Smallcap Discoveries: Weekly Update: June 27

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Subject: Smallcap Discoveries: Weekly Update: June 27 - July 1

June 27 - July 1

Market Commentary

Market Commentary

North American stock markets were lower on the week. The DOW ended the week down by 1.3%, Nasdaq was down by 4.1% and the TSX was lower by 1.1%.

Uncertainty over interest rates and the slowing economy continue to cause volatility in the markets as investors position themselves in anticipation of further rate increases or possibly rate decreases as some are starting to suggest we may have seen peak inflation. This week PCE report showed a slight slowing in inflation coming in at 0.3% for May lower than most forecasts and brings the annual rate down to 4.7% from 4.9% the previous month.

US personal spending in May saw its slowest growth in 5 months coming in at 0.2% vs economists’ forecast of 0.4% and down from 0.6% in April. Evidence continues to pile up signalling that the US economy is slowing down, and this could be good news for the market. The Fed needs to see these trends continue to weaken if we are to expect the Fed to slow interest rate increases or possibly reverse course and start to lower rates as some are suggesting will happen before the end of the year. The strength of the US consumer will be closely watched over the coming months.

The 10-year T-bond yield dropped from 3.10% to 2.91 this week suggesting there is a mood change amongst bond investors and forecasting a possible economic slowdown ahead. We saw bond yields drop in Europe as well. This is helping to push mortgage rates lower in the US.

We are witnessing a rapid change in the data. Inflationary pressures are subsiding and nowhere is this more evident than in the commodity markets.

Wheat

Corn

Cotton

Lumber

Natural Gas

Even Gasoline appears to be rolling over

All these inputs dropping like this takes time to work through to finished goods, but you can see the trend here. We may start to see some bigger drops in the PCE, PPI and CPI soon.

Energy

The deteriorating economy appears to be weighing on oil prices. The potential for recession and possible demand destruction has oil putting in its first monthly decline of the year. Physical oil markets continue to be very tight, but the futures are starting to price in some better supply/demand balance in the coming months. Drilling activity continues to climb with another good jump in Canadian drilling activity up another 12 rigs this week.

Longer term it’s hard to imagine any significant weakness in energy prices without a materially higher rate of production. WTI oil closed the week at $108.40 and Nymex natural gas closed at $5.73.

If the US Fed is serious about breaking inflation, they’ll have to see energy and ,specifically gasoline, prices stabilize or fall. Any further weakness and the stock market would cheer.

WTI Oil

It might be too early to call the top in bond yields but if we are nearing a top, it makes you think that we may be closer to an end to the bear market than many investors think.

One of the sectors hit hard from the rise in interest rates is housing/construction. A turn in interest rates could bring attention back to this sector in a big way as both in the US and Canada there continues to be a structural shortage of housing units. It’s important to understand that home builders are driven by volume and not necessarily price.

Real estate has been perhaps the sector most affected by higher interest rates. The price of real estate may stay static or go down but that may or may not affect the volume of new homes built. If demand continues most builders will just build cheaper homes.

Arguably, one of the reasons for the deficit in new home construction was supply shortages and high material prices. Lumber, steel and other building material prices sharply falling could improve housing affordability and help move more volume. Many are still reporting very strong results and valuation metrics are at near historic lows. This is not unusual at cycle peaks but if interest rates do head lower this sector will be a major winner. Many investors have steered far away from the sector, many home builder stocks are down 40% - 60%+, some of the US construction related stocks’ charts are showing early bottoming, it could be the perfect contrarian play. I think it’s a sector that we should keep a very close eye on.

US Construction ETF

DR Horton – DHI

Earning's Season

We are entering Q2 earning season. We love earnings season. We spend a lot of time going through all the earnings releases and it’s a major part of our discovery process. I expect to see lots of earnings surprises and guidance revisions. We hope to find a handful of new ideas. When there is a major change in the economy, we tend to find new ideas. Companies that are able to take advantage of the economic changes. Newer businesses that are able to grow a niche. We started to see it late last year when energy companies were really starting to grow their revenues, We saw it again with energy service companies too. We are hopeful that we will find a few new “Generals” that could lead us in the next bull wave when ever that may start.

The sector that I continue to see bullish signals from is the life science space. As I said last week, we continue to get data that is telling us more capital is entering the space. Nasdaq new 52 week highs continue to be predominately life science companies. The XBI etf continues to show good relative strength vs the Nasdaq index. Over the course of the last year the Nasdaq index has far outpaced the life science sector.

However, in the last several weeks we seen a marked divergence and the XBI has significantly outperformed Nasdaq. Another signal that we may see life science as one of the new Generals” leading us higher when the markets do finally turn higher.

One of the US listed life science companies I have been following for years is Twist Biosciences (TWST). I dipped my toe into this one this past week. Some of my industry experts are big fans of their science (They are partnered with ImmunoPrecise Antibodies on one of the Talem assets). It’s also one of the larger holdings within the XBI etf. My thinking is that, if I’m correct and, we continue to see capital flows into life science and XBI, TWST will be an early benefiter. Hopefully, TWST can be one of those Generals I’ve been looking for.

Reading

Summer is here, markets continue to be unsettled so I’ve decided to dust off some of my favorite investing books. This week it will be How I Made $2,000,000 in the Stock Market by Nicolas Darvas and Reminiscences of a Stock Operator by Edwin Lefevre

I highly recommend that you read these classics.

To your wealth,

Paul and Trevor

Buys and Sells This Week