Market rotation into Energy Sector

[dan_s]

Since I started putting out a Sweet-16 Protfolio back in 2001 we have had several years where the portfolio has picked up 20% to 30% in the 4th quarter. October has been a good month for the S-12 and it "feels" like we have more upside. I do agree with Andrew that we could see a small correction before stock prices head higher.
Winter's increasing demand for natural gas and home heating oil, the Feds move to increase the money supply and any news on improving economic conditions will push oil prices higher.
Dan

Capital Markets Monitor by Andrew McGrath Miller

We'll see how resilient the market is as it processes the much anticipated trifecta this week. The next congress will likely reflect consumer malaise and Washington will be even less effective. QE2 will likely be a gradual $100 billion a month in Fed purchases with language incorporated towards flexibility. The October jobs report confirms unemployment is and will remain stubbornly high, underpinning further stimulus efforts. The market will reveal how much of this is priced in. Investors may well sell the news, but the bid under equities is currently resilient. Attempts by the market to retreat have been met with strong intra-day buying.

We believe the market is overdue for a small correction or perhaps simply a pause in its ascent. A period of consolidation would be welcome after the 12-15% gains in the U.S. market. With investor sentiment readings at extreme levels and bond yields creeping back up, the market needs to stop and catch a breath. Don't look now, but we are nearing 52 week highs on some indices, and we expect this will also add resistance without catalysts to drive the market higher.

For all the concern about the muddle through economy, the disconnect with corporate earnings continues and this should bode well for equity prices for the near term. With roughly 45% of the S&P 500 having reported, Q3 earnings season is on track to beat expectations and post 35% year over year growth. 70% of companies are besting earnings estimates, though fewer are besting on the top line. Materials (93%), Financials (93%), Industrials (67%), Consumer Discretionary (65%), and Technology (64%) have all seen better than half of the reported companies in the S&P 500 best sales estimates.

Even more impressive, the operating margin for the group is currently 1.4% higher than expected for the 500 companies as a whole. Companies are finding more operational efficiencies, despite increasing cost pressures. Earnings strength has tailed off over the past week, and we expect this to continue in the weeks ahead as smaller companies report and the aggregate beat rate declines.

In another headwind to equity prices, earnings growth is slowing. Current expectations for the next two quarters call for an average 2.2% quarterly earnings growth, which means the year over year rate of increase is decreasing. In fact from a peak in Q1 2010 (92%), the annual rate of corporate earnings growth is declining to 35% this Q3, to an expected 13% year over year rate in Q2 of 2011. Certainly low to mid teen earnings growth can produce equity returns

The U.S. capital markets are one of the most efficient engines of capital allocation in the world. Capital is rapidly re-directed to investments addressing emerging opportunities across the capital structure. Last week, the launch of a Rare Earth Minerals ETF, after the latest export restriction by China, is a perfect example of the speed and ingenuity that few other markets can replicate.

This also underpins my concern that our markets are increasingly designed with liquidity and trading in mind, rather than with a primary goal of funneling capital from savers to productive investments. We know that the average hold period for equities has decreased from 2 years 30 years ago to less than 6 months today. Could it be the explosion of information has rendered many of us traders and not investors?

Activity in the equity markets has been very robust. The IPO market is humming, with 20 deals completed offerings in October. Deals are generally pricing and trading well, with international stories continuing to resonate with investors. This trend will endure as investors look abroad for growth investment opportunities and more cross border listings increase institutional knowledge of global markets. It is increasingly a flat world for investors as well as operators.

For energy companies, we are seeing extraordinary demand for E&P equity at the moment as investors rotate back to Energy. Many investors see energy as a fertile hunting ground for generating outsized returns before year end, and smaller cap companies are also winning in this regard. Energy XXI (EXXI), an E&P company with exciting deep prospects in the shallow Gulf of Mexico, raised $500m through a combined common convert structure. Demand was extremely strong, allowing the company to increase the total offering size by 25% from $400m against a $1.1bn market cap. The convert was 8x oversubscribed and the common, which priced down 3.7%, was 4x covered. Proceeds will be used to take out a 16% second lien note due in 2014, thereby providing the Company financial flexibility as it looks at acquisition targets. Madison Williams was a Senior Co-Manager on the offering.

The primary high yield market is so robust, covenants are being loosened and it's making the acquisition market too competitive for some. Blackstone bemoaned the competition on its quarterly call, indicating other PE firms were bidding too aggressively and making it difficult for Schwartzman's gaggle to find acquisition targets that would generate the level of returns they seek. The firm indicated it would deploy capital toward opportunities in Asia, Latin America, the energy sector, and within its GSO hedge fund unit.

Agricultural prices continue to soar, with Cotton up 4.6% last week and Corn up 3.9%. Our broader basket of agricultural commodities is up 40% in the last two months versus an average gain of 11% for the industrial metals. A mixture of printing money, a declining dollar, and erratic weather continues to push the Agricultural complex creating significant strains on developing countries. The result will be a moderating of the growth in disposable incomes for the emerging consumer class and social unrest.

Lastly, we would be remiss not to mention the gains in Natural Gas prices the past two weeks. From a low of $3.43 on October 18th, the forward month price has risen to $4.04, an 18% gain. With the current spot price at $3.35, we see the dynamics of a tight storage market as we enter the winter heating season. After retreating some in Q3, storage levels are again trending toward the upper limit of the 5 year average. While the natural gas rig count appears to be rolling over and we expect 2011 E&P CAPEX budgets to shun the gas market, the forward strip is still well below the consensus estimates for gas prices (see page 10). As we have indicated before, the technological advances on the supply side need to be met with technological advances on the demand side. Natural gas is roughly 50% cleaner than oil, its BTU content is 6 to 1 and yet the price is currently 20 to 1.