What we Know and Think we Know about Manufacturing

Richard Croft
November 7, 2011
7 minutes read

Allow me to begin with some background about what we know and think we know. Which is really another way of asking what is being priced into the market?

It would seem from recent stats out of the US and Canada that a double dip recession is unlikely. Replaced by a prolonged period of slow growth which the US Fed estimates to come in between 2.5% and 2.9% in 2012. A significant downside revision, by the way, from previous estimates and probably somewhat optimistic in terms of what will actually be achieved.

In support of that latter comment, I note the Fed’s concern about jobs, as the governors expect US unemployment to remain stubbornly high ranging from 8.5% and 8.7% in 2012. And just in case you were looking for Fed statements with substance intended to bring clarity to the situation, fear not… as the most recent communiqué was laced with caveats such as talk of “significant downside risks,” concerns about “strains” in financial markets, and other oleaginous bafflegab. But as I said… the takeaway is that a double dip recession is less likely!

GDP growth encompasses both the service sector and the manufacturing sector. Of particular interest here is the impact a slowdown has had and will continue to have on manufacturing. More importantly, we want to assess how much of that has been baked into the performance of global equity and fixed income markets? That’s important, because each of us must weigh our opinions against the collective wisdom of the market. All with the intent of handicapping potential outcomes.

Digging beneath the headline numbers, US manufacturing came close to stalling completely in October, while expansion in the services sector slowed just a notch. The Institute for Supply Management’s (ISM) manufacturing index fell to 50.8 in October, just slightly above the 50 mark, which is the threshold between expansion and contraction.

The ISM service sector index edged down slightly, to 52.9 in October from 53.0 in September. Still, in the US, 80,000 new jobs were created in October, while the jobless rate inched down to 9.0% from 9.1%. Job creation is still far from what’s considered optimal growth (150,000 new jobs created per month), but the trend is in the right direction.

In Canada, new job growth came to a shuddering halt in October, as the jobs market actually contracted by 54,000 positions. That put paid to any hopes that September’s red-hot growth would become a trend.

As expected, job losses were highest in the manufacturing sector, where output has slowed to a crawl (up only 0.8% in the past year). And that doesn’t bode well for GDP growth in coming months, also dashing any hopes that August’s 0.3% month-over-month GDP growth pace will continue into the fourth quarter.

Now within this context, let’s overlay the eurozone, where recession is not off the table. According to the new president of the European Central Bank (ECB), Mario Draghi (former governor of the Bank of Italy), parts of the eurozone may slip into a “mild” recession in the first quarter of 2012. It remains to be seen how the ECB defines “mild,” but we have to assume that any slippage will cause manufacturing to slump and unemployment to climb.

In an attempt to get in front of the recessionary threat, Mr. Draghi started his new post by announcing a 25-basis-point rate cut. Traders’ initial reaction was positive albeit short-lived.

Here’s the rub! At issue is to what extent have these headlines been baked into the market? Certainly traders have baked in some harsh expectations by slamming Canadian industrials in recent months. Car parts maker Magna International Inc. (TSX: MG; recent $35.17), and engineering construction company SNC Lavalin Group Inc. (TSX: SNC; recent $49.99) both with exposure to European markets, have felt the effects on their earnings outlooks, and thus on their share prices.

The real question for traders is whether the market has taken more than its traditional pound of flesh from this sector. Technicians suggest that the stocks are oversold which might lead to a short term rally. SNC Lavalin is already showing signs of a comeback, although technicians are quick to point out their concern that it may be setting up for a double bottom.

Magna remains stalled for now, but one could argue that its European exposure has been discounted. Like I said, traders views that differ from market consensus.

If you share the opinion that much of what we know and fear is baked into the pie, you should look to trade a rebound in the Canadian industrials over the next six months. Options on both MG and SNC are at the higher range of Canadian option implied volatilities. Meaning that SNC (35% implied volatility) and MG (42% implied volatility) options are expensive. The implication is that covered call option writing strategies may be more effective with these companies.

With SNC you could buy the shares at $49.99 and write the March 52 calls at $3.30. If the shares are called away in March, the five month return is 10.6%. If SNC remains unchanged through March, the return is 6.6%, and with the premium received you have hedged your downside to $46.69. That’s about 50% of the way to a double bottom should that come to pass.

With MG, buy the shares and write the MG March 38 calls at $3.00. Five-month return if exercised is 16.6%, return if unchanged is 8.5% while the downside breakeven is reduced to $32.17, about where the stock found support on the latest go around.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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