The Domino Effect

361 Capital Weekly Research Briefing
August 10, 2015
Timely perspectives from the 361 Capital research & portfolio management team
Written by Blaine Rollins, CFA



(Mark McKinney)

One by one, the market dominoes continue to fall…

Market sentiment took another punch to the gut last week when the market’s ‘momentum’ stocks took a significant body blow. This group consisting of top 2015 performing names broke a few ribs last week: Mallinckrodt, Alnylam, Cerner, Time Warner, Tesla, Disney, Biomarin, Lamar, IMS Health, Starz, Hanesbrands, Skyworks and Comcast. With the Momentum groups shellacking, the bulls not only lost some great stocks to hide behind but they also lost another reason to be long the market. Add to this the fact that there are now more stocks hitting 52-week lows than 52-week highs, and one has to really dig deep to find a reason to commit dollars to U.S. equities.

Josh Brown hit the nail on the head this weekend by writing how the feedback loop of the market is no longer positive…

The rat runs left and reaches the cheese. He is rewarded by the maze. Guess which direction he runs the next time through. And the next. And the next.

Run left, get cheese. Run left, get cheese.

Another rat is dropped in and proceeds to run right. No cheese. He gets an electric shock instead. Guess which direction he never runs in again.
(TheReformedBroker)

Here is the Momentum ETF which was hit -1.69% on Thursday. Detailed is the GIC breakdown which shows a list of the top performing Consumer and Healthcare sub-sectors which have been pillars for the market’s new highs…

While Consumer Discretionary & Healthcare were underperformers last week, the Market was still feeling the most pain from Energy stocks…

Oil stocks were led lower by another break toward 2015 lows in Crude Oil.

Goldman Sachs did not help the commodity by writing a comprehensive piece detailing reasons for lower prices longer-term and how the risks are now skewed to the downside. Given the current overproduction, Goldman even suggests that storage could fill up this fall which would create a collapse in the forward pricing curve.

Plains All American Pipeline noted the difficulty in pipeline transportation assets in their conference call last week…

We see the main incremental takeaways on the call as Plains believing that the crude oil market will take longer to correct (now mid/end 2016), cheap capital has facilitated an overbuild and near term oversupply in logistics that could crimp industry profitability, and that ship or pay arrangements have created market disruptions which adversely impact Plains’ business model more than anticipated. While none of these factors individually appear that surprising given current market conditions, the fact that these issues combined to reduce what was already considered a conservative original guidance clearly spooked the market.
(JPMorgan)

Too much oil + too many pipelines + not enough demand to consume or store = a collapse in Energy MLP prices…

Meanwhile, top U.S. energy companies continue to produce as their production costs continue to fall…

Chesapeake Energy CHK had earnings Wednesday morning (this is considered the post child for U.S. shale) and they boosted their ’15 production guidance. CHK is seeing higher production even after taking curtailing actions as they are becoming more efficient (“our daily production averaged 703,000 barrels of oil equivalent per day for the second quarter, which is a 13% increase year-over-year adjusted for asset sales. As a result of our strong production, we are increasing our 2015 production guidance range to 667,000 to 770,000 barrels of oil equivalent per day, or by 4% compared to our previous guidance. The strong production performance in the first six months of the year positions the Company to enter 2016 at a higher rate than previously forecasted. We currently expect our 2015 exit rate to be around 660,000 barrels of oil equivalent per day, which is outstanding when you consider our ramp-down in activity across our portfolio and our present voluntary curtailment of approximately 50,000 barrels of oil equivalent per day on a net basis”).
(JPMorgan)

ConocoPhillips & Total expect to make money producing at less than $60 per barrel…

In a note to clients this week, analysts at Credit Suisse noted that ConocoPhillips and Total have both said the cost of production for U.S. shale will fall 30%, and that 80% of shale oil produced will make financial sense to produce with prices below $60 a barrel at the end of this year. The oil-futures market projects oil prices will bounce back to near $70 a barrel. The price of West Texas Intermediate crude oil finished the week below $44 a barrel. Credit Suisse also notes that, despite the massive drop in the U.S. oil rig count, production has remained steady. Meanwhile, large oil companies or countries that depend on oil revenue to meet spending commitments have continued pumping oil because they still need to bring in that revenue, almost regardless of price.


(BusinessInsider/CreditSuisse)

So it is now looking like the Saudis played a very bad hand of poker for Thanksgiving 2014…

The Saudis took a huge gamble last November when they stopped supporting prices and opted instead to flood the market and drive out rivals, boosting their own output to 10.6m barrels a day (b/d) into the teeth of the downturn. Bank of America says OPEC is now “effectively dissolved”; the cartel might as well shut down its offices in Vienna to save money. If the aim was to choke the U.S. shale industry, the Saudis have misjudged badly, just as they misjudged the growing shale threat at every stage for eight years. “It is becoming apparent that non-OPEC producers are not as responsive to low oil prices as had been thought, at least in the short-run,” said the Saudi central bank in its latest stability report. “The main impact has been to cut back on developmental drilling of new oil wells, rather than slowing the flow of oil from existing wells. This requires more patience,” it said.
(Telegraph)

And now Saudi Arabia is preparing to sell debt to raise money to fund its deficits…

Saudi Arabia is returning to the bond market with a plan to raise $27bn by the end of the year, in the starkest sign yet of the strain, lower oil prices are putting on the finances of the world’s largest oil exporter. Bankers say the kingdom’s central bank has been sounding out demand for an issuance of about SR20bn ($5.3bn) a month in bonds — in tranches of five, seven and 10 years — for the rest of the year… the decision to ride out a sustained period of lower prices has put a huge strain on the finances of major oil exporters, including Saudi Arabia which requires an oil price of $105 a barrel to balance its budget. The kingdom has drained $65bn of its fiscal reserves to maintain government spending since the oil price plunge began. Sama currently has $672bn in foreign reserves, down from their peak of $737bn in August 2014. The plan to resort to capital markets, if confirmed, demonstrates the priority Riyadh is placing on maintaining government spending, despite the pressure cheap oil is putting on its budget.
(FinancialTimes)

Big Oil might still find oil to produce profitably at $60 per barrel, but they are also tacking a chainsaw to their Capex budgets…

Oil companies are making the largest cost cuts in a generation to reassure investors. They’re risking their own future growth. From Chevron Corp. to Royal Dutch Shell Plc, producers are firing thousands of workers and canceling investments to defend their dividends. Cutbacks across the industry total $180 billion so far this year, the most since the oil crash of 1986, according to Rystad Energy AS, an Oslo-based energy consultant.
(Bloomberg)

Capex cuts are so bad that the Oil Service companies are cutting prices and now even giving credit to customers (BAD IDEA! BAD IDEA! BAD IDEA!)…

Business is so tough for oilfield giants Schlumberger NV and Halliburton Co. that they have come up with a new sales pitch for crude producers halting work in the worst downturn in years. It amounts to this: “frack now, pay later.” The moves by the world’s No. 1 and No. 2 oil services companies show how they are scrambling to book sales of new technologies to customers short of cash after a 60% slide in crude to $45 a barrel (it hit a new six-year low of $44.24/bbl overnight). In some cases, they are willing to take on the role of traditional lenders, like banks, which have grown reluctant to lend since the price drop that began last summer, or act like producers by taking what are essentially stakes in wells. At Halliburton, some of the capital to finance the sales will come from $500 million in backing from asset manager BlackRock, part of a wave of alternative finance pouring into the energy industry that one Houston lawyer said on Thursday allows companies to “keep the engine running.”
(Fortune)

The Capex slowdown is obviously bad news for the big Energy employment states. Note the wage inflation slowdown in Texas…


(@SoberLook)

An interesting method to track the oil boomtown slowdown = raw sewage volume…

The population of a U.S. oil boomtown that became a symbol of the fracking revolution is dropping fast because of the collapse in crude oil prices, according to an unusual metric: the amount of sewage produced. Williston, North Dakota, has seen its population drop about 6 percent since last summer, according to wastewater data relied upon heavily by city planning officials. They turned to measuring effluent because it was a much faster and more accurate way to track population than alternatives such as construction permits, school enrollment, tax receipts or airport boardings. U.S. Census Bureau figures are usually too old as a full-fledged population count only happens once a decade, with sporadic updates in between. That’s not going to catch any swift changes in the population of cities like Williston. “Here in Williston, the growth rate is not predictable,” said David Tuan, director of the city’s public works department. “Measuring wastewater flow tends to be the most-efficient way to track population.”
(Reuters)

Barron’s decides that Commodity prices have fallen enough…


(Barron’s)

And Berkshire Hathaway elects to take advantage of the baby getting thrown out with the bathwater, and buys Precision Castparts on the cheap…

PCP is one of the finest companies I ever came across while I was at Janus. Big cash flows, solid IP, wide moat businesses and very good management. While Power/Industrial is only 30% of revenues, its weakness for the last 2 years has caused a 40% underperformance in its stock price for the last 18 months. The low price that BRK paid likely reflects the future uncertainty of the Energy end-markets, plus the lack of industrial acquirers that could today do a $37b deal. BRK will also be able to give its AAA balance sheet and capital base to PCP to continue to acquire in the aerospace and industrial space.

“Given the weak global oil & gas demand, we are anticipating volume and price pressures and expect declines in excess of 30 percent in this market for fiscal 2016. Within our general industrial and other markets, we are expecting fiscal 2016 to be similar to fiscal 2015, with risk of derivative impacts due to weakness in the oil & gas markets.”

(Precision Castparts Corp 10-Q June 28, 2015)

It was another bad week for credit as both High Yield and Leveraged Loans sold off as worries in the Energy, Materials and Industrial space continued…

(@SoberLook)

I still think one of the most important dominoes in the equity market to watch is Credit. The Financial Times had a good long note on this last week…

A U.S. equity bull market showing signs of fatigue this year has investors nervously watching the poor performance of junk bonds. In past cycles junk-rated debt has tended to act as a barometer of investor sentiment ahead of other markets, notably equities. This reflects how investors view high-yield bonds as similar to equities, rather than a pure fixed income product, because both are strongly linked to the fundamentals of the companies that issue them and are less susceptible to changes in interest rates. But during the past few months that relationship has diverged, raising a question over whether the turmoil will remain contained in the junk bond market or at some stage spill over into equities.
(FinancialTimes)

Worries in Energy, Metals and Materials also impacts Emerging Market Bond Yields which continue to float higher…

Speaking of Emerging Markets, have you ever seen Stagflation in action? Look no further than the host of the last World Cup and next Olympics…

Down from 41.0 in June to 40.8 in July, the Brazil Composite Output Index was at its lowest mark since March 2009. Although both manufacturing and services output fell, the accelerated drop in private sector activity reflected a sharper retrenchment in services activity. The seasonally adjusted Services Business Activity Index posted 39.1 in July, down from 39.9 in June, to remain below the no-change mark of 50.0 for the fifth successive month. Moreover, the latest reading was the joint-weakest in the survey history. The downturn remained widespread across the services categories covered by the survey, with all of the sub-sectors registering substantial falls in business activity. The steepest contraction was at Hotels & Restaurants, followed by Transport & Storage.
(MarkitEconomics)

Back in the U.S., the economic data remains strong highlighted by last week’s ISM Services data point…

@KathyJones: #Dollar strikes again. Service sector pulls ahead, while manufacturing sector slows. #ISM (Chart of the Day)

And combined with a solid Non-Farm Payroll gain on Friday sends the market to bet on September for the first Fed rate hike…


(@PlanMaestro)

Even the 1 year Treasury yield is giving banking account savers hope for a 1099 form this year…

Speaking of a yield pickup, look at the cap rates on hotels — surprised they are still so high. But have you seen the room rates for the kids’ winter or 2016 spring breaks yet? That is if you can even find an airline ticket!


(@PlanMaestro)

The Dow Industrials is a narrow Index but still gets the 6pm major network news mention.

So if the viewers hear down, down, down, down, down, down and down, it will influence psychology. Chad Gassaway shows that when combined with a < 200 day moving average it can also provide a decent headwind for investors…


(@WildcatTrader)

@TheStalwart: I thought maybe I was hallucinating, but it turns out that yes, in fact, a popcorn company just had an IPO

Need another falling domino?


(@SiliconValleyInvestor)

Some good news for high growth Biotech stocks and cutting edge research –> The Government will allow Medicare payment for high cost drugs that show significant improvement over existing drugs…

The Obama administration has decided that Medicare will pay for one of the newest, most expensive cancer medications, which costs about $178,000 for a standard course of treatment. Patients, doctors, hospital executives and insurers have expressed concern about the high cost of prescription drugs, especially new cancer medicines and treatments tailored to the genetic characteristics of individual patients. Medicare officials recognized the cost and value of one such product, the anticancer drug Blincyto, by agreeing to make additional payments for it starting Oct. 1. The drug is made by Amgen for patients with a particularly aggressive form of leukemia. The decision suggests a new willingness by Medicare to help pay for promising therapies that are still being evaluated. It is also significant because Medicare officials reversed themselves on every major scientific issue involved. After receiving pleas from Amgen and a dossier of scientific evidence, the officials agreed that the drug was a substantial improvement over existing treatments for some patients… Blincyto “is not substantially similar” to other drugs available to leukemia patients, the administration said, and it “represents a substantial clinical improvement over existing treatment options.”
(TheNewYorkTimes)

And especially good news for Architects…

In addition to July’s employment report, the U.S. Bureau of Labor Statistics also released data today on job growth in June for smaller sectors of the economy… Architectural services added 2,700 jobs in June, up from the 800 jobs added in May. June was the strongest month for job growth in architecture since February of 2007, when the industry added 3,100 jobs.


(ArchitectMagazine)

@GoogleFacts: According to Albert Einstein if the honey bees were suddenly disappeared from the earth, humans would see an apocalypse within 4 years.

And so, Career of the Decade/Century will likely be awarded to the Beekeepers…

The trouble all began in 2006 or so, when beekeepers first began noticing mysterious die-offs. It was soon christened “colony collapse disorder,” and has been responsible for the loss of 20 to 40 percent of managed honeybee colonies each winter over the past decade. The math says that if you lose 30 percent of your bee colonies every year for a few years, you rapidly end up with close to 0 colonies left. But get a load of this data on the number of active bee colonies in the U.S. since 1987. Pay particular attention to the period after 2006, when CCD was first documented.

As you can see, the number of honeybee colonies has actually risen since 2006, from 2.4 million to 2.7 million in 2014, according to data tracked by the USDA. The 2014 numbers, which came out earlier this year, show that the number of managed colonies — that is, commercial honey-producing bee colonies managed by human beekeepers — is now the highest it’s been in 20 years. So if CCD is wiping out close to a third of all honeybee colonies a year, how are their numbers rising? One word: Beekeepers.
(WashingtonPost)

@pmarca: It seems likely we are witnessing the birth of four major new American automakers: Google, Apple, Tesla, and Uber. Who would have guessed!

Another big reason for less future Oil use in the U.S…

With large tech companies like Google and Uber circling driverless cars, the conversation has mostly been one of “how soon can we do this?” and not “should we?” Of course, autonomous cars would be cool, but what are the advantages besides the obvious luxury of not needing an error-prone, human hand behind the wheel?

Researchers from the Lawrence Berkeley National Lab in California say another advantage exists— an environmental one. If a fleet of autonomous electric taxis were to replace everyone’s gas-powered, personal cars, we could see more than a 90 percent decrease in greenhouse gas emissions and almost 100 percent decrease in oil consumption from cars, all while saving money in the long run. Right now that may seem like a long shot, but a study earlier this year said that 44 percent of Americans would consider buying a driverless car in the next 10 years, even if it would cost $5,000 more.
(PopularScience)

Not Governor Rick Perry’s Tesla…


(@Will_Daniell_)

Speaking of Politics, I’d be interested in hearing an American History teacher explain this Debate exchange to his/her students…


(@harrylambert1)

Finally, your summer Video of the Week…


(@MaxStossel/YouTube)

If you like the ideas Blaine Rollins shares each week in the 361 Capital Research Briefing…
Then you should learn more about how he incorporates these ideas in the mutual fund he is managing, the 361 Global Macro Opportunity Fund. Contact 361 Capital or your advisor for additional information.

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