Rita’s wrath dissected

COMMENTARY Analysts split on suitable, yet profitable, plays

On

the cold battlefield that is

Bay Street, the fast-money crowd has split into two camps on how to profit from Hurricane Rita as this red, swirling blob on TV weather maps chugs toward the Texas coast.

The primary hurricane plays among investors these days are best described as “death and destruction” and “ rebuilding,” said a hedge-fund manager yesterday. “ Some guys want to profit off pain and death, and I can’t say I wouldn’t mind profiting as well. But the rebuild plays will be interesting.”

The first category hardly needs explanation. Investors are placing bets on the sectors and industries already hard hit by Katrina and now exposed to the wrath of Rita.

In particular, the storms are exacerbating the Achilles heel of the U.S. economy: the debt-laden consumer.

Surging gasoline and natural gas prices “are pushing an already stretched U. S. consumer over the edge,” said Allan Brown, chief executive and portfolio manager at Burlington Capital Management Ltd. Because the market is so volatile, “the key is to take a view and build the positions around that view,” he added.

So, Burlington has been shorting retail and restaurant stocks. There is a strong correlation between disposable income, which had already been falling before Katrina hit, and the shares of retail companies.

Interest rates are rising, companies like Delta and are Northwest are laying off thousands and a few million people in the southern U. S. may be left without homes. “Not exactly a recipe for economic prosperity,” Brown said.

Then there’s the unsettling view that the storms will blow a giant hole in the U. S. budget. With George W. Bush unwilling to raise taxes, it could reduce the attractiveness of the U. S. to foreign investors and drop-kick the U.S. currency.

In turn, the buoyant Canadian dollar continues its rise, slowing down our manufacturing sector and squeezing companies reliant on exports. Add to that the distress of North-American automakers and Magna International Inc. looks like a decent short. Investors are also expecting gold to benefit from a falling U.S. dollar.

As millions of Texans evacuate their homes, hedge funds are also targeting manufacturers dependent on petroleum products, thinking their costs will rise dramatically with energy prices. Similarly, shorts are trolling for firms with high transportation costs.

Other popular trades are shorting insurance companies and then going long on the sector once the stocks sell off. Traders are also betting on the pain and suffering of retail banks and lenders with heavy mortgage exposure in Texas, Louisiana and adjacent regions.

A less depressing approach than profiting directly from misery is buying up rebuilding plays such as construction and infrastructure companies. Examples include telecom and wireless firms. It will be easier to roll out wireless networks quickly before land lines are replaced.

Shares of Omni Energy Services, a small, Louisiana-based firm, jumped more than 40% yesterday to US$3.09. The company provides equipment and environmental services for the oil and gas sector, including offshore drilling sites, so its business is expected to take off.

In the short-term, there are endless ways for opportunistic investors to take advantage of all this misfortune. But buy-andhold types have to consider the long-term effects of these horrendous storms on equity markets. Volatility is on the rise, lending credence to the theory that we’re headed for a major correction.

Indeed, it doesn’t look good. And it feels even worse after digesting the gloomy analysis of Eric Sprott at Sprott Asset Management Inc.

“We believe that as consumer’s spending power goes, so will U.S. housing prices. And as housing prices go, so may a financial hurricane be unleashed that will bring the house of cards called the stock market crashing down,” Sprott warned in a note to clients yesterday.

Consumer confidence numbers are weakening, with the University of Michigan consumer index hitting a 13-year low this week. With other surveys revealing similar declines, “ it would appear the American consumer has finally bitten the dust,” he noted.

Aside from rising heating bills and gas prices, credit-card companies in the U.S. will soon double the minimum payment on credit cards to 4% from 2% — a bad piece of news with consumer debt at record levels.

Overall, Sprott figures consumers will have to fork over $2,500 more over the next six months than they did last year, or $400 a month. Without this cash, consumers can borrow less. Assuming a mortgage rate of 5.7%, you could finance $70,000 with that $400 payment. That’s a sizeable blow to borrowing power, so housing prices are headed down.

When that trend takes hold, purchasing power will take a further hit because Americans have refinanced their mortgages and used home-equity loans to fuel their overspending. Last year, for example, Americans withdrew some US$600-billion to US$700billion in home equity, Sprott points out.

“ We are at a loss to envisage how the consumer can envisage such an onslaught,” Sprott concludes. “ How the market can view the upcoming slowdown as anything but anathema to corporate earnings and stock valuations is beyond us. We believe it won’t.”

The storms are creating all kinds of short-term opportunities for hedge funds, which thrive on volatility and uncertainty. But this flurry of opportunistic trading points to one uncomfortable fact. The big picture, longer-term view of U.S. markets is not a pretty one. Trouble is brewing.

Financial Post kkalawsky@ nationalpost. com