Author: Ben Dickey, BSG&L Financial Services LLC
Disclosure: Long all stocks mentioned
The first quarter of 2012 came in with fairly good growth, both in GDP and employment gains. However, the second quarter results stumbled to 1.5% growth. The latest revision moved second quarter growth up to 1.7%. We have now seen GDP output decline from 3% growth in the fourth quarter of last year to 1.9% in the first quarter of this year and now down to 1.7% growth in the second quarter. Estimates for July and August are for approximately a 1.3% growth rate on average.
Our economy is still being impacted by several factors, with the European debt troubles being one of them. The world is waiting on Mario Draghi to decide what the European Central Bank is going to propose. (One plan under consideration involves unlimited purchases of government bonds, reports Bloomberg.)
The price of sovereign debt rises and falls on every news story about the crisis. Capital outflows from Europe are high, adding to the flood of foreign capital coming into the United States. To compound Europe’s problems, Finland, Germany and Belgium are beginning to have doubts about supporting southern Europe.
Another critical factor causing the slowdown in the U. S. economy is the massive fiscal cliff that the economy is facing at the end of the year. The expiration of the “Bush-era” tax cuts, the temporary reduction of the payroll tax cuts, and the extended level of unemployment benefits will all expire on December 31st.
Compounding the problem is the “Sequestration” of government spending, due to the failure of the Super Committee, is also scheduled to take effect in January, 2013. Not knowing whether or not the economy is going to actually go over the cliff at year end has many businesses in a wait and see mode of operations.
A whole lot of spending and expansion plans are on hold until a clearer picture unfolds. As a result of the economic slowdown, the overall market sentiment has turned extremely pessimistic. I believe that businesses will not have a clear understanding of the resolution to the fiscal cliff scenario until after the election in November.
However, amidst all the doom and gloom with the U.S. economy are several areas of bright sunshine. A byproduct of the weakening world economies is falling commodity prices, at least in the near term. Overall, even with all of the negativity, our economy does continue to expand, albeit at a slower rate. The U.S. Purchasing Managers Index (PMI) has shown growth in the manufacturing sector every month from August 2009 until May of this year. Although, June and July have turned negative, the manufacturing segment has shown slow but steady growth.
There are several other market segments doing well. Major technological advances in the oil & gas industry have allowed the U.S. to increase their oil production for the first time in over 20 years. As companies learn more about drilling in shale formations, they are decreasing the space between wells and pad drilling, meaning they can drill four or more wells from one location. Both of these items reduce the cost of drilling wells. There is also a move to lessen the use of ceramic proppant and replace it with sand which is cheaper. This will increase the profitability of companies drilling in the shale plays.
The low natural gas price is lowering operating costs for many manufacturing companies. Utilities, where they are able, are changing from burning coal to burning natural gas for electricity production. This should help lower utility costs to both the commercial and residential user, helping the U.S. economy.
In addition, the increased production of natural gas liquids such as ethane, propane and butane has lowered the input costs for the chemical industry. As a result, chemical companies are moving production back to the U. S. from overseas which is causing plants in the Gulf Coast to expand capacity at a strong clip. Several chemical producers we follow have shown nice price gains recently. New pipelines are under construction.
The lower leg of the Keystone XL pipeline from Cushing OK to the Texas gulf coast refineries has finally received the last approval. This should be finished by mid-2013. The new pipelines will lower transportation cost from the Eagle Ford, Permian Basin and Marcellus shale’s to the refineries.
The lower transportation cost provided by the new pipelines delivering natural gas liquids will make the U.S. chemical industry even more competitive. The Keystone will bring more crude oil to the refineries, allowing us to lower the amount of imported oil and allowing the refineries to improve their profits.
Throughout the world, emerging market economies have slowed down, but still have a growth rate of mid to upper single digits. China and India have slowed as export demand for goods going to Europe have slowed. However, an increasing middle class in these markets is beginning to make these countries less dependent on exports. In addition, Mexico, Indonesia, South Korea and Central America are growing at faster rates than the BRIC countries are.
Despite all the negative news, the market has improved over the last few weeks. There is a lot of anticipation of further Quantified Easing from the Federal Reserve which has helped the market move higher. However, over the last few days, some selling has been evident. At present, it is hard to tell if this is profit taking or the slow down is beginning to take a toll on the markets.
BSG&L has a long term investment horizon. This belief causes us to stay with an overweighting in our basic portfolio allocation to industrials in our Growth Portfolio. We like Caterpillar (CAT) as the best choice for heavy industrials. They are the behemoth in this business. Their sales in China and India have slowed, but their geographical diversity helps them.
We still like Deere & Company (DE), Honeywell International (HON), United Technologies (UTX), Emerson Electric (EMR), and Cummins (CMI) in the industrial sector as well. Several of these stocks are dramatically over sold. As the market settles down we will add to our positions.
In the energy service sector we like Helmerich & Payne (HP), Cameron International (CAM), Halliburton (HAL), Mitcham Industries (MIND) and Schlumberger (SLB). Our commodities and energy holdings have changed very little. We continue to like Continental Resources (CLR), Anadarko Petroleum (APC) and EOG Resources (EOG) in energy. EOG and Continental Resources have shown large increases in production year over year.
We are adding to our position in Oasis Petroleum (OAS). We still like industrial commodity producers Peabody Energy (BTU), Freeport-McMoRan Copper & Gold (FCX), Cliffs Natural Resources (CLF), and Southern Copper (SCCO).
Industrial commodity prices have seen a large pull back, pulling these company’s share prices down. Our belief is you should be building your cash position for now and let the markets settle down. I believe you will be able to purchase these companies at good value prices before the end of the year for another good upward move.
As we have been saying for quite a few months now, the pipeline companies and commodity Master Limited Partnerships are experiencing tremendous growth although their stock prices have been impacted by the drop in oil and natural gas prices. We think this is an excellent time to add to these positions for the long term increases in stock price and distribution amounts that we think are coming.
As a result, in our Growth Plus Income portfolio we continue to add Kinder Morgan Energy Partners (KMP), Linn Energy (LINE), Enterprise Products Partners (EPD), SandRidge Mississippian Trust (SDT) and SeaDrill Limited (SDRL).
These companies have good dividend rates and I believe that there is big demand for new pipeline construction. As new technology increases the output of oil, natural gas and natural gas liquids, this production will move through the new pipelines. We believe the above companies will show tremendous growth over the next ten years.
Just to restate, I believe the European debt problem and the upcoming U.S. elections have us concerned about market activity for the rest of this year. Hedging this volatility, in my opinion, will be hard. Gold last year was as volatile as the stock markets. I believe copper and oil will be the inflation hedges going forward.
Central Banks around the world have injected so much liquidity into markets, that when it is put to work, commodities will move dramatically in price. BSG&L is a long term investor. We believe if you are patient, build cash and buy good companies on pullbacks, your portfolio will have good growth over the long term.
Disclosure: The investments discussed are held in client accounts as of August 31, 2012. These investments may or may not be currently held in client accounts.The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.
BSG&L is a Texas-based registered investment adviser. Our founding principals, Ben Dickey and Kevin Londergan, have more than 30 years experience in both accounting and financial services.
At BSG&L, we believe that greater and consistent returns can only be achieved by identifying long-term tendencies in the investment markets and understanding fundamental shifts in expected investment returns.