Investor Strategy for Brazil

By Bill Cara –
In the first three parts of this series, I organized the 34 Brazilian stocks that trade on the New York Stock Exchange, first in order of their market capitalization, then in their industry sector group. Then I gave you some brief comments to say that the stock cycle in Brazil was topping out as in New York.
Since then, crude oil prices have risen sharply to $47 so the commodity price sensitive Brazilian market has continued to rally. The market has gone higher, higher and higher. I am now waiting for a sharp correction, linked to a pullback in the Brazilian Real versus the U.S. Dollar. Put options are favored at this point.

For long positions, I am biding time until a selling climax sets up the market for the second up-leg in a bull phase that started in New York in March 2003.
Today I am now going to lay out a strategic approach to investing in Brazil that ought to provide valuable insights to investors who might be interested in trading this market in future. This was a big task for somebody new to the Brazilian market to get his head around, so I apologize in advance for rambling.
As you know, I use trend and cycle studies to make capital market price forecasts. I happen to look on many levels for indications of market price direction such as equity market sector rotation, which is the rise and fall of groups of stock prices.
This article, then, is based in my belief in the concepts of sector rotation and price correlation as well as the fact that Brazil is a major trading nation and huge producer of basic materials.
Sector rotation is an ebbing and flowing phenomenon that is based on fundamental reasons, such as changes in trend of commodity prices, interest rates, and macro-economic supply and demand. It is also due largely to storytelling by Wall Street, whose salespersons are constantly trying to cause you to make portfolio changes (so they can take their piece). So there are a lot of crosscurrents in the equity markets.
Brazil versus the S&P 500
As best I can describe the sector rotation concept, it would be highly unlikely say for the Brazilian natural resource companies, banks or telecoms to all be rocketing to record high prices if at that same time their counterpart components in the S&P 500 are falling, or if the Brazil Real happened to go into a sharp down trend against the U.S. Dollar.
As the inter-connected global economy cycles from boom to bust and back –- in Brazil and elsewhere — it would be hard for Petrobras, for example, to be a sound investment while at the same time ExxonMobil or ChevronTexaco is not.
So, in addition for looking for evidence of sector rotation, I also look closely at correlation studies for each of the Brazil stocks that are NYSE-listed. I compare the price movement of these stocks to the S&P 500 stocks over a two-year period.
To my thinking, when commodity prices in the oil, steel and metals groups, or the Dow or the Brazilian Real are moving higher, so too will be the large caps of Brazil. Right now that’s what is happening with the Real and the oil price so stock prices are strong. In fact they are very strong. I am awaiting a sudden market correction, likely to follow a pullback in crude oil prices.
I am also expecting a decline in the U.S. Dollar followed by a selling climax to the Dow, which would pull down the equities market to bargain levels and set up a subsequent buying opportunity for stocks. In that event, I think Brazil would present terrific bargains because this is an international trading nation with a natural resources based economy that would be greatly aided by rising inflation in the U.S.
Oh, if investing could be so simple?
Investors, however, are aware that conducting business in an international environment is inherently unpredictable. They know that numerous variables have a material effect on interim operations or end results. In fact, the list is endless.
These variables include economic and market conditions, such as the volatility of market prices, rates and indices, the timing and volume of market activity, the availability of capital, and inflation; the liquidity of secondary markets, and investor sentiment; political events, including legislative and regulatory developments; plus competitive business forces, including the ability to attract and retain highly skilled individuals, and the ability to cost-effectively develop and support technology and information systems – among other factors.
Yes, there are plenty of complexities and Brazil, an emerging economy, does offer some significant nuances, but in the big picture they are not as great as most might believe.
So where do we start with respect to analyzing the Brazil stock market?
We all know, in any particular period, that revenues and net income for any particular large cap company tends to be highly correlated to its industry competitors. I also believe that the same situation exists for their direct competitors that are headquartered in Brazil.
Since investors trade market prices and not corporate revenues and net income, anyway, there is an investment strategy that does work. As you know, I am a top-down investor.
I think the key to successful trading is found in the time-series analysis of market prices and interrelated economic and commodity and futures market data – rather than say studies of the balance sheets and income statements of business corporations, alone.
By that I mean, the action of traders in the capital markets ought to be studied quantitatively and the results scrutinized for expected patterns of price movement for stocks of groups of companies and for individual stocks. For example, when interest rates rise, history proves that earnings and share prices will decline for most companies in the financial services sector. We call these interest-sensitive stocks.
And when commodity prices rise, say for oil, metals, and wood, history also proves that earnings and share prices will increase for the commodity producers.
Groups of companies have share prices that are expected to rise and fall in tandem; for example, the pattern of Banco Bradesco (NYSE: BBD), Unibanco – Uniao de Bancos Brasileir (NYSE: UBB) and Banco Itau (NYSE: ITU) as well as Dow 30 stocks like JP Morgan, Citigroup, American Express, General Electric and AIG Group should move reasonably closely together. That’s because these companies are interest-rate sensitive.
But, I found in studying the Brazilian stocks, there were other factors that also come into play. You have to look at the bigger picture.
The Brazilian Bovespa
Current news from Reuters regarding the Brazil financial markets and the Bovespa bourse is available via Yahoo Finance (Sao Paolo:^BVSP – News). Here is the summary from August 6.
If you are not resident in a major Brazilian city like Sao Paulo and are up to date with the domestic market news, it pays to read these reports daily.
For example, on Friday August 6, as the Dow was losing 1.5% of its value and investors were starting to panic, the Bovespa was growing. It ended the day up 1.5% on news that the government there introduced a fiscal stimulation package that should boost the Brazilian economy, including a reduction of capital gains taxes on stocks from 25% to 20%.
Current news from Reuters regarding the Brazil currency market
Investing in Brazil will require a close watch on the currency market, in particular the U.S. Dollar to Brazilian Real ratio. For example, from the end of May this year, the Real has been zooming against the Dollar. So too has the Bovespa stocks index. For the first five months of the year, however, the Bovespa index was falling as the Real fell sharply against the U.S. Dollar.
There was also a Forbes report recently that spoke to the issue of required regulatory controls in the country. This has been an ongoing subject of concern for foreign investors, but since my perspective on the Brazilian market is one of a short-term trader, it does not overly concern me. However, if you intend to invest there, you need to be aware of such matters.
A good info source is a publication called Brazil Economy. There are frequent news articles related to the Brazilian Real and to Bovespa-listed stocks.
Finally, before studying individual stocks, you ought to have a close look at the Brazil ETF (AMEX: EWZ).
The Brazilian Energy Stocks: PBR and TS
Yahoo Finance presents this Reuters monitor of the Sao Paulo energy stocks. Here is the market overview plus chart as well as the stock components of this index.
The five-year candlesticks chart of the Brazilian energy index comparing its performance against the Dow shows that the IEE has been in a growth mode from June but also that for the past five years the IEE has outperformed the Dow by over 150%.
The six-months chart of the IEE with STO technical indicator added reflects the recent strength of this sector.
On Friday August 6, Reuters reported: “Energy stocks recovered some ground although analysts warned that possible judicial resistance to the government’s drive to reform the sector made them a risky investment. “A very negative scenario would be if the court rules that the laws approved by Congress to establish the new model are not valid,” Merrill Lynch analysts said in a research report. “This would potentially delay implementation by a period of 3 to 6 months.””
The Daily data charts of the two main Brazilian oil companies, Petrobras (NYSE: PBR) (integrated) and Tenaris (NYSE: TS) (services), show that Tenaris is on a tear. The Weekly data charts for TS indicate that the current rally is over-done. The Daily data recent price spike is not likely sustainable.
The Weekly and Daily data charts for Petrobras also indicate a recent rally may be somewhat extended but not nearly to the extent for that of Tenaris.
On a fundamentals basis, oil giant Petrobras ($31.3 billion market cap) is the more conservative play. It is trading at a PE of 5.6, whereas Tenaris ($4.7 billion cap) is trading at a PE of 22. These figures were current as of a few days ago but as crude oil prices now are at $47 per barrel, the Brazilian oil stocks are up in price as well.
Petrobras is an international fully-integrated oil company giant that can be compared to ExxonMobil. Except for a period of about a month through April-May this year, when the Real was nearing the end of its fall against the U.S. Dollar and Brazil stocks were mostly in a free-fall, the charts show that PBR usually tracks XOM closely.
In August, the Real maintained its considerable strength against the U.S. Dollar, and so as XOM pulled back, PBR continued rising.
Over a two-year basis, compared to trading in S&P 500 stocks, Petrobras (NYSE: PBR) is 93% correlated to the price of Marathon Oil (NYSE: MRO), 92% against Apache Oil (NYSE: APA) and Occidental Pete (NYSE: OXY).
Tenaris (NYSE: TS) is 95% correlated to MRO, 94% to OXY, and 93% to APA and to Chevron Texaco (NYSE: CVX) over two-years.
The Brazilian Financial Stocks: ITU, BBD and BBD
In my view, there are no bargains at present in the Brazilian bank stocks, just as the other sectors are also a bit overdone. Based on the comparatively low PE’s for this equity market, there will be bargains later this year in Brazil after the global market adjusts to the new realities of geopolitical events, oil shock, rising interest rates and a sideways churning economy. At that point, I will recommend all three of these Brazil banks for purchase.
Here are the Bi-Weekly, Weekly and Daily data charts for the three big Brazilian banks, Banco Itau (NYSE: ITU), which is the largest at a market cap in excess of $10 billion, plus Bank Bradesco (NYSE: BBD) and Unibanco (NYSE: UBB).
The Dow has five interest-sensitive components that should be compared to the Brazilian banks, and they are AIG, AXP, C, GE, and JPM. Probably JPM is the most highly correlated. Its chart is quite similar to those of the three Brazilian banks except in mid-July the Brazilian Real (vs. the U.S. Dollar) gave quite a boost to all the Brazilian stocks at a time the Dow was relatively weak.
As soon as the Real starts to weaken against the U.S. Dollar, I anticipate weakness in these Brazilian banks.
On a price-earnings basis, BBD (at 8.9 PE) and ITU (9.7 PE) are trading at slightly better multiples than JPM (10.4 PE), but well under that of UBB (at 16.1 PE).
Interestingly, the three big Brazilian banks are more highly correlated to the price movements of the most economically sensitive stocks.
Over a two-year basis, compared to trading in S&P 500 stocks, Banco Itau (NYSE: ITU) is 95% correlated to the price of JP Morgan (NYSE: JPM), as expected, but also 95% to Caterpillar (NYSE: CAT) and United Technologies (NYSE: UTX). These are very high correlations.
Banco Bradesco (NYSE: BBD) is 93% correlated to JPM, but also 93% to AES Corp (NYSE: AES) and 91% to CAT.
Uniao de Bancos Brasileir (NYSE: UBB) is even less correlated to the big U.S. banks, but is 94% correlated to Freeport-McMorran Copper & Gold (NYSE: FCX), 93% to AES and 92% to CAT.
The Brazilian Basic Materials Stocks: RIO, SID, GGB, ARA, BAK, UGP, and VCP
Basic Materials is the strength of the economy in Brazil. There are stocks of some outstanding companies here that bear watching, and trading.
International commodity prices for oil, steel, and wood, which have been high recently, show indications of staying at or near these high levels. Therefore, I expect that these commodity price-sensitive stocks will generally stay within bullish long-term (secular) price patterns.
The correlation studies using two-year price data of the key Brazil Basic Materials stocks against the S&P 500 stocks showed few surprises.
Iron ore producer Companhia Vale Do Rio (NYSE: RIO) was 97% correlated to Phelps Dodge (NYSE: PD), 96% to UTX, and 95% to Dow Chemical (NYSE: DOW).
Steel company Siderurgica (NYSE: SID) was 98% correlated to PD.
Gerdau S.A. (NYSE: GGB), another steel company, was 97% correlated to Eaton Corp (NYSE: ETN) and MRO, as well as 96% to Ashland Inc (NYSE: ASH) and 95% to U.S. Steel (NYSE: X).
Aracruz Celulose (NYSE: ARA) was correlated 97% to PD, and 96% to Louisiana Pacific (NYSE: LPX) and Cooper Industries (NYSE: CBE).
Petrochemical producer Braskem (NYSE: BAK) was correlated 97% to PD, 96% to X and 95% to DOW.
Ultrapar Participacoes (NYSE: UGP), engaged in the distribution of liquefied petroleum gas (LPG) in Brazil, was 95% correlated to both UTX and CAT and 94% to Newmont (NYSE: NEM).
Votorantim Celulose e Papel S.A. (NYSE: VCP) was 97% correlated to PD and LPX and 96% to CBE.
So, as you can see, there are a lot of similarities in the price movements of groups of stocks, which is why I say stocks don’t trade in a vacuum and you should always study the price of one in comparison to several others.
The Brazilian Capital Goods Stocks: ERJ
Aerospace manufacturer Embraer (NYSE: ERJ), a major buyer of aluminum, was 97% correlated to Alcoa (NYSE: AA). It was also 95% correlated to UTX.
ERJ should be very highly correlated to Boeing (NYSE: BA) but as I have been writing since April or May, BA is under unbelievable promotion by Boeing CEO Harry Stonecipher, for some reason. BA has been flying high while all the rest have relaxed somewhat.
The Brazilian Telco Stocks: TSP, TNE, BRP, EMT, BTM, TCP, TRO, TSD, TMB, TSU, TND, TBE, and TCN
These stocks are also highly correlated to the natural resources industry rather than the telephone stocks in the S&P 500.
For TNE, BRP, BTM and TSD, I could find no meaningful correlation, but for the others there was a high mid-to-low-nineties correlation to the same stocks that are linked elsewhere in this report.
Telecomunicacoes de Sao Paulo, (NYSE: TSP) was correlated 95% to PD, 94% to X, 93% to AA, and 92% to DOW.
Embratel (NYSE: EMT) was correlated 96% to FCX, 94% to NEM and 93% to CAT.
Telesp Celular (NYSE: TCP) was 96% correlated to both PD and LPX.
Tele Centro Oeste Celular (NYSE: TRO) was 95% correlated to CAT, FCX and CBE.
Telemig Celular (NYSE: TMB) was correlated 94% to AA plus 95% to a couple high-tech stocks, Agilent Tech (NYSE: A) and Texas Instruments (NYSE: TXN).
Tele Celular Sul (NYSE: TSU) was correlated 93% to DOW and 92% to AA.
Tele Nordeste Celular (NYSE: TND) was correlated 93% to TXN, and 92% to FCX and AA.
Tele Leste Celular (NYSE: TBE) was correlated 93% to ETN and 92% to UTX and MRO.
Tele Norte Celular (NYSE:TCN) was 95% correlated to both PD and DOW.
The Brazilian Consumer-Related stocks: ABV, SDA, PDA, and CBD
Beverage producer (alcoholic and non-alcoholic) AmBev (NYSE: ABV) surprisingly to me had extremely low correlations to Coca Cola (NYSE: KO) at just 20%, Anheuser-Busch (NYSE: BUD) at 28% and Pepsi (NYSE: PEP) at 52%.
I could also find no meaningful correlation to retail sales food and department store Companhia Brasileira de Distribuicao (NYSE: CBD) and discount airline GOL (NYSE: GOL).
The other consumer-based stocks, surprisingly also, were highly correlated only to Energy and Basic Materials stocks.
Food producer Sadia (NYSE: SDA), was correlated 98% to PD, and 97% to both ETN and LPX, for some reason.
Another food producer, Perdigao (NYSE: PDA), was similarly correlated 97% to ASH, X and ETN for whatever reason.
The Brazilian Utility Sector stocks: CIG, SBS and ELP
Cia. Energetica de Minas (NYSE: CIG), an electric power utility, was correlated 95% to UTX, PD and DOW, which appears to be a consistent thread through much of the trading in Brazil stocks, regardless of sector.
Water and sewage utility Sabesp (NYSE: SBS), was, for some unknown reason, correlated 94% to CAT and 93% to gold stocks FCX and NEM. Sabesp is the largest (in terms of customers) water & sewage utility in the Americas and third largest in the world.
In summary, trading correlations in the mid-nineties are very high. These numbers are significantly indicative of common price movement.
For some reason, unknown to me, most of the Brazilian stocks, including banks and utilities, are correlated in that 92%-95% range to a group of S&P 500 stocks in the Energy and Basic Materials Sectors.
I suspect it has a lot to do with forex trading in the Brazilian Real. When the energy and basic materials stocks strengthen or weaken, the Real would undoubtedly strengthen or weaken against the U.S. dollar.
So these sector rotation, correlation and forex trading studies will be very important to your making money in the Brazilian equity market.
Using the usual technical indicators for the Brazilian stocks and their highly correlated S&P 500 stocks plus similar studies of the Brazilian Real, Bovespa and country ETF, the EWZ, I think you have a reasonable prospect for making good investments and successful trades.