White Smoke and the Ides of March

by Shawn Narancich, CFA Vice President of Research

White Smoke and White Flags While Catholics worldwide reveled in the selection of their new pope, investors betting against stocks are licking their wounds, helping push equity prices higher after surrendering cash to invest or cover misplaced bets. After setting consecutive daily highs for a record ten straight days, the Dow Jones Industrial Average finally took a breather Friday, pulling back modestly despite a continuing cadence of supportive economic data. Market technicians are debating the significance of low trading volumes, but the results are adding to a wealth effect that is also being buoyed by rising home prices.

The Ides of March

February’s retail sales report is illustrative.  In contrast to expectations that ranged from negative to muted gains, sales actually rose 1.1 percent from the previous month. The numbers beat all estimates despite February being the first full month of higher payroll taxes that served to reduce consumers’ discretionary income. The takeaway from this report is that our economy probably stands to grow faster in the first quarter than the 2 percent commonly predicted by economists. Also supporting this notion is U.S. industrial production, which also rose more than expected in February. Just what the doctor ordered – after a fourth quarter earnings season in which companies once again under-promised and over-delivered, surprisingly good economic data will be key fuel if the bull market is to make new highs. As stocks melt up, longer-term Treasuries also gained, with the benchmark 10-year bond trading up to yield a hair below 2 percent.

On the Front Burner While blue chip equities posted modest gains for the week, natural gas-focused energy stocks rocketed higher with the commodity. The clean-burning fuel, much maligned by commodity bears who foresee an endless supply of shale gas keeping prices unrealistically low, gained 6 percent on the week and is now up 23 percent in the past month. Why the rush to buy gas? Cold weather in the past couple weeks has helped reduce a surplus of natural gas inventory, which now stands just 5 percent above 5-year average levels. Less commonly appreciated is the fact that gas production is beginning to wane. In key states like Texas, Colorado, and Louisiana which, as Morningstar points out, account for 40 percent of U.S. production, production is falling. Pennsylvania, which contains the prolific Marcellus Shale, is still reporting production gains, but at decelerating rates. All of which recognizes the fact that when energy producers fail to drill as many new gas wells, gas production will fall. So with natural gas now trading at $3.90 per million British thermal units, where to now? For that prediction, we believe that the oil markets are instructive. With U.S. crudes priced between 90 and 110 dollars per barrel, producers with oil and gas acreage will continue to choose oil, because in most cases, the returns are superior. Yes, producers with acreage in the ultra-low cost Marcellus will likely expand their gas drilling, but rigs can’t be moved on a dime and the Marcellus only accounts for about 12 percent of U.S. production. As natural gas production continues to decline in higher cost, more mature basins, and secular demand for gas continues to rise, economics should support higher gas prices into the $4-5 range.

Our Takeaways from the Week

  • The Dow Industrials set a new high as stocks marched higher, driven by better than expected economic data
  • After a long spell of depressed prices, natural gas is on the rise