Jeff Saut Presents: Civility is the Glue
...as long as the U.S. government subsidizes alternative energy it should continue to have the "wind at its back"
Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.
"Civility is the glue that holds society together."
I have been traveling a lot over the past few weeks. First it was a week in New York City. Then a week in Toronto, and last week it was a stint in the heartland of the US. Other than being stunned by corn fields for as far as the eye could see, I was impressed by the civility, professionalism, and happiness of the Midwesterners. This was true not only at the corporate level, but even the folks that waited on me in restaurants. I don't know if their attitude stems from upbringing, Midwestern values, the fact that there doesn't seem to be a housing debacle in the Corn Belt, near full employment, or high grain prices. Maybe it's because every radio station played happy songs from groups like Hootie & the Blowfish and Jim Croce. But if I had to guess, I would guess that it is their upbringing combined with soaring grain prices.
Verily, times are good in the Corn Belt with factories like Archer Daniels (ADM) and Caterpillar (CAT) operating at full tilt. Clearly this is being driven by a couple of my firm's macro themes. First would be with more and more people entering the world's economy (read: Chindia), and subsequently per capita incomes rising, people are consuming more "stuff" (grains, meat, energy, etc.). Second would be alternative energy, in this case ethanol (as a sidebar, when I flew into Bloomington, Illinois I saw a plethora of electricity generating "windmills" that were not there a year ago). My firm has embraced the alternative energy theme, believing the world is at, or near, peak oil production whereby more crude oil will be consumed than can be found. Moreover, as long as the U.S. government subsidizes alternative energy it should continue to have the "wind at its back" (forgive the pun).
To this point, President Bush recently announced a renewable fuel standards proposal, making it likely that 35 billion gallons of fuel will come from renewable sources by 2017. Plainly, corn farmers and ethanol producers are beneficiaries of this mandate. Yet, not everyone is happy, as pointed out by The Wall Street Journal last week in an article titled, "Oil Industry Says Biofuel Push May Hurt at Pump." It seems in the wake of yet another week of record gasoline prices, political rhetoric in Washington aimed at refining companies is heating up. What is more interesting this time around is the emergence of comments from the refining industry, which is using the gasoline price spike as an opportunity to score political points against the ethanol industry.
We do not believe this argument is consistent with basic refining economics. First, no new U.S. refineries have been built in three decades, which long predates the current ethanol build-out. Second, U.S. demand for refined product has steadily increased despite growth in ethanol production. Finally, these anti-ethanol comments from refiners should be seen within the context of the current political climate in Washington regarding gasoline prices. Moreover, from the standpoint of ethanol investors, I view this latest surge of political rhetoric as "noise" that is a distraction from the fact that underlying ethanol fundamentals are quite robust. The crush spread currently exceeds $1.00/gallon, and based on current ethanol and corn prices, I think upward earnings estimate revisions are likely for 2Q '07 and possibly 3Q '07.
As my firm's alternative energy analyst Pavel Molchanov concludes:
"Constrained domestic refining capacity, along with ethanol's intrinsic octane and environmental advantages over gasoline, makes ethanol stocks, in our view, attractive value buys in the alternative energy space. As before, we recognize that this is a contrarian call, and while short-term commodity price fluctuations may produce large swings in the stock prices of ethanol producers, our fundamental bullish thesis is premised on long-term trends. Our top ethanol picks are US BioEnergy (USBE) and VeraSun Energy (VSE), followed by Aventine Renewable Energy (AVR) and Pacific Ethanol (PEIX)."
Turning to this week, obviously the main event will be Friday's employment report. However, said report is backward looking. For example, the employment report issued earlier this month was for the 3Q06. Yet as today's Barron's notes, "What it showed was eye-popping." To wit:
"Thus, compared with the gain for the quarter of 442,000 jobs report in the so-called establishment survey, the Business Employment Dynamics, or BED, reckoning was a scant 19,000 additions. In the manufacturing, the 9,000 jobs lost according to the payroll figures balloon into a loss of 95,000 jobs in the BED data; the improbable 20,000 additions in construction (think: housing) turns into a loss of 77,000 by BED's measure (and I would add those numbers don't capture illegal alien workers); the 507,000 gain in private services shrinks to 108,000 [using BED]. And so it goes. Or, more accurately, so goes the job mirage. One likely culprit, Philippa and Doug (The Liscio Report) suggest, is that curious concoction known as the 'birth/death' model used by the Bureau of Labor Statistics to estimate the gains/losses in jobs from the launching and demise of businesses. Thanks to this voodoo calculation, 156,000 were added in last year's third quarter and a hefty 388,000 in the opening four months of this year. Nice going, indeed, considering that first-quarter GDP growth probably, when the dust clears, will have fallen below 1%, and April was a punk month."
Indeed, in past missives I have stated that, "something happened in April" since retailers' same-store-sales fell off a cliff. Whether it was $3.00 a gallon gasoline, April tax-payments, weather, or waning employment related we don't know, but something definitely happened in April. Even more important was April's sub- 1.5% "flash" GDP report. Why is this important? Well, as noted by David Rosenberg at the recent Ira W. Sohn Investment Conference [as paraphrased by me]:
A recession is not necessarily back-to-back quarters of shrinking GDP, it's when GDP gets to 1.5% or lower. This is because with the U.S. population growing at roughly 1.5% per year, when GDP growth falls below 1.5% it means that real per-capita national income is actually contracting.
As for April's LEI report (reported 5/1/07), it's worth considering that of the 10 components that comprise the Leading Economic Indicators, only two were positive – stock prices and real money supply growth. Then there was the recent bounce in the ISM index driven by improvements in wood products, apparel, and an 8% "pop" in autos. Given the dreadful final demand in these three industries it is difficult to believe this strength is sustainable. What about last week's 14% stronger than expected new home sales? As my firm's real estate team stated, "that data took markets by surprise because it contrasts sharply with recent anecdotes from public builders regarding trends subsequent to March as most have made comments that April was largely worse than March. Peeling back the onion in the government data, I find that ALL of the upside as reported came from sales at the lower price points (homes less than $200,000), particularly in the sub- $150,000 market, which was also reflected by an 11% decline in median price. Hence, if there is improvement in the market, I think that would be at least one reason why the public builders haven't seen it yet." Hereto, I doubt if this bounce is sustainable.
In conclusion, I still can't figure out if the economy is slowing into a recession, slowing to a muddle, or reaccelerating, which is why I remain ambivalent on the major market indices. Nevertheless, my firm is having a good year due to stock selection and the discipline to sell mistakes. And, last week some more of my firm's investment names rallied because they were recommended by some of Wall Street's "best and brightest" at the Sohn Conference. Those names mentioned were: American Tower (AMT); Helix (HLX); Johnson & Johnson (JNJ); and UnitedHealth (UNH).
The call for this week: Last week the S&P 500 (SPX) valiantly tried to better its March 2000 all time closing high of 1527 and failed. This should come as no surprise because such "headline" levels often take a number of upside breakout attempts before succeeding. I had thought the S&P 500 would breach the 1527 level, as well as its intra-day high of roughly 1553, before potentially becoming vulnerable. Still, with the SPX some 9% above its 200-day moving average and at the top of its Bollinger Band (as can be seen in the following chart), it is pretty extended on a short-term basis. Moreover, according to Bloomberg the average stock in the SPX trades at 23.5x earnings and 4.5x book value, which are pretty heady valuations. Meanwhile, the yield on the 10-year benchmark T'note is trying to travel above 4.9% and the D-J Utility Average is breaking down. My firm continues to invest and trade accordingly.
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