Twelve Month Outlook - Investors May Get "Freight Trained"

Freight Trained - (Rodeo Term) Being run over by an animal that is traveling at top speed.

Investment Conclusion
I believe the equity markets and commodity prices perform reasonably well, albeit volatile, through much of the fourth quarter due to the recent monetary stimulus injected into the world economy. I also believe the significant sovereign debt outstanding results in each round of monetary stimulus having a diminished impact, reducing its impact in both duration and strength. Therefore, I believe there is a risk that investors move back into the market over the next few months chasing the monetary-driven valuation increases, only to become exposed to a significant correction in 2012 once the monetary stimulus diminishes. To put it more colorfully, investors potentially get run-over when a perceived bull run turns on them.

More specifically, I believe the equity and commodity markets peak at some point in the next 2-3 months and then begin to reverse. Without additional significant monetary stimulus in the first half of 2012 I expect the equity and commodity markets to move sideways to down during the first two quarters. Around mid-year I expect a violent correction in the markets due to one or more of the following causes: (1) decelerating growth associated with austerity, (2) accelerating inflation associated with monetary policies, and/or (3) major sovereign debt defaults associated with excessive debt levels. After this correction I expect equity markets to continue downward for an extended period of time before bottoming with the S&P 500 around 700, consistent with my previous views within my Sagflation thesis.

The following are four points supporting my argument that inflationary pressures move the markets over the next few months:

(1) ECB Switches to Monetary Stimulus
The European Central Bank, ECB, cut rates to 25 bps to 1.25% in a "surprise" move. The takeaway, in my mind, is that the ECB is prepared to aggressively stimulate the European economy through rate cuts over the next few months to offset an economy that is slowing due to the debt crisis. This moves likely drives commodity prices higher and possibly stocks higher due to more liquidity in the world financial markets. The change of course also likely weakens the Euro, although the US dollar also likely continues to weaken relative to a basket of foreign currencies due to the Fed's low interest rates and monetary stimulus.

(2) Europe Appeases Markets in Short-term 
My takeaways from the European Greek debt agreement were: (1) Over $1 trillion may be injected into the market, adding inflationary pressures, (2) market activity was perverted, setting an ominous precedent, (3) maybe contagion has been avoided stemming from Greece but what about Italy and other countries, and (4) a short term solution was created that may or may not accomplish its goals, if implemented at all. In short, the agreement pushes these issues into 2012 and likely amplifies their negative impact next year.

(3) The Federal Reserve Remains Expansionary
While the Federal Reserve did not announce any additional quantitative easing programs, it did say it "is prepared to employ its tools to promote a stronger economic recovery." I believe this wording positions the Fed for further quantitative easing. The Federal Reserve also expects to maintain the low interest rates. While the Fed obviously doesn't want to jump into action at the whim of the markets, it appears more focused on driving growth in the economy. My takeaway is that the outlook from the Fed's position is inflationary since they appear to be shifting to more worry about growth than inflationary.

(4) Japan Focused on Healthy Exports
Japan's central bank is focused on weakening the Yen to aid its export-driven economy. The central bank has agreed that the future purchases of financial assets may be warranted, setting the possibility of a sort of quantitative easing in Japan, adding liquidity and inflationary pressures to the world markets. This implies that each of the three major world currencies are implementing an expansionary monetary policy, increasing the likelihood of inflation building in hard assets, like gold, copper and other commodities. It also likely pushes stock valuations higher, until inflation pressures accelerate above 3-4% in the larger developed economies of the world.
 
My current positions I expect to let run until one of the following occurs: (1) the stock price approaches its 52-week high, which for many of my holding represents over 50% upside; (2) the S&P 500 climbs over 1,375; (5) worries about a sovereign nation defaulting begin to dominate the market; (4) inflation concerns begin to dominate market movements in the US; (5) the yield on the 30-year treasury tips above 4.5%; or (6) 1Q of 2012. Once one of these criteria are reached I plan to begin executing my exit strategy. I suspect the market may move up aggressively through much of the fourth quarter as portfolio managers who are under-performing their benchmarks attempt to make-up the difference, but the last week may prove a much more volatile quarter.

PEP: A Restructuring Story within the Declining Commodity Prices Theme

A couple weeks ago I laid out the theme of falling commodity prices within my Sagflation thesis, ultimately buying shares in Tyson Foods (Ticker TSN). In this post I continue with the deflationary theme but add in a restructuring story. One of my favorite signals when looking at a stock is a re-structuring or re-focusing of a strong brand. I call this the "Bain Capital" method since Bain Capital has a proven track record of buying distressed brand names and turning them around for a profit.

Pepsico, Inc. (Ticker PEP) has been popping up on my radar because of a re-emphasis on developing the popularity and identity of their brands, as opposed to just pushing volume. For about three years management has been focusing on improving productivity and re-investing savings back into R&D, brand-building and market-specific initiatives. During this time period of restructuring the returns of the business can appear worse than expected due to investment spending and uncertainty about the pay-off. However, as the investments begin to produce returns in the form of higher sales and improved margins, the stock can produce above average returns. For this reason, today I established a 2% position in PEP.

I have been considering Pepsico for its potential margin improvement due to my belief that commodity prices may continue to fall due to deflationary pressures. In the third quarter the gross margin declined 300 basis points annually, largely due to rising commodity prices. Sugar is a significant cost, as well as aluminum, corn, wheat, and gas. Due to a reduced supply of sugar from both Brazil and Australia, sugar prices have remained fairly high despite a pullback in other commodities. Since sugar prices have not declined significantly I have held back from Pepsico. That said, I expect more supply to come on the market as we roll through 2012 as growers are attracted by the higher prices in 2011. Management actively hedges commodity prices and the recent volatility may provide them with an opportunity to lock-in lower prices in 2012 relative to 2011, in my view. With all that considered, I decided Pepsico could benefit from falling commodities given its more stable sales characteristics and significant exposure to snack foods, which use corn and wheat. Wheat and corn prices have declined recently.

A risk to sales is that large retailers like Wal*Mart and Costco are able negotiate lower prices should the cost structure of Pepsico, and their competitors, decline due to falling commodity prices. Obviously these two retailers have significant leverage due to their size and from talking to a friend who has called on Costco, I know they can drive hard for price concessions. If Pepsico can increase volume of their products through their marketing campaigns, the company should have greater negotiating power when working with retailers. In addition, by improving productivity the company should be able to produce higher returns as the business lowers fixed costs and increases turnover. Improving returns should translate into an outperforming stock. That said, Coca-Cola has also worked on productivity improvements to lower its cost structure and has expanded vertically through its acquisition of the North American operations of bottler Coca Cola Enterprises last year.

Returning to the re-structuring plans, management began investing in its brands about 3 1/2 years ago when it focused on Gatorade. Management then moved to Tropicana, Pepsi Max, Sierra Mist, and Mountain Dew, each showing improvement. Now management is focused on Pepsi, a potential bigger bang for the buck after the cola fell to third place in the US in 2010 behind Coke and Diet Coke. Higher spending on marketing, funded by cost improvements, should enable Pepsi sales to improve going forward. In addition to the turnaround of established markets, the emerging markets remain a significant growth opportunity for the company to expand consumption with snack revenue growth of 31% in China and 26% in India this past quarter.

Last week they reported strong results after implementing price increases to offset rising commodity prices. An encouraging signal was that volume changes were within management expectations despite the price increase. Also encouraging was a reiteration of high single digit earning growth for 2011, despite less anticipated benefit from currency, implying the actual business is improving slightly better than expectations. Compare these results with a consensus EPS growth estimate of 6% in 2012 and I believe there is upside to forward year estimates should commodity prices fall or Pepsi sales improve.

The consensus analyst opinion is overweight for the stock. PEP trades at 13x the consensus 2012 EPS estimates. The dividend yield is an attractive 3.3%, higher than Coco-Cola's (Ticker KO) of 2.7%. PEP is trading close to its 52-week low.