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The Great Recalibration: The Appearance Of Risk Aversion In Credit Spreads And Equity ETFs

I have noticed a trend toward risk aversion that may adversely affect U.S. stocks. Investors may be in the process of adjusting their expectations for what central banks in Europe, Asia and the United States are capable of achieving. Sure, central banks may try to prevent recessions; they may attempt to inflate stock prices, decrease borrowing costs and/or depreciate currencies. In the end, though, their powers may extend no further than the collective confidence of market participants. Investors have seen a great deal of volatility in U.S. treasuries over the past six months. Early in the year, the combination of recessionary data stateside as well as quantitative easing (QE) measures in Europe helped propel demand for U.S. sovereign debt. Then came the massive unwind, alongside Fed hints at upcoming rate hikes; treasury yields spiked. More recently, the Greece default and the market meltdown in China gave treasuries their groove back. At present, the 10-year yield (2.25%) sits pretty darn close to where it sat at the start of 2015. If I had to project where that yield would be at the end of the year, I’d tell you that it might move up, down and around, but that it would ultimately be near where it is today. I feel the same way about the greenback. In essence, I anticipate that the U.S. dollar may jump around, but that it will not move substantially higher or lower over the next 6 months. In other words, irrespective of financial system shocks, geopolitical uncertainty or central banker gamesmanship, both the buck and the 10-year may be directionless. If I see little reason to invest in the greenback or bet against it, if I do not see value in adding meaningfully to treasuries in a portfolio or betting against them, why discuss U.S. sovereign debt or the U.S. currency at all? Primarily, I have noticed a trend toward risk aversion that may adversely affect U.S. stocks. Take a look at the price ratio between treasuries and crossover corporates – U.S. company bonds that span the lowest end of investment grade (Baa) universe through the highest-rated “junk” (Ba) arena. One can do this by comparing the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) with the iShares Baa-Ba Rated Corporate Bond ETF (BATS: QLTB ). In essence, since March, there have been higher lows in the price ratio and a consistent ability for IEF:QLTB to maintain above its long-term trendline. Moreover, the momentum in IEF:QLTB indicates a widening in credit spreads such that investors may be increasingly turning toward the return of capital over a return on capital. The credit spread evidence is hardly an indication of blood in the streets of Pamplona. Nevertheless, the iShares MSCI Spain Capped ETF (NYSEARCA: EWP ) sits near 2015 lows; its current price is well below a long-term 200-day moving average. Indeed, investors may be doubting the ability of the European Central Bank (ECB) to find a path forward. It is one thing to express a desire to “do whatever it takes” to preserve the euro-zone. It is another thing to keep debt-fueled excesses from fracturing alliances. Granted, the People’s Bank of China (PBOC) may eventually contain the fallout from the lightning quick collapse of Chinese equities in Shanghai. And central bankers may yet find a way to kick the toxic debt can down a European cobblestone path; that is, a disorderly “Grexit” for Greece is not an absolute certainty. Even the upswing in S&P 500 VIX Volatility (VIX) is merely a sign that folks are willing to pay a little bit more for index option protection than they were a few weeks earlier. On the other hand, the deterioration in U.S. stock market internals has been decidedly bearish. Both the NYSE Composite and the S&P 500 have significantly more 52-week lows than 52-week highs. Similarly, the number of advancing stocks relative to the number of declining stocks for both indexes has been steadily dropping since mid-May. What these breadth indicators tell you is that fewer and fewer stocks are carrying the entire ship. Like Atlas trying to hold the weight of the world on his shoulders, should he shrug, the benchmarks may buckle. If nothing else, we may be witnessing a “Great Recalibration.” (Did I just come up with a new term?) Investors may be in the process of adjusting their expectations for what central banks in Europe, Asia and the United States are capable of achieving. Sure, central banks may try to prevent recessions; they may attempt to inflate stock prices, decrease borrowing costs and/or depreciate currencies. In the end, though, their powers may extend no further than the collective confidence of market participants. Here’s a look at one last chart that supports the notion that the smarter money may be moving toward risk-off assets. On a month-over-month basis, the FTSE Multi-Asset Stock Hedge (MASH) Index is outperforming the S&P 500. The MASH Index is a collection of non-stock assets that tend to do well in bearish environments, including the yen, the franc, munis, long duration treasuries, inflation-protected securities, German bunds and gold. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Long Duke, But Don’t Load Up Just Yet

Summary An abnormal growth trend in the past two years has caused a relatively stable industry to see much decline due to energy conservation and a lack of overall demand. Bad PR surrounding the new EPA rulings on carbon pollution and coal ash have created nightmares for Duke, resulting in a 10% decline on the year. Capitalization on the higher demand for energy during the summer could help bolster the stock short-term, along with a potential share buyback. Achieving the EPS, setting a greater growth trend for the dividend, keeping the credit ratings high, and EPS growth at least a 5% for the long-term are all pivotal to. After viewing the dividend hike to 82.5 cents a share and sifting through some high short interest stocks, I came across a well-known name: Duke Energy (NYSE: DUK ). Deep in the integrated utilities, the Charlotte -based energy company is a long-time energy producer suffering from a poor growth trend due to a lagging commodities sector and lethargic demand. The company deserves a hold rating, as very few growth catalysts are leadings its outlook. Having only had a positive FCF since 2012, now in the amount of $1.09 billion on a LTM basis, I’m concerned that the recent dividend raise might eat too significantly into FCF. Furthermore, with Lynn Good increasing her salary by 50%, but more notably her short and long-term incentive opportunities to higher multiples of her salary, I believe the money could be better well-spent given their lagging growth recently. Sure, they did implement a new retirement program , but again, there are bigger problems that Duke is facing besides employee turnover. As I figured, the stock saw a lot of downward momentum at the end of the winter, and has really just been on a slow down trend since the spring started. We’re seeing really interesting support around the $70 level. The stock is at April 2013 levels, where they were fairing much the same as they are now. The second half of 2014 proved to be an exceptional growth trend, just about scraping the $90 level, but I can’t reasonably expect the stock to trend in that direction for quite some time. (click to enlarge) Source: Bloomberg We’ve seen a good, but not great three year revenue growth trend from Duke, with most of the gains coming in 2012. With revenues now well above $25 billion, I’m concerned that they won’t be able to sustain this level. Their International Energy segment has seen a small decline of 1.15% over the past three years, which accounts for about $1.4 billion in revenue each year. While much of their efforts are concentrated in Latin America, Brazil has been of particular interest to the company. Much of the operations are similar to their domestic segment, Brazil is suffering from a poor wet season and high water demand, causing reservoirs to be low and inefficient for their hydropower plants. Furthermore, I can’t see them having huge international growth when things like their quarter interest in National Methanol Company (NMC) in Saudi continues to suffer from extremely low margins. Luckily, International Energy does not account for a substantial portion of total revenue, but it’s worth noting that hydropower in Brazil will be lower in future quarters based upon thermal power being prioritized over hydropower and this trend will continue through the end of the year, already down 52.9% in terms of pricing. Sure, there are a few construction and renovation projects that Duke has going for them, but they’re not going to see the light of day until three or four years out, let alone reach their highest potential capacity. For example, a 750 MW natural gas-fired generating plant in South Carolina, which cost about $600 million, won’t be available for use until late 2017 ( 10-Q ). Even little things like the switching from lead acid to lithium-ion batteries in the Notrees Windpower Project in Texas are important steps in helping long-term efficiency and stability for the company. They just recently gained a 40% stake in the $5 billion venture to build the Atlantic Coast Pipeline, which will bring natural gas from Marcellus and Utica in Pennsylvania to West Virginia and coast Virginia and then to North Carolina. Additionally, a 1640 MW combined cycle natural gas plant in Citrus Country Florida, expected to be finished in 2018, will cost $1.5 billion. Based upon hedging activities from many oil companies, like Oasis Petroleum (NYSE: OAS ), running out next year, the input fuel could be very cheap to Duke. On a different note, the stock repurchase program that began earlier this year still has about 15% left approved, which represents a good buyback of about $225 million. This will certainly help push the shares up for a few sessions. The Commodities Caveat Apart from construction and financial growth catalysts, which will have seemingly minimal effects, the commodities market could really end up hurting this company if prices rise. While natural gas prices, via the Henry Hub below, have been on a great YOY downtrend, which reduces input costs, there’s a caveat present. (click to enlarge) Source: Bloomberg With an oversupply of natural gas and plants at Duke reaching 94% capacity, they’re going to suffer from limited profitability. Revenues will eventually decline due to a lower margin received for their output. While demand for natural gas isn’t increasing, but is rather just being adopted as coal-based energy retreats, Duke could have a real profitability problem on its hands, considering their profit margin is expected to drop over 9% this year. The exact same case applies to oil and company management has estimated that the negative effects will be anywhere from 2.5-5% of EPS. I firmly believe their operating margin will remain strong around 24%, but I would need to see significant improvement for this utility company to fend off tough macro conditions. Speaking of said conditions, with a proposed interest rate hike from the Fed later this year, company management has stated that EPS could be affected as much as -$0.07 in the following quarter. Need For Improvement I firmly believe that their regulated utilities segment needs to start showing growth before a reasonable entry point can be made into the stock. Accounting for $22.2 billion in total revenue, the entire segment is up about 27.92% in the past three years, but this has already been priced into the stock, considering many of the gains took place in FY 2014 and FY 2012. Their primary servicing region of the Carolinas, Florida, Ohio, Kentucky, and Indiana has about 7.3 million retail customers. Yet, take a look at the factors hampering their growth: Energy efficiency and conservation efforts, particularly in residential areas The Midwest and Carolina servicing regions were lagging; residential growth, overall, was down 1.4% A higher amount of unserviceable calls than normal this past winter and an increasing number of outages this summer Their commercial power segment, which really only represents a fraction of a percent of total revenue, has suffered a 53.22% three-year decline. Their focus, here, is on alternative energy sources, primarily wind and solar. Regulation Woes Rising Regulation via the EPA’s “Clean Power Plan” set to cut carbon pollution for power plants by 30% by 2030 will pass this summer ( Bloomberg ). This effectively eliminates a coal from being the major energy generator in the long-term, as now the cost structure is unfavorable. Coal Ash Disposal has become a recent nightmare for Duke as they are now required to dispose of the coal ash at four major sites sustainably by 2019 and have all sites cleared by 2029. CBS’ 60 Minutes even dedicated an entire segment towards criticizing the current disposal process of Duke. The estimated cost is about $3.4 billion, or about 3x FCF, currently. Again, the company will still be fine in the long-term as they have a current available liquidity of $6.4 billion, and while they could use a bump up in their credit ratings, the company is standing on solid ground. (click to enlarge) Source: Company Presentation Conclusion On the back end, Duke may benefit from higher D&A costs when it comes time for quarterly reports based upon the pipeline and construction activity, Duke Energy will report quarterly earnings on August 6th, just after the end of July surge of earnings reports from major oil and gas companies. It’s worth noting that their Q3 EPS levels have been historically higher than all other calls, and with projections showing a potential 50% increase in EPS from Q2 to Q3 of this year, the stock is definitely worth considering. Looking to the future, I believe this company will most likely be fine – but there’s too much short-term negativity clouding any decent chance at profitability. Note: All Financial Data Taken From Bloomberg Database Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

With High-Yield ETFs, Costs Can Be Hidden

By Gershon Distenfeld More and more investors see exchange-traded funds (ETFs) as an easy and inexpensive way to tap into the high-yield market. We have some friendly advice for them: look again. Financial advisors who use ETFs as core holdings in their clients’ portfolios-and even some institutional investors-often tell us they like them for two big reasons. First, ETFs passively track an index, which means they’re cheaper than actively managed funds. Second, they’re liquid. Unlike mutual funds, which are priced just once a day, ETFs can be bought and sold at any time, just like stocks. But when it comes to high yield, ETFs aren’t really that cheap or that liquid. Look for the Hidden Costs Let’s start with costs. Sure, some ETF management fees are quite a bit lower than mutual fund fees-but that mostly goes for ETFs that invest in highly liquid assets such as equities. In a less liquid market, like high yield, expense ratios can be as high as 40 or 50 basis points-not that much lower than many actively managed mutual funds. It’s also easy to overlook some of the hidden costs. For instance, anyone who wants to buy or sell an ETF must pay a bid-ask spread, the difference between the highest price that buyers are willing to offer and the lowest that sellers are willing to accept. That spread might be narrow for small amounts but wider for larger blocks of shares. And when market volatility rises, bid-ask spreads usually widen across the board. And ETF managers can rack up trading costs even when market volatility is low. This is partly because bonds go into and out of the high-yield benchmarks often-certainly more often than stocks enter and exit the S&P 500 Index. To keep up, ETF managers have to trade the bonds that make up the index more often. Frequent trading can also cause ETF shares to trade at a premium or discount to the calculated net asset value. In theory, this situation shouldn’t last long. If an ETF’s market price exceeds the value of its underlying assets, investors should be able to sell shares in the fund and buy the cheaper underlying bonds. But the US high-yield market has more than 1,000 issuers and even more securities, and it can be difficult for investors to get their hands on specific bonds at short notice. That means investors often end up overpaying. This can work the other way around, too. If something happens to make investors want to cut their high-yield exposure, the easiest way to do that is to sell an ETF. That can push ETF prices down more quickly than the prices of the bonds they invest in, adding to ETF investors’ losses. We saw this in May and June, when worries about higher interest rates rattled fixed-income investors. Outflows from high-yield ETFs outpaced those from the broader high-yield market ( Display ). Are Passive ETFs Really Passive? Investors might also want to consider whether high-yield ETFs are truly passive. For example, the manager of an S&P 500 equity ETF can easily buy all the stocks that make up the index. But as we’ve seen, that isn’t so easy in high yield-the market isn’t as liquid. ETF managers compensate for this by using sampling techniques to help them decide which securities to buy. Can a fund that requires active decision making and frequent trading be considered passive? We think that’s a fair question. Not as Deep as You Think Here’s another question worth asking: just how liquid are ETFs? Those who look closely may find that the pool isn’t quite as deep as they thought. Why? The growing popularity of ETFs means they have to hold an ever larger share of less liquid assets. If the underlying asset prices were to fall sharply, finding buyers might be a challenge, and investors who have to sell may take a sizable loss. Does this mean ETFs have no place in an investment portfolio? Of course not. We think that a well-diversified portfolio may well include a mix of actively managed funds and ETFs-provided that the ETFs are genuinely low cost and passive. We just don’t think those attributes apply to high-yield ETFs. And we suspect that investors who decide to use them as a replacement for active high-yield funds will come to regret it. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.