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There's Money In Relative Value - October 28, 2014

|Includes: CMCSA, DDD, Stratasys, Inc. (SSYS), TWX, XLU

Greetings,

It's becoming increasingly clear the economic system is still deleveraging, and that we should expect lower global growth going forward. Now that doesn't mean a stock market crash is imminent, since monetary stimulus has proven to be a potent tool in keeping asset prices elevated. However, it does mean that stock-picking will matter as fundamentals regain their importance.

Take the 3-D printer market, for example, which will continue to grow even if the economy stagnates. The two largest and most liquid 3-D printing stocks are: SSYS and DDD. In June, I wrote that SSYS is the name to own because of its exposure to the industrial sector (growth market), whereas DDD is more exposed to consumers (niche market). It turned out to be a nice call, SSYS has since rallied 16%. DDD, on the other hand, released preliminary third quarter results on Thursday well below market expectations. Since the announcement multiple analysts have downgraded the stock, which fell more than 15% on Thursday.

Stratasys (NASDAQ:SSYS) / 3D Systems (NYSE:DDD)

At the time I didn't recommend shorting DDD vs. SSYS, but that's the best strategy in a muddle-through economy. Pick a growth sector, identify the winners / losers, and hold a relative value position. This is an easy way to reduce your exposure to the broader market, and can be quite profitable. The SSYS / DDD spread is up 75% since June.

One obvious growth sector, at least in my mind, is clean energy. Warren Buffett also seems to think so. Large wind farms and solar plants are now cost-competitive with gas-fired power in many parts of the US even without subsidies. The unsubsidized cost of wind power has fallen from $201 per MWh in 2009 to $37 today. The decline in solar costs has been even more dramatic. Since 2009, the cost of electricity generation from large photovoltaic solar plants has dropped 80%, from $323 per MWh to $72. Compared to sectors like retail, clean energy is booming. If you're able to correctly identify the winners and losers, your portfolio will benefit in a big way. We'll have more on clean energy in the coming weeks.

Speaking of portfolios, we started buying shares in an outrageously cheap company two weeks ago, which has since rallied 4% - although it was up 15% at one point on takeover rumors. I'm not banking on an acquisition and will continue to hold this name because ultimately the value will shine through. If you'd like to know what stocks I'm referencing please click here for more info. Your subscription will pay for itself in no time.

Today's letter will cover several topics, including:

  1. Margin Call
  2. Dastardly Deflation
  3. Too soon for guns and gold
  4. Cup and Handle Chart of the Week

As always, if you have any questions or comments or just want to vent, please send me an email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld

Managing Editor - Cup & Handle Macro

  • Margin Call

Peaks in margin trading have been a precursor to bear markets in the past, notably 2000 and 2007. The current bull market has also been accompanied by record levels of leverage. Total margin debt peaked in February at $466 billion and stood at $463 billion in August.

NYSE Margin Debt (white) - S&P 500 (orange)

The idea that nominal amounts of debt have the ability to torpedo stock prices is incorrect. Gross margin levels are partially a function of equity prices, hence the strong correlation (chart above). However, by looking at margin debt as a percentage of stock market capitalization we see that debt does seem to be elevated relative to stock prices.

The chart above indicates there is no magic threshold where debt tips over the stock market. Instead, it shows that the last three major corrections have been preceded by an acceleration of credit growth. This makes perfect sense. In his (excellent) book Manias, Panics and Crashes, the late MIT professor Charles Kindleberger explained that asset bubbles rely on the growth of credit.

As it relates to the current market, it appears the stock market is not in danger of a collapse. Margin debt as a percentage of market cap remains historically high, but growth has been stagnant for the past few years. Stocks may be extremely vulnerable at the moment, but they're not yet a bubble.

  • Dastardly Deflation

If you were to gauge inflation based on the Bloomberg headlines last Wednesday, you'd think the US has gone the way of hyperinflation in Zimbabwe. The numbers were actually very tame. Y/Y CPI data for September came in above expectations at 1.7% Y/Y vs. 1.6% expected. However, there are several reasons to believe that prices could fall materially from here. For example, the futures market shows that gasoline prices will fall below $3.00/gallon nationally in the coming months. While that puts more money in consumer wallets, it's deflationary in nature. However, a stronger US dollar is the real threat.

US Dollar DXY Index (white, inverted) - US CPI Y/Y (orange)

The chart above shows remarkable correlation between the DXY US Dollar Index and CPI growth Y/Y - note the DXY is inverted. CPI has remained relatively flat since late July when the dollar started surging higher, but if the correlation over the last 7 years holds, we could see outright deflation in the near future. Obviously this would be a disaster for the Fed. There is no chance interest rates will be hiked in 2015 if CPI falls to fresh lows. If this forecast comes to fruition, be sure your portfolio owns some utilities (NYSEARCA:XLU), which have a negative correlation with interest rates. Treasury yields are already very low, but as we've seen in Europe and Japan they can go lower.

  • All is Not Lost

I realize this week's note has been especially bearish thus far, but there are few signs we're on the verge of a systemic crisis. 2-year swap spreads in the US, which measures the amount of credit risk in the system, are down 50% from the peak of the Euro-crisis in 2011. Banks in the US and Japan (less so in Europe) are well capitalized and very closely monitored. Twenty-five European banks failed "stress tests" over the weekend but the market took it as a positive. The banks now have nine months to shore up their finances or risk being shut down.

US 2-Year Swap Spread

Regulators are much better prepared for a crisis than in 2008. In fact, on October 10, the US and Great Britain staged a transatlantic simulation of a crisis in a large bank. This is a sign that authorities can now deal with the failure of a large institution, and "too big to fail" could be a problem of the past.

  • Cup & Handle of the Week

Another week, another classic cup and handle formation in FX. This chart implies that the Canadian Dollar (NYSEARCA:CAD) should continue to move higher relative to the Norwegian Krone (NYSE:NOK). Canada and Norway are more similar than you may think. Although their goods go to different markets both export a significant amount of crude oil. Most of Canada's crude is destined for the US, whereas Norway sends its oil to Europe. That is the major driver of this move.

Canadian Dollars (CAD) / Norwegian Krone (NOK)

On a relative basis, the US economy is vastly outperforming Europe; meaning the demand for energy is stronger in the states. The Canadian economy is also more diverse than Norway's, which relies on crude for over 50% of exports. Despite the dramatic fall in oil prices, Norway is in no real danger of collapse. They still have sizeable FX reserves and could still cut interest rates from their current 1.5% level. However, using any one of those tools to stimulate the economy would weaken the NOK and reinforce this cup and handle formation.

Reader Question:

**Editor's note: Every week we'll try to answer at least one reader question. If you would like to submit a question, please send us an email at info@cup-handle.com. We'd love to hear from you! **

Q: How about the HBO news! Does that change your view of cable? - ST

A: This question is in reference to this note. HBO and CBS have since started offering a streaming service available without a cable subscription. These announcements don't change my view, they just reinforce them. It makes me happy I cut the cord to cable before the announcement, so that I can claim to be an early adapter. While certainly a blow to cable companies, I don't think this represents the death knell. They're already making LOTS of money and they control the bandwidth through which these streaming services will flow. Last week, Comcast revealed that their number of cable users is falling but profits are rising. Cable giants also extremely well-connected politically. For those interested in reading more on the subject I recommend reading this article from the FT.

That's all, see you next week!

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