Morning Call

0 CommentsFriday • August 21, 2009 • by alwaters

Morning Call
August 21, 2009

Derivatives

Not too long ago, the average investor may have not even heard of derivatives, much less know how they worked. The financial crisis has, of course, added several new terms to the vocabulary of those even remotely interested in the workings of the financial markets. A Derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying). Rather than owning or trading the underlying itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying. Options and futures are examples of such.

More importantly, derivatives have been used by government entities and other institutional investors to hedge their portfolios, balance cash flows, and minimize risk. Despite much negative publicity following the Lehman collapse, the fact is that the system proved to be more effective and sound than many had believed.

In each transaction, parties and counterparties assume positions that each believes to be beneficial to them and that may reflect differing views of future events. The nature of these Over the Counter transactions makes it somewhat difficult to track but the notional value of the market is said to be about $700 Trillion. Regulators have pushed to standardize derivative trading on an exchange but this will be a complicated proposition. Thus far, derivatives have proven to be a valuable tool and a surprisingly stable market.

What to Buy

With oil prices once again ticking higher, we turn our attention to the energy sector. We expect to see positive movement in the drilling stocks which are typically sensitive to the slightest movement in crude prices. We are also taking a close look at a major integrated play today: Chevron (CVX). Chevron has been upgraded by some analyst from hold to buy on the basis of an estimated Net Present Value (NPV) of $97 a share. Shares are presently trading at $68. The company has a low debt balance sheet and a favorable balance of exposure to upstream and downstream operations. Technically speaking, Chevron shares have just crossed above their 200 day moving average. It also helps that Chevron shares carry a respectable dividend yield of close to 4%.

Market Outlook

It hasn’t exactly been smooth sailing along the way, but the bottom line is that equities have managed to add slowly to their upward movement. We have had some early morning jitters this week that have eventually worn off and the proverbial bulls have repeatedly bought into the dips and led the market to positive territory. For a change this morning, futures are pointing to a positive start to the trading day. At least part of the optimism in the US comes from news that the Conference Board’s coincident index, a gauge of current conditions, was unchanged in July after falling in 17 of the 19 months since the contraction began in December 2007. The Leading Indicators Index also climbed for a fourth month.

Asian equities were mostly lower overnight with the exception of China. The benchmark Shanghai Composite Index gained 1.7%, while the Shenzhen Composite Index for China’s smaller second exchange climbed by 2.5%. Japan’s Nikkei, however, fell 1.4%. Bargain hunting may have contributed to gains in China considering sentiment is actually a little shaky. Word has circulated that Chinese regulators plan to tighten capital requirements for banks, threatening to curb the record lending that has fueled the rally in the nation’s stock market. Banking regulators are concerned about excessive credit creation and the danger of an asset bubble.

In Europe, stocks began climbing at the opening bell and the major indexes are now up by an average of well over 1%. News that services in Germany and manufacturing in France had unexpectedly expanded, supported speculation that the global recession may be easing. In a stark contrast, European banks and industrial stocks are showing strength while in Asia most sold lower. In premarket activity in the US, the banks are somewhat mixed, while technology and retail stocks have gained some momentum.

Despite some trepidation toward events in China, commodities are showing strength this morning. With few exceptions, we are seeing positive movement across the board. Oil is particularly strong as it adds another Dollar to reach close to $74 this morning. After falling through its support line recently, gold is slowly rebuilding momentum; up by $5 this morning to $945. Industrial demand from China will remain a critical issue for gold and, as a result, prices may stay in a tight range in the coming weeks. We should see, however, a move to about $960.

Yesterday, Leading Indicators were positive but Initial Jobless Claims disappointed slightly. Today, the economic calendar includes Existing Homes Sales and the Department of Labor’s Mass Layoffs report. On the earnings side, we will have Ann Taylor Stores, JM Smucker, and a few others.

Investors will also be paying some attention to words from Fed Chairman Ben Bernanke as he speaks to a gathering in Jackson Hole, Wyoming, on the lessons learned from the financial crisis and efforts to aid the economic recovery. Although comments should remain generic in nature, hints of direction for Fed policy will be taken to heart. Questions as to whether Bernanke will stay on as Chairman in January are also on everyone’s mind. The White House had remained noticeably quite on whether Bernanke will receive a vote of confidence from President Obama. All told, we appear poised to finish the week on an uptick as the market has adjusted to a mixed bag of economic news. Metals and Mining as well as the energy sector have been very reactive to economic sentiment, and with that being somewhat positive today, we will expect positive movement in these sectors today.

Posted in: Morning Call: Daily Analysis of the Global Markets and Economy

Tagged with: bonds, economy, gold, oil, stocks