The Recovery is Picking Up Speed, Setting the Stage for Big Gains in the Next Year

Do you hear a rumbling, a honking, the smell of new carpet in the air? If so, it's all a result of the biggest surprise of the past month: the rise of U.S. vehicle sales, which was supposed to have ended with the "Cash for Clunkers" deal over the summer.

And it's a very positive surprise. 

The U.S. auto industry may be beleaguered, beaten, bruised and battered, but it is still extremely important to this country. If it can get rolling again, shocking the skeptics, then a lot of good things will happen.

When car sales rise, auto factory production rates rise, causing more car parts to be ordered, more steel and rubber and glass ordered and more advertising purchased. This leads to more people being hired in manufacturing, product planning and marketing, and all ancillary industries. A stronger auto industry will make the U.S. economy start to spin faster on its axis in ways no one is expecting. You cannot overestimate the importance of the improvement of this key industry, and yet I really don't think that investors are really onto it yet.

When you actually visit showrooms today and look at the new Ford Motor Co. (NYSE: F) and General Motors Corp. cars and trucks, you may be shocked to discover that they are actually much improved over what we've seen in the past decade. I have been shopping for a new car myself, and have been stunned to see how much progress has been made with fit, finish, technology, comfort and the professionalism of the sales forces. Marketing has much improved as well, with promotions moving away from rebates and discounts and focusing instead on technology, mileage and attractiveness.

One reason for the rebound in the auto industry is that the auto replacement cycle has been stretched about as far as it can go. There's a limit to the number of times that people will get their 12-year-old cars repaired; eventually they just need to get a new vehicle. And as employment trends brighten, and people decide to get new wheels to commute to their new jobs, the virtuous cycle will turn and turn.

Most of the companies involved in the auto rebound are manufacturers, which is one reason that industrial companies are outpacing their peers. As you can see in the chart above, the U.S. manufacturers in the Industrials SPDR (NYSE: XLI) exchange-traded fund (ETF are up much more than the rest of the market. Very few people saw this coming, as U.S. heavy industry was considered the least likely to benefit from a rebound in the economy this year.

This shows once again, as if we needed another lesson, that it pays to think hard about least-expected results, as they tend to have the greater chance of occurring. Top auto and auto parts manufacturers to pay attention to are Ford, Dana Holding Co. (NYSE: DAN), ArvinMeritor Inc. (NYSE: ARM) and Modine Manufacturing Co. (NYSE: MOD), as shown above.

Jet Black

The leaders in the industrials are not just companies tuned to the auto sector, but also aerospace-focused companies that are preparing for a new product cycle at The Boeing Co. (NYSE: BA), if its 787 Dreamliner ever gets off the ground (literally), and a renewed military buildup in Afghanistan. 

There are very few major product-cycle stocks that have been more exciting than Boeing over the past few decades, as its industrial ecosystem is gigantic. The reason: The building of new planes involves so many expensive parts made mostly by U.S. companies, including aviation electronics from Rockwell Collins Inc. (NYSE: COL) and Honeywell International Inc. (NYSE: HON); interiors, landing systems and engine controls from Goodrich Corp. (NYSE: GR); precision metal components from Precision Castparts Corp. (NYSE: PCP); specialty steels, titanium and other metals from Allegheny Technologies Inc. (NYSE: ATI); and interiors from BE Aerospace Inc. (NYSE: BEAV).

There are also high-yield dividend stock opportunities in this sector: the specialty finance companies that buy planes, lease them out, and then securitize their cash flow. Jet lease cash flows provide these companies REIT-like dividend yields of 4.5% to 9%. Leading companies include Aircastle Ltd. (NYSE: AYR), Genesis Lease (NYSE ADR: GLS) and Babcock * Brown Air Ltd. (NYSE ADR: FLY). These stocks have all flat-lined for the past four months after sharp rebound in March, as some have curtailed their dividend temporarily, and look ready to move higher as jet orders start flowing again.

Just to give you an idea of the power of an aerospace cycle, the last big Boeing product cycle coincided with the last bull market, and shares of the aircraft maker rose from $25 in 2003 to $100 in 2007, as you can see above. Boeing shares have begun a recovery that's very similar to the one seen in 2003, with a rise above its critical 12-month average, and then a four-month stall. In fact, it's uncanny how similar the two recovery starts have been.

In many ways the Boeing product cycle could be just as strong this time for two reasons: First, its U.S. and European customers have been putting off buying new planes longer than usual due to the credit crisis of last year. Second, emerging markets, which are its best opportunity for new sales, are a lot richer now than they were four years ago. The disparity between the number of commercial aircraft in the developed Western markets vs. Asian and Latin American markets is huge. For a country like Peru and Indonesia, nothing says "we made it" like replacing old 707s with brand-new Boeing or Airbus aircraft.

This is going to be a long-running theme once it gets going. Put these stocks on your radar, so to speak, and I'll let you know when it's time to get aboard and start rolling down the taxiway.

Margin Madness

One of the main reasons stocks have performed so well this year has been the deep cost cutting by corporate executives. Despite one of the worst recessions in generations, profit margins have been protected at all costs mainly through payroll cuts. According to Citigroup estimates, businesses have cut more than five million additional positions this recession compared to the prior two downturns. 

The cuts have saved more than $250 billion from the expense line of corporate income statements -- roughly equal to about 10% of peak corporate profits. Also, labor costs as a percent of GDP have fallen from a high of nearly 60% in 1970 to just 55% now. 

As a result, profits have consistently exceeded analysts' expectations this year. Eighty percent of Standard * Poor's 500 Index companies reported earnings "beats" in the third quarter, 73% in the second quarter, and 65% in the first quarter. 

The inevitable question now is whether this performance can continue. The skeptics say that companies cannot save themselves into prosperity. And thus, earnings growth will slow as the calendar flips into 2010 even as economic activity is set to ramp up as the recovery rolls on. But these people are missing two important points. 

The first is that because of the compression on what accountants call "variable costs" -- things like labor and materials that vary with production -- margins are set to explode higher on just small increases in sales. Two, there are some "fixed costs" -- which are things like mortgages that don't vary with production -- that actually behave like variable costs over time. These are things like research and marketing budgets. It takes a few quarters for management to pull down these expenses, and Wall Street analysts don't do a good job of forecasting it. Thus, a reduction of these costs will provide another boost to earnings over the next few quarters. 

If all this talk about accounting makes your head hurt, here's the bottom line: Due to the changes in fixed-cost leverage, earnings of large companies are set to grow very quickly as sales expand. And, because of the slow response of some expense items, we've yet to see the final benefit from existing cost-cutting initiatives. 

The bears aren't properly accounting for this, as they seem to think that companies will need large increases in sales to keep earnings moving higher, and this is just not so.

The two sectors that are best positioned to take advantage of these two trends are basic materials and industrials. Companies in these areas have some of the largest fixed costs and will enjoy the largest earnings bounce as business activity increases. Just look at the chart above. You can see how the operating margin of materials stocks in the S*P 500 has fallen back to the troughs reached in the 1991 and 2001 recessions. In the recoveries that followed though two downturns, margins more than doubled. I expect a repeat performance over the next few years. 

This is another reason that I am excited about the prospects for the industrial and basic materials companies focused on the aerospace cycle. Stay tuned for new picks this week to take advantage.

Special Situations Update: Cytori Therapeutics

Just a quick comment now on our special situation position Cytori Therapeutics Inc. (Nasdaq: CYTX). The company presented interim results from a European clinical trial called RESTORE 2 to a conference in San Antonio on December 12. The trial of 32 women showed that breasts reconstructed by physicians using Cytori's procedure achieved a high rate of patient and physician satisfaction and improvements in the condition of their breast deformity after six months, according to the company.

If you haven't been following my coverage of Cytori, the short story, from a layman's point of view, is this: About 1 million women each year are diagnosed with breast cancer. Those who are treated with a partial mastectomy are left with a deformity in their breast that can be quite unsightly. Plastic surgeons for years have worked on solutions ranging from implants to grafts from other parts of the body, such as the abdomen or back. The implants can be rejected and don't have a natural feel, and the grafts leave a second impact zone on the body and can also be rejected. Doctors have tried to use fat grafts obtained by liposuction in the past, but these have a poor record because the fat tissue often dies quickly, loses a lot of its size as it dries out or is absorbed, and can be rejected. 

Cytori's solution is threefold: Doctors take 100 cc to 200 cc of adipose tissue (otherwise known as fat) from a women's waist or rear, and then treat it in their proprietary machine at bedside with enzymes in such a way that they are able to separate growth factors and stem cells. The cell-enriched fat is then implanted via a needle in a procedure that's done in an hour in an outpatient clinic with local anesthetic. The difference is the growth factors and stem cells -- also called adipose-derived regenerative cells, or ADRCs -- because they help the fat revascularize and retain its natural shape and feel. The magic, if you will, is partly the machine and partly the software that helps doctors determine the right amount of stem cells and growth factors that will work properly for each patient. 

The results were presented at a major breast cancer symposium in San Antonio on Saturday by Dr. Eva Weiler-Mithoff, M.D., co-principal investigator for the trial at the Glasgow Royal Infirmary. To view a video in which she presents results, click here and then click Play.

The synopsis of results, as released by the company: Seventy-three percent of patients and 82% of doctors reported satisfaction with the outcome after a single treatment reported in difficult-to-treat breast cancer patients. The trial reported improvements in both breast defect and overall shape. This is considered a very good result because all of the women who undergo Cytori's procedure have already failed to achieve satisfactory results with other methods; they are the hardest cases.

The procedure is already approved for use in Europe and Japan, and the machine is sold by General Electric. The purpose of the European trials is not for safety -- because it's already approved -- but to prove to insurance companies that the breast reconstruction procedure should be reimbursable due to its clear effectiveness at restoring a woman's sense of physical and mental well-being after surgery. 

Some British clinics are also using Cytori's machine, called Celution System, for breast augmentation as well. Patients say that they like the fact that the augmentation is done with their own tissue, and that the breast looks and feels natural because the cell-enriched fat becomes an integral part of the body rather than an interloper. A British woman wrote a first-person column about the procedure, which you can read by clicking here.

Shares of the stock are up 30% since I recommended them in November, almost in a straight shot. Expect some consolidation now, but my expectation is that the stock will advance to $8 over the next six months, en route to a new all-time high above $10 in 2011 and possibly on to $40-plus over the next five years.

Of course there are a lot of hurdles to cross before anything like that can happen. But that is the sort of growth path that great medical device companies have followed. A prime recent example is Intuitive Surgical Inc. (Nasdaq: ISRG), which makes endoscopic devices used in urologic, gynecologic, cardiothoracic, and general surgeries. The key elements for success is that the device must have a wide number of potential applications, be heavily patent protected, have a big jump on competitors, and solve an unmet need in a cost- and time-effective manner.

So far it appears to me that the Cytori system and therapy meet these criteria. But it is still a long way from earning a 20x multiple of sales, as the top devices tend to deserve in their early growth stages, because the therapy must be approved and deemed reimbursable in the United States first, and the company has to avoid screwing up as a business -- which is not a simple matter.

The next major event on the company's calendar, I believe, will be results from cardiac trials in Europe early next year. As I've said before, approval for use in cardiac disease applications -- in which heart muscle strengthening could be accomplished at relatively low cost without major surgery -- would be a grand slam. 

The bottom line is that regenerative medicine using a patient's own stem cells has been one of those concepts that has been on the horizon for a long time. It looks like it's finally on the verge of breaking through, and could be a major new medical theme for the 2010s.

Week in Review

Monday: Abu Dhabi came to the rescue of fellow United Arab Emirates member Dubai -- putting the Dubai World debt crisis to bed for now. Mexico had its credit rating downgraded by S*P credit analysts, but unlike last week's downgrade of Greece, investors largely ignored the news. This could be a sign that the market is becoming less worried about potential troubles with sovereign debt. 

Tuesday: A day of mixed economic news. A tinge of inflation returned to the latest report on producer prices: The Producer Price Index increased 1.8% month over month in November, well over the 1% consensus estimate and the 0.3% increase in October. The Empire State manufacturing survey for December reflected a slowdown in manufacturing in the New York region.

Industrial Production report for November was pretty strong: Overall production increased 0.8%, topping the 0.6% expectation. Haver Analytics notes that the improvement from October was across the board but was greatest in construction supplies and materials -- literally the building blocks upon which economic growth is based. On an annual basis, industrial production continues to move closer and closer to positive growth.

Wednesday: The Federal Reserve left interest rates unchanged at the conclusion of its two-day policy meeting. The day's real news surrounded the wording of the Fed's policy statement and the so-called "exit strategy" that will see the Fed shut down its extraordinary support initiatives. These programs carry cryptic names like the Term Securities Lending Facility and helped pump extra cash into the capital markets during last year's financial crisis.

Wall Street insiders know that well before interest rates are official raised there will be de-facto rate hikes associated with the unwinding of these programs. That's what happened today. And that's why some interest rates are starting to creep higher. And that's why bonds are selling off. But rest assured: History suggest higher commercial interest rates won't kill the bull market, and the Fed is unlikely to overtly tighten rates until late this year at the soonest.

Thursday: Bank stocks were hammered after a botched attempted by the U.S. Treasury to sell its stake in Citigroup in the midst of secondary stock issues by both Citigroup and Wells Fargo.

The week ahead

Monday: No major economic releases. The U.S. Treasury will sell a batch of short-term bonds.

Tuesday: The government will release its final revision for third-quarter GDP. The original estimate was 3.5%, which fell to 2.8% in the first revision. Consensus estimate is for another fall, this time to 2.7%, on lower inventories and exports. Also, existing home sales for November will be reported.

Wednesday: Personal income and spending data for November will be released. Also, consumer sentiment for December and new home sales for November will be reported.

Thursday: NYSE will close early for the Christmas holiday. Durable goods orders for November will be reported. Also, weekly jobless claims.

Friday: Markets closed for Christmas.
I hope you have a great holiday. See you next week.

[Editor's NoteFor the first time in 70 years, U.S. T-bills are paying 0% interest, while U.S stocks are continuing to rise. According to Bloomberg News, this last happened in 1938, when T-bill yields fell from 0.45% to 0.05%. Then came 1939, when stocks began a three-year slide that took the Standard * Poor's down 34% after the U.S. Federal Reserve prematurely boosted borrowing costs to battle phantom inflation.

Sounds eerily like the present, doesn't it?

Very few market columnists see the parallels. And even fewer see the differences. But as this column demonstrates, veteran portfolio manager, commentator and author Jon Markman sees it all. And that's why investors subscribe to his Strategic Advantage newsletter every week.

To navigate today's markets, investors need a guide. Markman is the ideal choice.
For more information, please click here.]

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