Monday, April 27, 2009

The technical case for a short trade in NUE

NUE looks good technically only on a short term basis. Positives include – October 08 lows held in November and late feb/early march 09 retest held well above the prior lows. Its also technically positive that the recent move came on solid volume and exhibited good relative strength. The stock’s short term moving averages have also turned up. The best one should say about this chart is that the longer term downtrend has lost its momentum and the shares have perhaps (and I stress the perhaps) stopped going down so one might conclude that new lows are unlikely at this point. But even that might be presumptuous as if you view this chart on a longer term basis (like on the weekly chart) the chart looks like the primary trend is still down. The way I see it, it appears that a 5 year uptrend has reversed and a major top has been completed. There was major support in the $46 to $48 area which failed last year. That failure was subsequently retested and failed. Since then, the sell off accelerated and came on higher volume and worsened relative strength. The shares proceed to get cut in half after trading down over 50%. The whole peak to trough move took roughly 70% off the shares. The shares have since exhibited impressive support below $30 (bouncing sharply from that level a number of times). Now the action since the October low and today has measured a roughly 70% and in my opinion represents not a reversal of a primary trend but a consolidation of a hard and fast 70% peak to trough decline. The shares are up almost 70% off that October low and the latest move (since the beginning of march) equate to a roughly 38% move. And that retracement has now traced out a 3 lower highs on a weekly and coincidentally a daily.

Thus I think that taking a short trade here is a good risk/reward. On a short term basis, it stands to my technical reasoning that $37.60-$37 area is the next stop, and I expect that level to find fleeting support which ultimately fails. Given the recent momentum and sentiment shift I don’t expect this to be a lay-up so I would go small initially and/or look to cut a sizeable position in half on a move above the recent high near $44 (say $44.60), because major resistance is in the $46-$48 area. I would however lay it out in size north of $45 because I do have confidence that there would be no fundamental justification for long buyers anywhere near $45. I think NUE is the best house in a bad neighborhood and I think they’ll struggle to earn $3 in 2010, so a $4.50+/share earnings estimate for 2010 has nowhere to go but down.

Misplaced hope is Steel and Energy yields opportunity on the short side

Energy demand continues to deteriorate beyond bearish expectations, yet the ranks of the bulls have swelled as many look past near term supply demand imbalances on the idea that significant and rapid declines in rig counts will lead to equilibrium in supply and demand such that inventories will decline to levels closer to 5 year averages. I don't doubt that will ultimately happen but I do strongly doubt that it happpens as fast as most think. Furthermore, I'm confident that any recovery will be gradual and less vigorous than most suspect as I think a new normal, inconsistent with inventory levels during the recent period of strong global growth. We'll need a rapid and substantial economic recovery for crude and distillate prices to make meaningfully higher price moves and we'll need growth and hurricane related supply disruption for natural gas to find its new equilibrium anytime soon.

I continue to think that natural gas production, supply and inventories are not likely to fall as much as declines in rig counts suggest. I expect natural gas prices to remain soft until late this year and think that rallies can be significant but are likely to be short lived as fundamental support fails to manifest. Industrial demand continues to surprise on the downside. Demand from manufacturing, steel and chemical industries continue to weaken. We remain in the grips of a global inventory de-stocking dynamic which appears to have reversed in Asia as what I believe is opportunistic purchasing of raw materials like scrap steel, copper, lead and zinc by the Chinese. I think that raw material stocking is apt to subside going forward as it is unsupported by sufficient end market demand. Demand though likely stronger and more responsive to Chinese stimulus given the more rapid and proportional measures is likely in my opinion only to soften the blow of the current global recession rather than leading to a resumption of rapid growth.

Similarly, consumer demand for gasoline continues to soften, so refinery utilization is low and unlikely to rebound meaningfully as distillate inventories are also on the high side. And continued ramping of low cost middle eastern natural gas and LNG production is likely to keep natural gas prices under pressure globally. In this context, hope related to an economic recovery driven by infrastructure development supported by U.S., Chinese and Eurozone stimulus should fade. Thus I think the time is right to press the short side in steel and energhy once again as it appears a reality check is imminent. In this context, NUE, DVN, XTO appear particularly vulnerable to me.

Friday, April 3, 2009

Time to get less long and more short

Think the time has come to step off the offensive accelerator and reduce long exposure and increase short exposure; in other words, position more market neutral. The market is up 20% in a month and extended on a short term basis with many economically sensitive names with poor near term prospects and unclear longer term prospects up significantly. The bulls are out in force and shorts are being forced to cover. The move from 666 to 800 was understandable as cataclysm risks faded when the treasury moved on asset purchase programs and committed to save too big to fail banks equity investors by any means necessary.

Moves to effectively force a preferred for equity swap with a signal that the treasury would also push a move up the capital structure and swap debt for equity as necessary to effectively share the capital burdens between debt and equity investors to keep the banks in the private sector put the screws to the shorts as they effectively changed the game. Regulators also moved to ease the balance sheet pressure levied by mark to market rules.

Clearly positives for equity investors in banks and to the extent that they fostered viability (perhaps regardless of solvency), these moves were a positives and understandable improved sentiment and forced short covering. What these moves don’t do however is make all well and good in the world. Credit markets are still under pressure, consumer spending, incomes, wealth, business spending, capex, and corporate earnings are all still under pressure. European macro fundamentals appear to be deteriorating fast. There is no reason that I can see to believe that consumers or businesses will be in a position to spend more anytime soon. And at some point soon, equities will need fundamental support.

For all those reasons, I’ll be stepping up the short exposure today. I recognize the technical momentum at hand so I’ll do it slowly and expect to deal with a little pain in the short run. The fundamentals, earnings and valuations are my shepherd but the volatility and countertrend moves in an uncertain but hope induced market are a killer so I must continue to adjust market exposure accordingly.

I’m still very bearish on natural gas and still bearish on steel. I let a very nice gain in NUE disappear by only covering half on a terribly negative preannouncement and letting the other half go 10 points against me. That always sucks because I thought about covering the whole thing and putting it back on a few points higher. But I didn’t so that’s spilled milk and some pain in the PA as they say and I’m not going to cry about it. That said, I’m going to short more this morning as the fundamentals have turned from incredibly good to disaster yet hope reigns supreme as investors look to NUE as a play on early cycle macro sensitivity as well as global stimulus related infrastructure. That’s optimistic to put it mildly, naive might be a better description. Anyway you cut it I'm still betting that estimates still have to come down more for the balance of the year and next year and think the shares would be under pressure as that happens because they aint cheap.

I continue to think that NUE is clearly the best house in a bad neighborhood that is going to stay bad for many months to come. NUE’s residential and commercial construction, auto, infrastructure end markets are not coming back nearly as fast as bulls hope. Although NUE typically benefits from scrap declining more than end market pricing, as well as lower energy (natural gas) costs, costs can not decline fast enough to stave off severe margin pressure because volumes have plummeted. NUE and most of its competitors are suddenly operating at 40-45% utilization rates. At such levels, companies like NUE simply are overwhelmed by negative operating leverage. Demand and pricing would have to recover significantly to change the revenue and margin pressure dynamics and I don’t see that happening anytime soon. Pricing might stabilize as the industry has done a great job of making regional and product markets less competitive through consolidation and have now move to shut capacity quickly so inventories don’t balloon. However, volumes need demand to recover in a big way and there are too many end markets under severe pressure to expect that to happen soon. That’s my call on I’m sticking to it.

Wednesday, April 1, 2009

The case for being short Natural Gas equities

Oil and Natural Gas equities have rallied on the prospect of an economic recovery, reflation gaining traction and dollar weakness. Although I do understand (and agree) that dollar weakness should act to support all commodities in general, I’m confident that the fundamentals on the whole favor sustained weakness in prices as supply, demand and inventories are all likely to pressure prices both short and long term. If the emerging view that rapidly declining land rig activity signals a speedy return to balance in natural gas supply and demand as inventories get drawn faster than is generally expected is incorrect (as I believe it is); then you have an excellent opportunity to short natural gas levered equities like DVN, XTO, CRK and RRC.

If I’m right, then sustained natural gas price weakness is apt to weigh on profitability, cash flow and multiples. Estimates for 2010 would have to come in considerably and multiples would compress such that shares of most nat gas producers would decline significantly. And I have little doubt that the bulls, which hang their hat on significant rig activity declines leading to meaningful production declines, will be wrong. They'll be wrong because although land rigs are coming offline at a rapid rate, the production decline is likely to be less sensitive than generally believed and has historically been the case. I think production will remain high for several reasons but the most under appreciated in my view has to do with the nature of recent production increases. Its going to take many more rigs coming offline than most think in order to re balance this market and get prices going up meaningfully.

Recent production increases have come from relatively low cost shale plays which have been, in many cases financed with increased debt on balance sheets of companies which, in many cases, bet their balance sheets on sustained high prices. In prior cycles, it had been the case that relatively high cost resources (which required high prices to be profitable) came on line in the late stages of a bull market in energy. Similar to what has happened to oil sands and the like. In the current cycle, unconventional gas plays like the Barnett, Fayetteville, Marcellus and Horn River Basin shale plays have ramped at a higher rate and faster pace and have done so on favorable unit costs and overall superior economics. The Finding and Development costs have surprised to the downside as the initial production has been much better than expected in most cases while improved technology has also led to a lower initial decline rate, as well as, a fatter tail with regard to out year decline rates.

The net net of this is that the recent industry production additions are profitable on lower prices. The important drivers as I see them are all have risks to the bearish side. On the demand side, industrial and residential demand both have risk to the downside in my view. Utility demand might increase slightly but it is likely to happen as utilities let lower prices come to them. And even at $4/mcf, coal is competitive and often hedged more so than other utility raw materials. If you also consider competition from alternative energy sources this cycle, its reasonable to expect sustained price weakness.

On the industrial side, demand related to chemicals, steel, fertilizers and other industrial end markets all have risk to the downside in my opinion. And if that wasn’t enough, there has been a tremendous amount of LNG capacity that has come online in recent months. Huge fields in the middle east, north sea and russia have ramped. Some of the largest fields in the world (in Quatar and Kuwait). The north field in Qatar is huge (probably the largest ever) and it has ramped up, importantly with liquification capacity at a time when worldwide inventories are high and demand in Europe and North America are weakening significantly. With shipping rates down sharply, LNG can be delivered to North America at $1.50/mcf. With nat gas in the high $3s still and demand in Europe and Asia weakening, its quite likely that LNG imports to the U.S. will rise meaningfully, and take share from conventional gas.

Although I do agree that energy markets are self correcting, I think that the market is underestimating the duration of the adjustment phase. By all accounts, supply is likely to continue to surprise on the upside while demand surprises on the downside. There has been billions of dollar of capital invested in capacity expansion whose variable costs are relatively low and the associated debt must be serviced even though all in cost economics suggest such production is better shut in.

So a wash out is in the making and although I do think the market is likely to correct sometime in 2010, there will be a lot of pain in the meantime. First class companies like DVN will struggle to be profitable. Excellent operators like XTO will see their solid 2009 cash flow consumed by debt service and be forced to hedge 2010 production at substantially lower prices than 2009 was hedged at. Many of these companies managed to hedge the bulk of their 2009 production at $9+/mcf. Today, spot remains under pressure and the futures continue to flatten out through 2010. This suggests that bullish promoters like T. Bone Pickens and Aubrey McClendon are crazy to expect a return to $8 or 9/mcf anytime soon. More importantly, persistent price pressure and futures price weakness suggests that all substantially unhedged nat gas producers will have no choice but to eventually hedge 2010 production at prices less than $6/mcf at best. And at such prices, most natural gas companies are barely profitable. If that turns out to be the case, then estimates for 2010 are way too high and most if not all companies are going to guide down and/or miss expectations over the next few quarters. The current stock prices would thus be significantly overvalued.

Full Disclosure: Have been short CRK, for months and just put DVN on friday.

Thursday, March 19, 2009

Of Dollars and Sense - Havent I've seen this movie before?

On January 29th of this year, I wrote a comment to a crowd of writers and readers at SeekingAlpha on the semantics of the many Milton Friedman disciples which were essentially arguing that inflation wasn’t inflation unless it was accompanied by simultaneous increase in money supply. Ridiculous I said, because the author wrote what seemed like a 10 page tome which not once mentioned purchasing power. My counter-argument was that purchasing power was what really mattered as that’s what dictated consumption which at the end of the day also dictated production, profits, incomes, spending, investment and everything that makes the world go round (or not).

I went on to say, “And I'll say upfront that I agree that the inflation we all know but don't love is apt to surge in a way that can put us in a banana republic sort of conundrum; I just am not convinced it's around the corner, because I think the current economic circumstance is likely to suppress demand more and longer than most think, credit has changed dramatically, and there is likely to be a transmission problem with regard to getting that credit into enough hands that can overwhelm the enormous amount of excess capacity in product, service and labor markets that have been created almost overnight. So there's no telling how long deflation (not the asset kind, but the kind that increases purchasing power meaningfully) is apt to persist because this is anything but a free market economy anymore - ie. the Fed is likely imo to be successful in keeping rates low and the dollar from collapsing in the near term. But some day in the not too distant future inflation will get going and it will inflict pain of the non-theoretical kind - your and my pocketbook and bank accounts and by extension our quality of life. It’s just near impossible to predict when and to what extent but also how far and long deflation goes before it turns. My guess is that wont happen until the economy here and globally improves - which I doubt happen anytime soon. People looking for a 2nd half recovery are way off; we'll be lucky if happens by year end 2010 IMO.”

Yesterday afternoon I saw what the fed announced and saw the dramatic movement in treasuries and sell off in the dollar and immediately thought that I might very well have to re-think how fast that inflation shows up. My reaction was to buy a couple of small positions in gold miners and try to fade treasuries via shorting the TLT. I had been looking to get long gold shares and thought the setup was upon me but I wanted to wait one more day because several gold related charts I saw looked as if they had developed mini head and shoulder tops and I thought they would try to complete those patterns before failing (in a downside break) and that would set off a sharp move higher (accompanied by short covering by early top callers) in gold equities. By the way, I like taking advantage of failed patterns; there are a few that I play whenever I see them, this is one of them. So I bought a little GG and AUY; and that came out of a toss up between NEM, GG and AUY. Actually thought that NEM might be the safest of the 3 but went with the 2 I thought might move most. I have long thought that the dollar must decline precipitously going forward as longer term fundamentals required that (as did the survival of our country’s manufacturing base). And when it started, I thought the Fed and Treasury would welcome the move and not look to thwart it, I just wasn’t so sure the moment was upon us in late January.

So that’s what I’m thinking now, long gold, U.S. equities should retain a bid, I’m not so sure the same is true for global equities. I am also looking to fade a couple of natural gas stocks as the commodities rally. I’ve been short a steel stock and a couple of nat gas stocks for a while now and will look to add to those positions as the move against subsides. I also put a small long on a refiner in order to hedge my negative nat gas bets in the very short run. I’m not so sure its time to go all in on the refiners yet but figured they should move on a vigorous dollar decline so I took a small shot there and it caught a nice bid. I plan on keeping that on a short leash, I’ll cut it as soon as it turns into a loser or 15% higher, whichever comes first.

Last thing I’ll say and I’ll comment more on this soon, is that yesterday’s moves reminded me of The early 1950’s (think it was 1951) Fed – Treasury accord, so I started to think this was a re-run of that episode and I wondered what the implications were, wondered if the dollar should really collapse fast and/or inflation might surge sooner and faster than I thought, and if it was in fact a re-run of that episode, would some sort of price and wage controls be necessary and what were the implications of that. I have to think more about that and get back to you on that but it really had me scratching my head.

Tuesday, March 10, 2009

A few thoughts on playing offense and defense as the world turns

Still doing my best to get the full site done as soon as I can – its been any day now for a month but I’m making good progress and at the point where I’m polishing it up, working out some programming kinks and testing a few features; it should be done and ready to launch this weekend. Pretty exciting as I think it will be good.

In the mean time, I figured I’d share a few quick thoughts on today’s massive rally. If you’ve read my posts you know that I’ve been very bearish for a long time now, especially on banks, energy, ag equipment and steel. I’ve been long a few healthcare names and building a position in an industrial name I will discuss in detail soon. In the last week, I tried to get a little cute and play for an oversold bounce and rally in crude which whipsawed me – got long, sold long, got short and covered short at the open today (thankfully did it small). I also have been buying a battery company, caught a nice quick move in GE (not typical for me b/c been avoiding troubled names no matter how apparently cheap; but thought I catch a 15-20% move in a couple of days so I took a shot with a 5% stop Friday and sold this morning), and a bought a small bank and japanese consumer electronic name at the open today.

I also covered half of 2 small positions in natural gas stocks I’ve been short for a while now (still negative), and covered half of a short position in a steel name. And yes, I wish I covered the whole thing but I’m committed to staying short some natural gas equities because I think many are still too bullish, the market is positioned to keep prices weaker, longer than most expect and sentiment is still not sufficiently bearish given fundamental developments in recent weeks and months. I’ll have more to say on that soon as I discuss more nat gas shorting opportunities in the coming days. I also covered my ag equipment short way too early (couple of weeks ago almost 5 points and 25% higher).

Even though I thought the economic and earnings backdrop are as bad as they’ve ever been, and most companies were likely to see earnings and outlooks under pressure, I started covering shorts and taking shots on the long side because I thought sentiment was catching up with reality and the reality of economic unraveling and its ramifications were finally becoming properly appreciated. Thus I felt that oversold conditions, coupled with heightened fear and the capitulation type selling in most names set the stage for a substantial bounce – something on the order of 15%-20%, which equates to a move back to 765 or as high as 800 in a best case (20%) scenario in the S&P500. How low a low this is remains to be seen.

Even though I thought we’d see a sharp rally today, I kept some of my shorts on because I didn’t think the bounces would be as strong as they were in energy and materials and I want to remain short some of these names for the next earnings report and thought it would be too difficult to be nimble enough to do much better trying to hop in and out and back in. Its typically the case that I catch a nice move lower in a short, cover on a 15%+ gain in a few weeks and avoid the couple day 10% bounce and miss getting back in fast enough to play the next leg down that I knew was coming.

So that’s how I played a few volatile days; where I felt the market was very oversold by all measures, and sentiment had gotten extremely bearish. Now the hard part, how long to stay as long as I’ve been since last July and when to add back more short exposure? The short answer (and of course this is subject to change without notice) is not so fast. Given the breadth and strength of the rally with solid participation from Techs, Financials, Industrials and Cyclicals, I plan on staying with a relatively net long position for at least tomorrow and probably the next few days.

So the moral of the story is that I think you have to stay true to well reasoned secular views but also be conscious of market conditions and sentiment and thus ready and willing to act somewhat nimbly (yes I know that’s oxymoronic) when a reversal has a relatively high probability. The high volatility makes it difficult to do wholesale so I scale in and out of positions and net market exposure. So I’m not up as much as I could be on a day like this, but I can usually add risk adjusted out performance on day 2 through 5 or 7.

I think it could take another 3-4 days to get to 765 and think 800 in the next couple of weeks wouldn’t be a shocker so I’ll look to get more long in the first half hour tomorrow (mostly at the open), and I’ll look to scale into some shorts and out of some longs as we approach 765 or more. My biggest mistake in the last year have been not staying short as long as I would have liked to; trying to be too nimble. In recent weeks, and months I've dealt with that by not completely covering shorts which I'd like to stay in and putting on longs, in spite of my longer term market view. And thats worked very well.

On another note, a friend (who knows I’ve been a gold bug for a while now, but out as of 2 weeks ago) asked me about shorting gold here and my reply was that although I wouldn’t, I wouldn’t be surprised if that worked for a couple of days but I’m not doing that because I don’t think the party is over. I think there is at least one more leg higher, thinking $1150/oz. by year end so I’ll be looking to get long some (of the equities, not the GLD if/when gold hits $850 because I think it can find support there and is very likely to find support near $800. This entry is going to be really tough I think because I'll want to chase strength which could be fleeting in the very short run; we’ll see.

Monday, February 23, 2009

Response to American Labor Arbitragers Everywhere

This is a response to an economist who suggested that we weren't really losing many manufacturing jobs and it wasn't a big economic deal to begin with. the guys went on about how we would focus on solid productivity as trumping both massive manufacturing job losses and ewer well paying jobs domestically. Both naive views in my mind so I had to do my best to enlighten the easily convinced:

Less people making less to produce more (productivity) is great for the business owner, but it is not in the best interest of us as a nation. When you forsake the ability to produce labor intensive goods you also give up the ability to innovate in the future and create value accordingly. You give up the ability to add value (however small) at each step in the value chain. You can bet your half baked theory that someone will create significant innovations in autos, machinery and the like at some point and it wont be us

There are universities in China that have majors in things like bra engineering - and they now produce differentiated, value added bras that our wives spend $50 and $60 in Vicki's hush hush. For now that value creation is being split nicely in the retailer's favor but its a matter of time till there are bootlegs available for half that price and it then becomes the beginning of the end of another American company. Once upon a time the brits were good manufacturers and had a strong economy, as were the Germans, as were the Japanese and others. As their manufacturing base lost its luster, so too did the economic growth, and real incomes. These countries became second rate economies where too many battle for too few jobs and wages and standards of living collapse. It isn't long till too few are left who can afford the few things still produced domestically. Don't lose sight of the fact that one's spending is another's revenue. The view that we will retain high value added, high paying jobs is naive. The Chinese, Indian's and Brazilians amogst other now have not only cheap labor, but also knowledge, technology and capital to knock off almost everything. As they do, they will put more U.S. businesses and consumers out of commission.

Of course we are using technology and a better educated, more industrious workforce to produce more efficiently and that much is a good thing. But make no mistake about it, the driving force of much of this is little more than labor arbitrage with unintended consequences that will haunt us for years to come because those jobs arent coming back and we aren't manufacturing jobs to replace them.

Employing more Americans which earn a better living than walmart cashiers and greeters, to produce more goods to sell to everyone else globally is a better economic situation for most Americans and us as a nation in the long run than the opposite scenario. If you agree with that, then you ought to agree that we should be promoting policies designed to encourage investment in manufacturing that creates jobs here instead of doing exactly the opposite