Wednesday, November 11, 2009

>Gold rally may be snagged by fund option selling

London - The rally in gold may be reined in by options selling sometime in the next four to six months, if hedge funds and other institutional investors begin to view the rally as overstretched, some market observers said this week.

Options in Comex gold and the over-the-counter market are predicting the precious metal has a 25% chance of being above $1,400 per troy ounce by the end of 2010, even though few market participants will make such bullish predictions, said JP Morgan managing director Neil Clift.

At this week's annual London Bullion Market Association conference in Edinburgh, a poll of audience members found the average forecast for gold's price in September 2010 was $1,181 an ounce. On Friday at 1626 GMT, spot gold was trading at $1,092 an ounce, up 24% this year but 28% below the $1,400 an ounce level.

The disparity between the high prices predicted by options and much lower consensus price forecasts could be an opportunity for investors to sell gold options, which could trigger a significant correction in gold prices within the next six months, Clift said.

"I'm in the bullish camp. At the moment the market is in bullish mode and I actually am probably more a bull than most," Clift said. "[But] at some point we'll see people coming in to sell options. There is potential value to be had in selling away the topside. It may be a long time before that happens. But at some point it will."

Gold rallied to a record high this week on news that the Reserve Bank of India bought 200 metric tons from the International Monetary Fund. The purchase appeared to confirm predictions that central banks were losing confidence in the dollar and wanted to increase and maintain their gold holdings.

Gold's dramatic ascent since July, without any significant correction, may tempt some longs worried about a short-term correction to sell options to protect their gains.

A gold call option is a bet by the buyer that prices will rise to a specific price. The buyer gets the right but not the obligation to buy gold at a specific price, but has to pay a premium for this, which is collected by sellers. The seller is betting against prices rising that high. If it does, he has to pay the price to the buyer, or deliver the equivalent in gold--though this rarely happens. If not, his profit is the premium. The opposite of this is a put option, where the buyer bets prices will fall and the seller is less bearish.

In the gold market, options markets are normally larger than gold futures and forwards markets, giving them a significant influence on prices. In the Comex gold market, for instance, the amount of call options on Nov. 4 totaled 42.96 million ounces, or 1,336 metric tons, nearly half the 2,416 tons produced by gold miners in 2008.

Some observers said large institutional investors who have long positions in gold futures, physical gold or gold exchange traded funds may decide to sell call options or buy puts as a hedge to protect the profits they made on this year's bull run. The amount they collect in premiums will offset losses they may incur on their long positions if gold prices correct or fail to rise as high as options predict.

At the moment, buying gold call options is the most popular strategy, indicating investors in general remain bullish on gold, said the head of precious metals trading at a large investment bank in London. There is a premium of 6% in buying one-year to two-year dated call options relative to puts, meaning investors are buying more calls than puts, he said.

But that trend could change if some investors who are already long on gold decide prices have peaked and want to protect their gains, observers said.

Clift said sovereign wealth funds, hedge funds, pension funds and ETF holders that already own a lot of gold may want to sell options to hedge the gains they have already made and thereby maximize their returns.

"No matter how strong fundamentals are, when something just goes in one direction and everyone's on the trade, it has to reverse at some point," Clift said.

Raymond Key, global head of metals trading at Deutsche Bank in London, said in coming months there will be growing use of options trading, particularly in gold ETF markets.

High net-worth individuals, who may be long on gold, either in physical metal or in ETFs, may sell more shorter-dated options with the expectation that gold prices will correct before resuming a longer-term uptrend.

Such strategies grow in popularity when "the market is going up in a straight line" and investors who are long on gold want to take advantage of corrections or consolidation phases, Key said. "It would temper the rally," he said.

Another choice available to these investors is to buy puts, betting that prices will fall and again hedging their long exposure, said Jeffrey Christian, managing director of U.S. based commodity research and consultancy CPM Group.

Even if the gold price does not decline to the specific price of the put, the value of the put will increase as the gold price draws closer to the option price, and the investor can sell his put back for a profit, Christian said.

While this may not necessarily push prices significantly lower, it could stimulate options trading, and this often exaggerates price movements, he said. "If they did sell, they will accentuate the decline in prices."


>Monetarism of financial assets (ECONOMIC RESEARCH)

We can draw a distinction between two types of inflationary episodes in the past, analysed by “conventional monetarism”:

• episodes of moderate inflation, due to excessively expansionary monetary policies would lead to major strains on production capacity or the job market (1970s, early 1980s, late 1980s, India currently);

• episodes of hyperinflation (Germany in the 1920s for instance), due to a flight (because of mistrust) from money, as holders of money try to get rid of it by buying goods and services, leading to a very rapid rise in the prices of these goods and services.

The first kind of inflation has now disappeared, owing to the significant flexibility in the supply of goods and services (globalisation, deregulations) which implies that the rise in the demand for goods and services no longer results in a rise in their prices. It has been replaced by inflation in asset prices, because of the stickiness of the supply of assets (real estate, equities, bonds, commodities, etc.).

The second kind of inflation (hyperinflation in prices of goods) could, for the same reasons, be replaced by hyperinflation in asset prices: if economic agents want to get rid of money because the money supply is growing too fast, they buy real assets (commodities, gold) and not goods, as is perhaps already beginning to happen.

We are referring to the conventional monetarist explanation of:
1. inflation;
2. hyperinflation.

1. Inflation
Inflation, in the conventional monetarist explanation, is due to the excess demand for goods and services in comparison with the supply stimulated by the excess monetary (and credit) creation, in a situation where the output of goods and services can no longer rise (where the supply of goods and services becomes sticky).

In a nutshell, we have:

This occurred, for instance in the late 1970s and early 1980s in the United States and Europe, with, after the oil shocks that led to a contraction in supply, monetary policies that were at initially expansionary and led to the appearance of a situation of excess demand for goods and, therefore, inflation.



After Friday’s stock market action, the risk of the first real correction since the March bottom
has risen significantly. The S&P500 is now 1.0% below its 50-day exponential moving average
(EMA) while, from a Dow Theory perspective, the Dow Jones Transportation Average has turned weak of late (see Figure 1). It is also of note that the financial stocks, the leaders of the bounce since March, have begun to lead the market down

Fundamentally, it is also interesting that the American stock market has finally started to respond to disappointing consumption data. The culprit on Friday was September’s personal

spending report. Nominal personal consumption fell by 0.5% MoM and 0.3% YoY in September,
after a 1.4% MoM rise in August which was partly driven by the “cash for clunkers” (see Figure
3). This suggests that investors may no longer view such data as “lagging” as has been their
habit in recent months. Meanwhile, the hope for the bulls must be that the market is
sufficiently weak in the next few days for the Fed to remove all “exit” talk from the
communiqué to be released on Wednesday after this week’s FOMC meeting. The other hope
must be that the renewed stock market jitters prompts Congress to renew the First-Time Home
Buyer Tax Credit until April as is now being pushed by growing numbers of Congressmen.

To read the full report: GREED & FEAR


What's changed
Larsen & Toubro (L&T) today announced an EPC order win valued at Rs69bn from Maha Genco (Maharashtra State electricity company) for a 3X660MW Supercritical Power plant.

The price for this order is about 25% lower than the average pricing we have seen for new orders in the Indian power equipment sector until now.

We believe this trend of intense competition (as seen in the order win for L&T today) will only scale up as new players with domestic manufacturing capabilities continue to ramp-up operations. We believe this will result in a loss of pricing power and market share for BHEL, leading to declining blended returns and margins. We estimate return on capital for the company will be under pressure for all incremental orders and look for a decline of 320bps over next three years.

Price war in power equipment market is on; reiterate Conviction Sell

Our Sell rating (Conviction List) on BHEL is predicated on the thesis of structural changes in the Indian power equipment market which we believe are negative for the company: 1) increasing competition leading to pricing pressure, 2) lower margins on all supercritical category orders (technology sharing payments), and 3) average delivery periods staying high in spite of increased capacity (regional vendor network difficult to expand).

Our 12-month P/B-based target price implies 39% downside potential from current levels. The stock is currently trading at 7.0X 12-month fwd BVPS and 27X 12-month fwd EPS (premiums of 18% and 30% respectively to its own 5-year median), which we believe doesn’t price in the structural headwinds outlined above.

Key risks
Favourable regulatory changes such as import duties on equipment; steel price volatility impacting margins as orders for steel are placed in advance.

To read the full report: BHEL


Novelis results significantly above estimates
Novelis reported adjusted EBITDA and PAT of USD 187 mn and USD 195 mn, which were much above our estimates of USD 131 mn and USD 32 mn, respectively. Novelis reported net revenues of USD 2.2 bn (in line with our estimates), down 26% Y-o-Y (up 11% Q-o-Q), largely due to 35% Y-o-Y decline in aluminium prices and 10% Y-o-Y decline in volumes.

EBITDA surpasses target of USD 250/tonne; USD 285/tonne sustainable
EBITDA/tonne showed (our estimate lower then company estimate due to different set of adjustments) marked improvement at USD 258/tonne from USD 165/tonne in Q1FY10 due to improved demand, better pricing and significant operational efficiencies during the quarter. It was better than our estimates and the company’s guidance. Management has guided that an EBITDA of USD 285/tonne is sustainable going forward.

Focus on cost efficiencies: 70% target achieved
Novelis has achieved operational efficiencies and cost reductions across regions. It has managed to reduce conversion costs by cutting down costs in labor, energy, alloys etc. On a run-rate basis, it has already achieved cost savings of USD 100 mn against target of USD 140 mn by Q2FY11 (on run-rate basis). Though current incremental savings may look moderate, Novelis continues to identify further areas for cost reductions in manufacturing and procurement.

Derivative losses of FY09 continue to be reversed
In FY09, with the collapse in LME prices, Novelis recorded MTM losses on its aluminium derivatives. For instance, the company recorded total unrealised losses of USD 684 mn in Q2FY09 and Q3FY09. However, this has no underlying business issue since this will eventually be offset by higher revenues from customers. In FY10, as aluminium prices are recovering and normalcy is returning, these losses are getting reversed. In H1FY10, the company has recorded unrealised gains of USD 553 mn and net gains of USD 152 mn.

Outlook and valuations: Strong turnaround; maintain ‘BUY’
We are encouraged by the recent multi-year contracts signed by Novelis and the price increases of USD 45/tonne which are sticking. We continue to be positive on aluminium and the results of Novelis show that demand and pricing power are returning to the industry. We are retaining our FY10 EBITDA estimate and FY11E consolidated EBITDA estimates based on H1FY10 actuals. Considering the much higher–than-expected unrealised derivative gains in H1FY10 in Novelis, we are revising up our FY10 PAT for Novelis. Our revised consolidated EPS estimate for FY10 is up at INR 16.8 from INR 9.7 earlier. We, however, keep our FY11 EPS unchanged at INR 14.8 considering that derivative gains are one-off.

Based on FY11E EV/EBITDA (6.5x for India aluminium business and 5.5x for Novelis), our fair value works out to INR 169/share. We maintain ‘BUY’ recommendation on the stock, and rate it ‘Sector Outperformer’ on relative return basis.

To read the full report: HINDALCO INDUSTRIES


We upgrade our view on the India Hotels industry from Cautious to In-Line. We cite improvement in tourism trends and likely deferment of oncoming room supply, which would be positive for RevPAR trends. We believe that F2010 will be weak due to weaker RevPAR and hence, earnings for F2H10 will still look weak. However, a likely pickup in tourist arrivals in F2011 would help room rates and occupancy rates improve on a sequential basis, which could drive stock performance. We have now rolled forward our DCF models to F2011 as we believe F2H10 will be weak; however, investors should start focusing on earnings in F2011 and beyond
– when we expect a recovery to kick in.

Upgrading IHCL and Hotel Leela: We upgrade IHCL to Overweight (from Underweight). We believe an improvement in the sector outlook would help the company show better performance; coupled with an improvement in its international portfolio, earnings should recover strongly. We upgrade Hotel Leela to Equal-weight (from Underweight). We remain Underweight on EIH, mainly due to rich valuations.

Recovery Under Way

Balance sheet stress decreasing: The macro outlook has improved considerably and liquidity may not be as much a constraint as it was a year ago. Hence, balance sheet stress may continue to ease, which in our view would be positive for IHCL and Hotel Leela.

Valuations: We reiterate our belief that markets will start to discount longer-term earnings. On a 12-month forward P/B, IHCL is trading at 1.7x (close to its long-term average of 1.8x), Hotel Leela at 1.4x (against the long-term average of 1x) and EIH at 3.2x (against the long-term average of 2x). On our new PT of Rs 88, IHCL would be trading on a 12-month forward P/B of 2x, which we believe is reasonable against its long-term average of 1.8x. Also, a likely turnaround in international operations in F2012 could be a key trigger for the stock.

To read the full report: INDIA HOTELS