An End in Sight

Longer term, the bulls continue to have the fundamentals on their side. As I pointed out in the previous PF Weekly, the 1.2 percent monthly surge in the Conference Board’s Leading Economic Index (LEI) for May follows a 1.1 percent jump in April.

To put this into context, consider that going back to 1971 there have been only six occasions where LEI has managed a 1 percent jump or better in a month. And looking back over the past 500 months’ worth of data, there’s never been an instance where the LEI has registered two consecutive gains greater than 1 percent.

Clusters of positive monthly gains in LEI above 0.5 percent typically suggest an end to recession. Given this backdrop, I’m sticking with my projection that the recession in the US will end either late in the third quarter of 2009 or early in the fourth quarter. I suspect there’s more upside to come for stocks as the market snaps back from the worst recession since at least 1982.

In the short term, I continue to be wary of the potential for a further pullback in the broader averages, perhaps of as much as 10 percent from recent highs, toward 850 on the S&P 500. There are literally hundreds of different bits of economic data released for the US alone each month, and it’s highly unlikely that they’ll all indicate an end to the recession.

And there’s a big difference between indications that the pace of economic contraction has eased and indicators showing outright economic expansion. The noise in the data will undoubtedly prompt more waves of profit-taking such as we saw over the past 10 days.

Any such pullback would mark an outstanding buying opportunity, and we’ll be looking to take full advantage in Personal Finance.

The best-performing sectors of the stock market during the recent run-up have been cyclical groups that stand to benefit most from an economic recovery. Energy and technology are two such sectors that we’ve been recommending in PF. Both sectors have performed well and remain outstanding plays for the remainder of the year.

But in their zeal to grab cyclical stories, investors have shunned more defensive groups such as health care and consumer staples. The S&P 500 Health Care Index is up less than 15 percent off its March lows, compared to a 40 percent rise for the S&P 500.

This is typical during the early stages of big rallies and economic recoveries as investors look to invest in stocks most leveraged to recovery. But as the recovery takes hold, the rally typically broadens to include more sectors, and underperforming groups play catch-up.

Health care remains among my favorite defensive groups right now, and we’ll be highlighting it in the July 8, 2009 PF.

Wall Street is famous for overreacting to rhetoric out of Washington, DC, and this appears to be the case with the health care sector today. In fact, the group is setting up for a major run-up just as we saw after the Clinton health care plan foundered in the early 1990s. Back then, health care stocks outperformed the S&P 500 by a margin of more than 2-to-1, certainly no mean feat during the ’90s bull market.

Since President Obama announced his plans for a health care reserve fund in his preliminary budget back in February, the sector has been plagued by a cloud of uncertainty. These worries aren’t unfounded; some analysts estimate that the sector could see an across-the-board 25 percent hit to earnings if the US were to adopt a European-style socialized health care system.

But the sector is already priced for a worst-case scenario. On a price-to-book basis, the S&P 500 Health Care Index is trading at its lowest valuation in two decades. And historically the sector has traded at a hefty valuation premium to the S&P 500. On a price-to-book value basis, the S&P 500 Health Care Index now trades in-line with the S&P.

Meanwhile, legislation is likely to pass, and some of the measures will be an incremental negative for the group. However, any health care reform act is likely to fall far short of the worst-case scenario.

A recent analysis published by the Congressional Budget Office (CBO) indicates draft legislation that was recently passed by the Senate Committee on Health, Education, Labor and Pensions (HELP) would increase the size of the US budget deficit by more than $1 trillion between 2013 and 2019. And the CBO didn’t even analyze the even bigger costs of creating a government healthcare insurance company that would compete with private insurers or some planned alterations to the Medicaid program.

Some Democrats are already saying the bill will need to be revised. Fiscally conservative Democrats and Republicans are unlikely to support a reform package of this size with a more than $1 trillion budget impact. The most likely scenario: a compromise bill that strips out the most controversial plans and waters down reform so that both sides can claim victory and save face.

Once the worst-case scenario is off the table, health care stocks will likely see considerable upside. For more details and actionable advice, check out the July 8 Personal Finance (available online Saturday, July 4).

Another traditionally defensive group that’s performed well lately is the master limited partnership (MLP). MLPs are traded on the major exchanges just like any other stock, but they’re not taxed like corporations.

MLPs don’t pay any corporate level tax but simply pass through their profits and cash flows to shareholders (known as unitholders in MLP parlance) as distributions. Unitholders then are responsible for paying their taxes on distributions received.

Taxation of distributions is highly advantaged. Typically, the vast majority of the income you receive from an MLP is taxed as return of capital, meaning that you aren’t responsible for paying any tax on that distribution immediately.

In many instances, MLPs allow investors to defer taxation on the vast majority of their distributions for many years, if not indefinitely. Best of all, MLPs have remained one of the very few investments not to be touched by President Obama’s proposed tax hikes.

I see three major factors driving upside in MLPs. First, income-oriented investors will be looking for investments offering high yields that won’t be badly hit by proposed tax reforms. This search will become frenzied as the special tax rates for qualified dividends sunset in coming years. MLPs offer a solution, as the average yield for the group is just shy of 10 percent, they offer tax deferral, and are attractive from an estate-planning standpoint.

Second, easing credit and liquidity conditions are a major positive for MLPs. MLPs typically build capital-intensive projects such as oil and gas pipelines and storage facilities; these projects are typically funded by debt and new issuances of units (shares). During the vicious credit crunch and bear market last year, debt markets were closed to all but the largest, well-established MLPs. And even these firms were forced to pay a far higher rate to borrow money than has been the norm in recent years. This made it tough to fund new growth projects that allow MLPs to boost distributions.

At the same time, in a weak market no company wants to issue additional shares. Trying to issue stock last October or November would have resulted in a nasty plunge in an MLP’s stock price.

But markets are re-opening. Starting in January and into February, we began to see the larger MLPs take on new debt at reasonable interest rates. By April and May this trend had broadened to include some of the smaller MLPs with lower credit ratings and riskier business profiles. And over the past four weeks, as share prices have risen, we’ve seen several MLPs announced new unit offerings.

While prices typically drop when new units are issued, these offerings have attracted plenty of demand and allowed the firms to raise considerable sums in a short period of time. The normalization of credit markets will allow MLPs to fund a widening slate of growth projects in coming years that ultimately mean rising distributions for holders.

Finally, MLPs are typically involved in the crucial energy midstream business--pipelines, storage facilities and gas processing plants are three common assets MLPs own. The US badly needs to build out its energy infrastructure. One obvious example is the fact that the country is home to some of the world’s most prolific natural gas fields like the Haynesville Shale of Louisiana. Development of these fields has been severely hindered by the lack of adequate pipeline capacity to move gas to market. MLPs will play a key role in building this crucial infrastructure.

I’m so confident in the long-term prospects for the MLP space that I’ve started a specialized service, MLP Profits, with my long-time colleague, income guru Roger Conrad. We offer a risk-free trial for those interested in finding out more about the group. Click here for more information.

Speaking Engagements

Eight score and one year ago, with the onset of the California Gold Rush, San Francisco earned a reputation as a prospector’s town. It’s time again to seek paths to prosperity--and to enjoy one of the most beautiful natural settings in the US, if not the world.

Venture west for the San Francisco Money Show Aug. 21-23, 2009, at the The San Francisco Marriott and discover how Elliott Gue, Roger Conrad and GS Early can help you profit in these adventurous times.

Elliott will detail the new direction for Personal Finance and provide his forecast on energy markets for 2009. Roger will discuss utilities, Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0. GS, a constant at PF for two decades, will be there to speak on emerging tech, nanotech and defense tech.

Click here or call 800-970-4355 and refer to priority code 014315 to register as a guest of Personal Finance.