The bullish thesis for a rally: a technical indicator review.

While we could be in for a rough period for the remainder of the year, there is a growing conviction that at least an intermediate term bottom has been set, and we could be due for a rally. A few indicators point towards increasing risk appetites amongst investors. Here's a review of some of them:

• The yen carry trade(JPYUSD) trade is extremely oversold right now, and below 200 day MA. There's always a reversion to the mean with respect to the 200 day MA. Resumption of the carry trade has been bullish for equities in the past.
  

• Tips look like they've entered a period of downtrend, indicating growing risk appetites.

• Bond yields rallied and broke their downtrend, at least for now. (Hat tip: Bespoke group) Previous bear rallies failed at this level. That's a positive.

• S&P broke through the 50 day MA decisively and has been making a series of higher highs and higher lows since the March lows.
  
  



• VIX in some sense anticipates future stock market volatility. The 200 day MA has acted as support ever since the credit turmoil began. VIX dropped below the 200 day MA. This should imply lower volatility for the next few weeks, which in turn is bullish, assuming of course that it stays below the 200 day MA. It looks like a correction in the long term upward trend in volatility (that's not a clever way to look at this though) .
  
  


• Credit default risk on the investment banks has declined dramatically. (Hat tip to the excellent folks at Bespoke again) Is it time for a rally in the financial sector?
  
• Traderfeed has some more thoughts on why we could have hit a market bottom.

If Dow Industrials can close above 12,750, it will trigger a Dow Theory buy signal. (Refer to this post on the strength of the transports). Alongwith a break of the S&P 500 above it's overhead resistance at 1390, that should pull in new money, and help the averages up another 5-10%, if we can close above these numbers.

Disclosure: None

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Dissecting Intel's quarter.

The investment thesis in Intel consists predominantly of :

1. Competitive wide moat 45 nm strategy, and aggressive pursuit of Moore’s law.
2. Low cost differentiator due to economies of scale.
3. Margin expansion due to lower ongoing costs and operating expenses.
4. Potential growth by targeting new markets like Consumer Electronics (CEs), Mobile Internet Devices (MIDs) and Ultra Mobile PCs (UMPCs).
( Discussed in a later post. This post discusses their current quarter)

Intel posted mildly positive results, which was good enough given the lack of optimism. Intel breaks out their results into the digital enterprise group (servers, PCs) and the mobility group(notebooks, netbooks).

Revenues came in at $9.7 billion, with a net income of $1.5 billion. Revenues were impacted by a higher tax rate, and asset impairment charges. Company guided to a $9 – 9.6 billion revenues for Q2, and gross margins of 56%. For 2008, the company’s expects $5.2 billion in Capex, $6 billion in R&D and $5.9 billion in SG&A expenses.

Let’s dig a little deeper.

North America: Strongest growth this quarter (up 17%), thanks to a strong demand for high end 45 nm server chips. Their new quad core is their competitive strength here, (helped with the delay in Barcelona). Flat ASPs (average selling prices) in microprocessors.

Growth drivers in this segment were large internet datacenters and infrastructure build out for cloud computing. The important question to ask is this: Will the IT spending in the US remain resilient? If a business slowdown in the latter part of the year/next year occurs, any effect in IT infrastructure budgets could potentially impact sales in this segment. A justification was made based on the return on investments because of the energy efficient solutions, but color me skeptical. It can also be argued that in a slowdown, IT spending would go up because of productivity gains. It didn’t happen the last time around, and IT spending remains correlated with business spending. It’ll be interesting to see if virtualization and cloud computing have any effect on sales of microprocessor chips.

Margins: One reason margins were higher was because of higher utilization of factories for inventory buildup.The 45 nm ramp in shipments was predominantly in the high-end server segment.

Margins for the desktop group ticked up because of high end server chips, while the mobility group saw a decline in their margins. Since mobility comprises an increasingly larger part of Intel’s revenue source, they will also shoulder a bigger chunk of the cost of production. Moreover, there was an increase in advertising for the mobility (Centrino) based product line. Mobility has had sharp ASP declines, and this trend should continue or accelerate with the introduction of their mobile internet devices/ Ultra-mobile PCs. Intel is pursuing a cost reduction strategy in this segment by introducing a lower bill of materials solution. It needs to do this in order to maintain it’s margins.

Shift of expenses from SG&A to R&D for qualification of 32nm could depress gross margins in coming quarters. This is possibly the biggest reason I could be negative on Intel, and adopt a wait and watch strategy for at least two quarters. I see limited upside if they can’t use their operating leverage. Caveat here is that their cost reduction turnaround has produced good results so far. Also, in the ramp to qualify their earlier process technology in 2006 (45 nm), they were locked in a bitter price war with AMD, which really affected their profitability. Will history repeat? I don't think so.

Buybacks: Intel has had a strong buyback for the past few years(it bought back $2.5 billion this quarter). Unfortunately, the buyback hasn’t shrunk the share count yet, because of stock dilution caused due to employee stock options. Given that Intel started awarding more stock based incentives sometime in 2005/2006, I would expect that going forward 18 months or so, buybacks would actually start shrinking share counts, and be accretive to the EPS figures.

Currency affects: Intel gets 75% of their revenues from outside the US. A strong Euro/Asian currencies and a weak dollar is good for Intel. Since their components are priced in dollars, it simulates demand in the European economy, and is responsible for the above trend growth there.

Emerging markets: For emerging markets, appreciating local currencies drive PC and notebook penetration by making Intel’s products more affordable to a wider population. Increasing wage growth in India and China should accelerate this trend as well. Laptops are a fashion accessory (all across the world actually).

Restructuring: Intel’s restructuring program is producing good results. Employee head count is down to 84 thousand. They are conservative on Capex, R&D and SG&A. This should help in mitigating costs while they qualify 32nm.

Volume growth: Since notebooks have a quicker replacement cycle than PCs, this should drive volume growth, offsetting the ASP erosion. This trend towards volume growth should accelerate with Intel’s foray into new markets, more than offsetting the ASP declines.

Netbook launch: Should open up new markets with their aggressive price points. Most sales will be in mature markets and tier one cities in places like China. This needs a separate post. I’ll just add that in this segment, the wireless connectivity solutions and added functionality, and not the microprocessor strength, is what will drive adoption rates. Intel has been going down the WiMax route. We could see a sharp deacceleration of growth or even a decline in the notebook segment should these $200-$300 products catch on. This market is not the duopoly like the notebooks/PC markets were. Is Intel’s microarchitectural strength a valid edge here? (I’ll address this in another post)

Intel needs the new markets. PCs are in a decline. Laptops will be increasingly replaced by smaller form factor wireless mobile devices. Like the notebook became the replacement for the desktop, I view their Atom line as a replacement to their notebook products at some level. Only difference is that notebook chips were low volume high ASP, while the UMPC segment will be at a lower ASP. It would be nice if going forward they broke out that revenue segment in a separate category.

Technicals: I like Intel’s chart. It looks neutral in the intermediate term, given that it’s below 200 day MA, and broke it’s upward trend channel. However, it’s been consolidating for a few months now. There looks like a long term support on their chart going back to 2002, and a potential double bottom. MACD is ticking up to a potential crossover, but I’d hold off for now.

Conclusion For long term investors, I like the risk-reward situation with Intel. Given its generous yield, share buybacks and competitive moat, the company has maybe a 10-15 % downside in the worst case situation, and plenty of upside with new markets, international growth and operating leverage. That’s an attractive proposition in this volatile environment. Intel remains one of the best names for new money in the blue chip investment universe.

Disclosure: No positions in any securities mentioned above.

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Market commentary by Citigroup’s chief strategist.

I saw this interesting interview of Tobias Levkovich on CNBC last week. He shared some good points:

• Market Valuations: His price target is 1550(S&P 500), based on valuations, sentiment, and implied earnings growth. Predicts flattish earnings(~$86) in 2008 and 2009 for S&P500. Energy and materials will underperform in 2009 (because of declines in the commodities sector). This would be offset by outperformance in the financials and the consumer discretionary. Refused to discuss specific valuations. Valuations need to be discussed based on risk premiums, historical context, and bond yields; and not in a vacuum. Pointed out that homebuilders looked deceptively cheap in 2005.
  
  
• Commodities: Cyclical conditions will effect the commodity trade severely. To put it simply, commodity prices do go down in a recession. (Note: I discuss this in my post here). A similar thing happened during the inflationary 1970s recession. Agriculture, fertilizers and the chemicals look like the dot-coms.
  
  
• Savings rate: This is going to get worse in the next 5-10 years because of demographics. Retiring baby boomers would be using their savings. (This would be worldwide.) Not really a problem because wealth is growing enormously. Implication: Savings rate isn't a useful metric anymore. This could potentially have negative implications for the markets?
  


• Elections: Current year would be the first time since 1928 that sitting President or VP isn't up for reelection. So the administration doesn't have the motivation for election year stimulus that normally happens. Conclusion: Historically, election years have been good for the stock markets. May not be true this year.



• Asia: Asian companies have really low return on equities (ROEs), even though asset turnover is at a 16 year high. Whenever this turnover goes low, the ROEs will collapse. Don't want to be there when that happens. Not sure where this data point came from, but this is interesting if true. (Note: To understand the DuPont ROE breakdown, refer to this entry)
  


• Real estate: Real Estate bubble and appreciation are far worse outside the US. So you cannot point to the US selectively. I agree. Except the problems in the US are not just about house price appreciation, but caused primarily due to negligent and fraudulent lending practices.



• Post-elections: Critical issue for the post election year is this: are we moving towards more protectionism? Will we abrogate on tax treaties? What about tariffs/ protection quotas? Could be very devastating for markets. Asserts that taxes will go up across the board regardless of who gets elected. This is because they will look to fix AMT before they extend the Bush tax cuts.



• Markets: He talked of a W shaped pattern in the markets. Things will get worse before they get better. The worsening credit conditions effect the economy with a 9 month lag. Hence mid-year to year end, we'll still have problems and will see a slowdown in the industrial side of the economy. Earning estimates for the year end are still too high. Note that there has been some chatter about a double-dip recession. See this and this. Double dip is essentially a W pattern.



• Industrial sector: Talked about an industrial sector slowdown. Even though people talk of resilience in the US exports and the BRICs, two thirds of the “international” for US companies is in Europe. This could hence slow down.

Disclosure: None.

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On the strength of the transports, and commodity weakness..

From the video interview of Barry Ritholtz, came across this interesting comment:

Coal is a huge story. Strength of the transports does not mean economy is getting better. Thanks to a weaker dollar, we are exporting a lot more fertilizer and coal. North America is the Saudi Arabia of coal. (Likes ACI)

The basic point is that the transports reflect the underlying strength of the agricultural(commodities) and the energy sector, which the industrials don't. Dow theory as practised in the past may not be a relevant barometer of domestic stock market strength in a globalized world. Though this is an interesting point, I'm not completely convinced, yet! The Dow industrials are composed of companies who predominantly sell outside the US, alongwith commodity names like Caterpillar. Are the higher commodity(fertilizers) and energy(coal) demand a result of a weaker dollar, or the secular demand from the engines of India and China? I would argue for the latter.

The commodities and energy sectors are going through a speculative blow-off. They are cyclical sectors disguised in a 'secular term' trend. While I don't dispute the 'secular' uptick in demand due to consumption in the emerging markets, to expect the commodities sector to be impervious to a global slowdown is baloney.

Here's the punchline and a prediction (for what it's worth!): The current correction in the commodities space is not a multi-week phenomena. I'd argue that this time next year the commodities sector will be lower than where it is today. Given the cyclicality of the commodities sector, I would expect the transports to roll over and join the industrials.

The positive divergence we have seen in the transports is at best a short to an intermediate term bullish signal. The Dow theory sell signal of 2007 is still very much valid, and the rollover in the commodities space is only a confirmation of that.

Secondary point: While I'm positive on coal, I'm even more positive on natural gas and LNG(and would prefer holding CHK to ACI) . Carbon trading and emissions control(whenever that happens in the next 5-10 years) will make these more profitable and desirable energy sources, when compared to coal. (But maybe they'll come up with a way to make 'clean coal', and this point would then be no longer valid. )

Ah! The joys of investing and identifying secular term trends!

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