U.S. Q1 earnings season kicks off tomorrow

Alcoa (AA) starts the U.S. first quarter earnings season with Intel, Google also due to report this week.

Tricks of the Market Makers

On the London Stock Exchange (LSE) there are Market Makers for many smaller companies and less heavily traded shares. Market Makers are financial institutions who have agreed with their clients (the quoted company) and who have been approved by regulators to “make a market” in the shares of the client. Their role is to guarantee a market in a particular share so that investors can buy and sell easily i.e. they make a lightly traded share more liquid. They in effect assume some risk in return for the chance of the profit on the spread by acting as the middleman. Each stock always has at least two market makers and they are obliged to deal. Even if no other trader on the other side of the trade at a particular time, market makers will guarantee to buy and sell the shares in which they make markets. They make their money through the difference between the buying and selling price, the so called bid-offer spread. The bid price for a stock is the price at which the market maker is currently willing to buy, or is bidding for, shares. The ask price is where the market maker is currently willing to sell, or is asking for, shares. The bid price is always lower than the ask price so the market maker can make money on the spread.

Market Makers are not supposed to allow themselves to go short, but in process of making a market they may well find themselves short of a stock. If this situation they can purchase from another Market Maker, move the price to get the shares from sellers of the stock or borrow the shares from an institutional investor. Therefore a market maker can make money in both rising or falling markets, as long as they correctly predict which way a stock's price will move. The more actively a share is traded the more money a Market Maker makes so they will try and encourage trading of a particular stock by moving the price up or down to bring buyers or sellers into a market.

Some tricks of the Market Makers

1. An institution places a big order for a stock. The market maker doesn't have enough stock to complete the transaction so he has two options 1) drop the price to trigger sales 2) increase the price to trigger sales. If the price is dropped other buyers may be tempted in and the market maker may still be short of stock and owe the institution shares it is guaranteed to provide. So sometimes for no apparent reason the stock price drops dramatically, a so called "tree shake" to trigger stop losses and allow the market maker to pick up the stock he needs. 

2. If a particular share rises dramatically on an announcement, market makers sell stock to meet these orders and sometimes they sell these buyers stock they don't actually own in anticipation that they'll able to pick up stock more cheaply in the future to meet these buy orders when the share price reverses down. By gathering shares at a lower price they can meet the obligations of the buyers at a profit. This is why the share price can often drift down for days or week after a big announcement so that the Market Maker can guarantee that they can deliver all the shares they have promised by triggering sales. 

Portfolio review of the week April 10th 2010

Last night, the Dow Jones Industrials briefly pushed through the 11,000 mark for the first time since September 2008 and finished the week at a 18-month high of 10,997, up 70 points. The Nasdaq Composite Index rose 17 points to 2,454 and the S&P 500 rose 8 to 1,194. In the U.K., the FTSE 100 rose 58 points to finish at 5,771.
It has been a good week for the Contrarian Investor UK portfolio with some excellent profits made and taken in gold miner Norseman Gold (NGL) and the Falkland Islands explorers. After several days of profit taking the portfolio is relatively small and concentrated in GW Pharma but new opportunities are being explored. 

GW Pharma (GWP) - GW pharma continued to drift down this week on small volumes to finished at 109p, down around 4%. At this level it is only a few pence from where it was when the company issued the regulatory update on Sativex spray on March 18th. This update confirmed that there were no major issues outstanding and that UK launch was on track for Q2 2010. As this announcement de-risked the regulatory stage significantly, especially on the issue of efficacy which was the stumbling block at the last submission in 2007, the current share price seems surprisingly low. Less than a month ago investors still had a high risk that the licence application to launch in Europe would fail, now GW pharma are in the situation where all aspects of efficacy, safety and quality has been addressed. I topped up my holding further during the week at 107p and now have a position similar in size to pre-regulatory announcement. Though the share price may drift down further, the upside reward at these levels look good especially with news of licence approval due in May from the UK and Spain.

Falklands Islands Drillers (Desire Petroleum DES, Rockhopper Exploration RKH, Falkland Oil and Gas FOGL) - A volatile week in the Falkland Islands oil stocks was exploited with some nice profits made on FOGL and RKH. Rockhopper had a large move up this week as Desire's Ocean Guardian rig now moved to its Sea Lion prospect in the North Falklands basin with spudding likely any day. I have now sold on my positions at solid profit and will wait for any pull back as a further investment opportunity.

Norseman Gold (NGL) - Australian gold miner Norseman had a very strong move up this week from under 50p to finish the week at 62p. Though fundamentals are good for this company, such a large move up in the Contrarian Investor UK portfolio holding with a buy point in the mid-40p range, profits were taken at the end of the week. Thank you Jim Slater for the tip!

BHP Billiton (BHP) - Short placed on the commodity plays BHP Billiton and Kazakhmys (KAZ) earlier in the week were closed at reasonable profits after the price of copper went over the key $8000 a tonne level. The commodity companies remain good trading opportunities given their volatility.

SSL International (SSL) - Rumours surfaced yet again this week that Reckitt Benckiser (RB.) was considering buying SSL which moved the share price up to a high of 885p. I remain unconvinced by this possibility of a Reckitt buy. By Friday these rumours were discounted and the price had dropped back to 856p. Shorts placed at 885p were closed at a good profit.


Coal of Africa (CZA) - Continue to hold CZA with no news this week.

Markets on the up again

After dropping close to 50 points at the open, the Dow Jones Industrials finished in positive territory at 10,927 (up 30 points) as strong numbers came in from U.S. retailers such as GAP for March. This is helping to drive European markets higher with the FTSE 100 currently up 52 points to 5,766.

Falklands Islands oil shares profits taken

This week speculative investors have moved money from Desire Petroleum (DES) to fellow North Falklands basin driller Rockhopper Exploration (RKH) following news from Desire's Liz well that it was non-commercial and was being plugged. After a sharp rise in RKH from the lows 40's to close to 60p on Tuesday, today it is down around 4% on the evitable profit taking.

After making some large profits on RKH and Falkland Oil and Gas (FOGL) this week I no longer hold any of the Falkland's Islands drillers. Why have taken my money off the table? 1) The results from Rockhopper Sea Lion drill site will not be available for around a month 2) The spudding of Rockhopper well is unlikely to drive a significant new inflow of investment into the stock given news flow will take some time and speculators have been badly burnt on Desire (Desire has now fallen from a peak of around 130p to today's 45p). 3) most of the rotation within the sector from DES to RKH has probably taken place on Monday/Tuesday this week. For now Contrarian Investor UK stays on the sidelines but will keep an eye on things for any potentially fruitful entry points

Do rising bond yields mean U.S. inflation is coming?

Earlier in the week 10-year U.S. treasury bond yields moved close to 4% and are approaching their 2008 highs. Part of the reason for the move was the government bond auction yesterday and often yields increase prior to these auctions in order for buyers of the new debt to get more favourable entry points. After listening to Frank Curzio's Podcast (the S&A Investor radio podcast) he talked about his fears for impending inflation in 2011 because of the movement of the 10 year treasury bond, but is he right to be fearful? The 10 year generally sets consumer loans such as mortgages so would hurt the consumer recovery.

Government bond yields can go up because:
1. Investors believe that the creditworthiness of the debt issuer is going down e.g. as i the case of the Greek government
2. Fear of inflation in the future
3. Higher interest rate expectations in the future driven by an expanding economy

Historically, the 20-year treasury bond yield has averaged approximately two percentage points above that of three-month treasury bills. Generally when the gap between short and long term treasuries increases it is a sign that the bond market expects the economy to improve in the future because the Federal Reserve will increase interest rates. Currently the yield on the 2 year is at 1.04% and the 10 year is at 3.86%, nearly 3% higher.

If fears of inflation were driving this increase in bond yields you would expect that inflation indexed treasuries which pay more interest the higher the rate of inflation would be rising at a much fast rate than standard treasuries. But this has not been the case. 

So in summary I do not agree with Frank Curzio's hypothesis that we are on the verge of a period of rising inflation despite all the paper being printed by the central banks for the bail-outs. I do see inflation coming into the equation but not for a while yet. Perhaps we should worrying in late 2011?

Market on its way down this morning

The Dow Jones Industrials finished down 72 points at 10,898 last night despite a positive U.S. Treasury's 10-year note auction and Federal Reserve Chairman Ben Bernanke's optimistic outlook for the American economy saying "if economic conditions improve, as I expect, we should see increased optimism among consumers and greater willingness on the part of banks to lend, which in turn should aid the recovery". The FTSE 100 is currently down around 40 points with resource stocks on their way down. The markets are awaiting feedback from the Bank of England and European Central Bank meetings.

Reckitt's Becht earns close to £100 million in 2009

Reckitt Benckiser (RB) Chief Executive, Bart Becht, earned £93m in 2009 making him one of the best paid business leaders in the world. Having grown earnings per share from 92p to 195p over the last few years it could be said that Becht deserves this payout which is largely a share based compensation package. However, is any CE really worth close to £100 million a year despite being credited with making Reckitt the P&G of Europe? At least Becht will donate three million Reckitt shares, worth £110 million, to his charitable trust.

SSL rises on Reckitt's takeover rumour

From today's Telegraph "On Tuesday, Royal Bank of Scotland told clients that last week they had an "interesting" meeting with Reckitt Benckiser's management. "There were a couple of off-the-cuff comments on 'attractive opportunities' that sounded interesting. Suffice to say, one brief comment was with regards to the condom business and how it would fit into their acquisition template," said the RBS salesman. He concluded: "The whole SSL/Scholl North America dynamic, the stumbling block last time around, has changed a bit and could make the takeout story more intriguing now." SSL gained 20½ to 841p."

SSL shares are up another 29p this morning to 871p. I am sceptical because SSL's Scholl brand is owned by Schering Plough in the U.S. under the Dr Scholl umbrella. Also RB will be reluctant to over pay. Assuming a takeover price of £10.00 and earnings per share of 35p in 2010 this puts it on a forward p/e of 29. Finally it would be surprising if RB would be able to accelerate the growth of Durex too much faster than SSL itself. The contrary argument is that cash rich Reckitt needs a big acquisition to fuel further earnings growth. Could be an interesting couple of days for RB and SSL but the likelihood is its yet another false rumour. Shorts placed between 875p and 880p this morning.

Rockhopper gains as much as 20%

Rockhopper Exploration (RKH) gained as much as 20% (and has now settled 16% up) this afternoon as Desire Petroleum (DES) issued another news release about the Liz well saying that the well was being plugged and abandoned as a gas discovery. DES said that 17 metres of net  "hydrocarbon pay' were encountered between 2961 and 3031 metres but the reservoir quality was poor. The Ocean Guardian rig is now moving to the Rockhopper's Sea Lion site and spudding is expected towards the end of the week. After rising as much as 20% on the news,  2/3 of the Rockhopper position and the Falklands Oil and Gas (FOGL) position were closed for solid profits as results from the Rockhopper well will not be available for around a month following the spud.

Steady drop in GW Pharma share price as we await Sativex UK approval

GW Pharma (GWP) dropped today to 112p to buy, around 12% higher than following the announcement of a positive regulatory assessment on the safety, quality, efficacy of Sativex 3 weeks ago. Since approval of the product in multiple sclerosis is more or less assured in May and a UK launch due by end of Q2, the current share price seems to a good opportunity to increase exposure given the fall from close to 130p at the time of the positive clinical trial in cancer pain in early March.  Volume is very light and the share price looks like it is being walked down by the market makers. The question of course is whether the downward trend of 1-2p price falls per day will end. The market cap is only £145 million and a £10 million payment is due from Bayer Schering and £2.5 million from Almirall on licence approval.

Copper prices up 300% since lows of early 2009 to $8000/tonne

London copper futures rose to their highest level since August 2008 to move over $8000 per tonne, another worrying signal of an overheating commodity sector. The all time record for copper prices was $8,860. Copper prices have nearly tripled from a low of $3,328 per tonne reached in February 2009, with a gain of 20% year to date. The second quarter of the year typically sees Chinese copper demand surge as copper consumers fire up production after the Lunar New Year holidays in January or February. China's 10.7% growth in fourth-quarter gross domestic product are driving demand for the metal. Santiago Gonzalez, Chile's Mine minister recently said the disparity between stocks and prices is the greatest in 20 years, and that the situation is being closely monitored.

Templeton's Mark Mobius talks of emerging markets volatility ahead

In 2009, most emerging markets funds doubled in value from the March lows. In 2010,  returns have been closer to developed markets. The iShares MSCI Emerging Markets ETF is only up 1.9% year-to-date versus the FTSE 100's 4%, but has gained 78% on a 12 month basis.  The actively managed and top performing Templeton Emerging Markets investment trust (TEM) run my Mark Mobius is up 7.4% year to date  (98% on a 12 month view), three and half times the exchange traded fund, partly because the EFT is a dollar denominated fund and the dollar has signficantly strengthened against the pound in recent months . In this weekend's Barrons, Mobius says "If you're coming in now, make sure you dollar-cost average, and be ready for corrections," but Mobius expects emerging markets to post gains "in the teens or double digits in 2010, even with corrections along the way."

Portfolio review of the week 3rd April 2010

Falkland Island Oil Explorers  -Another bullish week on the markets was tempered by the collapse in the Falkland Island oil drillers on Monday as Desire Petroleum (DES) was forced to issue a premature news release on the progress of the Liz well following a report in the Sunday Times that reservoir quality was poor. Another update from Desire on Thursday afternoon indicated that drilling was continuing to greater depths after hydrocarbon shows with  final report due late next week. It seems that there is a significant amount of gas (yet to be confirmed) but oil seems to be elusive to date and given the geographical location and the current world gas price this is clearly not an advantageous position. Desire's share collapsed 50% on Monday to around 50p and have held steady for the rest of the week. Fortunately a holding in Desire was sold the previous week. Position's in Falklands Oil and Gas (FOGL) and Rockhopper (RKH) fell through stop losses on Monday as sentiment turned against the explorers. However, having stabilised later in the day I bought back both as the geological structures are unrelated to Desire's prospect and Rockhopper' s well is due to be drilled next by the Ocean Guardian rig with spudding in early April.

GW Pharma (GWP) - GW Pharma continues to drift downwards following the positive news on Sativex a couple of weeks ago. Things are expected to be quiet until May onwards when an update on national approval from the UK and Spanish regulatory authorities would be expected. The interims are also in May and news on other regional licensing deals outside North America and Europe would be expected as well as the U.S. FDA cancer pain application wit Otsuka Corp.. I sold around 2/3 of my holding on the news and bought back some at 115p. I am monitoring this share closely for a further buying opportunities on a slide back below 110p because May and June news should drive this to well over 130p.

Norseman Gold (NGL) - A position was started in this Australian gold company on Monday. See the previous article, http://contrarianinvestoruk.blogspot.com/2010/03/norseman-gold-looks-solid-australian.html.

Coal of Africa (CZA) - The Coal of Africa position was increased this week as Morgan Stanley increased their share target to 200p  (current 145p) and a full UK market listing is due.

BHP Billiton (BLT) - A contrarian short on BHP Billiton was placed on Thursday morning following a week of strong rises as the rise in commodity stocks seems overcooked.

Genzyme (GENZ) - The position was closed on the rebound to $53.

Micron (MU) - Short term trades at just over $10.2 were made and closed before the quarterly earnings at $10.8

Contrarian Investor U.K.'s outlook for the stock markets for the rest of 2010

With the S&P 500 and FTSE 100 up 45% in the last 12 months (4% in the last quarter) and the U.S. market finishing higher 28 days out of 31 in the last month it seems the market's upward momentum is unstoppable. But what seems to be in store the rest of 2010?

THE CASE FOR THE BEARS
1. UNEMPLOYMENT. Although the market was closed on Friday in the U.S., the Labour Department said nonfarm payrolls rose by 162,000 in March, the largest gain since March 2007, although nearly one-third came from temporary hiring for the Census and behind estimates of 200,00 gains. But U.S. unemployment remains stubbornly high and is likely to remiain so for some time as the rate stayed at 9.7% last month, in line with economists' expectations. It is sobering to think that 1 in 10 Americans is out of a job and given corporate America's drive to keep costs low and productivity high, this is unlikely to drop sharply any time soon. f you take into account part-time workers looking for full-time jobs, unemployment is about 17%. In Europe, U.K. unemployment is 8%,  German is  7.5% and French is 10%. 

2. MORTGAGE ARREARS. Around one in four U.S. home owners are in negative equity on their mortgages (i.e. they owe more than there home is worth to their mortgage lender) . Then their are the "shadow inventories" where lenders are unwilling to foreclose on properties because they will have to declare losses on their books and so they are allowing owners who are not paying anything to stay in the property.

3. DEBT. Government debt continues to grow at a significant rate. The U.S. deficit since the beginning of the fiscal year in October now stands at $651.6bn, meaning the goverment are on track for an annual deficit of$1.4tn, more than 10% of GDP, and the highest level since World War II. The US government recorded a budget deficit of $221bn (£147.6bn) in February - the largest monthly deficit in its history. In the U.K., Chancellor Alistair Darling confirmed that the UK budget deficit is likely to be around £167 billion this year with UK national debt balloon to well over £1 trillion. Current UK public sector net debt is £848.5 billion or 60% of GDP. Excluding Financial sector intervention (i.e the bail out Northern Rock, Lloyds and RBS), public sector debt is £743 billion or (52.7% per cent of GDP). Though to put things into context, Japan for example have a National debt of 194% of GDP, Italy 117%, Greece 108%, Germany is 77% and the U.S. is 71% of GDP.

To date, government debt has been able to be financed by countries such as China with large fiscal surpluses who have been buying up bonds like U.S. Treasuries.  Whether this continues if credit agencies move to downgrade countries from Triple A status is another matter. Recently, the problems of the PIIGS (Portgual, Ireland, Italy, Greece, Spain) debt has worried the bond markets. A Greek debt bail out was fashioned last week by the euro zone countries after it struggled to roll over its borrowing requirements as investor appetite for its bonds wained. 

4. CHINA.
In 2008 the Chinese government instituted a $585bn economic and infrastructure stimulus package, helping to continue strong economic growth in 2009. The country now has a population of 1.3 billion people, with income per capita roughly one-tenth of U.S. levels. After the collapse of commodity prices in 2008, aggressive Chinese buying of iron ore, Copper and other industrial products have helped propel commodity stocks like BHP Billiton and Anglo American. Copper prices are up a 160% in the past year and a half. 2/3 of the growth in many of these commodities is expected to come from China. Although, But is there cause to be concerned?

We often hear that speculative bubbles are impossible to forecast until after they have popped. Edward Chancellor's "10 Sign Posts of Manias and financial Crises" has compelling similarities to what we are seeing in China.

"Great investment debacles generally start out with a compelling growth story."
"Blind faith in the competence of the authorities." (do we really trust the Chinese government?)
"A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear."
"Great booms are invariably accompanied by a surge in corruption."
"Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward." (Money supply grew by nearly 30%, interest rates maintained well below nominal growth rates)
"Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts." (Chinese currency, the renminbi, is pegged to the U.S. dollar)
"Crises generally follow a period of rampant credit growth."
"Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won’t let bad things happen to the financial system. Irresponsibility is condoned."
"A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious." (Chinese banks are particularly reluctant to report problematic loans)
"Dodgy loans are generally secured against collateral, most commonly real estate."

5. TIGHTENING OF MONETARY POLICY
After a period of extraordinary low interest rates around the world it is likely that interest rates will begin to rise in late 2010 or 2011. China and Australia have already begun tightening.



THE CASE FOR THE BULLS
1. LOW INTEREST RATES AND BENIGN INFLATION FOR NOW
Interest rates around the world look set to remain low for the foreseeable future as inflation remains low despite the huge increase in money supply in countries such as the U.S. and U.K.. This means companies can borrow money cheaply and invest in growth.

2. CORPORATE PROFITABILITY
As workers work harder as they fear for their jobs, productivity is continuing to rise. For example in the U.S., productivity rose 6.9% in the fourth quarter of 2009.  This together with job cuts means costs have been slashed and earnings enhanced.The S&P 500 companies  (excluding financial companies) hold almost $1.2 trillion in cash, or more than 10% of assets, the largest amount since the 1960s. Corporate earnings over the next couple of quarters will be strong particularly if firms deploy this cash to increase dividends or increase share buy-backs.

3. LOW INVENTORY LEVELS

Many companies have worked hard to work down inventory levels during the recession meaning that any increase in consumption will quickly increase orders and hence revenues. 

4. STIMULUS
The U.S. government still has two-thirds of the $863 billion stimulus money to spend over the next 18 months which is good news for infrastructure companies in particular.

CONTRARIAN INVESTOR U.K.'s VIEW
On balance, I am a little worried about things. There are some strong indicators that the second quarter may be strong as productivity and cost cutting continues to feed through. But the second half of 2010 may be more challenging especially if the Chinese "economic miracle" comes off the rails. It will be increasingly a traders market not a "buy and hold". In 2009 you could have bought almost any stock and seen its share price increase and perhaps double or triple but in the later part of 2010 things are going to get tougher especially if the Federal Reserve, European Central bank start to curtail "cheap  money" by increasing interest rates.I will not be committing significant new funds to buy and have plenty of cash on the sidelines to take advantage of any move down. Although stocks are not expensive on traditional valuation metrics such as price/earnings, they are not at bargain levels so although I expect a move up in the U.S. S&P and DOW over the coming weeks, the upside potential is not so high to justify 100% holdings in stocks. Better to have cash for a 5-10% correction to take advantage of any opportunities that arise in favoured stocks.