The Stock

What to Trade: Buy Vale (NYSE:VALE) under 31 with a stop at 23.25.

Why Now: The global economy is experiencing a soft landing, and Chinese economic data will surprise to the upside later this year. That’s traditionally a good time to buy basic materials stocks.

The Story

With Yiannis in his native Greece and Elliott in his hometown of Alexandria, VA, this month’s Stocks on the Run meeting was conducted by telephone. Despite the distance and time difference, both editors were on the same page, hunkered down over drinks and a savory meal.

After spending the morning catching up on work, Elliott decided it was time for a bit of fresh air and some lunch. Ensconced at the bar of Jackson 20, a local favorite attached to the Hotel Monaco in Alexandria, VA, Elliott orders a glass of Malbec and a flank steak with frites. With that squared away, he readies his notes and dials Yiannis’ mobile phone.  

Yiannis: Nai?

Yiannis voice is barely audible.

Elliott:  Hey, man. Can you hear me? If that’s wind, I guess you’re already on Mykonos.

Yiannis: Wait, I’m headed inside. I’m at Solymar in Mykonos, can you hear me now? It’s easy to lose track of time on the beach.

Elliott: Glad to hear you’re suffering while you toil away in a beach chair. That’s European austerity for you.

Yiannis: Cut me some slack. The market has rallied and the euro is back over USD1.30 while I’ve been on the beach–do you think that’s a coincidence?

Elliott: Ha! All jokes aside, I like what’s happening in Europe, and I don’t just mean the food, wine and beach scenery. Fiscal austerity appears to be working already. Governments across the EU have passed some extremely tight budgets. I’m really impressed that this commitment to fiscal discipline involves spending cuts rather than higher taxes.

More important, the market is also impressed. The euro has rallied, European credit markets are normalizing and credit default swaps suggest that the risk of default is falling quickly. The growing calm has encouraged robust bond issuance in the EU and US, a sign that creditworthy companies still have access to capital.

Meanwhile, recent economic data from the EU has actually been better than US releases. Looks like rumors of the EU economy’s demise were greatly exaggerated.

Yiannis: Man, pause for a breath–or a sip. I agree with you, if the European Central Bank doesn’t panic and radically alter its policies, European fiscal policy will pay off and bring deficits to sustainable levels.

Elliott: All right, I’m going to concentrate on drinking this Malbec from here on out. What’s your big idea for this month?

Yiannis: It’s time to buy materials stocks. I like Brazil-based Vale (NYSE: VALE), a diversified miner with heavy exposure to iron ore. We both agree that outlooks for the EU economy are overly bearish. And although the US economic growth has slowed, leading indicators are far from levels that would suggest an outright contraction. I expect a soft landing for the developed world, with economic growth continuing at a weak pace.

The Chinese economy is on better footing than the talking heads would have you believe. The government has successfully stepped in to cool the property market but has no intention of killing the housing cycle; the powers that be have always encouraged homeownership.

And remember that China’s housing market is nothing like the bubble that occurred in the US; the minimum down payment on a mortgage loan is 20 percent, and around 25 percent of all housing transactions are all-cash deals that don’t involve any financing.

The Chinese market has been out of favor, and sentiment is bearish, but the data will surprise to the upside later this year.

All of these factors set the scene for strong performance in the materials sector.

Elliott: What about pricing? Iron-ore prices tumbled earlier this year alongside other commodities. Also, I heard that producers are pushing a new system where iron supplies would be re-priced quarterly–a plan that received considerable resistance from China and other major consumers.

Yiannis: Iron-ore prices have stabilized and are turning up. The three-month forward price of iron ore hit a high of USD180 on April 21. The recent low was USD102 on July 9. It rallied 30 percent to USD133 but remains 26 percent below the year’s price peak. And there hasn’t been much pushback to the quarterly pricing scheme.

Elliott: Ok, I’ll bite. Why Vale specifically?

Yiannis: Vale boasts the best iron ore in the business, the kind that’s used in high-end steel products. The company has a strong balance sheet and has cut costs substantially, offering earnings leverage as demand for iron ore accelerates. Vale also has a USD13 billion investment budget aimed at accelerating their organic growth.

Better yet, the stock is cheap, and valuations should expand as sentiment on China and commodity pricing improves in the second half of the year.

Elliott: I’m generally impressed with Vale’s operations. Although I don’t cover the iron-ore industry, I follow the firm’s activities in coal and fertilizer, two markets with strong growth prospects. Coal mining outfits have noted high demand from China, India and other emerging markets in their second-quarter conference calls. Fertilizer inventories are fairly tight in many key producing countries, and crop demand is strong.  

Yiannis: And don’t forget Vale also has exposure to copper, nickel and other key metals that are in high demand in emerging markets.

I’d also point out that a weaker US dollar is traditionally bullish for materials, especially in Asia.

The weather in Mykonos is gorgeous, but conditions have turned for the worse in Old Town Alexandria, where the sky has gone from bright and sunny to dark and ominous. The crack of thunder signals the start of yet another summer rainstorm.

Yiannis: What was that sound? Did you fall off your barstool? 

Elliott: Ha. It’s still lunchtime, man. That was thunder. The temperature is in the triple digits and the humidity is brutal; we’ve had storms just about every afternoon this week. Looks like I’ll be stuck here for a while.

Yiannis: Sounds like you should have stayed in Greece, man. So what do you think about my pick?

Elliott: I like the story; let’s go with Vale for the August issue. Since I’m stuck here with nothing to do but order more Malbec, let’s discuss last month’s recommendations.  

Yiannis: Your short play on First Solar (NSDQ: FSLR) is doing well. I noticed the stock gave up $10 after the company announced second-quarter earnings. But First Solar beat the consensus estimates–what’s going on there?

Elliott: First Solar beat expectations, but analysts’ estimates varied widely; a lot of the bulls forecast a huge earnings surprise that would have sent the stock to the moon, sun or wherever. These overly optimistic predictions didn’t pan out, and the good news was already priced into the stock. To make matters better for us, the company’s earnings guidance was also weaker than the bulls had expected.

Then Spain announced a 45 percent cut to subsidies for solar power. Spain, Germany and other EU nations were big supporters of solar power during the boom times, but a commitment to fiscal discipline outweighs support for alternative energy the days.

These developments make me feel even better about shorting First Solar; the stock is going down, and I expect it to sink below $100 this autumn.

Yiannis: US Airways (NYSE: LCC) also looks to be on track. Airline names did well in July, but US Airways outperformed significantly. Why didn’t the stock break above $11?

Elliott: US Airways has performed well, both in this advisory and on my return flight from Greece. As we discussed last month, the stock benefits from the recovery in business travel.

The sharp rally in crude oil to over $81 a barrel may have spooked the market; US Airways has exposure to volatility in jet-fuel prices. Although I expect oil to hit $100 a barrel, that won’t happen over the next month or two. The stock probably tailed off because traders took profits once it broke to new two-year highs. It’s done well so far, and I still like the story, but let’s cut US Airways to a hold and raise the stop to $7.25 to reduce our risk.

Yiannis: Sounds like all of our picks are on track. I’m headed back to the beach. I’ll see you in London in late August?

Elliott: I’ll be in the world’s greatest city for a wedding. Let’s try to squeeze in a game of real tennis and some dinner.

Yiannis: I don’t know about the greatest city part…

Elliott:  Well, if you don’t know then let me tell you.

Yiannis: Whatever, man. The beach is calling. I’ll see you in London later this month.

New Trade:

Vale (NYSE: VALE)–Buy < 31, Stop-Loss @ 23.25.

Open Trades:

US Airways (NYSE: LCC)–Hold, Stop-Loss @ 7.25.

First Solar (NSDQ: FSLR)–Short > 110, Stop-Loss @ 145.

PennWest Energy Trust (NYSE: PWE)–Buy < 23, Stop-Loss @ 14.

ProShares Short Russell2000 (NYSE: RWM)–Buy < 44, Stop-Loss @ 37.15.