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Have No Fear, Policymakers Are Here - March 3, 2015

|Includes: Apple Inc. (AAPL), GPS, JPM, MCD, VLO, XOP

Greetings,

After a rocky January, the stock market got back on track in February with the S&P 500 finishing the month +5.5%. The bull market celebrates its sixth birthday this month, and do they ever grow up fast. If stocks stick to their current trend-line (chart below), we'll see the S&P 500 well above 2,300 by the end of this year.

Of course, there are numerous reasons to believe the market won't reach such elevated levels. For one thing, besides Apple (NASDAQ:AAPL), profits are slowing rapidly. As of February 10, Apple's 4Q profit growth exceeded those of all S&P 500 companies that had reported (347 of them), combined. In aggregate, those 347 companies reported a 3% contraction in earnings.

The much ballyhooed bonanza in consumer spending that was expected after oil prices plunged is M.I.A. Consumer discretionary companies, stores that depend on disposable income, are forecast to post profit growth of 5.8% this quarter and 8.9% in the second. Four months ago, the forecasts were for a 15% increase for each quarter. Despite the obvious warning signs, it's hard to have a sizable correction when policymakers seemingly have a fix for every problem.

Whether it be Greece, Ukraine or deflation the markets still trust policymakers to snuff out any problems that may arise. It doesn't seem to matter if they actually solve these problems as long as the consequences are kicked far enough down the road for the rally to continue.

The European Union is now in outright deflation (along with the US) but investors appear confident the ECB's QE program, which kicks off this month, will be the solution. However, the logistics of this program are more complicated than you may think. The ECB's purchases will be made in proportion to each country's share of the EU's population and GDP, meaning they'll need to buy 12 billion EUR of German Bunds every month until September 2016.

The problem is that Germany's net issuance for 2015 is projected to be just 15 billion EUR. In other words, the ECB is planning to buy more than 25 times the amount Bund issuance will grow over that period. So when new 5-Year German notes are sold with negative yields, as they were last week, we shouldn't be surprised because investors are simply paying up for supply. It might seem like this purchasing program could backfire, but markets won't start worrying until policymakers lose control.

The Cup & Handle Fund was down marginally last week, up 10% since inception. I'm starting to build a position in a high-conviction currency position, and so far it's been moving in my favor. My February investment pick, which was energy related, has already rallied more than 12 % since the recommendation went out - if you'd like to start receiving these letters click here.

Today's letter will cover several topics, including:

  • The Wal-Mart Wage War
  • Premium Diesel
  • Paying For Your Money
  • 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

The Wal-Mart Wage War

A week after Wal-Mart (NYSE:WMT), America's largest private sector employer, announced it would increase starting wages for its US employees to $9 per hour (up from $7.25), TJ Maxx, Marshalls and HomeGoods followed suit. IKEA and Gap clothing have also announced pay increases recently. Some economists believe McDonalds (NYSE:MCD) will ultimately have to start paying higher wages to match its competition for low-skilled labor.

While Wal-Mart's decision is certainly good news for workers, it may amount to little more than smart public relations for a company that would have increased wages anyway due to legal and financial reasons. Many states have already raised their minimum wage to $10, and the Obama administration has been pushing for a federal increase. Prior to the announcement, less than 1% of Wal-Mart's workforce made the current federal minimum wage of $7.25. The announcement will boost average compensation from $12.94 to $13 per hour - costing the company $1 billion.

That may seem like a lot of money, but it's nothing for a company of that size. If Wal-Mart took the $7.6 billion it spends on share buy-backs and gave that money to employees, it would translate to a $5.63 raise for all workers. That would save the federal government a lot of money considering Wal-Mart's low-wage workers cost US taxpayers an estimated $6.2 billion in food stamps, Medicaid and subsidized housing. As an added bonus, much of the extra pay will go right back into the stores. After all, Wal-Mart employees are the stores' best customers.

Public relations aside, Wal-Mart's announcement looks to be the beginning of a trend in wages. Higher pay combined with the US falling into outright deflation for the first time since the Great Recession is putting significant upward pressure on real wages, which are now at a six year high. This trend isn't enough to force Janet Yellen into hiking rates, but she must be pleased with the developments.

Premium Diesel

Prices for low-sulfur diesel are at their highest premium to WTI crude oil in history. The coldest New York City February in more than a century combined with persistent natural gas pipeline bottlenecks has boosted demand for fuel oil to power generators and heat homes. The supply side of the equation is just as bullish. The cold weather cut output at several East Coast refineries last week, and a strike by the United Steelworkers has reduced capacity. Two weeks ago, refineries operated at 88.7% of capacity, down from 95.4% in early December.

Companies like Valero (NYSE:VLO), which derives more than 90% of revenue from refining activity, have dramatically outperformed oil and gas E&P stocks since oil prices started declining last June. Cheap oil is not necessarily bad for Valero, which buys crude as a feedstock. Instead, VLO shares tend to fluctuate based on margins, which have been very strong this winter.

On January 29, Valero reported fourth quarter earnings that blew away EPS expectations by $0.50. The quarterly margin was $12.48 per barrel, an increase of 11.4% Y/Y and 5.7% Q/Q. Since refiners typically use natural gas to power their operations, they're also benefitting from lower production costs. Even once the weather warms up, refinery maintenance and increased driving demand are likely to support fuel prices. Valero and its competitors offer a nice shelter for oil investors beleaguered by falling prices.

Paying For Your Money

JP Morgan, the largest US bank by assets, announced last week it will start charging large institutional clients for deposits. The bank says holding very large deposits has become too costly under new liquidity rules, and that it no longer makes financial sense to hold such large sums. Other US banks including Bank of New York Mellon and Goldman Sachs are already charging customer for large deposits, and several European countries have cut their deposit rates below zero.

JP Morgan is encouraging its hedge fund and private equity clients to shift their excess cash into money market funds. At the moment, JP Morgan's largest money market fund is yielding a mere 7 bps - or 18 bps below the current Fed Funds rate. Either way, when you take inflation into account, real interest rates on bank deposits have been negative for some time. The fact that banks are charging for deposits is really just a matter of bookkeeping, because cash continues to lose value.

Chart of the Week

After nine months of delays, the shipping lines and dockworkers' union at West Coast ports finally agreed to a labor deal last week and resumed normal operations. The two busiest US seaports, Los Angeles and Long Beach, which handle 43% of US imports and 27% of exports, are just starting to clear the largest backlog of ships in more than a decade. West Coast ports are an important cog in the American economy, but they're still miniscule by Chinese standards.

7 of the world's 10 busiest seaports are based in China, accounting for the bulk of global trade. The world's largest port in Shanghai sees more than 32 million TEU's (twenty-foot equivalent units) every year - more than four times the volume moving through Los Angeles. The heavy concentration of shipping activity on Asia's Pacific Coast is a striking reminder of Asia gigantic population and outsized role in the global manufacturing sector. It's a moot point because organized labor is essentially non-existent in China, but a strike by Chinese dockworkers would be significant threat to the global economy.

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: Can you give an update on your views on Greece? Is the situation manageable? - VO

A: My position on Greece hasn't changed much in quite a while. The economy is small enough that the EU could handle a "Grexit," but it sets a dangerous precedent for other debtor countries - namely Spain. The latest agreement to reevaluate the situation in four months is yet another effort to "kick the can." However, I am watching for two developments. First, all the uncertainty has encouraged Greek citizens to pull their money out of banks and stash it in cupboards, flowerpots and mattresses. It will be interesting to see whether the number of robberies increases and what impact that has on voters. Second, the "radical" left-wing Syriza party, that's in control of the government, is now under heavy pressure to become more radical. If there's a confidence vote and Syriza is voted out for being too conservative, it would be clear that Greece is headed for a total reset where they reintroduce the Drachma - Greece's pre-Euro currency.

That's all, see you next week!

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

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