I’ve mentioned my concerns about Emerging Market Equities over and over on this site for the past year and a half. (Please read them here). These stocks have been largely on a one-way ride since many of them came into existence compliments of performance chasing investors, ETF convenience and financial advisors who have overemphasized the fallacy of international portfolio diversification. Meanwhile, extremely successful international investors like Jim Rogers and Marc Faber have been sounding the warning bells for months and the bulls kept saying how wrong they were.

Now they are facing a new threat which has to do with investors needing the liquidity back - the same liquidity that has pumped up these emerging market equities. They are being sold because that’s where the profits are still available to be harvested. To the extent that hedge funds and sophisticated investors have benefited from high exposure to international markets, these stocks are at their mercy.

I have no evidence that emerging market equities will be hammered but they are in double jeopardy as I see it. First from the profit taking to resolve some global credit crunch issues then from the risk that the US will eventually head into a recession and cool its demand for emerging market products. Many of these markets have not faced a bear and I hope that none of my fears come true. Until I see stable trading in emerging market equities, I will hesitate to believe that the US markets are ready to find a bottom.

It looks like hurricane season has finally arrived. Well, at least the speculation about hurricane season in the form of oil bids has arrived. When I wrote Oil Change last week, I mentioned that I would be bearish on oil until the first threatening tropical storm appeared in the Atlantic. So much for me making fun of the oil traders when they get confused if they are Oilmen or Weathermen! I have no clue whether Tropical Storm Dean will find its way into the Gulf as a hurricane or if it will cause any disruption to energy supplies.  However, I expect that its very appearance will plug the recent slide and push oil back toward the recent highs.  Consequently, I am changing to a bullish stance on oil.

For the past 7 years, Large Caps underperformed Small Caps and it’s only recently that the Blue Chips have started to gain ground. Investment manager after investment manager not wedded solely to Small Caps have been saying this would happen. Unfortunately, they’ve been saying it for most of the 7 years that they have been grossly wrong. They get no credit with me for being right in the short term and I have been dubious that Large Cap outperformance is a sustainable long term strategy.

I keep hearing about how Large Cap fundamental valuations are so reasonable and so much cheaper than the market and especially Small Caps. That is undeniably true. I have also heard that the majority of Large Caps pay dividends while most Small Caps do not. I agree with that - just click here for the proof. I have also heard how the low dollar is disproportionately beneficial to the Large Caps / Multinationals who have significant operations outside the United States. I agree that the Large Cap operations benefit more than Small Caps from currency issues. However, I see no evidence that it has helped their stocks more than it has helped / hurt / or been neutral for Small Caps. Just run the charts of Russell 2000 and Russell 1000 vs the US Dollar Index - hopefully you’ll see my point.

But all that talk about being cheaper, paying better dividends and being advantaged by the weak dollar is a minor point. According to the advocates for Large Caps, the biggest advantage is that they are much “safer” than Small Caps. First off - there is no such thing as a “safe” or “safer” stock. All stocks are risky - it’s only your individual tolerance for risk that matters.

How many times have you heard that the Large Caps have less volatility, lower betas, etc. etc.? To me that implies that when there is trouble in the market that Large Caps will hold up better. So on a day like today where there was a touch of panic, this theory was being tested. AND IT FAILED MISERABLY. The Russell 2000 went down 1.36% today vs. 2.96% for the S&P 500. Meanwhile, the Russell 1000 declined 2.88% which was almost perfectly in line with the market. Similarly, the S&P 100 declined 3.17% vs. 1.38% for the S&P Small Cap Index. And if you don’t like percentage price changes, just compare the volume of shares traded in the Dow stocks versus their 90-day Average Volume. 20-50% more volume today than normal is not calm. Citigroup had over 100% more volume but who’s counting?

Large Caps have fundamentally cheaper valuations, are more likely to pay dividends and their operations benefit more from a weak dollar. That I agree with. As for evidence that their stocks will perform better in turbulent times - that did not happen today. Maybe it will over time, maybe it will not… but just because Large Cap investors and fund managers want it to happen does not mean it is true.

The consolidation of exchanges in the US and global markets has been interesting from the conversion of the NYSE and NYMEX to publicly traded entities to the acquisition of foreign exchanges. I guess the evolution of electronic trading made it inevitable that things would turn out this way but I am a traditionalist of sorts and skeptical of the Utopian environment of one or two huge global exchanges that are open 24/7. Don’t think I want to go back to the Buttonwood tree but the “for profit” nature of the public stocks like NYX, NDAQ, CME, BOT, ICE, NMX, & ISE has changed things. At some point, competition and efficiency balance each other out and I suspect we are getting to the point where efficiency will not be incrementally beneficial to investors and a lack of competition will actually hurt them. Every time I hear more consolidation talk, the execs involved keep rambling about how great this will be for investors. Yet, I am not sure how bad it’s been up until now or how I am going to notice how wonderful it will be. Let’s get real, it’s not about investors (retail or institutional) - it’s all about the exchanges and their shareholders. Mind you, that’s the way it should be in a capitalist society. I’d just prefer to call it like it is.

With the current deals and those that are being rumored, the list of seven exchanges I just mentioned could easily drop to 5. And I don’t mean to slight the negotiations going on with the Deutsche Bourse or LSE or Borsa Italiana or OMX or Bombay or Singapore, etc. etc. exchanges. Except for the NDAQ and LSE rejection, I am a bit surprised that we are not hearing opposition to all the consolidation talk - either within US boundaries or from the EU. But I suspect that is coming given how few exchanges are left. As for this concept of self-regulatory bodies like the NYSE and NASD, that seems like a stretch if we keep heading to this “One World” financial market system.

I look at the fundamentals of the publicly-traded exchanges and I just shake my head. It’s almost impossible to use the usual fundamental valuation metrics on any of them and feel like they are not grossly overvalued. Pull up the your favorite fundamental screen for the 7 stocks I mentioned and you’ll find averages like these PE(ttm) of 48, PE(fwd) of 37, Price-to-Book of 9, Price-to-Sales of 14, Price-to-Cash Flow of 44. The only saving grace is the “projected” growth rates that hover in the 20% range. And that’s what you are paying for - growth. But then you have to deal with the real question, where is this growth going to come from? Financial innovation over the recent past has been fantastic with the expansion of the ETF world, Derivatives / Options trading, the commodity explosion but that was organic growth and I expect that it will not continue expanding at the rate of the past five years for the next 5. I know the “experts” are all telling you that growth will be exponential, if not linear but time will tell. I remember similar things being said about Internet/Tech companies a few years ago. Just compare the fundamentals (above) of the exchanges to 1999 tech stocks and it’s all too familiar.

The consolidation going on is all about acquiring growth from order flow and new products sitting at the exchanges that have what the others want. None of the targets are cheap and the selling stakeholders are in the driver’s seat. Certainly, there are fixed costs that can be squeezed out of floor exchanges, but I doubt those reductions will result in valuations anywhere near the market multiple. And that gets us back to the growth. The fact is that to obtain 20% per year we need a lot more trading volume and volatility. Or more realistically, the oligopolist environment we are approaching will give the last remaining exchanges the opportunity to raise listing fees and clearing and transaction fees. That may sound great for meeting the growth numbers of the publicly traded exchanges, but those fees are not vapor. They will have to get passed on to someone and that someone usually turns out to be the investor. When the consolidation is over and the inefficiencies of archaic systems have been removed, growth will have to come from pricing power. As near monopolies, they will either have that control or it will have to be regulated by a government body. Neither of those sound too appealing to me.

Two weeks ago, I said I would update my view if I became bearish on Gold. That happened last week after it failed the $690 resistance levels I have been worrying about. Now, I don’t expect support until $640 per ounce and with the CPI data coming in with muted numbers, I do not see an emerging catalyst to hold back a slide. The long-standing inverse relationship between the US Dollar and Gold is definitely still a factor, but I am watching it closely. As I wrote in the May Market Forces post, I am looking for the USD index to trend higher this month, and that is consistent with a bearish move in Gold. However, the global macro and trade data is always threatening to disrupt the dollar’s advance. Lastly, the growing protectionism of the Dems as witnessed by the May 9th version of a currency witch hunt might shake up the whole mess. Until further notice, I am a Golden Bear.

A few weeks ago, I wrote a post about the “Biotech Premiums“ that resulted from the MEDI/AZN deal and cautioned that when the momentum slowed down, it could get painful. Today’s DNDN whacking is indicative of what can happen with biotechs when there is any negativity. But Dendreon’s current problems aren’t just an isolated event. Last week, I saw a lot of weakness in the industry group and I just took another peak at the charts and HEDGEfolios signals. Putting it mildly, there is some serious discounting going on in the more speculative names. In the past two weeks, I have given 59 signal changes in the Biotech group - 51 of them are new DOWN signals. If you have a position in these names, I would be paying a lot of attention to them.

Small cap community / regional banks did well last week.  As I was reviewing the charts, I saw a consistent and broad based improvement in this sector which has performed poorly since the beginning of the year.  Initially, I thought that the weak jobs report on Friday and associated decline in treasury yields might have been the biggest impetus for the stock improvement.  That was not the case… unless it was just a matter of investors guessing correctly all week long and putting a bid in this group.  When I looked at the daily charts, I saw strength that was forming from Monday forward.  So what does all this mean?  It means that I am less pessimistic about small financial stocks.  It might be a reflection of rates or credit quality not being as bad as expected or a commentary on the mortgage mess not being as bad, but whatever the reason, the action in this sector stood out.

Big news from Saudi Arabia and the oil market is not reacting. I guess there were only 172 terrorists plotting to blow stuff up and the authorities caught every single one of them. I am glad this was prevented but taking the approach that this was not a sign of persistent and future trouble is dangerously ignorant.  It will be interesting to see how long it takes to hear Saudi Arabia’s condemnation of terrorism.  That happens whenever an Islamic country is attacked by terrorists like when Jordan was hit in November 2005.  And then shortly thereafter, you don’t hear so much about their hatred of terrorism.   If the vast majority of peace-loving Muslims would speak out and take action against extremism whether it was in their country or not, there might be a chance for peace.  Until that happens, count on more terrorist plots being stopped and more terrorist attacks that could not be stopped.  Today’s actions prevented more fear being priced into oil, but for how long?

I know everyone loves the idea of decent yield at a time when rates are so low and Fed rate cut dreams have given them another boost, but the Utilities sector is overdone at this point. I have been giving DOWN signals on some of these stocks during 2007 and that has not worked out as well as I had hoped. Still, the technicals and fundamentals keep telling me to look for any opportunity to exit UP signals. Having this low growth sector as a leader of S&P performance is not encouraging to me. High profile buyout premiums like TXU have certainly fueled this rally but the investor love affair with yield chasing has been the bigger factor.

Along the way, prices have risen so high that the yield on utilities are right around historical lows of about 2.8% versus 6.3% at the start of the bull run. The last time the yield on the S&P 500 Utilities Index was lower than today occurred in 2000 but no one seems to care that you can get a much higher yield in a money market account. The utilities index has risen about 13% this year and since past bear market ended in October 2002, they have advanced almost twice as much as the S&P 500. Lovers of utilities will point out that total returns are a function of capital appreciation as well as dividends. I get that, but there comes a point when that story is more about the past than the future. We are at that point.

I pulled up the valuation metrics I used last April and compared them to today’s numbers on the same 90 utility stocks covered by HEDGEfolios. The average PE(TTM) was 18.5 last year and it’s 26.7 now. The average forward PE was 16.6 last year and now it’s 23.6. At a significant premium to the the S&P 500, Utilities are richly valued and as previously mentioned, dividend yields have declined dramatically. Were investors so wrong about valuations back then or are they more wrong now?

One of the most dangerous portfolio management scenarios is focusing on returns while ignoring risk and I see that in abundance with utilities and frankly, most yield plays whether that is mortgage-backed securities, junk bonds, REITs, etc. Investors have been told for eons that stocks like utilities are defensive plays because the high yield will serve them well during periods of slow growth. However, that usually occurs after a period where Utility stocks were out of favor and that is not the case in the current environment. You cannot avoid risk for this long and not have to deal with repercussions down the line. As the old saying goes…”I’d rather be out wishing I was in, than in wishing I was out.”

In the research for my previous post comparing cars to computers, I tried to find a good reason for cars becoming so complex. Supposedly, today’s vehicles are so much better than they used to be and that may be true depending on your perspective. Paint colors, less rust, nicer interiors, better sound, etc. etc. - lots of cosmetic stuff seem better to me. You might have guessed that I am not a car fanatic. For me, vehicles are about transportation: 4 wheels and a motor that move people and things from place to place with safety (including pollution control), reliability, and utility. Except for rare cases like antiques or exotics, vehicles are terrible assets to own. I understand that many people love cars for emotional reasons and I support their right to do that but that’s not for me.

Outside of the esoterics of style - why don’t we evaluate the factors that should have been improved from making cars more complex - like fuel economy? Isn’t that what everyone bitches about when gas heads to $3.00 per gallon? For some reason, I don’t hear how “fun” and “cool” cars are when that happens! Just take a look at this chart from the US EPA report entitled Light-Duty Automotive Technology and Fuel Economy Trends: 1975 Through 2006 and you’ll see that while improved dramatically from 1975 to 1987, not much good has happened for the past 20 years.

If you really want to dig deeper and find out what we did right from 1975-to-1987 and what we did not do right from 1987-2006, just look at the data in the EPA report that shows the changes in mpg, weight, horsepower, 0-60mph time, % trucks, % 4-wheel drive, and % manual transmission. It’s clear that weight is the biggest contributor to improvements in fuel economy. Advances in aluminum, other lightweight alloys, plastics, and composites have done a lot and sadly, not much has been accomplished with all the computerization of the vehicle. Sure - we can go from 0-60 a few seconds faster than we did in 1987 and the vehicles have more horsepower to push around all the weight that has been added. But I don’t call that much progress for 20 years - do you? In fact, I find it pathetic that automotive manufacturers have done almost nothing to compensate us for cars that are much more expensive to buy, maintain and repair.

This country is full of people who love to complain about big oil making “excessive” profits and supposedly ripping them off - but that is a farce. When gas prices rise, consumer behavior and gasoline demand do not respond. Instead, all we seem to hear are complaints about how bad capitalism is and how we need to tax big oil to change their behavior. So as we head towards $3, $4 or $5 per gallon this summer, let’s look in the mirror at our behavior. Manufacturers are making cars that have done little to improve fuel economy so shame on them. However, shame on the consumer who buys them. Obviously, American consumers prefer big, heavy cars and SUV’s that go real fast with lots of horsepower.

I am confident my opinion is not as easy to accept as blaming big oil, but we need to do better than pointing fingers and whining. We need to change our consumption behavior and our purchasing behavior. Until we do that, automotive manufacturers are unlikely to invest in technology that gives us better fuel economy. It hasn’t happened for the past 30 years despite the lessons from the 70’s oil crisis. I doubt it will happen now.