The Bear Market Has Just Begun

 

Today the narrow-minded canyons of Wall Street are littered almost entirely of trend-following bulls and cheerleaders who don’t realize how little there is to actually cheer about. Stock values are far less attractive than they were on that day back in 2009 and this selloff has a lot longer to run. There are hordes of perma-bulls calling for a V-shaped recovery in stocks, even after multiple years of nary a downtick.

Here are six reasons why I believe the bear market in the major averages has only just begun:

1) Stocks are overvalued by almost every metric.One of my favorite metrics is the price-to-sales ratio, which shows stock prices in relation to the company’s revenue per share and omits the financial engineering associated with borrowing money to buy back shares for the purpose of boosting EPS growth. For the S&P 500 (INDEX: .SPX), this ratio is currently 1.7, which is far above the mean value of 1.4. The benchmark index is also near record high valuations when measured as a percentage of GDP and in relation to the replacement costs of its companies.

 

2) There is currently a lack of revenue and earnings growth for S&P 500 companies. Second-quarter earnings shrank 0.7 percent, while revenues declined by 3.4 percent from a year earlier, according to FactSet. The Q2 revenue contraction marks the first time the benchmark index’s revenue shrank two quarters in a row since 2009.

S&P 500
SNP3:13PM EST
  • Virtually the entire global economy is either in, or teetering on, a recession. In 2009, China stepped further into a huge stimulus cycle that would eventually lead to the largest misallocation of capital in the history of the modern world. Empty cities don’t build themselves: They require enormous spurious demand of natural resources, which, in turn, leads to excess capacity from resource-producing countries such as Brazil, Australia, Russia, Canada, et al. Now those economies are in recession because China has become debt disabled and is painfully working down that misallocation of capital. And now Japan and the entire European Union appear poised to follow the same fate.

This is causing the rate of inflation to fall according to the Core PCE index. And the CRB Index, which is at the panic lows of early 2009, is corroborating the decreasing rate of inflation.

 

But the bulls on Wall Street would have you believe the cratering price of oil is a good thing because the “gas tax cut” will drive consumer spending – never mind the fact that energy prices are crashing due to crumbling global demand. Nevertheless, there will be no such boost to consumer spending from lower oil prices because consumers are being hurt by a lack of real income growth, huge health-care spending increases and soaring shelter costs.

4) U.S. manufacturing and GDP is headed south. The Dallas Fed’s manufacturing report showed its general activity index fell to -15.8 in August, from an already weak -4.6 reading in July. The oil-fracking industry had been one of the sole bright spots for the US economy since the Great Recession and has been the lead impetus of job creation. However, many Wall Street charlatans contend the United States is immune from deflation and a global slowdown and remain blindly optimistic about a strong second half.

Unfortunately, we are already two-thirds of the way into the third quarter and the Atlanta Fed is predicting GDP will grow at an unimpressive rate of 1.3 percent. Furthermore, the August ISM manufacturing index fell to 51.1, from 52.7, its weakest read in over two years. And while gross domestic product in the second quarter came in at a 3.7 percent annual rate, due in large part to a huge inventory build, gross domestic income increased at an annual rate of only 0.6 percent.

GDP tracks all expenditures on final goods and services produced in the United States and GDI tracks all income received by those who produced that output. These two metrics should be equal because every dollar spent on a good or service flows as income to a household, a firm, or the government. The two numbers will, at times, differ in practice due to measurement errors. However this is a fairly large measurement error and it leads one to wonder if that 0.6 percent GDI number should get a bit more attention.

5) Global trade is currently in freefall. Reuters reported that exports from South Korea dropped nearly 15 percent in August from a year earlier, with shipments to China, the United States and Europe all weaker. U.S. exports of goods and general merchandise are at the lowest level since September of 2011. The latest measurement of $370 billion is down from $408 billion, or -9.46 percent from Q4 2014. And CNBC reported this week that the volume of exports from the Port of Long Beach to China dropped by 10 percent YOY. The metastasizing global slowdown will only continue to exacerbate the plummeting value of U.S. trade.

 

6) The Fed is promising to no longer support the stock market. Back in 2009, our central bank was willing to provide all the wind for the market’s sail. And despite a lackluster 2 percent average annual GDP print since 2010, the stock market doubled in value on the back of zero interest rates and the Federal Reserve ‘s $3.7 trillion money-printing spree. Thus, for the past several years, there has been a huge disparity building between economic fundamentals and the value of stocks.

But now, the end of all monetary accommodations may soon occur, while markets have become massively over-leveraged and overvalued. The end of quantitative easing and a zero interest-rate policy will also coincide with slowing U.S. and global GDP, falling inflation and negative earnings growth. And the Fed will be raising rates and putting more upward pressure on the U.S. dollar while the manufacturing and export sectors are already rolling over.

I am glad Ms. Yellen and Co. appear to have finally assented to removing the safety net from underneath the stock market. Nevertheless, Wall Street may soon learn the baneful lesson that the artificial supports of QE and ZIRP were the only things preventing the unfolding of the greatest bear market in history.

Michael Pento produces the weekly podcast “The Mid-week Reality Check,” is the president and founder of Pento Portfolio Strategies and author of the book “The Coming Bond Market Collapse.”

 

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OIL Declines – (as we forecast) – Expect ” more of the same “

Oil Falls to 5 1/2-Year Low as Russia, Iraq Boost Output

Oil dropped to the lowest since May 2009 amid growing supply from Russia and Iraq and signs of manufacturing weakness in Europe and China.

Futures headed for a sixth weekly loss in New York and London. Oil output in Russia and Iraq surged to the highest level in decades in December, according to data from both countries’ governments. Euro-area factory output expanded less than initially estimated in December. A manufacturing gauge in China, the world’s second-largest oil consumer, fell to the weakest level in 18 months, government data showed yesterday.

Prices slumped 46 percent in New York in 2014, the steepest drop in six years and second-worst since trading began in 1983, as U.S. producers and the Organization of Petroleum Exporting Countries ceded no ground in their battle for market share. OPEC pumped above its quota for a seventh month in December even as U.S. output expanded to the highest in more than three decades, according to data compiled by Bloomberg.

Oil Prices

“We’re seeing more of the same,” John Kilduff, a partner at Again Capital LLC, a New York-based hedge fund that focuses on energy, said by phone. “The Chinese and European PMI figures signal weaker demand, while there’s ever-increasing supply. Nobody is cutting back on output and now the Russians are posting post-Soviet production highs.”

Brent for February settlement fell 53 cents, or 0.9 percent, to $56.80 a barrel on the London-based ICE Futures Europe exchange at 11:31 a.m. It declined to $55.48, the lowest since May 7, 2009. Volume for all futures traded was 30 percent below the 100-day average. The European benchmark slumped 48 percent last year, the second-biggest annual loss on record behind a 51 percent tumble in the 2008 financial crisis. Brent traded at of $3.24 premium to WTI.

West Texas Intermediate for February delivery rose 32 cents, or 0.6 percent, to $53.59 a barrel on the New York Mercantile Exchange after dropping to $52.03, the least since May 1, 2009. Volume for all futures traded was 34 percent below the 100-day average. Prices are down 3.2 percent this week.

The surge in oil supplies in Iraq and Russia signaled no respite in early 2015 from the glut that’s pushed crude prices lower. The two countries provided 15 percent of world oil supply in November, according to the International Energy Agency.

Russian oil output rose 0.3 percent in December to a post-Soviet record of 10.667 million barrels a day, according to preliminary data e-mailed today by CDU-TEK, part of the Energy Ministry. Iraq exported 2.94 million barrels a day in December, the most since the 1980s, Oil Ministry spokesmanAsim Jihad said.

The final two burning crude-storage tanks were extinguished at Es Sider, Libya’s biggest oil port, National Oil Corp. spokesman Mohammed Elharari said by phone from Tripoli. The fires started Dec. 25, when Islamist militants shot rockets at the port in a second attempt to capture it.

OPEC Production

OPEC’s production slid by 122,000 barrels a day from November to 30.24 million last month, led by losses in Saudi Arabia, Libya and the United Arab Emirates, a Bloomberg survey of companies, producers and analysts shows. The 12-member group has a collective target of 30 million a day.

U.S. oil production averaged 9.12 million barrels a day in the week ended Dec. 26, according to the Energy Information Administration. Output increased to 9.14 million a day through Dec. 12, the most in weekly data that started in January 1983.

Inventories of gasoline surged in the week ended Dec. 26 as production climbed to a record, EIA data showed.

Gasoline futures declined 3.14 cents, or 2.1 percent, to $1.4407 a gallon in New York. Diesel decreased 3.18 cents, or 1.7 percent, to $1.8018.

Regular gasoline at U.S. pumps fell to the lowest level since May 2010. The average retail price slipped 0.9 cent to $2.231 a gallon yesterday, according to Heathrow, Florida-based AAA, the nation’s biggest motoring group.

Sector will respond to the lower commodity price but their share price will decline – example;

NEW YORK (MarketWatch) — Linn Energy LLC LINE, +15.20% said Friday it has approved a 2015 budget that cuts oil and natural gas capital spending to $730 million from about $1.55 billion in 2014, the latest company to respond to the recent slide in crude oil prices. “After careful consideration, LINN’s senior management proposed and the Board of Directors approved a 2015 budget that contemplates a significantly lower current crude oil price than in 2014,” Chief Executive Mark Ellis said in a statement. The budget assumes an unhedged NYMEX price of $60 a barrel. The company is cutting its annual dividend to $1.25 a share from $2.90, he said. Linn Energy has signed a non-binding letter of intent with GSO Capital Partners LP, the credit arm of The Blackstone Group LP BX, +0.56% to fund oil and gas development. GSO has agreed to commit up to $500 million to fund drilling programs. Shares were down 6.2% in premarket trade.

Three weeks after Chairman Steve Schwarzman said it’s going to be the best time in years to invest in energy, Blackstone Group LP (BX) is putting money to work.

Blackstone’s $70 billion credit arm, GSO Capital Partners, committed as much as $500 million to fund oil and natural gas development for Linn Energy LLC (LINE), according to a statement today. The Houston-based energy producer rose as much as 18 percent after the announcement, after losing almost 70 percent of its value in six months as crude prices plummeted.

Private equity firms, while taking steps to shore up energy companies in their portfolios, are hunting for investments in oil and gas producers after Brent tumbled more than 50 percent since June. Energy presents the best opportunity for Blackstone in many years, especially for the New York-based firm’s credit unit, Schwarzman said at a Dec. 11 conference.

“There are a lot of people who borrowed a lot of money based on higher price levels, and they’re going to need more capital,” he said at the conference in New York. “There are going to be restructurings to do. There’s going to be a fallout. It’s going to be one of the best opportunities we’ve had in many, many years.”

Photographer: Patrick T. Fallon/Bloomberg

Steve Schwarzman, co-founder, chairman and chief executive officer of Blackstone Group

Under the five-year agreement with Linn, Blackstone would fund drilling programs at locations selected by Linn for an 85 percent working interest in the wells, according to the statement. If the projects produce a 15 percent annualized return for Blackstone, its stake will drop to 5 percent.

Oil ‘Crisis’

The plunge in oil may usher in a new era for investing in distressed debt, according to Howard Marks, the billionaire co-founder of Oaktree Capital Group LLC. In a letter to clients last month, Marks said his Los Angeles-based firm is becoming more aggressive as companies that borrowed heavily in the low-interest rate environment now come under pressure.

“We knew great buying opportunities wouldn’t arrive until a negative ‘igniter’ caused the tide to go out, exposing the debt’s weaknesses,” Marks wrote. “The current oil crisis is an example of something with the potential to grow into that role.”

Linn, a master-limited partnership, is the latest producer to cut spending on expectations of lower oil and gas prices. The company said today it expects oil to average $60 a barrel in 2015, although it has hedged about 70 percent of its expected output at higher prices. Brent fell 1.9 percent to $56.23 a barrel at 2:38 p.m. in New York.

Active Developer

The agreement with Blackstone, which is non-binding, is “designed to allow Linn to be an active developer of assets with growth capital,” Mark Ellis, Linn’s chief executive officer, said in the statement. “This agreement creates a dynamic alliance.”

The company’s shares rose 13 percent to $11.44 at 2:47 p.m. in New York.

Please see our recent articles published this week on  2015 Energy Sector Forecasts ( archived) 

 

Apple is wholly unoriginal … and that’s okay ? Here Comes Sam(sung)

Apple is set to announce a handful of new products next week that you’ve already seen elsewhere. But when it comes to Apple, that’s not a problem.

Whether it’s larger phones, a smartwatch or a new mobile payments system — all of which are rumored to be announced next week — Apple will be following the lead of other companies that already have products on the market. That’s prompting renewed criticism that the company has lost its ability to innovate following the death of former CEO and co-founder Steve Jobs.

But even if Apple isn’t the first company to make these products, its track record indicates that it still has the opportunity to reap gains by executing them better than the competition.
“Apple is not usually first to market — they typically make an existing product much better and more usable,” said Amit Daryanani, an analyst with RBC Capital Markets.

Apple is widely expected to unveil a pair of larger iPhones next week measuring 4.7 inches and 5.5 inches, up from four inches on the iPhone 5S.
Those larger phones will finally give Apple (AAPL, Tech30) some entries into the “phablet” market. That product category has been led in recent years by rival Samsung.
For Apple, the larger phones are low-hanging fruit. Customers spent over $10 billion in the company’s App Store last year, the bulk of that going to gaming apps. Bigger screens and faster processors on the new iPhones will make those games even more compelling.
As for smartwatches, Apple will be following on the heels of devices from companies like Samsung, LG and Motorola that sync with smartphones and offer features like directions and fitness tracking.
But the recent crop of smartwatches have underwhelmed reviewers and failed to present a compelling reason why they’re more convenient than simply taking your phone out of your pocket. If Apple can find a way to improve on those models — perhaps with more sophisticated health tracking or location awareness — consumers may finally have a reason to ditch their old Timexes en masse.
The opportunity is even bigger in mobile payments, where smartphone-based systems like Isis and Google (GOOGL, Tech30) Wallet have been around for years without catching on.

Apple has reportedly been working with major credit-card companies on an iPhone-based payment system. The company already has more than 800 million credit cards on file thanks to iTunes and App Store accounts, according to some estimates, giving it a massive ready customer base.
Add to that the security of the iPhone’s fingerprint identification system and Apple could finally push merchants and consumers to ditch plastic and move to smartphone-based transactions.
“To say that Apple is coming out with a product that already exists ignores the fact that there were MP3 players before the iPod and smartphones before the iPhone,” said Walter Piecyk, an analyst with BTIG. “Those products defined their categories

Having trouble with your iPhone 5 battery? You might be eligible for a free replacement.
Apple (AAPL, Tech30) said “a very small percentage” of iPhone 5 smartphones may “suddenly experience shorter battery life or need to be charged more frequently.”

Don’t get too excited just yet. After a year or two, everyone’s iPhone battery seems to carry less juice than it once did. But Apple’s repair program is limited to certain customers in the United States and China.
Only iPhone 5 smartphones sold between September 2012 and January 2013 are eligible, and only those that fall within a certain range of serial numbers. Apple has opened a website that allows people to determine whether their phones are eligible. (To access your serial number, tap Settings > General > About > Serial Number).

Investors curbed their bets on Apple on Wednesday.

One possible reason: They got a reminder that the company won’t have a free run at the market this fall even with the release of the hotly anticipated iPhone 6 and supposed iWatch.

Apple’s shares fell 4.2%, having hit an all-time closing high of $103.30 on Tuesday. The drop coincided with rival Samsung’s event at the IFA show in Germany, where it previewed new versions of its Galaxy

Apple Inc. (AAPL)-Nasdaq
Prev Close: 103.30
Open: 103.20
Bid: 98.79 x 100
Ask: 98.82 x 100
1y Target Est: 106.83
Beta: 0.83
Earnings Date: Oct 27 – Oct 31 (Est.)
Day’s Range: 98.58 – 103.20
52wk Range: 63.89 – 103.74
Volume: 125,424,577
Avg Vol (3m): 49,884,300
Market Cap: 592.44B
P/E (ttm): 16.60
EPS (ttm): 5.96
Div & Yield: 1.88 (2.00%

iShares SouthKorea ETF (EWY : NYSE : US$65.27), Net Change: -0.13, % Change: -0.20%, Volume: 1,332,424
Arms race?

Samsung unveiled new versions of its Galaxy Note smartphone on Wednesday, featuring a crisper, 5.7-inch display edition version of the Note with a curved edge screen on one of the phone’s sides, helping users to stay focused on their main screen without having to respond to calendar reminders or incoming emails.

It also demonstrated a Virtual Reality headset that on version of the Note with a curved edge screen on one of the phone’s sides, helping users to stay focused on their main screen without having to respond to calendar reminders or incoming emails.

. The launch comes just less than a week before Apple’s September 9 event where Apple is expected to roll out a 4.7- and 5.5-inch iPhone 6 as well as a possible iWatch device. Last week, Samsung said it would begin selling a stand-alone wristwatch, the Samsung Gear S, which will be able to make and receive calls without having to be tethered to a smartphone. Apple is also expected to join forces with credit card companies to provide a mobile payment option for the iPhone 6 and iOS 8.

HeartWare International BUY

HTWR : NASDAQ : US$96.40
BUY 
Target: US$110.00

COMPANY DESCRIPTION:
HeartWare is a development-stage company that designs, manufactures, and markets miniaturized left ventricular assist devices (LVADs), which are surgically implanted pumps to offset decreased pumping capability in individuals with heart failure. HeartWare’s axial flow HVAD incorporates its proprietary “hybrid” platform, wherein the impeller (or rotor) used in the pump is suspended by passive magnets and dual hydrodynamic thrust bearings.
All amounts in US$ unless otherwise noted.

Investment recommendation
We recommend investors add to/start positions in HTWR. We view the Circulite acquisition announced Sunday night positively – both in terms of 1) the large, new market opportunity it opens up for HTWR in the Class majority of the potential capital outlays to future milestones (CE Mark, FDA approval, sales goals).
Investment highlights
 We estimate the TAM for device therapy in the Class III HF patient population approximates an incidence of 500,000 potential patients in the US and 570,000 in Europe annually. If we assume a conservative 10% “sweet spot,” we would derive an annual worldwide market opportunity approaching $5 billion.
 The majority of Class III heart failure patients have few viable therapeutic options. To wit, only a small portion of these patients (i.e., 20-30%) are practical candidates for bi-ventricular pacing (i.e., CRT therapy), and studies suggest at least one-third of these patients do not respond to CRT therapy. Many of these Class III HF patients could benefit from Synergy or Sunshine Heart’s C-Pulse.
 Wood to chop – We assume HTWR was able to get this deal done with relatively little money up front in part because of a documented thrombosis issue with Synergy in the early days of its initial commercial launch in Europe. This issue may ultimately prove unsolvable; time will tell. That said, HTWR’s engineers and R&D staff
have proven highly effective addressing issues with HVAD in the past.This experience/productivity, coupled with the relatively low pricepaid for this “shot,” strike us as a risk very much worth taking, as asuccessful re-launch of Synergy would significantly expand HTWR’slong-term revenue potential, not to mention providing a synergistic product platform that spans both Class III and IV HF.

TransDigm Group

TDG : NYSE : US$148.76
BUY 
Target: US$170.00

COMPANY DESCRIPTION:
TransDigm Group, headquartered in Cleveland, Ohio, is a leading supplier of engineered components and systems
for military and commercial aircraft. Approximately 90% of sales are from proprietary products, and approximately
75% from sole-source products.
All amounts in US$ unless otherwise noted.

Investment recommendation
TransDigm Group (TDG) will report its Q4/13 and full year results on November 14, 2013. The focus will be on the initial 2014 outlook; we see an in-line Q4/13. We believe the initial commercial AM outlook will call for high-single-digit growth, which we view as a positive. We see total organic growth of ~6% in 2014, and we believe defense sales will finally show a decline. We like TDG for the cash deployment catalysts, acquisitions, and execution capabilities. We are raising our PT to $170
from $165.
Investment highlights
 While the near term commercial aftermarket is mixed, we believe TDG will see acceleration as 2014 progresses driven by stronger demand for engine parts (~20% of AM sales), continued strong fundamentals, as well as more normalized parts purchasing. We believe initial guidance of up 8%-10% will be viewed as encouraging.
We believe Q4/13 results will be in line.
 We see an incremental ~$1B in 2014 cash capacity for either acquisition or other cash deployment options, with acquisitions as the preferred use. The key risks to TDG, in our view, are the potential for rising interest rates, or new business. We believe there is a relatively strong acquisition pipeline and the company should continue to see
better than expected execution on recent acquisitions.
Valuation
Our $170 price target is based on the average of a 22.0x EPS multiple, and a 13.5x EBITDA multiple, applied to our 2014 estimates. We believe that a valuation at the upper end of the historical range is justified due to the potential for better aftermarket sales and cash deployment

 

OraSure Technologies BUY HIV /Test Kits

OSUR : NASDAQ : US$5.97
BUY 
Target: US$10.00

COMPANY DESCRIPTION:
OraSure develops, manufactures, and markets HIV, HCV and drugs of abuse rapid test kits, primarily for the point-of-care setting to deliver immediate test results. Its business principally involves oral fluid technology (in addition to blood) as an alternative specimen collection. OraSure also has a legacy meddevice business for the removal of warts and other benign skin lesions by cryosurgery, or freezing.
All amounts in US$ unless otherwise noted.

Investment recommendation
OSUR reported strong Q3 results that beat on the top and bottom line, and issued Q4 guidance above our expectations (largely due to a change in revenue recognition). We are bullish on OSUR’s growth levers in HIV OTC, HCV and MDx collections, and reiterate our BUY rating and $10 PT.
Investment highlights
 Q3/13 results beat. Q3 revenues of $24.7M (+12%) topped our $24.0M/Street’s $24.2M/guidance of $24-24.5M. Q3 EPS of ($0.03) topped our/Street’s ($0.10) as OPEX came in $2.2M below us.
 HIV-OTC sales accelerated. HIV OTC net sales of $1.8M matched ourestimate and includes $217K sold to public health clinics. OSURlaunched its new marketing campaign in late September to better target MSM and African American women.
 DNA Genotek strong again. Q3 HCV revenues of $1.6M (+72% Y/Y)were strong, largely driven by a large order from a multinational organization for use OUS. DNA Genotek generated another record quarter with revenues of $5.0M (+48% Y/Y) due to strong uptakewith commercial customers like 23andMe and Ancestry.com.
 Guidance/Model. OSUR guided Q4/13 revs of $27.5-28.0M, ahead ofour estimate, as OSUR expects a ~$2.0M Q4 benefit as its revenue recognition changes in Q4 to a “sell-in” model from a “consumption” model. We bumped up our Q4/13 revenue estimate to $27.7M from $25.0M. We lowered our ’14 rev estimate to $108M from $111M to
reflect more conservatism in HIV OTC as retail channels smooth out.
Valuation
We reiterate our $10 PT, which uses a ~5.0x P/S multiple on our 2014 revenue estimate of $108M.

 

Ducommun BUY Target $ 34

DCO : NYSE : US$26.87
BUY 
Target: US$34.00

COMPANY DESCRIPTION:
Ducommun, headquartered in Carson, California, is a supplier of aerostructures and components for commercial and military aircraft and engines, as well as a supplier of electronic assemblies and systems for commercial, military, industrial, medical and natural resources markets.

IMPROVING MARGINS AND DELEVERAGING TO DRIVE UPSIDE
Investment recommendation
We are initiating coverage of Ducommun (DCO) with a BUY rating and a $34 price target. As execution continues to improve, confidence in cash flows and debt reduction should increase, serving as positive catalysts. We believe H2/13 represents the bottom for non-A&D sales, which should provide additional upside into 2014.
Investment highlights
 While structures represent only 42% of sales, sentiment on segment margin improvement is important for DCO stock. We believe strong improvement in 2013 (100bps over 2012) and then steady improvement into 2014-2015 will be positive, demonstrating execution capabilities and success with new programs. Improved execution is also reducing the negative overhang from the 2011 LaBarge acquisition.
 DCO on track to reduce debt by ~$30M each year through 2015, which would contribute ~$0.10 to EPS. We believe the non-A&D sales will trough in H2/13, adding to the 2014 upside.
Valuation
Our $34 price target is based on the average of a 15.0x EPS multiple and an 8.0x EBITDA multiple, applied to our 2014 estimates. We believe even with the strong 2013 YTD performance (up >70%), investor interest will remain positive as execution improves.