natural resources and economic growth

I ended up with my first stock market job, more or less by accident–and without any finance experience or training–in the late summer of 1978.  A few months later, the firm’s oil analyst was headhunted away and I took his place.  Within a couple of years (an MBA from NYU at night along the way) I had picked up a bunch of metals mining companies, too, and was in charge of the firm’s natural resources research.

The oil industry was (and still is) really non-intuitive–more about my early adventures tomorrow.  Today I want to write about the mining industry, which is a little more straightforward.

natural resources in the 1970s

I started out by reading the annual reports and 10-Ks of the major base metals mining companies for the prior five or six years.  What stood out clearly was that all the firms held very strongly a series of common beliefs, namely:

1.  that global economic growth would continue to be strong for as far into the future as one could imagine,

2.  that the availability of all sorts of base metals–lead for batteries, copper for wiring and tubing, iron ore for steel, and so on–was a necessary condition for this growth

3.  that, therefore, demand for base metals would grow at least in lockstep with GDP increases.

Implicitly, the companies also assumed that:

4. that oversupply was highly unlikely,

5.  that substitution among raw materials–like aluminum or PVC for copper–wouldn’t be an issue, and

6. that, because of 4. and 5., the selling price of output from future orebody discovery/development would never be a concern.

CEOs’ conviction was buttressed by reams of computer paper containing economists’ regression analyses “proving” that all this stuff was true.

a massive investment cycle…

Naturally, the companies, not risk-shy by nature, went all in across the board on new base metals mine development.

As I was reading these documents in 1979-80, the first (of many) massive new low-cost orebodies were coming into production.  This wave turned out to have been enough to keep most base metals in oversupply–and a lot of mines unprofitable–for the following twenty-five years!!!  Miners were also in the midst of a massive switch to exploring for gold, where high value deposits could be developed quickly and at low-cost–causing, in turn, a twenty year glut of the yellow metal.

…that didn’t work out

The mining CEOs turned out to be wrong in a number of ways:

–like any capital-intensive commodity business where the minimum plant size is huge, industry profits for base metals are determined by long cycles of under-capacity followed by massive investment in new mines that causes long periods of over-capacity

–although it wasn’t apparent in the 1970s, substitution of cheaper materials has been a chronic problem for base metals.  Take copper.  There’s aluminum for heat dissipation and wiring, PVC for plumbing, and glass/airwaves for audiovisual transmission.

–Peter Drucker was writing about knowledge workers as early as 1959.  Nevertheless, the mining companies and their economists weren’t able to imagine a world where GDP growth might not require immense amounts of extra physical materials.

I’ve been looking for a sound byte-y way to put this all into perspective.  The best I can do is a gross oversimplification:

–real GDP in the US has expanded by 245% since 1980.  Oil usage is up by about 10% over that period; steel usage is down slightly.  The supposed dependence of GDP growth on increased use of natural resouces simply isn’t true.

Why am I writing about this today?

…it’s because I continue to read and hear financial “experts” say that weak oil and metals prices imply declining world economic activity.  To me this argument makes no sense.

 

 

 

Jim Paulsen’s latest on US stocks in 2015

Although I don’t think I’ve ever met Jim Paulsen, I like his work.  He’s fundamentally sound, with an optimistic bias–kind of the way I’d hope others would describe me.

As I read his most recent Economic and Market Perspective release, he’s trying awfully hard to be bullish   …but can’t find enough facts that will support a bullish position.

The basic issue he’s dealing with is that, as he puts it, the S&P 500 entered 2015 trading at 18x trailing earnings, a high rating the index has achieved only about a quarter of the time in the past.  On the surface, that’s not overly worrying.  If we look at the wider universe of all US stocks, including smaller-cap issues, the NYSE Composite and Nasdaq, however, the US market is trading at record-high levels based on PE, price/cash flow and price/book.

Not only that, but the high valuations aren’t concentrated in a few market sectors, as was the case during the Internet Bubble of the late 1990s.  The median stock has all the characteristics of the averages.

Paulsen’s thinks the best that we can hope for is that stocks will move sideways until value is restored through higher corporate earnings–a process that will probably take all of 2015.  As I read him, he believes it’s highly unlikely that stocks can go up during this period.  There’s a good chance of one or more declines of 10% during the year.  Declines could be deeper.  The only safe haven he can see is in stocks outside the US.

my take

The one factor Paulsen may not be giving enough weight to is the price of alternative investments–here I mean bonds, not hedge funds.

Generally speaking, stocks and bonds are in equilibrium when the interest yield on bonds  =  the earnings yield on stocks, i.e. 1/PE.

In 1973, just before the onset of a major bear market, the 10-year treasury rate was 6.5%.  This would imply a stock market multiple of 15.  The actual multiple on the S&P was 19.

In 1987, just before another major market downturn, the 10-year yield was 7%, implying a stock market multiple of 14.  The actual multiple was about 20.

In 1999, just before the Internet Bubble popped, the 10-year was yielding 6.7%, implying a stock market multiple of 15.  The actual multiple was 30!

Right now, the 10-year Treasury is yielding 1.82%, implying a stock market multiple of 55!  The actual multiple is 18.

My conclusion is that today we’re in a weird situation where there’s little relevant historical precedent.

working backwards

If we work the bonds-stocks equivalence equation the other way and ask what 10-year Treasury yield an 18 multiple on the market implies, the answer is 5.5%.  Even if we take Paulsen’s median multiple for all US stocks of 20, the 10-year Treasury yield should be 5.0%.  This suggests the hard-to-fathom result that current stock prices already factor in all the tightening the Fed is likely to do over the next two or three years.

Looked at a little differently, significant stock market downturns come either when PEs are out of whack with bond yields or when earnings are about to evaporate because of recession, or both.  Neither appears to be the case today.  The closest I can come is the idea that the sharp depreciation of the euro will undermine the 2015 results of US companies with significant euro-based earnings or assets.  But that exposure isn’t big enough to offset even tepid US domestic earnings growth.  And I think the US will be much better than “tepid.”

the bottom line

The fact that an experienced dyed-in-the-wool bull has turned bearish is a cause for worry.  It is also true that PEs are high.  The key difference between Paulsen and myself is how we regard bonds as influencing stock pricing.

 

 

 

 

Shaping a portfolio for 2015: elaboratng on yesterday’s post

A reader had two questions about yesterday’s post, which I figured it would be easier to answer here than simply in a comment.

emerging markets

The big attractions of emerging economies to an equity investor are the possibility of very rapid economic growth for the country and of finding future titans of world industry as infants.  The two standard paths of gaining exposure to these markets are: to invest directly or to buy a developed-world multinational with significant presence in the economy in question.

Some emerging markets aren’t open to foreigners.  For those that are, the most important thing to realize, I think, is that there is typically little local support for stocks.  There are usually no pension funds or other local institutional investors (because there are no pensions and residents aren’t wealthy enough to afford financial products like insurance).  Local citizens don’t have enough money to be able to own stocks.  As a result, emerging market performance ends up being heavily dependent on foreign inflows and outflows.

Foreign flows can be very cyclical.  When developed market investors are feeling confident, inflows to emerging markets are typically very large.  When they’re scared, outflows are the order of the day.  Because there’s little local buying power, these outflows invariably cause sharp price declines.

Right now, oil-exporting emerging markets are being hurt very badly by the declining price of crude.  investors are also worried that emerging markets-based companies may have borrowed excessively, in US$, during the past few years of easy credit.  Such debts were a big factor in the crisis in emerging Asian markets that started in 1997.  In fact, today’s developments in Russia sound a lot like what happened in Malaysia in the late 1990s.

Yes, emerging market will eventually settle out.  I don’t think we’re anywhere close to that point, though.

rent vs. buy

Take Adobe.   Say you’re a web designer who wants to start a business on your own and that you want to use Adobe tools.

Buying a Creative Suite package to get started used to cost $2,500 – $3,000.  That’s a lot.

Many people would do one of two things:

–bite the bullet and buy, but never, ever upgrade; or

–find a bootleg copy on Craigslist for $200 or so.  Yes, it would probably stop working after six months, but it was cheaper than getting an “official” copy.

How many people took the second route?   I don’t know  …but probably a lot. I once heard Bill Gates estimate that 40% of the small business users of Office in the US were using counterfeit copies

Adobe has now gone over to a rental model.  $50 a month gets you access to the Creative Cloud version of all the Adobe tools.  The same sort of thing for photographers–$10 a month for Photoshop + Lightroom, vs. $600 to buy  (Amazon is selling the last disk version of Photoshop for $1500).

The plusses:

–the move from buy to rent changes a big one-time capital expenditure by a small business customer into an affordable monthly operating expense.  If users stay subscribers for at least five years, Adobe gets more money from rental than from a sale.

–Just as important, matching the tool expense more closely with customer cash flows is bringing a whole bunch of former illegals into the fold

–the company may also be attracting casual photography users who would never before have contemplated using Photoshop, but for whom $10 a month isn’t a big deal

–subscriber growth has continually exceeded consensus expectations.

The rental model isn’t exactly new.  It has been used for all sorts of equipment for years, from copiers to burglar alarms to colonoscopes.

What surprises me is that Wall Street has been so slow to figure out that the rental model works for software, too.  Yes, in the early days, the accounting looks ugly.  In fact, the faster the transition to rental goes, the uglier the income statement looks.  Development expenses remain the same, but instead of chunky sales revenue, the company only shows subscription payments for that month.  But professional analysts should be able to see past that.  My guess is that they miss completely the bootleg copy phenomenon.

 

 

 

 

 

Shaping a portfolio for 2015 (vii): putting the pieces together

I expect 2015 to be a “normal” year, in contrast to the past six.  This is important.

Over the past six recovery-from-recession years, global stock markets have had a strong upward bias.  Yes, outperformance required the usual good sector and individual security selection.  But if “bad” meant up 12% instead of up 15%, most of us would be happy enough with the former.

This year, though, is more uncertain, I thin.  Whether the S&P 500 ends the year in the plus column or the minus depends on importantly on four factors:

–PE expansion.  Unlikely, in my view.  

–interest rates.   Arguably, rising rates may cause PE contraction, ash or bonds become more attractive investment alternatives to stocks

currency changes.  A rising currency acts much like an increase in interest rates.

profit growth.  In a normal year, earnings per share growth is the primary driver of index gains/losses.  It will be so for 2015, in my view.

Another point.  Four moving parts is an unusually large number.  There are other strong forces acting on sectors like Energy and Consumer discretionary, as well.  Because of this, unlike the past few years, where one could make a plan in January and take the rest of the year off, it will be important in 2015 to monitor plans frequently and be prepared to make mid-course corrections.

profit growth

Here’s my starting point (read:  the numbers I’ve made up):

US = 50% of S&P 500 profits.  Growth at +10% will mean a contribution of +5% to overall index growth

EU = 25% of S&P 500 profits.  Growth of 0 (due to euro weakness vs. the dollar) will mean no contribution to index profit growth

emerging markets = 25% of S&P 500 profits.  Growth of +10% (really, who knows what the number will be) will mean a contribution of +2.5% to             index growth.

Therefore, I expect S&P 500 profits for 2015 to be up by about 7% – 8%.

interest rates

The Fed says it will raise short-term rates, relatively aggressively, in my view, from 0 to +1.5% by yearend 2015, on the way to +3.5% by yearend 2017.  This plan has been public for a long time, so presumably at least part of the news has already been factored into today’s stock and bond prices.  What we don’t know now is:

–how much has already been discounted

–what the Fed will do if stocks and junk bonds begin to wobble, or emerging market securities fall through the floor, because rates are rising.  My belief:  the Fed slows down.

–is the final target too aggressive for a low-inflation world?  My take:  yes it is, meaning the Fed’s ultimate goal of removing the US from monetary intensive care may be achieved at a Fed Funds rate of, say, 2.75%.

My bottom line (remember, I’m an optimist):  while rising rates can’t be considered a good thing, they’ll have little PE contractionary effect.  Just as important, they won’t affect sector/stock selection.  The major way I can see that I might be wrong on this latter score would be that Financials–particularly regional banks–are better performers than I now anticipate.

If rising rates do have a contractionary effect on PEs, the loss of one PE point will offset the positive impact on the index of +6% -7% in earnings growth.  So the idea that the Fed will slow down if stocks begin to suffer is a crucial assumption.

 

currency effects

The dollar strength we’ve already seen in 2014 will make 2015 earnings comparisons for US companies with foreign currency asset/earnings exposure difficult.  Rising rates in the US may well cause further dollar appreciation next year.  Even if the dollar’s ascent is over, it’s hard for me to see the greenback giving back any of its gains.

Generally speaking, a rising currency acts like a hike in interest rates;  it slows economic activity.  It also redistributes growth away from exporters and import-competing firms toward importers and purely domestic companies (the latter indirectly).

The reverse is true for weak currency countries.  At some point, therefore, companies in weak currency countries begin to exhibit surprisingly strong earnings growth–something to watch for.

growth, not value

Typically, value stocks make their best showing as the business cycle turns from recession into recovery.  During more mature phases (read: now) growth stocks typically shine.

themes

–Millennials, not Baby Boomers

–disruptive effects of the internet on traditional businesses.  For example: Uber, malls, peer-to-peer lending.  Consider an ETF for this kind of exposure.

–implications of lower oil prices.  Consider direct and indirect effects.  A plus for users of oil, a minus for owners of oil.  Sounds stupidly simple, but investing isn’t rocket science.  Sometimes it’s more like getting out of the way of the oncoming bus.

At some point, it will be important to play the contrary position.  Not yet, though, in my view.

–rent vs. buy.  Examples:  MSFT and ADBE (I’ve just sold my ADBE, though, and am looking for lower prices to buy back).  Two weird aspects to this: (1) when a company shifts from buy to rent, customers are willing to pay a lot more for services (some of this has to do with eliminating counterfeiting/stealing); (2) although accounting for rental operations is straightforward, Wall Street seems to have no clue, so it’s constantly being positively surprised.

 

 

Shaping a portfolio for 2015 (vi): the rest of the world

world GDP

A recent World Bank study ranks the largest countries in the world by 2013 GDP.  The biggest are:

1.   USA         $16.8 trillion

2.  China         $9.2 trillion

3.  Japan          $4.9 trillion

4.  Germany          $3.6 trillion.

The EU countries taken together are about equal in size to the US.

stock markets

From a stock market investor’s point of view, we can divide the world outside the US into four parts:  Europe, greater China, Japan and emerging markets.

Japan

In the 1990s, Japan choked off incipient economic recovery twice by tightening economic policy too soon–once by raising interest rates, once by increasing its tax on consumer goods.  It appears to have done the same thing again this year when it upped consumption tax in April.

More important, Tokyo appears to me to have made no substantive progress on eliminating structural industrial and bureaucratic impediments to growth.  As a result, and unfortunately for citizens of Japan, the current decade can easily turn out to be the third consecutive ten-year period of economic stagnation.

In US$ terms, Japan’s 2014 GDP will have shrunk considerably, due to yen depreciation.

If Abenomics is somehow ultimately successful, a surge in Japanese growth might be a pleasant surprise next year.  Realistically, though, Japan is now so small a factor in world terms that, absent a catastrophe, it no longer affects world economic prospects very much.

China

In the post-WWII era, successful emerging economies have by and large followed the Japanese model of keeping labor cheap and encouraging export-oriented manufacturing.  Eventually, however, everyone reaches a point where this formula no longer works.  How so?    …some combination of running out of workers, unacceptable levels of environmental damage or pressure from trading partners.  The growth path then becomes shifting to higher value-added manufacturing and a reorientation toward the domestic economy.  This is where China is now.

Historically, this transition is extremely difficult.  Resistance from those who have made fortunes the old way is invariably extremely high.  I read the current “anti-corruption” campaign as Beijing acting to remove this opposition.

I find the Chinese political situation very opaque.  Nevertheless, a few things stand out.  To my mind, China is not likely to go back to being the mammoth consumer of natural resources it was through most of the last decade.  My guess is that GDP growth in 2015 will come in at about the same +7%or so China will achieve this year.  In other words, China won’t provide either positive or negative surprises.

For most foreigners, the main way of getting exposure to the Chinese economy is through Hong Kong.  Personally, I own China Merchants and several of the Macau casinos.  The latter group looks very cheap to me but will likely only begin to perform when the Hong Kong market is convinced the anti-corruption campaign is nearing an end.

EU

In many ways, the EU resembles the Japan of, say, 20 years ago.  It, too, has an aging population, low growth and significant structural rigidity.  The major Continental countries also have, like Japan, strong cultural resistance to change.  These are long-term issues well-known to most investors.

For 2015, the EU stands to benefit economically from a 10% depreciation of the euro vs. the US$.  As well, it is a major beneficiary of the decline in crude oil prices.  My guess is that growth will be surprisingly good for the EU next year.  I think the main focus for equity investors should be EU multinationals with large exposure to the US.

emerging markets

I’m content to invest in China through Hong Kong.  I worry about other emerging Asian markets, as well as Latin America (ex Mexico) and Africa.  Foreigners from the developed world provide most of the liquidity in this “other” class.  If an improving economy in the US and higher yields on US fixed income cause a shift in investor preferences, foreigners will likely try to extract funds from many emerging market in order to reposition them.  That will probably prove surprisingly difficult.  Prices will have a very hard time not falling in such a situation.

 

Shaping a portfolio for 2015 (v): the US

a healthier economy

2015 will likely be the first normal year for the US economically for a long time.  The unemployment rate is close to full employment levels; job creation is high–and accelerating; recent signs suggest that wages are beginning to rise.

Wage gains are important for two reasons:

–higher wages imply more consumer spending, which means accelerating economic expansion, and

–the resulting increase in the price level diminishes the possibility of deflation.

alone in growth mode

The EU is, generally speaking, a less dynamic area than the US.  But it is also years behind the US in putting recession in the rear view mirror.  It is still struggling with structural problems–Greece, for example, is flaring up again.

I continue to believe that Abenomics is not going to solve Japan’s economic woes.  So pencil in no growth there.

China is attempting to transition from being an export-driven economy to a doemstic demand-oriented one.  As one would expect, it is encountering tremendous resistance from the export establishment.  This struggle will keep the Chinese economy range bound around 6%-7% GDP growth for a while.  Big numbers, yes, but no acceleration like the US is experiencing.

a lower oil price

I’ve written about this in more detail earlier in this Strategy series.  For the country as a whole, a lower oil price is a plus.

Assuming, as I do, that prices will stay around this level, effects will likely be:

–the biggest percentage change in disposable income for the less affluent,

–diminishing interest in alternate energy sources

–economic, and possible political, troubles for oil-producing countries–Russia, the Middle East and Africa.

We’re already seeing renewed interest in gas-guzzling cars and trucks in the US.  But also–a good thing, in my view–politicians are beginning to talk about raising taxes on gasoline.  This would provide funds–at least in theory–to repair decrepit roads and bridges.  By encouraging conservation, it would also lessen the long-term economic power of the oil producers.  And it would bring US policies more in line with the rest of the developed world.

rising interest rates

The good economic news opens the door for the Fed to begin to raise interest rates from the current emergency-low levels.  I’ve written about this too in more detail earlier in this Strategy series.

Normalization of rates is a long-term plus.  But rising interest rates will also tend to slow growth a bit, both by raising the cost of borrowing and by rising interest rate differentials between the US and other countries giving strength to the US$.

structural factors

The Internet continues to be an amazingly powerful force of creative destruction in the economy.  No end in sight.

Millennials have surpassed Baby Boomers as the largest segment of the population.  In addition, Millennials will be the chief beneficiaries or rising wages, while Boomers will see their incomes drop as they enter retirement.

my bottom line:  the fact that the US is coming further out of recession is a huge long-term plus, both for the economy and for US financial markets.  Purely from a stock market point of view, however, there are a lot of conflicting variable in the equation for 2015.  And that’s apart from trying to handicap what the markets have already begun to discount.  More about this when I put all the pieces together in a couple of days.

Shaping a portfolio for 2015 (iv): interest rates

The Fed has made it clear that it intends to begin the multi-year process of raising short-term interest rates back to normal sometime in 2015.  The agency says it expects to boost the Fed Funds rate from the current zero to around 1.5% by next December.

This is a good news/bad news development for investors.  On the one hand, the economic data clearly show that the US is finally–after six years–coming out the other side of the Great Recession.  On the other hand, rising interest rates are typically not good for securities markets ( a rising return on holding cash makes long-term investments like stocks or bonds look less attractive.).

If the Fed were to begin next April, it would have to do a .25% interest rate increase about every six weeks to get to 1.5% by yearend.  That’s just the beginning, though.  Fed documents indicate that the final goal is a Fed Funds rate of 3.5%.

what history shows

Rising rates are unequivocally bad for bonds.

In contrast, inpast periods of Fed-induced rate rises stocks have gone sideways to up.  That’s because the downward pressure that rising rates exert has been offset by upward pressure from strong-growing earnings.

 four differences today

1.  In past plain-vanilla recessions, interest rate hikes come pretty quickly after the worst of recession is over.  So consumers are just starting to spend (a lot) to satisfy needs deferred during the downturn.  In this case, however, we’ll be six years past the bottom.  Is there any pent-up demand left?    …probably not.  So the typical surge in earnings may be absent.  This is a minus for stocks.

2.  The Fed has been unusually clear  for a long time in publicizing what it intends to do and over what time frame.  Arguably, investors have absorbed this information and already made some portfolio adjustments in advance of the Fed’s actions.  I don’t see this in fixed income markets, but…

3.  The rest of the developed world hasn’t made anything close to thepost-recession progress in that the US has.  As a result,foreign interest rates  either remain at emergency lows, or are even dropping.  Rising interest rate differentials–and a strengthening US$–suggest that international fixed income investors may increase purchases of Treasury bonds, cushioning the fall in their prices.

4.  The Fed is acutely conscious of the repeated mistake that Japan has made over the past quarter-century of trying to return to normal too quickly–and pushing that country beck into recession instead.  Because of this, it’s possible that stock market weakness might cause the Fed to slow down planned interest rate rises.

my take

I think rising interest rates will make 2015 a sub-par year for stocks.  Will “sideways to up” hold true as it has in the past?  I don’t know.  I think a lot will depend on whether the Fed’s commitment to raising rates is greater than its wish to have relatively stable financial markets.  My guess is that stability is more important.

The Fed’s ultimate target for short rates is 3.5%.  I think that’s too high for a 2% inflation world.  I think 3% is more likely.  But let’s keep 3.5%.  Add a 2% real return to that and we get the endpoint for the yield on the 10-year Treasury,  5.5%.  This would imply a price earnings multiple for stocks of 1/.055, or 18x.  Arguably, then, the current multiple on stocks already discounts all the tightening the Fed is setting out to accomplish.

Even I think that the last paragraph paints too optimistic a picture.  What I’ve written may ultimately prove to be correct, but I don’t think the consensus would be willing to put much faith in this idea.

My starting out point is that interest rate rises will make next year a volatile one for stocks.  Without positive influences from earnings growth or foreign money flows, rising rates have the power to push US stocks down by, say, 5% in 2015..  At the same time, I think that good stock and industry/sector selection will enable investors to generate positive portfolio returns.