The View From Los Angeles

[dan_s]

Good morning from Los Angeles. It is a beautiful day out here, actually very cool. A nice change from the heat and humidity in Houston.

Susan and I are out in LA visiting my son Chase and his lovely wife Eyrun. Thought I'd post a few thoughts while everyone is getting ready.

With oil prices hanging tough so far, it is now fairly certain that 2nd quarter results for the Sweet 16 are going to be quite strong. My only concern is that several of our favorite companies have significant operations up in the North Dakota Bakken. Western ND has had lots of rain and flooding in many areas. I'm sure the water is making it difficult to get wells completed. Spring is always a mess in North Dakota.

GPOR and DNR are both selling a high percentage of their oil into the Gulf Coast market, getting over a $10/bbl premium for that oil. I don't see any evidence that the analysts are picking this up in their forecasts provided to First Call, especially for GPOR which is selling 85% of their oil at up a $15/bbl premium to WTI prices. GPOR gets the premium on their hedged volumns as well.

It has been bone dry in South Texas so look for a lot of progress from those companies drilling in the Eagle Ford (ROSE, GEOI, CRZO) and the Permian Basin (XEC, GPOR, AREX from our Watch LIst).

MIND should be reporting very strong 1st quarter results on June 6. I'm expecting the share price to run up into the announcement.

Gran Tierra (GTE) should be reporting a 3,000 BOPD increase in production for the 2nd quarter. IMO GTE is a STRONG BUY. It is heavily weighted to oil, virtually debt free and it has incredible exploration upside.

TransGlobe Energy (TGA) is now officially back in the Sweet 16, replacing Newfield Exploration (NFX). There is nothing wrong with NFX. It is still more than 15% below my Fair Value estimate. Something just had to go and it was the closest to my Fair Value estimate.

China's demand for diesel fuel is going way up. The fuel is needed for power generation. This will offset any decline in demand caused by high gasoline prices in the U.S.

There are some milestones coming up for the market in the next 90 days. Below are some thoughts from Fidelity Investments research team:

Milestone 1: End of QE2
The Fed’s $600 billion QE2 program is scheduled to end in June. Will risk assets like stocks and commodities be able to stay up without the Fed’s steady medication that the market has come to rely on? Or is the system healthy enough to survive without life support?

There are bullish and bearish arguments.

The bullish arguments: Everybody knows that QE2 is about to end, so it is “in the market” and therefore no big deal. The economic expansion is now entrenched enough that QE is no longer needed. The jobless rate is finally coming down, manufacturing surveys continue to show strength, and company earnings are robust. Finally, even though the Fed is about to stop easing, it seems unlikely that the Fed will actually tighten any time soon, either by letting its balance sheet shrink or by raising rates. We could get a period of “QE2 Lite,” where the Fed continues to reinvest maturing bonds, to give it some more time to assess things. I think only after a sustained period of strong payroll growth is the Fed likely to shrink its balance sheet (either through attrition or asset sales), let alone actually raise rates (which I believe might not happen until 2012).

The bearish arguments: For one, a year ago we all knew that QE1 was ending in March 2010, yet that didn’t prevent the S&P 500 from correcting 17% that summer (although the end of QE1 was by no means the sole cause). Also, it’s an undeniable fact that since the March 2009 low, the rally in stocks and other risk assets has been almost perfectly correlated with an expansion in the Fed’s balance sheet. Therefore, the thesis that the market can stand on its own two feet could be something of a leap of faith (but I guess there is only one way to find out). Finally, the U.S. economy seems to be weakening somewhat, just as it did a year ago, judging by the decline in the Citigroup Economic Surprise Index (shown below), which looks at economic releases and compares them with expectations. When the data come in better than expected, the index rises; when data are weaker than expected, the index falls. The current decline shows a loss of economic momentum, and could affect bond yields as well.

There’s also the ongoing weakness in home prices. At the same time, Europe is still spreading deflation via not only its fiscal austerity (old news) but now also a tightening in central bank policy (new news). Put all this together and one can conclude that the deflationary winds could blow once again, right at the same time that the Fed is about to stop easing.

Milestone 2: U.S. debt ceiling showdown
The looming showdown in Congress over the debt ceiling is another milestone, especially since Standard & Poor’s placed U.S. debt on “negative watch.” While few observers actually believe that anyone would let the debt ceiling stand and therefore allow the United States to go into default, the political parties are far apart. I think that there may be a game of chicken up to the “drop-dead” deadline of July 8 before an agreement is reached on raising the debt ceiling. The closer it gets to that date without a deal, the more havoc it may wreak on the dollar, Treasury yields, and asset prices in general.

Why could this be such a nail-biter? The two parties are miles apart on ways to cut the budget. The Republicans want to cut $6 trillion, mostly through spending cuts, and the White House wants to cut $4 trillion, mostly through increased taxes. My thoughts on this are that the Republicans may be inclined to keep pressing hard on their plan out of fear that if they compromise with the president, it could provoke the Tea Party movement to splinter off into an official third party during the 2012 election cycle. And I feel that has the potential to hand a victory to President Obama the same way that Ross Perot did to Bill Clinton in the early 1990s. This dynamic is probably not lost on the Democrats, giving them that much less incentive to compromise with the Republicans in the hope of forcing a split.

Milestone 3: Debt crisis in Europe
The European debt crisis that began in January 2010 just doesn’t want to go away. The crisis first flared up in January 2010 (Greece). It then subsided but flared up again in the summer of 2010 (again, Greece). That prompted decisive action by the European Union (EU) and the European Central Bank (ECB) through the creation of the European Financial Stability Facility (EFSF) and the buying of peripheral debt. Again, the crisis subsided, but then it flared up again in late 2010, this time in Ireland. Once again, things settled down. But now it’s flared up in Portugal, and Greece is becoming an even bigger problem than before.

As the chart below shows, the spread of 10-year Greek bonds over German bonds (the benchmark) has now reached 1,200 basis points (or 12 percentage points), wider even than the 968 basis points reached earlier this year and the 965 basis points last summer, when the EFSF was first created. And the spreads between the Irish and Portuguese bonds and the safer German bonds are also showing that investors are demanding much higher interest rates.

From my point of view as an investor, there are three issues in Europe. First, Greece needs to restructure its debt. In my view, it’s just as plain as day. If you can’t grow your way out, which is unlikely with forced austerity, and you can’t inflate or debase your way out, which is impossible given that Greece has neither its own currency nor its own monetary policy, then the only way out is through a debt restructuring. So why isn’t this happening? Because too many European banks, insurance companies, and pension funds own either Greek sovereign or bank debt. If Greece defaults, everybody loses. The result? More limbo.

Second, why is the ECB raising rates and shrinking its balance sheet while the periphery is bleeding? I would like to know. Is there a deflationary policy error in the making as a result of the ECB’s seemingly myopic focus on inflation? Could well be. Imagine this scenario in the United States: We have fiscal austerity at the state and local level (which we do) and at the federal level (which is possible), and, on top of that, the Fed starts raising rates and shrinking its balance sheet at the same time. That would not be a pretty picture.

Third, Spain is the real key, in my view. If the contagion spreads to Spain, the crisis could overwhelm the rescue structures that the EU has in place. In my opinion, that is when the euro could weaken dramatically, like it did a year ago. If the euro goes down, then the dollar likely goes up. And if the dollar goes up, it is akin to a form of monetary tightening. If monetary tightening spreads to the rest of the world via a stronger U.S. dollar, that could have negative repercussions on emerging markets and commodity prices. And so on. That’s the very definition of contagion.

Fortunately, this is not happening so far, and judging by the spread on Spanish debt to German debt, it is not expected to happen. As long as Spain is able to be ring-fenced, it seems unlikely that the European debt problem will spread to the United States and the rest of the world. That would be a good thing.

What’s the next milestone for Europe? Europe’s banks are currently undergoing their third stress test. The irony is that these are scheduled to be completed by the end of June and reported in early July, coinciding with the debt ceiling deadline and the end of QE2.

[dan_s]

May 28, 2011
The End of the World
by Elliott H. Gue

The media frenzy over Harold Camping’s prediction that the world would end last weekend is a sad commentary on the state of domestic news reporting. I particularly enjoyed coverage of Camping’s admission that he had miscalculated the date (which is now Oct. 21, 2011, in case you want to prepare).

An equally dubious doomsday cult holds sway on Wall Street today: Bearish commentators who predict that the sky will cave in.

Make no mistake about it: US economic data have softened over the past month and a half. But alarmist rhetoric about the economy “hitting a wall” is vastly overdone and reminiscent of the calls for a double-dip recession last summer.

At this point, recent weakness in economic data appears to be a temporary soft patch--not the beginning of another recession.

That being said, my outlook will change if I see signs of a more dramatic downturn or persistent weakness in the key indicators that provided advance warning of the Great Recession and enabled me to call the end of this historic contraction before the National Bureau of Economic Research gave the official word.

In last week’s issue of Personal Finance Weekly, I highlighted a worrying trend: the major uptick in jobless claims over the past few weeks.

Last week, I argued that seasonal adjustments, coupled with a handful of special factors, have contributed to the recent spate of disappointing employment data. For example, a shortage of car parts from Japan has caused a temporary slowdown in the automobile industry, making the economy’s recent wobble appear worse than it actually is.

Last week’s data on initial jobless claims support this assessment.

The number of initial jobless claims--people filing for first time unemployment benefits--has trended steadily lower since the beginning of 2009.

This rate of decline slowed last summer, but quickly resumed by the end of 2010 and into early 2011. When initial jobless claims spiked in early April, this sudden shift alarmed investors.

By the end of the month, initial claims had spiked by more than 100,000 from a low of 375,000 in mid-March. Last week, initial claims came in at 409,000--in range with the January and February numbers.

This improvement reassures me that temporary factors are the main driver behind the weakness in initial claims data.

However, I will watch these numbers closely in the coming weeks in case they flash a warning sign about the direction of the economy.

What’s more troubling is the recent weakness in the Institute for Supply Management’s Non-Manufacturing Purchasing Managers Index (PMI). I see no reasonable explanation for its recent deterioration other than actual softness in the service sector of the economy.

Manufacturing and Non-Manufacturing PMI are among my favorite leading indicators of US economic health. Readings above 50 indicate growth, while levels under 50 suggest contraction. The general rule of thumb is that a reading below 46 or 47 indicates that the economy is headed for recession.

As you can see, the Manufacturing PMI is hovering above 60, a reading that’s consistent with overall economic growth of about 4 percent--quite a difference from the 1.8 percent pace logged in the first quarter. Meanwhile, Non-Manufacturing PMI pulled back sharply in April, to levels last seen in summer 2010. Nevertheless, this leading indicator still indicates that the economy is growing.

But the severity of the decline bears close watching.

Bottom line: The US economy appears to have hit a soft patch. This growth scare acts as a headwind for stocks and has hit high-flying commodities.

Looking beyond the next month or so, I see this as a wobble not a downturn; the US economy should grow by roughly 3 percent in 2011.

Rocky, But Not as Bad as 2010

You should be aware of these headwinds and adjust your investing strategy accordingly.

But don’t let the doomsayers make you panic: The US isn’t headed for recession this year. In fact, I believe investors are overreacting and this decline will ultimately prove a solid buying opportunity.

First, it’s worth noting that although recent data have weakened, we’re a long way from levels that would indicate outright recession.

Second, because the Non-Manufacturing PMI is based on a survey of companies in service-related industries, it’s logical to assume that the spike in oil prices may have had a temporary impact. If that’s the case, the subsequent pullback in oil should be a positive. I’ll be watching to see if this holds true.