The Big Cattle Bust

On Friday, January 27, the USDA reported that the size of the cattle herd in the U.S. is the smallest in 60 years, or 91 million. One the recent reasons for the declining herd count is the droughts last summer in Texas and Oklahoma, which caused a shortage of grass and water and thus ranchers sent more head to slaughter. Another major structural driver for the declining herd count has been the soaring price of corn over the past few years, driven by the demand for ethanol in gasoline. It has become increasingly costly to raise cattle in the U.S. due to the government decisions to increase mix of ethanol in gasoline. Additionally, the higher prices for corn and other crops has resulted in more land switching to crops and away from cattle. These factors have helped drive supplies to such low historic levels.

On the demand side, export growth of beef increased 22% last year, driven largely by the falling dollar that made US exports less expensive. Given the recent announcements by the Federal Reserve to keep interest rates at current levels into 2014 and the willingness to provide more stimulus, it would appear a weaker dollar remains likely.

I considered buying an ETF/ETN focused specifically on cattle future prices. I am not allowed to trade futures and derivatives in my IRA. The ETN iPath Dow Jones UBS Livestock Subindex Total Return (Ticker COW) appeared to fit the exposure until I looked at its performance. In 2011 retail beef prices increased over 10% but the price of COW actually declined. 

I have a ~2% position in my IRA in Tyson Foods (Ticker TSN), one of the largest beef producers in the world as well as chicken and pork. The stock has performed reasonably well since I purchased it in October 2011, trades below 10x the consensus 2012 EPS estimate, and has a consensus recommendation of Overweight. Originally I had established the position to play falling corn prices, enabling the company to expand margins. This thesis may continue to play out as corn prices remain off their 2011 peak, in my view. Management gave a presentation in December outlining a close relationship between beef revenue and cattle prices. The company also has a strong presence as an exporter. One of the main risks, in my view, is that Tyson cannot pass along higher prices to the consumer as retail grocers like Albertsons push back against price increases. I expect price increases in the U.S. to eventually go through and export growth to provide extra juice for the company.


I decided to expand my position in TSN to ~4%.


Tyson Foods reports earning this Friday before the market open.

Old Cars Providing New Opportunities

This month it was widely reported that the average age of cars and trucks on U.S. roads is almost 11 years, the oldest ever recorded. In other words, the average car in U.S. was sold in 2000. While car sales have improved, rising 10% to 12.8 million in 2011, the absolute level remains below the traditional replacement level of around 16 million. Since there is not a large scale substitute for owning a car or truck, investments in mass transit remain modest in this country, a logical conclusion is that people need to begin replacing older vehicles, in my view.

Ford (Ticker F), reported disappointing results relative to analyst expectations, producing an EPS after one-time items of $0.20 versus expectations of $0.25. Weakness in Europe and flooding in Thailand were the primary cause of the disappointment. European sales may continue to slide as the economy deteriorates due to austerity measures aimed at reducing sovereign debt. Asia demand appears healthy with Ford expecting to build seven new plants in the region, although the company expects to cut some production in the region during the first quarter. U.S. sales increased 11% in 2011 and the company grew its market share, the best signal, in my opinion, of improvements in the business. My takeaway on Ford is that company is improving its business but worries about soft demand outside of the U.S. may keep the stock price from appreciating.

Taking into consideration the macro thesis of an aging fleet of vehicles in the U.S. and the Ford-specific data points suggesting earning should remain healthy, albeit muted, I believe the best investment position is in Ford debt and U.S. commodity suppliers.

Ford (Ticker F) - My ~4% position in Ford debt (CUSIP 345370BJ8) offers a yield of about 6%, attractive in these markets when considering there may be some upside in price, in my opinion, should the company continue to improve.

US Steel (Ticker X) - My ~8% position in US Steel debt (CUSIP 912909AD0) should benefit from growing automobile demand within the US. An additional demand driver is steel requirements in domestic oil and liquid gas drilling. Costs for US Steel should decline due to the lower price for natural gas, to which management has increasing switched from coal. In a November 2011 presentation management stated they felt natural gas would provide cost saving at or below $5 mmbtu. Recently the cost of natural gas has fallen to around half this price. These factors of anticipated growth in domestic automotive sales, oil and liquid gas drilling, and falling natural gas prices are the reason for my relatively large position in US Steel debt, which is yielding over 8% at current prices. The dividend yield on the stock price of US Steel is below 1% and the PE on the 2012 consensus EPS estimate of $2.48 is about 12x, interesting but not yet exciting in my opinion. I do not expect management to increase the dividend until the price of the company's debt recovers, again suggesting that the better position is in the debt as opposed to the equity, in my opinion.

Natural Gas Prices Near a Bottom?

Today I established a couple positions to increase my exposure to the natural gas market. The natural gas market has sold off significantly, dropping from over $5 MMBtu to under $3 in the past year, recently hitting the lowest level in over ten years of $2.32. Over production has been the primary cause of the price decline, but a warmer than usual winter has also contributed to lower demand during the typically seasonably stronger demand winter months.

Numerous producers have started to cut production, including Chesapeake Energy Corp., ConocoPhilips and Occidental Petroleum. While more production cuts are likely needed to balance supply and demand, I believe the price of natural gas likely begins to stabilize and may even bounce back above the $5 mark during the next year. The reason for my optimism includes the production cuts, the potential for either a colder weather pattern in the next month or a hot summer, and the likely increasing use of natural gas at lower price points. At under $3 I believe natural gas becomes a much more attractive fuel alternative for companies able to switch between natural gas and higher priced coal. Longer-term, the low natural gas prices should attract new uses for the fuel, including transportation, heating, electricity and industrial production.

So I have established the following positions:
~3% position in Penn Virginia Corp. Sr. 7.25% Notes 4/15/2019 (CUSIP 707882AC0) - This company is having difficulties and its stock price (Ticker PVA - $4.76) has dropped significantly. Lower natural gas prices have obviously not helped but the company has been investing in oil production, increasing revenue from oil relative to gas. Management does not instill confidence with a lawsuit outstanding for over-paying the previous CEO and CFO. In addition, the company has slipped a bit on production relative to guidance, calling into question execution. That said, management is out talking to investors, which is usually a good sign of their confidence about the future of the business. The company does not have any significant debt due until 2016 and has adequate liquidity. While the stock may ultimately prove a better bet, I decided to establish a position in the senior debt at a yield north of 9%, a more comfortable risk/ reward balance in my view.

~2% position in ProShares Natural Gas ETF (Ticker BOIL) - This is 2x leveraged ETF that tries to track movements in the natural gas futures markets through derivatives. This position is purely focused on the price on the natural gas. Because it is leveraged I have purposely kept the position relatively small.

Also, yesterday I reduced my position in silver slightly after a significant increase in silver prices due to the remarks by the Federal Reserve yesterday. Basically, the Fed stated its intent to keep interest rates low for multiple years and has not ruled out additional quantitative easing, both reducing the value of the dollar and increasing the value of precious metals. I plan to put money back into silver if the price retreats again.

A Few New Positions in Gold, Agriculture and Short the Market

Established a few new positions in my IRA over the past week, which include:

~5% Gold (Ticker GLD)
~4% Agricultural Commodities (Ticker DBA)
~4% S&P 500 Short (Ticker SH)

The position in gold is based on my belief that central banks begin printing more money, devaluing fiat currency. In addition, I believe we may see increasing destabilization of regions of the world, making precious metals more attractive.

The position in agricultural commodities is based on prices for many of these commodities trading at relatively low valuations, suggesting that there may be a rationalization in some production over the next year.

The position that effectively shorts the S&P 500 is based on the S&P 500 trading near the high end of its recent trading pattern. Based on my view that European economic activity continues to slow and other regions remain slow, I expect the market turn-around. It is also a hedge to help cover any downside in the equity markets in the near future.

Commodities

Bought a ~3% position in Silver today. I continue to believe central banks are likely to print additional money, increasing the attractiveness of precious metals. I plan to closely watch silver and gold prices over the next week.

I am also watching Corn and Soy. Corn is down almost 6% today due to higher-than-expected inventory levels. If corn prices continue to fall I will likely buy.

Debt Rising

As highlighted in the WSJ today, consumer debt has been rising. The Federal Reserve is actually happy about this trend since, they argue, it signals consumers are more optimistic about the future and the economy should begin to recover. My push-back to this argument is what happens should interest rates go up 1-2% after the Federal Reserve finishes its quantitative easing measures? Consumer debt might keep rising but a larger percentage of income has to go to debt service, providing a drag to the economy. Maybe the Federal Reserve intends to keep interest rates low into perpetuity, but I believe their argument is dangerously short-sighted and even "twisted."

My errands took me through a mall this morning and I noticed multiple stores with 70% off sales. This may just be an effort to blow out the last inventory from Christmas, but 70% sales doesn't suggest health, in my view. If anything, it suggests the retailer is competing more based on price than quality, style or service. Chains advertising these sales included Gap and Banana Republic (Ticker: GPS), Limited (Ticker: LTD), Express (Ticker: EXPR), Pac Sun (Ticker: PSUN), and American Eagle (Ticker: AEO). Brooks Brothers (private), Abercrombie (Ticker: ANF), J. Jill (private), and the Loft (Ticker: ANN) also advertised sales in excess of 50%. Hanna Anderson (private), Pottery Barn Kids (Ticker: WSM), and Crate & Barrel (private) all either had Spring inventory or small tactical sales, just to offer my view of healthier looking businesses.

Under my Sagflation thesis I believe there are fundamental deflationary pressures in the economy. One aspect of the deflationary pressure is an oversupply, especially within retail, in my view. Whether it comes from the rise of shopping on the internet or relatively inexpensive financing to expand store fronts, I believe the retail segment likely needs to rationalize. Especially if consumers begin reducing spending because of flat income coupled with rising interest rates, as well as food and gas expenses.

Apparently the consumers in China are continuing to spend. There has been some worry that as Chinese export growth slows that the Chinese economy likely stalls. China bulls argue that domestic spending can make up for the slowing export growth. I remain skeptical of this argument simply due to the numbers involved. Many areas of Europe likely contract this year and the US remains wobbly. I know there are a lot of Chinese, but the fundamental drivers of their economy of construction and manufacturing seemed a little peaky, in my view. Either way, with the rather opaque statistics about economic trends in China, we may not realize how good or bad it is in the country until it is too late.

My portfolio remains largely in cash and corporate debt. The equity markets are near the upper end of their ranges so unless you believe something could cause it to breakout, I believe a more prudent position is defensive. Especially with Europe potentially gearing up again for another round of debt crisis.

May You Live in Exciting Times...

Volatility, The Only Stable Outlook
Volatility. Many experts appear to expect a severe amount of it in 2012, which is kind of ironic since volatility implies unpredictability. Or, more directly, most experts are predicting unpredictability. Thanks for the help!

If the markets are as volatile as predicted then buy-and-hold strategies are in for a long year; talented traders and stock pickers could have a banner year; and mistakes are potentially magnified. So my goals for 2012, in this order: (1) Avoid mistakes, (2) Re-evaluate positions continuously, and (3) Pounce on opportunities.

Sagflation
In 2012 I believe my Sagflation thesis can continue to explain market dynamics. Under my Sagflation thesis, fundamental deflationary pressures impact economic activity and prices swing wildly as the efforts of the central banks and possibly fiscal policies attempt to provide stimulus. I expect this highly volatile phase to stretch through at least 2012, and possibly into 2014, before we see the early signs of how the economy can move in a new and more exciting direction. Make no mistake, I expect the next few years to provide a challenging environment to be invested in equities, but I expect the early signs of "what's next" to begin to pop-up. 

In 2012 I expect debt to continue to overwhelm governments and individuals around the world, providing significant deflationary forces as governments and individuals reduce spending. Make no mistake, the recent improvements in the economy were enabled by rising consumer debt levels. These higher debt levels are a result of the Federal Reserve lowering interest rates. I expect the Federal Reserve to keep interest rates low, and even target mortgages specifically, which likely enables consumer debt to continue to rise and keep the US economy somewhat stable. Eventually this debt will come due and unless inflation accelerates materially through the expansion of the money supply the debt load likely becomes a significant burden on economic activity. I believe it unlikely central banks continue to expand the money supply due to a growing debate within the US about its effectiveness, strong push back from inflation-wary countries like Germany, and increasing uneasiness about the effects the accommodating efforts have on the middle class. 

                                                                  Source: St. Louis Federal Reserve - FRED Economic Data

Adding to the deflationary forces are the potential trends of falling house prices (especially in China) and stagnant wages due to relatively high unemployment. Real disposable income in the US has remained relatively flat for almost five years. The combination of falling asset prices in the form of housing coupled with stagnant income means that the economy has a difficult time growing in a healthy way. In other words, demand likely declines as consumers struggle with no growth in disposable income, coupled with potentially rising food, energy and financing expenses.

                                                                   Source: St. Louis Federal Reserve - FRED Economic Data

Additionally, I expect to see money sloshing around the world economy seeking healthy returns. Typical safe havens like US treasuries appear less attractive with diminishing yields and increasingly risky as their fate is tied to the whims of the Federal Reserve, as opposed to market fundamentals. Riskier commodities and equities rise and fall quickly as investors chase returns but remain nervous about the risk. The sovereign debt of many countries has become too large and inter-connected with other countries, increasing the risk profile and reducing the ability of investors to diversify. The most attractive risk-return appears, in my view, in corporate bonds. Thus pension funds, annuity companies and other investment vehicles that provide defined benefits are likely actively searching for acceptable returns. Additionally, derivatives and ETFs that allow for easy movement of money likely drive asset prices higher and lower, depending on the prevailing sentiment.

On a positive note, I expect 2012 to begin to offer the first glimpses of the "light at the end of the tunnel." It may appear distant, and even disappear at times, but the first clues of a new world order likely come into focus over the next few years. Possible shining beacons to direct us include energy production innovation, advances in optical processing, and opportunities for creative destruction of control systems based on improving communication and processing systems.

Allocation Choices
US Treasuries are a dangerous investment choice in 2012, in my view. With the Federal Reserve actively twisting pricing it is difficult to glean data points that accurately depict the fundamentals. For the reason of Fed intervention, I reiterate my view published in June 2011 that the yield on the 30-year treasury touches 2.5%. With the yield hovering around 3% I do not see an attractive risk- reward to enter into either a large long or short position. Should the yield on 30-year treasuries touch 2.5% I would consider shorting longer-term treasuries. Otherwise, I plan to steer clear of this asset class.

US equities likely swing wildly in 2012, in my view. I plan to approach this asset class with extreme caution, looking for extreme moves either up or down before entering positions. At this point I expect equities to bounce around in a range for the first half of 2012, likely between 1,100 and 1,300 for the S&P 500. Any break outside this range in the first half of the year may offer a trading opportunity, in my view. The intervention by the Fed likely helps boost equity valuations and provide some feeling of health in the economy as financing remains inexpensive. My main concern is my 1-3 year outlook for equities continues to expect the S&P 500 to drop below 700. Left to its own devices, without intervention by the Fed, I believe the market would be on its way to this bottom. Once the Federal Reserve reduces its aggressive actions, the market may head in that direction. For much of the second half of 2011 I had been fighting with myself as I tried to buy dips while in a bearish mood. Not surprisingly, my performance suffered. While being careful, I find the steel, automotive, defense, telecommunications and media segments interesting.

Instead of playing equities I plan to over-weight corporate bonds in an effort to reduce the volatility but still benefit from favorable fundamental trends in the economy and activist policies by the Federal Reserve. In order to realize an attractive yield in quality companies, I plan to invest in the upper tier of high yield bonds, or BB +/- rated bonds. Ideally, the company exhibits improving fundamentals, offering both the opportunity for a credit upgrade and appreciating price should the ratings yield curve flatten. I also plan to diversify into various sectors with more emphasis placed in automotives (due to an aging fleet or cars in the US), telecommunications, consumer staples, and media

Commodities, like equities, may prove extremely volatile in 2012. For this reason they could prove an attractive investment, if timed correctly. Precious metals have pulled back significantly from their highs, making them an attractive investment, in my view, because of the potential of further monetary easing and instability in the world during 2012. The prices of many agriculture commodities, like corn and soybeans, have also pulled back significantly that may offer an attractive investment opportunity. Finally oil continues to hold onto a fairly lofty price despite my expectation of a slowdown in economic activity. Crude oil prices may remain near $100 in the first half of 2012 since the US economy appears to have a little momentum and the Fed could offer additional stimulus measures. If crude oil goes much above $100 a barrel I may short oil.

At the start of 2012 my largest exposure at around 30% is in corporate bonds, rated just below investment grade. I have chosen to put money here in order to try and avoid some of the volatility in the equity markets yet maintain exposure to anticipated improving fundamentals within certain segments in the steel, auto, telecommunications, consumer, industrial and chemical segments. Specifically, I have invested in bonds issued by US Steel, Ford Motors, NOVA Chemicals, Great Lakes Dredge and Dock, Valassis Communications, and CSC Holdings. Each of these positions provide a yield between 5-8%. In the near future I expect to add positions in precious metals and agriculture commodities due to the dramatic pull back in many of the prices of these commodities. These positions may prove more volatile but dips in their charts combined with on-going aggressive monetary policies in many countries should turn around prices, in my view.

After an exciting 2011 I'm quite happy to add some ballast to my portfolio and maintain flexibility.

2011 Performance Wrap-up

For the year my IRA increased 8.3%, relative to flattish performance by the S&P 500 for the year. For the month of December I slid backwards about 2% as positions in precious metals worked against me. I continue to believe that central banks likely pursue an expansionary policy going forward, and thus I plan to re-establish positions in precious metals in the near future. The timing in December was simply off, in my view, and timing is everything in these markets.

I plan to publish my outlook for 2012 in the near future.