Can This Market Be Trusted?

Includes: BSC, SPY, TRP, XHB
by: Toro

Monday's market rally is not to be trusted. That does not mean we cannot go up from here. That does not mean we will not see higher highs in the near future. However, until we see some evidence that this isn't merely an oversold bounce into a lower high, then this rally should not be bought.

Take a look at the S&P 500 (SPX):

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S & P Chart

The last high was lower than the previous high. The last low was lower than the previous low. And volume has been heavier on the downside than the upside.

Now take a look at the Shanghai Index:

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Shanghai Index

It looks similar to the U.S. market, with the exception of the collapse that occurred at the beginning of June.

The Nazdaq is doing better though. Take a look at the chart below:

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That is bullish.

The semis are also doing better, and are exhibiting behavior opposite of the broad market, with higher highs, and higher lows.

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SOX Index

I own one semiconductor name and one semi-cap equipment name. I have been very impressed at resilience of my equipment stock, which has flat-lined for much of the year, but won't go down (much) on bad news.

The following chart indicates that the oil service stocks are smoking:

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OSX Chart

I just wonder if the market can keep hitting new highs, if the OSX is also hitting new highs.

Oil looks very strong here. I think we're going to test, and then break the highs.

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WTI Chart

I purchased a basket of Canadian oil trusts.
I cannot find anyone who has anything good to say about the trusts. The Canadian government passed the law to repeal trust status in 2011, four years from now. Many of the fields in the trusts are in decline, but I think the point of maximum pain is right here (assuming the price of crude doesn't collapse).

After the change in law was announced, the market puked the trusts out. It came as a complete surprise since the Conservative government had promised not touch the trusts during the previous election. However, upon news that the Canadian telecom companies BCE and Telus were considering trust status, the government changed the law, fearing a hollowing out of the tax base. This completely sideswiped the market, and the trusts were crushed. The loathing was palatable.

Now, however, many of them appear to be bottoming. They are pure pass throughs on the price of oil (and gas). If oil is rising, there is no reason why they should not either. Or, at least their dividends should rise.

My basket is yielding just under 14%. That means I will recover 56% of my cost just on the dividends alone by the time they are forced to convert to corporate status. Upon converting, and paying corporate tax, they would be yielding 10%. A UBS piece recently postulated that, to survive as corporations, the trusts will have to cut dividend payments 10% to fund operations. Let's say they have to cut 20%. Thus, they will be yielding 8%. The average life of the fields of my trusts is about 10 years. Let's say it is 8 years. Therefore, I will be paid dividends of 32% of my cost, or 88% in total, assuming oil averages $60 over the next decade.

In addition, the governments of Canada and the United States are negotiating the repeal of the antiquated 15% withholding tax on dividends, which will attract more international capital into the industry, including Americans, who constituted a large portion of ownership.

Also, the valuation of the trusts is about half that of the U.S. master limited partnerships. There are differences in the structures, but not so much so that the MLPs should trade at a 100% premium to the trusts. Rest assured, the trusts are pondering a change in domicile to the U.S., and conversion to an MLP structure, especially those with majority American ownership, although the Canadian government will attempt to stop this.

The point is that this group doesn't need much to go right to give it a lift. It reminds me of the rural CLECs a few years back, when they were left for dead, with land lines declining, and their core business under attack from cable competitors, all the while paying a 7% dividend, even though they generated no free cash flow after the divie. I bought Alaska Communications at $10, and sold it at $13. Today, it is just under $16.

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Alaska Communications

Another analogy is TransCanada Pipelines (NYSE:TRP). In 2000, Trap, as it is known in Canada, had disappointed with a bad quarter, which cut the stock in half from C$20 to $10. Everyone hated the stock. But the dividend yield was 8% and held. The company's problems weren't deep - it wrote-down overseas investments which had nothing to do with its core business - and eventually the stock recovered.

Gold doesn't look healthy to me, though perhaps it is just consolidating. But, it has broken its uptrend, and may have further to fall.

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Gold Chart

I am a bull long-term in gold, but I want to see better action in the stock before I get involved again. A piece of good news is that GFMS recently stated that mine output was at a 10-year low in 2006. One of my favorite investment strategies is to invest in declining supply. It usually means higher prices down the road.

Silver looks even more disconcerting to me.

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Silver Chart

The bulls may spin the weakness in gold and silver to be bullish. I disagree. I think gold and silver are barometers of global liquidity. If they are weak, I believe stocks will follow.

Same with the base metals. The base metals have been rolling over. I own one base metals company, a zinc play, which is dirt cheap relative to the group. But I am worried about the weakness in the price of zinc. However, the stock's technicals are very strong, and until they behave otherwise, I'm sticking with my position.

Speaking of which, Boo-Yah Man made a great comment on RealMoney last week about the behavior of investors when explaining why he owned two base metals companies.

I don't suffer fools gladly, though. While there's no such thing as a stupid question, questions do become stupid when they are asked over and over again by people who have no idea what they are doing and think this is a game where everyone has to win and it's easy money.

I thought that was great. Well said, Boo-Yah Man!

What worries me most, though, is tighter credit. With a 4-handle on the 10-year, bonds are working off the oversold condition. However, spreads have seen their lows, in my opinion, and the next leg is up, and my bet is the magnitude will not be "a bit."

From the Fox Street Journal:

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Rates Chart

I keep hearing that submerging prime won't have an effect on the rest of the economy and the market. I do not agree. What matters is confidence. Confidence, as much as anything, has lead to record low spreads. As confidence erodes, spreads will widen, which will have all sorts of ramifications for the economy and the market, none good other than to wash out the excesses.

Any takers on Bear Stearns? Not me. If I could, I'd be shorting it right here. Its trading at 1.6x book. It traded down to 1.25x in 2000. I think the mortgage mess isn't even remotely over. Trading at 2000 lows would take Bear down to $110.

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BSC Chart

Speaking of shorting, I'd avoid the homebuilders like the plague. I think the XHBs will eventually bottom with a 1-handle.

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WHB Chart

I really feel that there are lots of things in this market to worry about.