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Strange Things Are Afoot - December 16, 2014

|Includes: iShares iBoxx $ High Yield Corporate Bond ETF (HYG), LUV, MCO, SPY, TSLA, XOP

Greetings,

Call me juvenile, but "Bill & Ted's Excellent Adventure" still ranks as one of my all-time favorite movies. It has everything: history lessons, adolescent humor and Keanu Reeves in his prime. Early in the film, when the main characters are mystified by a time-traveling George Carlin, Ted delivers the infamous line, "Strange things are afoot at the Circle-K, my friend." That's exactly how I feel about global economics today.

Market developments over the past six months have created an environment where a "crisis" seems all but inevitable. The world's reserve currency, USD, is now 11% stronger than it was in June. Crude oil, an input cost for virtually every company on earth, has fallen 42% since June. Europe and Japan, the world's largest and fourth largest economies, are in recession, while China, the third largest economy, is getting ready to lower growth forecasts.

Several metrics indicate the market is headed for major volatility. For instance, since 1990, every time 1oz. of gold bought more than 20 barrels of crude oil, there was some form of "crisis" - usually emanating from abroad. At the moment, that metric is just below 19 but it's rallying quickly.

This doesn't necessarily mean US stocks will get dragged into the turmoil. The European sovereign debt crisis in 2011 triggered an -18% correction, but the S&P 500 finished +15% higher on the year. The same thing happened in 1998 when the Asian currency crisis led to a significant decline, but the US market finished the year +27% higher.

Getting back to oil, I want to be clear that while lower prices benefit consumers in the US, it's hardly a bullish development. In fact, policymakers are extremely nervous about the decline. The Saudi's are purposely oversaturating the market, but supply is just one half of the equation. Even though prices are falling, OPEC slashed their 2015 demand forecast last week by 70k barrels per day, which would be the weakest figure in 12 years. At the moment, oil is a deflationary headwind for a global economy already shaky on its feet. Strange things are afoot in these markets.

It's too early to say how this crisis will play out, but I have some theories. Investors seem alarmingly complacent despite the warning signs. I haven't entirely re-positioned my portfolio for this "crisis" scenario yet because stocks will probably drift higher into year end, but I'm staying alert for opportunities. My December Investment Letter will almost surely touch upon these theories- if you'd like to start receiving these letters click here. It's $8.25/month, which would buy you more than 3 gallons of gas. Except that gasoline won't boost your portfolio.

Today's letter will cover several topics, including:

  • Junk-Stocks
  • 2014's #1 Performer
  • Tumbling Tesla
  • 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

Junk-Stocks

In the petty world of financial markets, stocks have been giving junk bonds the cold shoulder for several months. Prices on high-yield bonds have declined -2.4% this month and -5.7% since August, while stocks hit fresh all-time highs. Spreads between Moody's BAA-rated corporate debt and US Treasury's are the highest they've been since September 2012.

High-yield bonds were without a doubt the main beneficiary of the QE-era. I'm not ready to say that QE in the US is gone forever, but the Fed has been absent from the bond market since October. Not coincidently, that's exactly when junk bonds started to roll over.

The other problem is oil. The industry has been one of the most prolific junk issuers over the last few years. Since early 2010, energy producers have raised $550 billion of new bonds and loans, making up anywhere from 15-20% of all US junk debt according to various sources (up from only 5% in '05). Research firm CreditSights Inc. predicts the default rate for energy junk bonds will double to 8% next year.

I've said numerous times over the past 6 months that the best way to play this junk-bond theme is through the iShares High-Yield ETF (ticker: HYG). There should be some technical resistance around $86.50 at the 2012 low, but there's no telling how far this ETF could fall if default rates pick up. The bigger question is how long the stock market can ignore these warnings signs before capitulating.

Who is #1?

Of all the stocks in the S&P 500, Southwest Airlines (ticker: LUV) is the (so far) top performer of 2014 having rallied 120% YTD. I speculated on November 4 that domestic airlines should continue to rally given the decline in oil and the strengthening US economy. Southwest fit that bill perfectly. The company has little presence outside the US and only hedges 20% of its exposure to oil.

The news surrounding LUV has been great. 80% of the company's workforce is unionized, and management signed a deal with key groups on December 8 ensuring labor stability for at least the next four years. Several analysts also upgraded LUV in the past few weeks, as they expect net margins to keep expanding for some time.

However, I'm less optimistic about LUV in 2015 now that all these bullish factors have been priced into the stock. The chart is bordering on parabolic, expectations will be harder to beat, and traders will be surely be looking "buy the losers" and "sell the winners" when the calendar turns on December 31.

Tumbling Tesla

Shares of Tesla Motors (NASDAQ:TSLA) have already stumbled 30% from their September peak, but they could have further to fall. Lower gasoline prices boosted sales of traditional auto manufacturers in November, but Tesla is far from traditional. In fact, lower prices at the pump make Tesla's electric vehicles relatively less appealing compared to their combustion-engine counterparts.

On top of that, the company seemingly has major issues in China, which is Tesla's second most important market after California. Tesla's head of Chinese operations, Veronica Wu, left the company last week, shortly after the resignation of the company's chief of Chinese communications, Peggy Yang.

The chart is starting to look like a clear head-and-shoulders top, and the 50 day moving average (NYSE:MA) could soon pass below the 200 day MA - a very bearish technical development. Tesla CEO Elon Musk is still thought of as a real life Tony Stark, but as any comic book fan knows, Stark Industries had its share of financial difficulties.

Chart of the Week

A very astute reader of this newsletter, who's always sending charts and factoids my way, alerted me to the holy grail of beer statistics last week. The website is full of interesting historical facts, but I was surprised to learn that the inflation-adjusted price of a 6-pack has fallen 33% since 1954.

There's evidence that people have been brewing beer for more than 6,000 years. However, it wasn't until World War II, when food shortages led to the brewing of a lighter beer, that its popularity exploded. From there, the brewing industry consolidated rapidly and economies of scale led to a steady decline in the inflation-adjusted price. Today, there are so many options for beer aficionados that there's even talk of a bubble in craft brews.

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: You mentioned in the last video that GoPro could get hit by new issuance, can you explain? - PF

A: Typically after issuing an IPO, company insiders have to wait four months before selling their shares. In the first week of October, GoPro founders Nick and Jill Woodman said they planned to gift 5.8 million shares to their charitable organization. The unusual move, made with approval of the IPO's underwriters, slammed GPRO shares -14% on October 2.

December 23 is when the lockup on virtually all other insider shares become available for trade. This could be especially troublesome for GoPro because 35% of outstanding shares are held short. With a P/E multiple of 141x, I'd say those shorts are justified.

That's all, see you next week!

For any questions or comments, please email us at: info@cup-handle.com

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