December 2, 2014

Greetings, What is it about that brings market volatility? The Friday after Thanksgiving 2009 was the second craziest day of my trading career – the of 2010 being the first. That was the day that World, the Emirate’s main investment vehicle, proposed to delay repayment of its debt, which raised the risk of the largest government default since Argentina in 2001. It was also the day Greece revealed its financial situation was more precarious than rating agencies had been led to believe – kicking off the European sovereign that persists to this day. And I’d be remiss not to mention that November 26, 2009 was also the date Elin Nordegren smashed a 7-iron through the back window of her then-husband Tiger Woods’ SUV. This year, the big Black Friday headline was that OPEC agreed to maintain current production quotas despite the decline in oil prices. WTI futures fell below $70/barrel for the first time since early 2010, and ultimately leveled off around $66/barrel. Many commentators seem to think the Saudi’s are trying to put the squeeze on shale players in the US, but I still believe they’re punishing Russia, Iran, Venezuela and the other sociopathic oil producers.

The crude sell-off put a small dent in my portfolio, only 2-3%, and we’re still up 13% since inception. I deployed some cash on Friday morning, dipping my toes into an oil-related position I’ve been watching for a while. For those who don’t subscribe, I’ll give you the hint that it wasn’t Brazil’s state-controlled energy giant Petrobras (ticker: PBR). Petrobras, which was already under pressure for its inability to develop reserves, confirmed last week it’s being investigated by the SEC for allegations that it was at the heart of a vast laundering and kickback scheme. The probe could even ensnare Brazilian President Dilma Rousseff, who was just re-elected. More interesting to me is how discounted oil will impact the balance sheets’ of major exporters. Rapid moves like this are when the market exposes vulnerabilities, and much of the emerging world is exposed at the moment. More on this theme below…

You probably already noticed the banner headline at the top of this note, but I’ll be leading another webinar this Thursday at 12pm EST discussing “5 Macro Misconceptions in the Market.” I want to thank everyone who joined my last webinar for their kind words. The upcoming discussion will touch on some timely topics; I hope you’ll join me. There are a fixed number of openings for the live- version where you can ask questions, so be sure to register in advance. Marketfy will post a recording later on.

Today’s letter will cover several topics, including:  Nuclear IPO  The Fundamentals of Debt  Herding Cattle  Chart of the Week

As always, if you have any questions or comments or just want to vent, please send me an email at [email protected].

Until next time, tread lightly out there,

Michael Lingenheld Managing Editor – Cup & Handle Macro

Nuclear IPO Two weeks ago, I mentioned that China’s new climate deal should be a boon to the domestic nuclear industry, as the country diversifies its energy generation away from fossil fuels. Sure enough, last week state-owned CGN Power (ticker: 1816 HK) issued an IPO in Hong Kong that raised $3.16 billion, making it one of the few pure-play nuclear companies in . Beijing plans to triple nuclear capacity over the next six years, making this IPO particularly attractive to some. Shares won’t come cheap, however. CGN Power opened trading with an enterprise value worth 12.8x last year’s EBITDA, substantially higher than the 6.7x multiple of US nuclear operator Exelon (ticker: EXC). This is problematic because China still regulates electricity prices more than the US. For example, new nuclear power plants can’t charge more than neighboring coal-fired plants. The Chinese also still prioritize wind and solar energy over nuclear. In my mind, CGN Power may very well turn out to be a good investment because the nuclear build-out in China is simply massive. However, regardless of the operator, all of these plants will need uranium for fuel. Uranium miners continue to trade at extremely depressed levels, even though increased demand is all but inevitable. Expect a fundamental deficit by 2017. I’ve written about this before, but miners like Cameco (ticker: CCJ) should be the main beneficiaries of this theme.

Get in Line for Debt Several prominent and highly respected hedge funds have been hurt this year by short bond positions. At some point the 33-year old bull market in bonds will come to an end, but in the meantime, shorting bonds is an uphill battle. According to JPMorgan, demand for debt securities has surpassed issuance five out of the last seven years. Forecasts shows that demand will outstrip supply by another $400 billion in 2015. Since the end of 2007, JPMorgan estimates bond demand has exceeded supply by more than $2.5 trillion, including a gap of almost a half-trillion dollars this year.

The problem is that banks, both central and commercial, have an insatiable appetite for debt. Central banks in the US, Japan, UK and now Europe have expanded their balance sheets by loading up on bonds. The Bank of Japan, for example, holds 20% of outstanding JGB’s and is projected to own 50% by 2018. Meanwhile, new regulations have forced commercial banks to improve their capital ratios. Purchasing bonds, which are extremely liquid and qualify as tier-1 capital, is the easiest way to improve capital ratios and placate regulators. The result is a massive supply/demand imbalance that increasingly favors bond bulls. This year alone, benchmark yields in all 25 developed nations tracked by Bloomberg declined, with those in Germany, Italy and France setting record lows. Bonds may be in bubble-territory, but the fundamentals suggest it won’t pop anytime soon.

Following the Herd You may have opted for meat other than turkey on Thanksgiving, and if beef was the choice, you certainly paid up for it. After sputtering briefly in August, cattle futures have continued their relentless rally. The December 2014 contract is up nearly 30% YTD, and rolling futures have rallied 110% since 2009. Analysts at the Livestock Marketing Information Service (LMIC) describe the supply/demand developments this year as “near perfect.”

If conditions stay the same, LMIC expects the cattle market to be robust until at least 2017. Strong fundamentals and falling feed costs make it easier for cattle farmers to hold onto their inventory – driving prices even higher. It has even gotten to the point where “cattle thefts” are on the rise.

Chart of the Week You may have missed it last week, but Nigeria simultaneously hiked interest rates 100bps, from 12% to 13%, and devalued its currency, the Naira. Aside from Boko Haram, which continues to kill dozens of innocent civilians every week, Nigeria’s biggest problem is falling oil prices. Africa's top producer relies on crude for 70% of the government revenue. In a statement, Godwin Emefiele, governor of the Nigerian central bank, described the country’s fiscal revenue outlook as “not too impressive.”

Nigeria is hardly an integral part of the global financial system, but this devaluation does underscore an unsettling trend. The strengthening US Dollar is putting the squeeze on oil exporters all over the world. Venezuela, Iran, Brazil, and Russia all rely heavily on oil revenues to balance their budgets. Cumulatively, they matter a great deal to the financial system. Even Great Britain, which doesn’t export much crude, counts on the oil and gas sector for 17% of tax receipts. Nigeria must now try to rein in inflation before Presidential elections early next year. Don’t be surprised if other oil exporters follow Nigeria’s lead. Except that if a major economy devalues their currency it will have serious implications for the broader market.

Reader Question: **Editor’s note: Every week we’ll try to answer at least one reader question. If you would like to submit a question, please send us an email at [email protected]. We’d love to hear from you! **

Q: Last week you gave thanks to central bankers for supporting asset prices. What is your response to those that argue that relative price performance very closely tracks relative EPS growth? - CH

A: I actually agree with that statement 100%, EPS is probably the most important variable in determining price movements. And EPS growth has mimicked the rise in stocks.

However, I would point out that share buybacks are approaching all-time highs because of (among other reasons) the low interest rate environment, giving EPS a major boost. 30% of Russell 1000 companies have spent more on buybacks in the past two years than they've generated in free cash flow, which is unsustainable in my opinion. To be clear, I'm not bearish stocks or assets - especially in the US. My point about supporting asset prices is really more about the limits of monetary policy, and the economic dislocations it creates. Right now, monetary policy is the only tool being used to stimulate growth and I think that's going to create huge volatility – which is great for my trading strategy.

That’s all, see you next week!

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