Self-Sustaining (Saut)

“Self Sustaining”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

December 12, 2011

“The violent swings in the U.S. stock market have damaged investors’ psyches, but money managers at this week’s 2012 Reuters Investment Outlook Summit see the environment as a buying opportunity. The sell-offs this year have produced low price-to-earnings multiples on the stocks of companies with world-class, global franchises and strong balance sheets, investors said. In fact, U.S. corporations still have record amounts of cash on their balance sheets ($2 trillion), which could lead to shareholder-friendly moves including share buybacks, dividend increases, and mergers and acquisitions. ’I think this is going to be a good environment for shareholder value,’ said Leo Grohowski, chief investment officer of BNY Mellon Wealth Management. Technology and energy stocks warrant overweighting, said Grohowski, adding that he is ‘slightly overweight financials.’ He predicts the benchmark S&P 500 index will end 2012 at 1,350 points, an 8 percent gain from current levels. For the most part, money managers like Grohowski think bad news from Europe is already priced into the markets. ‘The economy globally is much stronger than people think,’ said Ken Fisher, chief executive of Fisher Investments, who said he is overweight anything ‘economically sensitive’.”

. . . Reuters News, 12/7/11

As I read the above quip from the Reuters organization, I could not shake the feeling that it was me who wrote said article. Indeed, the volatility of the past five months has clearly dampened investors’ psyches to the point where the world is profoundly underinvested in U.S. stocks, which I think may be one of the best investments you can make over the next few years. Verily, hedge funds are having a terrible year, having been caught “short,” as well as underinvested with only a 43.8% net long investment position. Or how about the endowment funds that are only ~12% net long U.S. stocks? How can those endowment funds achieve their mandates of roughly 8% per year using 2%-yielding 10-year Treasury Notes? The answer is they can’t! Then there is the retail investor that is so freaked out they never want to own U.S. stocks again. Ladies and gentlemen, for the well prepared investor, who raised some cash last March/April, the July – August decline presented a great opportunity to reinvest that cash because the S&P 500 (SPX/1255.19) has rallied more than 17% from its recent reaction low. Moreover, I think there is more to come on the upside.

Consider this – it looks to me like the economic expansion is becoming self-sustaining, as can be seen in the attendant chart on page 3 from our friends at the Bespoke Investment Group, whose Economic Diffusion Index is near a six-month high. The self-sustaining sequence goes something like this: vehicle sales increase, vehicle production increases, employment increases, retail sales increase, profits increase, capital expenditures increase, credit expands, employment increases (again), and the virtuous circle repeats. Clearly there are potential headwinds – Iran could erupt, leading to $150+ per barrel oil, real estate could have another death spiral, our elected leaders could make a policy mistake, Euroquake could implode, etc. Yet, it increasingly seems to me that none of those ”boogie men“ are going to burst on the scene.

However, last Thursday it was a subtle sneak preview from the Euroquake “boogie man” that spooked the equity markets when Mario (3-card Monte) Draghi pulled a “now you see it – now you don’t” card trick by contradicting a “street friendly” statement from the ECB that hit the news wires just 10 minutes before. That sleight of hand caused a Dow Dump of 198 points. By Friday cooler heads had prevailed when the ECB clarified its comments. While the restatement fell short of the 50-basis point reduction in interest rates, as well as the equivalent of a QE2 type of announcement investors were hoping for, the ECB still made some pretty big moves. For example, the ECB now has a complete set of tools to provide unlimited liquidity to the banks. As the astute GaveKal organization writes:

1. “Two major three-year refinancing operations, on December 21st and on February 28th 2012, with full allotment. This will provide plenty of liquidity to banks, as well as drive the money market rate below target.
2. Easier ECB collateral requirements. Moreover, national central banks will be allowed to accept bank loans as collateral; one could see it as a sort of generalization of emergency loans (ELAs) that individual EMU central banks can provide to their local banks in distress – if so, this would be very expansionary.
3. Banks’ reserve ratios have been cut from 2% to 1%.
4. Fine-tuning operations are being discontinued.
5. Cheaper USD swap lines with less collateral (from an initial margin of 20% to the current 12%) will lessen the impact of a US$ crunch and cap interbank rates.“

We think you will see additional positive comments this week when the FOMC releases its policy statement Tuesday afternoon (2:15 p.m.). To wit, parsing recent comments from Fed Governors suggests there is another QE2 type of maneuver in the works. Accordingly, to the underinvested crowd the current news backdrop continues to be a nightmare.

Speaking of underinvested, consider this insight from The Economist:

“Meanwhile, the financial assets of developing-world investors are growing fast, but such investors tend to have a very small exposure to stock markets. Indians have only 8% of their wealth in equities. As they get richer, investors in the developing world will diversify their portfolios. McKinsey estimates they would have to raise their equity allocations to the 42% owned by American households to close the gap completely.”

Consistent with these thoughts, we continue to favor the upside unless the often mention 1217 level on the SPX is decisively violated to the downside. For trading ideas playing to the upside seasonality, we screened our research universe looking for the favorably rated stocks that have had the best relative strength since the “buying stampede” began on 11/28/11. That list includes: Dollar Tree (DLTR/$82.55/Strong Buy); Mastercard (MA/$377.42/Outperform); Nuance Communications (NUAN/$24.74/Strong Buy); Polaris Industries (PII/$59.80/Strong Buy); Ulta Salon (ULTA/$74.06/Outperform); and W.W. Grainger (GWW/$186.52/Outperform).

We have encouraged investors to consider numerous master limited partnerships (MLPs) over the past three years. Many of these stocks have done well and we continue to like the group overall. Last Tuesday our MLP analysts upgraded their recommendation on 4.4%-yielding Tesoro Logistics (TLLP/$31.74) from Outperform to Strong Buy. Their reasoning goes like this:

1. Stable, fee-based model provides solid DCF foundation. Ninety five percent of its 2011 revenue is backed by long-term, fee-based agreements, which carry minimum volume commitments. Tesoro Corp. (TSO/$21.79/Underperform) must pay regardless of whether it actually utilizes the partnership`s assets with fee adjustments to protect against inflation.
2. Multi-faceted approach to growth: $100 million 2012-2013 organic growth program (Bakken-focused), Martinez crude oil terminal dropdown to drive approximately $100 million run-rate EBITDA in 2013. 2012-2013 organic growth capex should approximate $100 million, double our $50 million forecast, likely reflecting 3-5x EBITDA (15-20%+ IRR fully financed). Focus will remain on the Bakken, related to increased volumes from third party contracts and a 50% increase in trucking volumes, driving $25-$35 million of incremental EBITDA by the end of 2013. In addition, the Martinez terminal acquisition is expected to contribute $8 million of EBITDA. All in, growth stands to exceed 2011 run-rate EBITDA by roughly 50% in 2013.
3. Compelling valuation. Based on the aforementioned growth drivers, we model 2011-2014 distribution CAGR of 12.5% with conservative coverage above 1.4x. Our revised $33 target price is based on a conservative 6.25% yield (140 bp above the stock`s current yield). Each 25 bp of additional yield compression adds $1/unit to our target price. Total return target is 17-18% (+500 bp above peer average).

Please see the company comment dated December 6, 2011 for the full story, including the full justification of the price target.

The call for this week: Last week the ECB’s interest rate cut took center stage, but that “cut” should be viewed within the context of the 40 world wide interest rate cuts that preceded it. Clearly, there is a global easing cycle underway; and, we think you will see more such news this week when the FOMC announces it policy statement Tuesday afternoon. Accordingly, I think stocks will continue to grind irregularly higher driven by portfolio managers trying to play “catch up” (read: performance anxiety), the upside seasonal bias, low valuations, improving economic trends, still depressed sentiment readings, and the knowledge that we have now entered the best performing six months of the year for stocks. And don’t look now, but our Analysts Best Picks for 2012 will be released after the close today.

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