Reversal of Fortune

Treasuries lower, everything else higher: That’s been the reversal of fortune in this market over the past several days, 180 degrees away from the action we saw for most of the second half of 2008.

Treasuries’ historic run last year was, of course, fueled by fear of an impending global economic depression. Investors fled practically everything else for the security of paper backed by Uncle Sam’s taxing power, as 90-day US Treasury bill yields actually went negative. Foreigners were especially insatiable buyers of US government-backed debt.

The partial retracement of Treasuries’ run--and the partial reversal of losses in almost everything else--may not signal a permanent return of investor confidence in the global economy and markets. There have been some interruptions in the steady stream of bad economic news in recent months, notably last week’s announcement of a very steep plunge in unemployment insurance claims.

But from China’s falling industrial output to the recent steep drop in the purchasing manager’s index in the US, the weight of evidence suggests growth is still slowing, and the overall situation may indeed get worse before there’s real improvement.

In short, there’s still a risk that bad economic news will send stocks lower and Treasuries higher. But the past couple weeks’ trading was nonetheless a welcome change from the previous action. And it appears confidence in at least some companies--namely those whose businesses remain strong in the face of current adversity--is building once again.

One of the more surprising turnarounds has been in oil prices. To be sure, the price is still around $100 a barrel below midsummer levels. But black gold has nonetheless risen nearly 40 percent off its lows. And energy producer stocks have followed the fuel higher, including several Canadian energy trusts that have been forced to reduce distributions recently due to the dramatic drop in oil and gas.

We’ve seen the same trading pattern in other stocks, commodities and fixed income investments that were huge losers last year. And the upward action has been particularly radical in several securities that were taking on water at a very rapid rate up until the last week of 2008.

In previous years, this tendency of one year’s losers to rally in the next year’s early months was known as the “January effect.” In recent years, the need for mutual funds to close out their books much earlier had caused the January effect to actually occur sometime in December.

In 2008, however, the selling continued basically to the end of the year. In my view, the magnitude of the losses sustained in the markets was a major factor, as the S&P 500 finished down nearly 40 percent, and most other averages and markets fared even worse. That smoked out a number of individual investors, hedge funds and other non-mutual fund holders of stocks, who wanted to get at least a tax benefit from the past year’s record pain.

We’ve also seen a large number of liquidation sales that continued up until the end of the year. Many closed-end funds in particular have been big sellers this year, creating huge volatility in some of the most unlikely securities. These funds were forced to sell in order to bring their debt levels back into compliance with their charters and Securities and Exchange Commission regulations.

Selling of losing shares in Canada continued right up until Dec. 26, as trades entered after that date wouldn’t have time to clear. Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF), for example, had been falling along with the market for most of the year, but then took an additional haircut of nearly a third of its value in December.

Happily, Yellow Pages shares also provide a very good illustration of the buying of recent days. After closing at a low of just CAD5.14 per share, the company that dominates Canada’s directory information business both in print and on the web has now rallied back to CAD7.26 in just seven trading days.

And it’s far from alone in its resurgence. Even the Philadelphia Stock Exchange Utility Index, which basically bottomed in late October, has managed a gain of more than 8 percent over the past 7seven or so trading days. Limited partnership (LP) Enterprise Products Partners (NYSE: EPD) is up nearly 15 percent over a similar time period, as have several other energy infrastructure LPs.

Even traditionally thinly traded and historically very stable preferred stocks have seen a massive rebound from selloffs that occurred for no fundamental reason. Xcel Energy Preferred E (NYSE: XEL E), for example, traded from the upper 70s to the lower 80s for the better part of four years. That was before succumbing to liquidation selling in October that eventually drove its price down to the low 60s last month. Since then, the shares have rallied sharply back to the upper 70s.

Will this rally morph into a full-on recovery for the market in 2009? Does it portend a bottom for the global economy this year, or will we simply see conditions worsen and eventually drag stocks and any bonds not issued by the US Treasury to new lows?

At this point, you won’t find a lot of analysts willing to commit to the recovery thesis. Considerably more have signed onto the idea that the worst is yet to come. In fact, more than a few analysts are now circulating the idea that the Obama administration’s planned $1 trillion stimulus package--combined with sharply negative real interest rates in the US--will trigger a mass exodus out of Treasury paper, more inflation and ultimately a major prolonging of the crisis.

We won’t know for certain who’s correct for some months. In fact, it’s quite possible both the bulls and bears will prove correct to some degree, as massive stimulus provokes a rally in the markets and an uptick in economic activity that does actually bring more inflation with it.

In the year-end edition of his Futures Market Forecaster, my friend and 30-year-plus commodity trading veteran George Kleinman advises investors to “have no stubborn opinions” about deflation or inflation because it could well go either way. In fact, he postulates that “certain commodities (food, gold) could possibly surge in deflation or inflation, while others could fall in either scenario.”

In my view, George’s agnostic outlook on commodities should also be applied to stocks. As it is with individual commodities, we’re now at washed out levels across the board for stocks. Even the safest companies such as Super Oils trade at single-digit price-to-earnings ratios. Chevron (NYSE: CVX), for example, sells for less than 7 times next year’s expected profits and AAA-rated ExxonMobil (NYSE: XOM) sells for less than 10 times.

General Electric (NYSE: GE) has had its share of problems over the past year, mainly with its credit division, and could well lose its vaunted AAA credit rating. But the company’s infrastructure arm stands to be a huge winner from President-elect Obama’s plans to inject hundreds of billions of dollars into projects, and investors can now pick it up at its lowest price since the early 1990s: barely 8 times earnings, 87 percent of sales and a yield of nearly 8 percent.

Utility stocks are off by more than a third from recent highs, despite the fact that dividends sector-wide are well protected by still-steady earnings and the almost total lack of credit pressures. Of more than 100 individual companies, only Constellation Energy (NYSE: CEG) has had troubles. And it is the exception that proves the rule, as the only utility that continued to expand in the energy marketing sector and thereby remained exposed to credit pressures.

Moreover, the 50-50 partnership inked last month with Electricite de France (France: EDF, OTC: ECIFF) to develop Constellation’s nuclear plants is a clear sign that even this is basically a strong company with few real long-term worries. EDF and Berkshire Hathaway (NYSE: BRK) unit MidAmerican Energy are now both 9.9 percent owners of Constellation. That’s an awful lot of financial backing for the company, as well as a major vote of confidence in its future health.

Coming off these depressed levels, it won’t take a lot to beat expectations, which is the key to higher stock prices. As long as the global economy weakens, there will still be the potential for meltdowns with individual companies, including those with already beaten down stocks. Liquidations and bankruptcies are still very possible in many economically sensitive industries, and there’s no guarantee of recovery.

On the other hand, the companies that continue to make their nut have the potential for dramatic share-price recoveries, even if the economy takes longer to rebound than expected. Again, it all boils down to posting strong results.

Steady third quarter earnings are no guarantee that a company kept its head above water in the fourth quarter, which included basically a freezing up of credit activity in the US in October. But those that were doing well to that point have the best chance of posting another solid report in the fourth quarter, and for keeping things together in 2009 as well. At current prices, there’s not much potential for real disappointment, short of bankruptcy and liquidation. And there’s plenty of room to beat expectations.

Energy producers and related stocks have perhaps the most room for upside surprises. That especially goes for Canadian companies, which have the benefit of being priced in a currency the value of which is tied to the price of oil. That hurt them last year, as oil and the Loonie dropped precipitously together. It will be a huge plus if oil rebounds to a level consistent with a healthy global economy. The bar has been set extremely low in the marketplace for both energy and the currency, as well as for the companies themselves.

Outside of energy, my other pick for an upside surprise is communications stocks, particularly the industry’s larger players. Since this bear market began in mid-2007, the Street consensus has been that communications services would be considered by consumers to be a luxury item rather than an essential service.

Quarter after quarter, pre-announcement commentary has focused on the theory that consumers and businesses would slow their demand for fast-growing services such as broadband and wireless and would speed disconnections of traditional copper landline connections. As it’s turned out--at least through September 2008--there’s been little acceleration in the loss of local phone connections, other than what would be otherwise expected from the advance of technology and growing availability of superior connections.

Meanwhile, wireless sales have continued to grow at a brisk clip, led by powerful increases in data services. And cable television offerings of entertainment, data and communications continue to grow those companies’ cash flow at a robust rate.

Perhaps the fourth quarter of 2008 or first quarter of 2009 will at last bring the long-anticipated slowdown in revenue. Telecoms in the purely wireline space, namely Qwest Communications (NYSE: Q) and some of the rural telecoms, did report some acceleration in local line loss and a dip in broadband growth. But to date, there’s no evidence the weakness is spreading to the industry’s biggest and strongest.

Meanwhile, AT&T (NYSE: T) trades at just 10 times projected 2009 earnings, Verizon Communications (NYSE: VZ) sells for only 12 times and Comcast (NSDQ: CMCSA) trades at only 1.2 times book value. That’s phenomenal value for the three leaders of one of America’s strongest, fastest-growing and, at least to date, most recession-resistant businesses.

Finally, global metals giants are selling at their lowest prices in many years, due to expectations that economic weakness will pulverize demand in coming months. To be sure, that is happening in a major way. A now five-month-long drop in Chinese industrial output is hurting that country’s demand for raw materials, even as rising demand there was a primary catalyst for pushing up prices in early 2008. And the rise in the US dollar has further depressed prices, crimping earnings at producers.

Even exceptionally well-heeled companies are slashing capital spending and new projects, as they retrench to deal with lower prices. Freeport McMoRan Copper & Gold (NYSE: FCX) recently suspended its distribution entirely, and Rio Tinto (NYSE: RTP) may be in danger of the same, as it deals with a sizeable debt load in a weakening market. Meanwhile, the most debilitated in the industry are in danger of vanishing. 

A rocky business environment is likely, at least until the global economy can rebound. On the other hand, Freeport and Rio trade and 4 and 3 times expected 2009 earnings, respectively, and these estimates do include projections for lower selling prices. Freeport trades for just 58 percent of its book value, while Rio sells for 90 percent. That’s a sure sign expectations for both companies are set extremely low. Again, it won’t take much to beat them and only a real catastrophe would take these stocks significantly lower.

Such a meltdown is certainly possible still if the economic picture darkens as much as some fear. But there’s something else going on here as well: We’re seeing supply destruction on a scale we haven’t seen in years, as new projects are postponed or cancelled and only the lowest-cost reserves are produced.

That’s enough to meet demand in the near term as long as the global economy remains this weak. But it’s nowhere close to what’s needed to meet the needs of the global economy in normal times. And given the tremendous fall in commodity prices, it’s going to take a long period of sustained high prices to restore enough confidence for producers to undertake the kind of projects needed to meet long-term demand growth.

The dramatic drop in commodity prices over the past several months has made it almost certain we’ll see another, possibly even more radical spike up in prices in coming months. That, in turn, will send the biggest and best producer stocks--locks to survive the coming year’s carnage--to even greater heights than they achieved this year.

This isn’t a bet for the timid, or for those who demand an instant payoff. But for patient risk-takers, the best of the biggest commodity producers offer compelling potential rewards in 2009, and quite possibly well beyond.

If you were to believe the mainstream media, there's little good news coming out of the financial services industry. Failures among smaller institutions continue to rise as losses on problem assets mount, while the Federal Reserve and Treasury Dept are pulling out all the stops to prop up the irresponsible mega banks deemed too big to fail. It's not surprising that share prices in the financial sector have suffered--and, in many cases, deservedly. But at the same time, it pays to look beyond the overwrought strokes with which the media paints the banking system.

Amid the prevailing doom and gloom, there are a surprising number of community banks that shunned the high-risk activities that dominate the headlines and now find themselves in a position for growth.

Click here to download a free preview of Banks of Opportunity, a report prepared by my colleagues Benjamin Shepherd and Peter Staas that highlights some of our favorite bank stocks for growth and income.

Redirect the stress built up during this long bear and bask in the Florida sunshine as winter extends into its extra six weeks: Join me and my colleagues Elliott Gue and Gregg Early Feb. 4-7, 2009, for the Orlando Money Show.

I’ll be talking about my new service focused on exploiting the greatest spending boom in history, New World 3.0, as well as topics related to utilities and the Canadian trust universe.

Elliott, the new editor of Personal Finance, will detail PF’s new direction and provide significant insight into his approach to stock selection and portfolio management. What’s required now amid these difficult times are clarity and focus, qualities Elliott has demonstrated in these pages and through The Energy Strategist for years.

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Click here to attend as my guest, or call 800-970-4355 and refer to promotion code 012651.