system. Add this $53 billion to the $70 billion of Troubled Asset Relief Program (TARP) paper that was recently paid off, and we have just experienced a $123 billion liquidity drain in a relatively short time period. The last time such a massive amount of liquidity was intentionally removed from the banking system was in mid-September, when the Federal Reserve open market operations drained out $125 billion in liquidity in just four calendar days. The painful end-result of that “experiment”: a 30% plunge in equity prices.

The liquidity drain (and the subsequent decline in equity prices that such a drain may precipitate) comes at a rather “convenient” time for the American master planners (the Obama administration, Bernanke’s Fed, and Geithner’s treasury department). You see, last week, spurred by the widening current account balance (the current account is closely monitored by economists because it reflects the amount of borrowing the United States must do from foreigners to finance its total trade deficit), the Treasury announced it will put up $165 billion worth of treasuries for sale this coming week: $31 billion in 3-month bills, $27 billion in 7-year notes, $40 billion in 2-year notes, $37 billion in 5-year notes and $30 billion in 6-month bills. Now, normally, the laws of economics dictate that such a massive onslaught of supply in any market would drive prices way lower, but a decline in treasury prices (and a consequent rise in yields) is simply an unacceptable outcome for the master planners. The master planners know, as we have been telling our clients for well over a year now, that any economic recovery will depend on restoring health to the American consumer, which itself will be contingent upon 1) a recovery in home prices, and 2) a recovery in employment. As we’ve said here before, higher long-term yields would completely derail both, since higher rates would exacerbate delinquencies on mortgage payments (and thus drive home prices lower), and higher borrowing costs would stifle business investment (thus impeding the hiring of new workers). So what better way to drive investors towards the “safety” of treasuries than to withdraw liquidity and force equity prices lower; what better time to drive investors towards the “safety” of treasuries than the present, when a massive supply of them are about to hit the market?

As such, we believe that the accompanying text to the Federal Reserve Open Market Committee’s statement that will be released Wednesday after two days of deliberation will suggest that although credit markets have stabilized and that equity prices have recovered substantially from their March lows, significant downside risks to growth still remain. Citing the low levels of inflation present in the system (PPI and CPI readings this past week showed inflation as non-existent), the Fed will affirm its current federal-funds target of 0%-0.25% and suggest that the market is over-pricing chances of Fed hiking (currently 48.8% for December and 99.5% for April 2010). Next, it will re-affirm its intention to purchase up to $1.75 billion of Treasury, agency, and mortgage-backed securities this year, with very real possibility that they will even step-up their purchases.

If equity prices do start the week of June 22-26 the way in which it started the week of June 15-19, this kind statement from the Bernanke Fed would cause a massive rotation away from risky assets and towards the “safety” of US Treasuries. Which, at the given time, is exactly what they want.

Adjust your portfolios accordingly.

EQUITY FEATURE TRADE 1: TREASURY ETFs/ETNs

Long: iShares Barclays 20+ year Treasury Bonds (TLT)
Short: iShares Barclays 1-3 year Treasury Notes (SHY)

The trade that is recommended to take advantage of the coming strength in long-dated bonds is to be long the iShares Barclays 20+ year Treasury Bond (TLT) and to be short the iShares Barclays 1-3 years Treasury Notes (SHY). This is the same trade I put on last week in the Futures market, and given the drain in liquidity we see occurring in the financial system, I am suggesting it here for those who do not currently have futures accounts here with us.

The ratio is currently at an area of support and we can see by the volume that there is clear accumulation of the ratio at this price level of 1.09 on the ratio. For those of you that do not know how a ratio works, it is quite easy to understand: it is achieved by dividing the price we pay for TLT by the price we sell short SHY.

EQUITY FEATURE TRADE 2: UTILITIES

Long: Southern Company (SO)
Short: Constellation Energy (CEG)

Another way for investors to benefit from a decline in long-term rates is by purchasing interest-rate sensitive stocks in general, and those in the utility sector more specifically. Since utilities carry a relatively large amount of long-term debt on their balance sheets, they tend to benefit from drops in long-term rates. But how does one play a spread trade within the utility sector?

A fairly recent academic research paper published by the MIT press examines the determinants of interest-rate sensitivity within the electrical utility sector. First, the research found that in almost every case, the bond rating of a utility’s debt has a strong influence on its equity sensitivity to interest rates such that the common stock of highly rated utilities is more interest rate sensitive relative to that of lower rated utilities. Next, the research found that once the rating of the debt is controlled for, the debt-level of the utility is positively correlated with interest rate sensitivity such that the more long-term debt on the books, the more positive the equity share performance from a decline in long-term rates. Third, larger utilities are found to be more interest rate sensitive than smaller utilities. Finally, evidence is also presented that a utility’s proportion of maturing long-term debt influences interest rate sensitivity.

The pair trade I have identified above fits each of the criterion outlined by the MIT research: Southern Company’s debt has a higher rating by all three debt-rating agencies than does Constellation Energy’s; it has more long-term debt; has a greater market-capitalization (indeed, Southern Company has the highest market cap in the electrical utility sub-sector); and has a greater proportion of maturing long-term debt.

Furthermore, Southern Company is one of four companies expected to share a set of loan guarantees totaling $18.5BN from Congress last week to build the next generation of nuclear reactors, a development which many analysts believe could be the catalyst that could vault Southern ahead of some of the sector’s strongest players.

On the other hand, according to a Wall St. Journal article published Saturday, Constellation Energy was one of six companies identified by the US Nuclear Regulatory commission (NRG) to be in arrears on their nuclear decommissioning funding, and have been told by the NRG that they have until the end of this year to explain how they will fix shortfalls in the funds.

PREVIOUS TRADE RECAP/UPDATE

I will now publish the returns of and commentary on our previously issued trade ideas in the following easy-to-read table.

DISCLAIMER

This newsletter is based upon factual information considered to be accurate and reliable but not independently verified or guaranteed by us. Opinions expressed are those of the author, are subject to change without notice, and do not necessarily represent the views of ScotiaMcLeod. This report should not be construed as an investment recommendation to you to engage in any transaction involving the purchase and/or sale of equity securities, futures contract(s) and/or commodity options. Past performance is not indicative of future results. The risk in trading futures contracts or commodity options can be substantial. Investors should carefully consider the risks of investing in light of their investment objectives, risk tolerance and financial circumstances. This report may not be reproduced in whole or in part, or referred to in any manner whatsoever, nor the information, opinions, and conclusions contained in it be referred to without the express written consent of ScotiaMcLeod.

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