going back up?

As far as US stock are concerned, I don’t know.

As/when the correction is over, however, it’s very important to look for signs of a leadership change.  At a minimum, one former hot industry/sector typically grows ice cold; at least one former laggard heats up.  Figuring this out and tweaking/reorienting your portfolio can make a big difference in this year’s returns.

the state of play in US stocks

down by 12% 

From its intra-day high on January 28th, the S&P 500 dropped to an intraday low of 12% below that last Friday before recovering a bit near the close.

What’s going on?

As I see it, at any given time, liquid investments (i.e., stocks, fixed income, cash) are in a rough kind of equilibrium.  If the price of one of the three changes, sooner or later the price of the others will, too.

What I think the stock market is now (belatedly/finally) factoring into prices is the idea that the Fed is firmly committed to raising interest rates away from the intensive-care lows of the past decade.  That is, rates will continue to rise until they’re back to “normal” –in other words, until yields on fixed income not only provide compensation for inflation but a real return as well.  If we take the Fed target of 2% inflation as a guideline and think the 10-year Treasury should have a 2% real return, then the 10-yr yield needs to rise to 4%  — or 115 basis points from where it is this morning.  Cash needs to be yielding 150 basis points more than it does now.

One important result of this process is that as fixed income investments become more attractive (by rising in yield/falling in price), the stock market becomes less capable of sustaining the sky-high price-earnings ratio it achieved when it was the only game in town.  PEs contract.

Stocks are not totally defenseless during a period like this.  Typically, the Fed only raises rates when the economy is very healthy and therefore corporate earnings growth is especially strong.  If there is a typical path for stocks during a cyclical valuation shift for bonds, it’s that there’s an initial equity dip, followed by several months of going sideways, as strong reported earnings more or less neutralize the negative effect on PEs of competition from rising fixed income yields.

living in interesting times

Several factors make the situation more complicated than usual:

–the most similar period to the current one, I think, happened in the first half of the 1990s–more than 20 years ago.  So there are many working investment professionals who have never gone through a period like this before

–layoffs of senior investment staff during the recession, both in brokerage houses and investment managers, has eroded the collective wisdom of Wall Street

–trading algorithms, which seem not to discount future events (today’s situation has been strongly signaled by the Fed for at least a year) but to react after the fact to news releases and current trading patterns, are a much more important factor in daily trading now than in the past

–Washington continues to follow a bizarre economic program.  It refused to enact large-scale fiscal stimulus when it was needed as the economy was crumbling in 2008-9, but is doing so now, when the economy is very strong and we’re at full employment.   It’s hard to imagine the long-term consequences of, in effect, throwing gasoline on a roaring fire as being totally positive.  However, the action frees/forces the Fed to raise rates at a faster clip than it might otherwise have

an oddity

For the past year, the dollar has fallen by about 15%–at a time when by traditional economic measures it should be rising instead.  This represents a staggering loss of national wealth, as well as a reason that US stocks have been significant laggards in world terms over the past 12 months.  I’m assuming this trend doesn’t reverse itself, at least until the end of the summer.  But it’s something to keep an eye on.

my conclusion

A 4% long bond yield is arguably the equivalent of a 25x PE on stocks.  If so, and if foreign worries about Washington continue to be expressed principally through the currency, the fact that the current PE on the S&P 500 is 24.5x suggests that a large part of the realignment in value between stocks and bonds has already taken place.

If I’m right, we should spend the next few months concentrating on finding individual stocks with surprisingly strong earnings growth and on taking advantage of any  individual stock mispricing that algorithms may cause.

~$70 a barrel crude (ii)

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.

Two thoughts:

—–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.

~$70 a barrel crude oil

prices equity investors watch

Investors who are not oil specialists typically use (at most) two crude oil prices as benchmarks:

Brent, a light crude from under the North Sea.  Today it is selling at just about $70 a barrel.  “Light” means just what it says.  Brent is rich in smaller, less-heavy molecules that are easily turned into high-value products like gasoline, diesel or jet fuel.  It contains few large, denser molecules that require specialized refinery equipment to be turned into anything except low-value boiler fuel or asphalt.  Because it can be used in older refinery equipment that’s still hanging around in bunches in the EU, it typically trades at a premium

West Texas intermediate, which is somewhat heavier and produced, as the name suggests, onshore in the US.  It is going for just under $64 a barrel this morning.

 

What’s remarkable about this is that we’re currently nearing the yearly low point for crude oil demand.  The driving season–April through September–is long since over.  And for crude bought, say three weeks from now, it’s not clear it can be refined into heating oil and delivered to retail customers before the winter heating season is over.

Yet WTI is up from its 2017 low of $45 a barrel last July and from $57 a barrel in early December.  The corresponding figures for Brent are $45 and $65. (Note that there was no premium for Brent in July.  I really don’t know why–some combination of traders’ despair and weak end user demand in Europe.)

 

why the current price strength?

Several factors, most important first:

–OPEC oil producers continue to restrain output to create a floor under the price

–they’re being successful at their objective, as the gradual reduction of up-to-the-eyeballs world inventories–and the current price, of course–show

–the $US is weakening somewhat.

 

 

My Lighting class is calling, so I’ll finish this tomorrow.  The bottom line for me, though:  I think relative strength in oil exploration and production companies will continue.

 

EU insurance companies and coal–FAANGs the next step?

Yesterday’s Financial Times had a curious article, one with no immediate investment implications, but one that I thought was noteworthy anyway.  EU property/casualty insurance companies have decided they will no longer offer insurance coverage for new coal mining projects.  Their rationale is that ultimately they will be the ones paying out claims for damage that results from using this heavily polluting fuel.  So it makes no sense to make their situation worse by supporting the projects that lead to big loss payouts.

 

When I was looking for my first stock market job, I asked an interviewer why he had become a securities analyst and what was most satisfying for him in his work.  He replied that the best part of the job was in influencing investors through his reports to apply high price-earnings multiples to socially responsible companies (thereby making it easier for them to raise new investment capital), and low multiples to dishonest or socially irresponsible ones (making fund-raising harder).

Performing an important social service wasn’t what I’d expected to hear.  But over the years I’ve come to believe that, despite the cynical persona most professional investors adopt, very many–me included–think the way my old interviewer did.  This is one reason that tobacco companies, for example, are rarely market stars.

There may be enough problems with fossil fuels that low multiples are already permanently baked into the cake   …and that coal will continue to be a fertile ground for value investing.  I don’t think so, but who knows.

The more interesting question to me, though, is whether this thinking is being/will be applied to firms like Facebook, Google or Apple–serving as invisible anchors to the rise of their stocks.

 

IT: sector advances happen in waves

My first stock market industry coverage responsibility came in late 1978 at Value Line.  A more experienced colleague was poached by an institutional investor (nirvana for a VLer at that time).  Even though I had only a few months’ training, I became the firm’s oil analyst.

This was just as OPEC was repudiating Western colonial control of the world oil supply–the overthrow of the Shah of Iran in 1979 being a main catalyst.  Oil prices tripled.  Oil stocks shook off their typical bond-like torpor and began a raging two-year+ bull market.

The advance didn’t happen all at once, however:

–Small oil and gas exploration companies in the US, for whom rising prices had the most direct positive impact, rose first.

–Then came medium-sized, mostly domestic US-oriented, integrated firms (meaning they refined and marketed oil products in addition to exploring).  Most of these were subsequently acquired.

–Finally, the big Seven Sister-class international integrateds moved up, too.

This whole process, as I recall it, took most of a year.  The exact timing isn’t so important.  The pattern is, though, because it’s one that recurs.  In particular,  I think, it’s a useful tool to assess the massive tech rally we saw in 2017.

Wall Street then paused while it worked out whether there was more to go for.  It said there was.  And the whole three-tier process began again.

At the end of Round Two, the stocks were all fully valued by any conventional lights.  But international unrest continued   …and the three-tier process happened once more.  At that point the stocks were wildly overvalued.

Easy to say in hindsight, you may be thinking.  But there was a company back then called American Quasar that clearly signaled the excessive enthusiasm.  AQ was the exploration firm that discovered the Rocky Mountain Overthrust belt of trapped natural gas and ran tax shelters (always a danger sign) to finance their exploration.  In my view, Round One of the sector advance fully valued AQ’s reserves.  Round Two very fully valued its future exploration prospects, as well (this almost never happens).  Round Three placed a huge multiple on large prospective acreage it had just leased and had not yet drilled (which turned out to be the only parts of the Overthrust not to have any hydrocarbons).

In early 1981, the spot price of oil on commodity markets began to dip, initiating a three-year bear market in which many oil stocks lost 2/3 of their peak valuations.

 

The way I’m thinking about it, IT stocks finished Round One in late 2017.  To my mind, the sharp rise in Intel shares last September-November is like the big international integrateds finally participating back in 1979.  It signals that the valuation gap between firms exposed to the hot areas of IT and the large left-behinds had grown too wide.  Investors thought it made more sense to bet that INTC could lift its game than to buy more shares of an already high-flier.  It’s a red flag.

Now we’re in a wait-and-see period.  My guess is that there will ultimately be a Round Two.  But, as I’ve written elsewhere, IT is already about 25% of the total S&P 500 market cap.  That’s a daunting size.  My guess is that other sectors will have to rally in a way that reduces the IT weighting to, say, 20% before tech before more than the strongest tech names take off again.  But I think IT will ultimately rally.

corporate taxes, consumer spending and the stock market

It looks as if the top Federal corporate tax rate will be declining from the current world-high 35% to a more median-ish 20% or so.  The consensus guess, which I think is as good as any, is that this change will mean about a 15% one-time increase in profits reported by S&P 500 stocks next year.

However, Wall Street has held the strong belief for a long time that this would happen in a Trump administration.  Arguably (and this is my opinion, too), one big reason for the strength in US publicly traded stocks this year has been that the benefits of corporate tax reform are being steadily, and increasingly, factored into stock quotes.  The action of computers reading news reports about passage is likely, I think, to be the last gasp of tax news bolstering stocks.  And even that bump is likely to be relatively mild.

In fact, one effect of the increased economic stimulus that may come from lower domestic corporate taxes is that the Federal Reserve will feel freer to lean against this strength by moving interest rates up from the current emergency-room lows more quickly than the consensus expects.  Although weening the economy from the addiction to very low-cost borrowing is an unambiguous long-term positive, the increasing attractiveness of fixed income will serve as a brake on nearer-term enthusiasm for stocks.

 

What I do find very bullish for stocks, though, is the surprising strength of consumer spending, both online and in physical stores, this holiday season.  We are now nine years past the worst of the recession, which saw deeply frightening and scarring events–bank failures, massive layoffs, the collapse of world trade.  It seems to me that the consumer spending we are now seeing in the US means that, after almost a decade, people are seeing recession in the rear view mirror for the first time.  I think this has very positive implications for the Consumer discretionary sector–and retail in particular–in 2018.