I’ve just updated my Keeping Score page for S&P 500 performance in June, 2Q18 and year to date.
Stocks are down today. The ostensible reasons are trade war fears + the administration’s distinctly un-American decision to seize and imprison the children of asylum seekers at the border.
It’s not clear to me that–important as these issues may be for the long-term attractiveness of the US as an investment destination–they are the reasons for the market’s decline. (Personally, I think the mid-term elections will give us the first true read on whether ordinary Americans approve of the UK/Japan-like road Washington has set the country on.)
But I don’t want to write about macroeconomics or about politics. Instead, I want to call attention to the useful purpose that down days, or strings of down days, for that matter, serve for portfolio management.
There are two:
–portfolio realignment. This is as much about psychology as anything else. Typically during a selloff stars go down more than the market and clunkers underperform. Because of this, clunkers that have been hiding in the dark recesses of the portfolio (we all have them) become more visible. At the same time, stars that we’ve thinking we should buy but have looked too expensive are suddenly trading a bit cheaper. The reality is probably that we should have made the switch months ago, but a down day gives us a chance to tell ourselves we’re better off by, say, 5% than if we’d made the switch yesterday.
–looking for anomalies–that is, clunkers that are going down (for me, this is typically a sign that things are worse than I’ve thought, and a sharp spur to action), or stars that are going up. Netflix, for example, is up by about 1.4% as I’m writing this, even though it has been a monster stock this year. I already own enough that I’m not going to do anything. But if I had none (and were comfortable with such a high-flier) I’d be tempted to buy a little bit and hope to fill out the position on decline.
I’ve just updated my Keeping Score page for May. IT rises to the top again.
About a week ago, Saudi Arabia and Russia, two of the three largest oil producers in the world (the US is #1), announced they were discussing the mechanics of restoring half of the 1.8 million barrels of daily output foreign companies have been withholding from the market since 2016.
…to stop the price from advancing above $80.
To be honest, I’m a bit surprised that oil has gotten this high. But producing countries have held to their cutback pledges to a far greater degree than they have in the past, with the result that the mammoth glut of oil in temporary storage a couple of years ago is mostly gone. In addition, the economy of Venezuela is melting away, turning down that country’s output of heavy crude favored by US refiners. Also, the world is worried that unilateral US withdrawal from the Iranian nuclear agreement may mean the loss of 500,000 daily barrels from that source.
On the other hand, short-term demand for oil is relatively inflexible. Because of this, even small changes in supply or demand can result in large swings in price. An extra 1% -2% in production drove the price from $100+ to $24 in 2014-15, for example. The same amount of underproduction caused the current rebound. So in hindsight, $80 shouldn’t have been so shocking.
Two factors, I think. There must be significant internal pressure among producing countries to get even a small amount more foreign exchange by cheating on quotas. Letting everyone get something may make it harder for one rogue nation to break ranks.
More importantly, a $100 price seems to trigger significant global conservation efforts, as well as to shift the search for petroleum substitutes into a higher gear. So somewhere around $80 may be as good as it gets for producers. And it leaves some headroom if efforts to hold the price at $80 fail.
My guess is that most of the upward move for the oils is over. I think there’s still some reason to be interested in financially leveraged shale oil producers in the US as they unwind the restrictions their lenders have placed on them.
rising interest rates
Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%). Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.
What does this mean?
For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds. No less, but also no more.
The reality is, of course, much more nuanced. Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds. For example:
–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class. So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.
–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination. In those days, listed companies either expanded or bought rivals for cash rather than paid dividends. So stock yields were low.
three important questions
dividend yield vs. earnings yield
During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks. For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.
Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-). If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%. This would imply that the stock market (next year?) should be trading at 25x earnings.
At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x 2019 eps. To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year. If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.
stocks vs. cash
This is a more subjective issue. At what point does a money market fund offer competition for stocks? Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now. Is this enough to cause equity holders to reallocate away from stocks? Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash. Maybe I’d also stop reinvesting dividends.
I doubt this kind of thinking is enough to make stocks decline. But it would tend to slow their advance.
Since the inauguration last year, the dollar has been in a steady, unusually steep, decline. That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).
The dollar has stabilized over the past few weeks. The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners. Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation. Either could be bad for stocks.
my thoughts: I don’t think that current developments in fixed income pose a threat to stocks.
My guess is that cash will be a viable alternative to equities sooner than bonds.
Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets. At this point, though, I think the odds are for slow further drift downward rather than plunge.
Two factors are moving the Energy sector higher. The obvious one is the higher oil price during a normally seasonally weak time. In addition, though, the market is actively looking for alternatives to IT. It isn’t that the bright long-term future for this sector has dimmed. It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher. With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.
The fancy term for what’s going on now is “counter-trend rally.” It can go on for months.
As to the oils,
–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff. In particular, all but the least adept shale oil drillers must now be making money. This is where investment activity will be centered, I think.
–refiners and marketers, who have benefitted from lower costs are now facing higher prices. So they’re net losers. Long/short investors will be reversing their positions to now be short refiners and long e&p.
–the biggest multinational integrateds are a puzzle. On the one hand, they traditionally make most of their money from finding and producing crude. On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil. This has been a horrible mistake. Shale oil output will likely keep crude well short of $100 for a very long time.
Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects. But, in theory at least, writeoffs aren’t supposed to create future profits. They can only eliminate capital costs that there’s no chance of recovering. As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.
The question in my mind is how the market will value this cash flow. As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation. Small companies in this situation would likely be acquired by larger rivals. But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that. Will they turn themselves into quasi-bonds by paying out most of this cash in dividends? I have no idea.
—–why fool around with the multinationals when the shale oil companies are clear winners?
—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over. So watch them.
I’ve just updated my Keeping Score page to analyze the relatively benign stock price action last month, as well as to outline S&P 500 performance for 2017 as a whole.
Happy New Year!!!