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The market's ready to rock: increase exposure to U.S. and emerging market small caps!
by James Passin
It's been a disastrous year for mainstream stock speculators. Most Internet cult stocks are spiraling down the toilet. The Dow's down 7.5% year-to-date. The precious NASDAQ Composite Index is flat. As I predicted in late 1999 and early 2000 issues of Taipan, the carnival-like gains enjoyed in tech paper have not survived the post-Y2K contraction of domestic liquidity. A textbook Chinese Year of the Dragon.
However, 2000 has been an excellent year for us. My recommended portfolio is up an average 39%, crushing all major U.S. indices. Our biggest winners include Avant Immunotherapeutics (AVAN, up 285%), Genus (GGNS, up 211%), and Lukoil Preferred (up 105%). The best performing components of my recommended portfolio are Russian/Former Soviet Union commodity producers and U.S. small cap technology.
Hurricane Hydrocarbons (HHLF:OTC) has clawed back from the dead, rising 16x off the 1999 low of US$0.25. My recommendation to hold onto your shares has been vindicated. If you used a dollar-cost averaging approach before I downgraded Hurricane to a Hold, you may be near break-even on your investment. I am providing a special update on Hurricane in this issue.
The preconditions exist to support a broad summer rally in U.S. stocks. This rally may have already begun. But don't expect the old angels of Q1 to lift their once-golden wings any time soon. The market is rotating into new themes that will provide market leadership in front of the election. I recommend increasing exposure to selected U.S. and emerging market small caps. I also recommend using the imminent rally as an opportunity to unload garbage (get out by September).
What inflation?
I sold my car when I moved to New York. Personally, I am not feeling the pain of high oil prices. Maybe you should ignore everything I write about inflation. Maybe you already ignore everything I write. But I never owned a gas-guzzling SUV or similar suburban monstrosity (I'm an Acura fan). It's hard for me to sympathize with whining, self-indulgent motorists who share the Clinton dynasty's philosophy of entitlement and instant gratification (no one whined that oil prices were too low in 1998 when oil-producing countries were driven to the brink of depression, threatening global stability).
Yes, oil prices are high. Historically, high oil prices signaled the emergence of powerful inflationary pressures. And the perception of emerging inflationary pressures has driven the Fed to engage in a rate hiking campaign. While there has been some inflation in the economy, I believe that the bull market in inflation is dead.
In an inflationary environment, people tend to spend as fast as possible, since they expect price levels to rise. Psychological acceptance of price hikes by consumers allows companies to pass on rising input costs. In other words, rising prices cause rising prices, creating a self-sustaining feedback loop.
In the current environment, there is absolutely no psychological acceptance of price hikes by consumers. The biggest issues in the presidential race are gasoline and pharmaceutical prices. There is no broad expectation that the general level of prices will keep rising. In the absence of doomsday supply disruptions — like, maybe, WWIII (since Y2K was a dud) — don't hold your breath for the emergence of an inflationary spiral.
Voodoo analysis
An objective technical analysis of leading inflationary indicators contradicts the "rising price spiral" thesis. I consider gold to be an excellent three- to twelve-month leading indicator of inflation. Gold recently spiked up to US$290 per ounce. In my view, this a sucker rally.
Sustainable gold rallies are usually led by or at least coincident with a rally in the XAU index. It's a simple concept: gold mining shares discount future prices of the metal. The XAU index has been diverging sharply from gold futures. While gold has rallied, the XAU index is making lower highs and lower lows, penetrating significant support levels. The poor technical behavior of the XAU index strongly suggests that the gold rally will reverse.
A highly reliable leading technical indicator of gold is the spread between the T-Bill yield and the twelve-month gold lease rate. When the spread is wide, gold hedging is profitable (since you can borrow gold at the lease rate, sell it short, and invest the proceeds in risk-free T-Bills). When the spread is narrow to negative, gold hedging loses its luster (since your return on T-Bills no longer exceeds your borrowing costs). Since there is absolutely no retail "daytrader" participation in this spread, it is a clear reflection of institutional psychology. The spread has carved out a base formation in mid-June and is experiencing a sharp rally, suggesting that a flood supply is about to hit the market from gold hedgers and short sellers. In this scenario, it is highly likely that gold is about to tank.
Not bad
Credit conditions in the U.S. are extremely tight. Junk bond spreads are higher than they were during the peak of the Asian crisis (although they have begun to relax). It's almost impossible for sub-investment-grade companies to obtain public debt financing. U.S. dollar swaps (the cost of swapping fixed rate for floating rate dollar debt) are also wide, although there is some technical evidence that conditions have begun to loosen. In fact, it's shocking that tight credit conditions haven't devastated the economy.
But the economy is slowing down. The triple combo of tight credit, monetary and fiscal conditions is beginning to take its toll. Not to mention the unfavorable climate for low-quality equity financing.
Interest rate-sensitive stocks, including major banks (MER, CMB, MWD, etc.) and insurance companies, are exhibiting bullish technical action — or, at least, feasible basing patterns. This confirms that the era of rising rates is drawing to a close.
Will earnings fall apart with the economy? Based on my assumptions that commodity prices will gradually soften and the dollar will modestly depreciate (offsetting flagging domestic demand), I expect that earnings for the Dow will be basically flat in 2000. This could make for some earnings disappointments in individual companies. However, given my projections for bond yields, the Dow — believe it or not — is not overvalued. Of course, the S&P 500 and NASDAQ Composite remain expensive.
The NYSE Cumulative Advance Decline Line, an important indicator of market health, has finally broken above the 100-day moving average. It also appears to be basing out. This is consistent with the scenario of a traditional Summer Rally.
I'm not worried about a "hard landing." NASDAQ crashed 40% without triggering bread riots. And the government, for the first time in decades, has tremendous backup fire power to fight a recession: a massive fiscal surplus. Whether Gore spends the surplus on grandiose redistribution schemes or Bush blows it on tax cuts, it wouldn't take too much time for the new president to juice up growth (whatever unpleasant distortions their policies would introduce).
I did it for the cookie
A few weeks ago, after wolfing down some fried red snapper with Szechuan sauce (and clawing through my cabinet for Pepcid AC), I opened up an amusing fortune cookie: "Now is a good time to buy stock." I agree: I have been increasing my exposure to equities.
I am upgrading Orckit (ORCT:NASDAQ) from a Hold to a Buy following the Tioga (TIGA:NASDAQ) spin-off. My fund has a position in ORCT. If you own ORCT, you have been paid a stock dividend of one share of TIGA for every share of ORCT. The spin-off created value for ORCT shareholders. However, ORCT crashed post-dividend following a shocking earnings disappointment. Given ORCT's leading position in the global DSL market, low US$280 million market cap, and the explosive growth in broadband, ORCT is a bargain at current depressed prices. The disposal of the semiconductor business has turned ORCT into an extremely attractive takeover target.
I am also reiterating my Buy on Ashanti Goldfields (ASL:NYSE). The stock has been destroyed. But gold hedgers should benefit from a rising T-Bill/gold lease rate spread. The current share price reflects hatred on the part of shareholders and analysts, not the sustainable cash-generating potential of the business. ASL has been priced for bankruptcy — an improbable outcome.
 The perfect storm
Hurricane is back. Back from the dead.
Twelve months ago, it looked like Hurricane Hydrocarbons (HHLF:OTC) was finished. Oil prices plunged. Cheap Russian oil flooded the domestic market. Hurricane went to war with its only refinery. It defaulted on its mounting debts. Bondholders had the company over a barrel. Vulture funds were long the bonds and short the stock, giving them no incentive to negotiate with shareholders. The stock traded for pennies. I looked like an idiot for recommending the stock.
Staring into the abyss of total shareholder value destruction, I recommended holding on to your position. While other newsletters might have consigned such a disaster to the wastebasket of the occasional bad recommendation, I provided periodic updates on the stock — and even took a trip to Kazakhstan to sniff around behind the scenes.
There were two seminal events that saved Hurricane. First, major shareholders, including Firebird Management, formed a group to defend their interests. Secondly, Bernard Isautier became Chairman of the Board and CEO.
Isautier's heroism resulted in the most rapid creation of shareholder value I have ever seen. I am actually considering naming my son after him, should I ever have one.
There's no point in reliving the entire sequence of events that led to Hurricane's collapse and recovery. What is important is this: Hurricane has emerged from creditor protection, merged with the Shymkent refinery, and is now a highly profitable, vertically-integrated oil producer with an outstanding asset base and excellent growth prospects.
At current levels, Hurricane is trading an enterprise value/annualized EBITDA ratio of just 2.5! Russian vertically integrated oil companies trade an EV/EBITDA ratio of 3.5+. Hurricane's share price could appreciate 40% and still be reasonably valued.
Given the high price of oil and the further realization of synergies between Hurricane and its Shymkent refinery, I expect Hurricane to rapidly ramp up EBITDA. The recent discovery of 50 billion barrels in the Caspian Sea should indirectly benefit Hurricane, by hastening the creation of new export routes via pipeline and improving overall economic conditions in Kazakhstan. Hurricane remains the only U.S.-listed play on Kazakh oil.
I continue to recommend holding Hurricane for further gains.
James Passin manages the Firebird Global Small Caps Fund for Firebird Management and is a Contributing Editor to Taipan. Passin's fund is currently a shareholder in Orckit. Several funds managed by Firebird are shareholders in Hurricane. The views expressed are strickly Mr. Passin's and not necessarily those of Firebird Management or Taipan.
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