Wednesday, July 2, 2008

Dealing With Deleveraging Doldrums

Surging oil prices sent US stocks into a tailspin today, knocking the S&P 500 below its March lows for the first time and sending the Dow Jones Industrial Average scuttling into bear market territory - down 20%. Here in Canada, the The S&P/TSX composite index fell 432.92 points, or 3%, to close at 14,034.11.

The hardest hit sector was materials as coal and mining shares tumbled hard. This article from SeekingAlpha caught my eye today (click on image above to enlarge it). The article attributes today's big selloff in coal and mining shares to institutional profit taking and sees it as a buying opportunity:

"This big selloff in the top performing names indicates that money managers and other institutional investors were most likely holding onto these names for window dressing purposes through the end of the quarter, only to take profits in them at the first chance they had. Investors that have been waiting to get into these names on a pullback might want to take a look at them now."

But investors should think twice before buying these pullbacks. What if something else is going on here? In particular, what if the global deleveraging process has just started to hit coal, mining and eventually other commodity shares? This might just be the beginning of a long slide for the last bubble to burst, namely, the commodity bubble. We might get another another parabolic blowoff rally or this might just be it. In any event, pension funds would be wise to go underweight the material sector because the downside risks are too high.

Yesterday the Fed released the results of its most recent auction - another $75 billion in loans to squeezed banks to help them overcome credit problems. JP Morgan stated that the worst is over for European banks as credit-related writedowns have peaked.

Wall Street claptraps are proclaiming that the worst is over. All these upbeat comments fly in the face of reality. One can easily argue that the deleveraging process for the financial system has barely started. I quote the following from this article published in the in the International Herald Tribune:

"Credit investors have one very clear message for equity investors: The duration of the slowdown will be longer than the stock markets think, and the effects of the credit crisis will stay with us for many years," the Dresdner Kleinwort credit strategist Willem Sels wrote in a note to clients. "Tighter financing conditions and higher corporate defaults will directly or indirectly affect almost any corporate."

I was speaking to a senior pension fund manager this afternoon and he told me that we might get a rally in equities during the last quarter of 2008 but that will be sold in 2009. He expects a very tough year next year and given his outstanding track record, I think investors should heed his advice and prepare for the worst. The deleveraging process will be painful and it will hit all asset classes hard, especially private markets as well as the financial and material sectors. It's time for pension fund managers to tweak their asset mix and start preparing for a prolonged period of weakness.

Finally, in my last post I wrote about why I think solar stocks should be bought after the recent deep correction. I firmly believe that this sector will experience a long secular bull run as the "green gold rush" continues to forge ahead. A lot of shorting took place in this sector after the Bureau of Land Management (BLM) announced moratorium on applications to build solar plants on public lands and some governments announced they will cut subsidies to solar companies. Tonight, in a surprise decision, the US government backed off and said it is calling off the moratorium. I expect massive short covering in this sector as we head into the long weekend and these shares should outperform the overall market going into Q2 earnings. Forget all those negative comments from Wall Street analysts; the problem with solar is that there really is no problem!

My favorite plays in the sector are SOLF, ESLR, FSLR, CSIQ, STP, SPWR, TSL, WFR and YGE but be warned: you need to have a strong gut to weather the volatility. You can also buy the Claymore/MAC Global Solar Energy ETF (TAN). If you want to learn more about solar stocks, watch this interview (click here).

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