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Sysco – A Beneficiary of Lower Inflation

(August 17, 2006)

Dear Subscribers and Readers,

Important note: In light of our mention of the Pension Protection Act of 2006 in last weekend's commentary, I urge every one of you to study up on the legislation, as this would eventually affect all U.S. workers (including those who do not plan to retire soon).  For more details, please see the following post that I made yesterday in our discussion forum.

There aren't a lot of times when this author could be used as a contrarian indicator, but last Thursday morning was definitely one of those times – the morning when we exited our 50% long position in our DJIA Timing System at a DJIA print of 11,060.  The good thing was that we made a 290-point profit on that 50% long position (since it was initiated at 10,770 on July 18th) – but the downside was that the Dow Industrials subsequently rallied much further in the next few trading days, rallying 267.12 points higher by the close last night.

Once in awhile, everyone will get whipsawed, but the biggest mistake that this author had made was not giving enough time for our trade to work out.  Even though we had always said that the Fed will pause and will have effectively ended its two-year hiking campaign on August 8th, many financial players were still not so sure.  By Tuesday morning, however, much of the uncertainty in Fed policy was dispelled due to the benign PPI numbers – as the probability of a 25 basis point rate hike plunged from 40% to 20% at the September 20th meeting (based on the Fed Funds futures) immediately after the release of the PPI numbers on Tuesday morning.  This was the post Fed meeting we had been looking for – even though it came almost a week late.

In our “post-mortem” analysis, it is probably safe to say that this author will need to develop more patience going forward.  For example – in our weekly relative strength chart of the RTH (the Merrill Lynch Retail HOLDRS) vs. the S&P 500 in last Thursday's commentary (“Is Our Short-Term Scenario Busted?”), I had used last Wednesday's data points to construct the latest weekly reading of RTH relative strength.  From the latest reading, I concluded: “Given that the relative strength of the RTH vs. the S&P 500 has been a leading indicator of the broad market (from two to eight weeks) since the beginning of this cyclical bull market in October 2002, this most recent dip of the relative strength of the RTH is definitely very ominous.”  In retrospect, this was not the right thing to do, as the RTH subsequently rallied more than 2% to finish at 91.13 for the week (after closing at 89.15 last Wednesday night).  This rally was enough to bring the RTH back from the abyss – resulting in the highest relative strength close of the RTH vs. the S&P 500 since mid July.  Following is the latest weekly chart of the relative strength of the RTH vs. the S&P 500 (with a revised reading for last week's data point).  Note that I am again using Wednesday's close for the latest weekly data point – but unless the action of the RTH and the S&P 500 diverges significantly for the rest of the week (we will be watching this during the next couple of days), the following chart should stand:

Relative Strength (Weekly Chart) of the Retail HOLDRs vs. the S&P 500 (May 2001 to Present) - 1) As of Wednesday at the close, the relative strength of the RTH vs. the S&P 500 continued its rebound from its 3 1/2 years lows two weeks ago. Again, it is time to start looking hard at retail - especially the large cap retail brand names such as WMT and HD. 2) This author jumped the gun last Wednesday as I had reported that relative strength of the RTH against the S&P 500 again sank to a new low at that time. However, keep in mind that this is a weekly indicator - and by Friday at the close, relative strength rebounded significantly to close at a two-week high.

Again, please note that the relative strength of the RTH vs. the S&P 500 has led the major market indices (from two to eight weeks) ever since this cyclical bull market began in October 2002.  Also note that this reading hit a 3 ½ year low just under three weeks ago – suggesting that the market may already have made a significant bottom.  But again, this is all conjecture at this point.  Personally, this author would like to be patient (easier said than done!) and wait until the action after Labor Day Weekend (first Monday of September) for further confirmation.  On a more important note, it is probably a good time now to buy retail stocks, especially the large cap brand names such as Wal-Mart or Home Depot.

But Henry, what about housing prices?  Aren't U.S. consumers especially tapped out right now – given higher interest rates, thus higher borrowing costs, and a higher incentive to save?

Yes, I recognize that consumer spending will most probably continue to be weak for the rest of this year, given that the resetting of ARMs and higher interest rates has still yet to totally work their way into the system.  The slowdown in the rise in home prices will also be a drag on mortgage equity withdrawal, a phenomenon that had been a significant provider in consumer liquidity over the last few years.  This view is also being “reinforced” by the latest economic analysis from the Bank Credit Analyst.  Quoting its August 14th daily commentary: “Consumers still have good income growth, but the discretionary portion is no longer growing, thanks to significantly higher costs for essential spending (especially energy and interest payments). Meanwhile, housing activity continues to slide, removing a key support for consumption and consumer sentiment.”  Following is the relevant chart courtesy of the Bank Credit Analyst:

Chart courtesy of the Bank Credit Analyst

Note that the monthly annual growth rate in U.S. retail sales (excluding autos and gas) is still “satisfactory” at nearly 5% - but at the same time, we are now seeing divergences in both growth in disposable income (less essential spending) and existing home prices.  This implies a deteriorating disposable income spending picture going forward unless 1) the Fed starts cutting overnight rates, and/or 2) oil and gas prices decline dramatically.

But – and we probably don't need to remind our readers this – please keep in mind that the stock market and stock prices are the ultimate leading indicators.  Given that relative strength of the RTH vs. the S&P 500 just closed at a 3 ½ year low a little less than three weeks ago and given the fact that the shares of the large-cap retailers refuse to decline further in light of an upcoming consumer spending slowdown, this author really finds it hard to be bearish here.  Interestingly, the P/E ratios of both Home Depot and Wal-Mart have not been this low since the late 1980s and the mid 1990s, respectively.  Even if the U.S. is to endure a consumer-led recession in 2007 (and we are still a long way from ever confirming that), the stocks of these two companies most likely will not decline too much from current levels.  Long-term investors should definitely study both companies this weekend and make individual buying decisions as appropriate.

And at the same time, the average U.S. consumer isn't totally tapped out either.  Sure, housing prices may decline in parts of the country, and the Federal Reserve just reported a “blow-out” number in consumer credit growth for June ($10.3 billion increase vs. an expected $3.6 billion increase).  However, on a year-over-year and on a smoothed basis, consumer credit growth is still benign – even taking into account the latest June 2006 spike.  Following is a monthly chart showing total consumer credit growth (along with revolving and non-revolving) from January 1989 to June 2006:

Monthly Annualized Consumer Credit Growth (12-Month Smoothed)*(January 1989 to June 2006) - Both revolving and non-revolving consumer credit growth has been on a declining trend in the last four years - even as the U.S. emerged out of its latest recession in November 2001.

As the above chart shows, the rate of consumer credit growth (surprisingly?) has steadily declined since November 2001.  More importantly, the rate of consumer credit growth has been effectively below nominal GDP growth since mid-2002 – suggesting that folks who refinanced their homes or who extracted equity out of their houses over the last four years have actually used some of that money to pay down their credit card and auto-related debt!  This also suggests that consumers are not totally tapped out, as consumers who are running out of funding options can always fall back on their credit cards or other means of revolving credit.

Readers should also keep this in mind: There is a definitely a very strong precedent for this (stock prices bottoming out well before the trough in consumer spending growth).  Go back to the chart from the Bank Credit Analyst and look at the dip in retail sales during the beginning 1993 and 1995.  While retail stocks did not do all that well – it is interesting to note that the stock market did amazingly well during that period.  But note that retail stocks didn't crash either (see the historical charts of WMT and HD and you will know what we mean).  Moreover, given that we are now seeing the lowest valuations in retail stocks in years (not to mention the most pessimism since March 2003), this author believes that the retail group as a whole is now a “buy.”

As we noted earlier, consumer spending minus essential spending could also perk up should oil and natural gas prices decline going forward.  We may already have seen a top in oil prices, especially given the recent weakness DESPITE a Fed pause on August 8th and a significant shutdown of the production in Prudhoe Bay and Prudhoe Bay pipeline.  At this point, U.S. domestic inventories are definitely sufficient to meet any shortfall in Prudhoe Bay production.  Quoting the Energy Information Administration: “The reduction in Alaska crude oil supply can be made up for in several ways. The primary means is via a drawdown of crude oil or product stocks and substitution of other supplies for the Alaskan crude oil. As of August 4, 2006, crude oil stocks on the West Coast were 2.2 million barrels higher than August 5, 2005, and U.S. crude oil stocks were over 11.8 million barrels higher. Similarly, gasoline and distillate fuel product inventories are above last year's levels for the United States (4.6 and 2.5 million barrels, respectively). Gasoline inventories for Petroleum Administration for Defense District (PADD) V (PADD V includes Washington, Oregon, California, Nevada, Arizona, Alaska, and Hawaii) were 30.2 million barrels, slightly less than last year. Distillate stocks were 12 million barrels, almost 2 million barrels more than last year. The Strategic Petroleum Reserve (SPR), which currently holds about 688 million barrels of crude oil, may also serve as a source of crude oil supply. Additional imports of crude oil and petroleum products are another feasible source of replacement supply.

Furthermore, the impact of such a shutdown is significantly less than the shutdown of Gulf Coast production last year.  Again, quoting the EIA: “While complete estimates of the volume and duration of reduced Prudhoe Bay crude oil production are not yet available and will not likely be for several days, the Short-Term Energy Outlook assumed that Alaskan crude oil production will be reduced by 300,000 bbl/d from EIA's expected level in August, 400,000 bbl/d in September and October, 300,000 bbl/d in November, 200,000 bbl/d in December, and 100,000 bbl/d in January, then return to full production. This production outage scenario was based on BP's initial estimate that the shutdown would last "several" months and is subject to change as further information becomes available.”

This author had been looking for a top in crude oil prices sometime in the next few months – and we may already have had our top – given the most recent technical action (we are also seeing a non-confirmation of the recent high oil price by both the Dow Transports and the OIH – two indices which have moved in tandem with the oil price since October 2002).  Moreover, as I have mentioned before, the hurricane season of 2006 is set to be relatively benign – and chances of a significant disruption in Gulf Coast oil or gas production this year should be next to zero.  We are also seeing a significant slowdown in China and other parts of Asia as the central banks of the region continue to raise borrowing rates and cut down on credit growth.  Finally, as shown by the following chart courtesy of the EIA, the growth in Non-OPEC oil production is projected to exceed the growth in world oil consumption by the first quarter of next year:

Growth in world oil consumption & non-OPEC production

While a significant decline in crude oil prices will certainly help consumers, this will probably help producers a lot more – as producers in general tend to spend more on energy than consumers do.  For example, the latest quarterly earnings report from food distributor Sysco showed that operating expenses had risen from 13.6% to 14.8% of sales – primarily because of higher energy costs (with higher pension expense making up about 1/3 of that increase).  Had operating expenses remain at 13.6% of sales, after-tax net income would have been about $63 million higher, or nearly 25% higher than what had been booked for the quarter!  Looking at the following chart, it is obvious why this author is now viewing SYY as a very compelling story.  Not only is the P/E ratio of SYY now at a nine-year low, but it is at a nine-year low despite abnormally depressed margins! 

SYY Weekly - In an environment of *normal margins*, the P/E of SYY would definitely be at an 18-year low.

As I mentioned on the above chart – if SYY had been able to maintain last year's margins, the P/E ratio would most definitely be at an 18-year low right now.  More importantly, there is now every reason to expect “more normal” margins going into next year, as oil prices should continue to recede for the rest of this year and into 2007.  Moreover, official (pessimistic) estimates are still calling for a 17% growth in earnings this year and an additional 14.6% growth in earnings next year.  And finally, despite being the dominant company in the food distribution sector (which in itself is growing at 5% a year), Sysco today only retains a 14% share of the market – suggesting that there is still a lot of room for growth for this $18.1 billion company.  Bottom line: At today's prices, Sysco is now a very compelling story.

For now, there is no doubt that the market is now on its best chance for a sustainable rally since the May 10th top.  Nevertheless, the picture is still not very clear – as volume does not usually come in until after Labor Day Weekend.  For now, readers should continue to focus on stock-picking and industry-picking – with an eye on both the retailers and semiconductors.  As for leading indicators of the stock market, readers should continue to focus on the retailers and the homebuilders.  Should the market only experience a half-hearted decline in the upcoming, inevitable correction (such as weak downside breadth or a decline on very light volume), then chances are this rally will be much more sustainable than all the attempts at a rally from mid-June to late July.  Readers please stay tuned.

Signing off,

Henry To, CFA

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