Tag Archives: investment strategy

thinking about 2016: oil

October 21, 2015 By in Energy, Gold, Industry Analysis, Mining, oil and natural gas, shale oil and gas Tags: , , , , , 1 Comment

Regular reader Chris commented about yesterday’s post that we may be in the early stages of a decade+ downcycle in the oil price.  I thought I’d elaborate on that thought today.

base metals–gold, too

I think the situation with base metals is very clear.  Capacity is typically added in very large increments, and by all parties in the industry at once, creating the top of the market.  The mines can be shut down, but the orebodies don’t disappear.  Neither does the machinery.  So operations can be restarted fairly easily.  As a result, the market only comes back into balance as economic growth slowly expands, eating into the oversupply overhang.  Last time around, in the early 1980s, this process took well over a decade.

oil

Th case of oil is slightly different.  The petroleum industry is far bigger and more important than metals.  In most cases, there are no good substitutes.  Use for heating and transportation can’t be postponed.

Discovery of new reserves is a much more important factor in production.  The ability of oilfields to extract output without significant new drilling can deteriorate sharply if wells are shut down, interrupting the underground flow of oil to them.  Because of this second factor, very small differences between supply and demand can have dramatic.

 

At the last oil peak in 1980-81, two factors conspired to stretch out in time the fall in prices needed to restore supply-demand balance.

–The US, the world’s largest petroleum consumer, enacted a byzantine series of price control laws to prevent higher oil prices from being passed on to consumers.  This delayed conservation into the 1980s, when the regulations were dismantled.

–Saudi Arabia, then the largest oil producer in the world, decided to cut its production in an unsuccessful attempt to prop up prices.  It went from 10+ million barrels per day in 1980 to just over 3 million in 1985.  Although other OPEC members also agreed to curtail production, widespread cheating (typical cartel behavior) undermined the supply reduction effort.  The oil market finally bottomed at around $8 a barrel (the high was $34 in December 1980) when the Saudis got fed up and began to restore production in 1986.

 

This time, neither factor is present.  The only residual of 1970s efforts to promote oil use in the US is the country’s relatively low level of tax, by world standards, on gasoline.  Saudi Arabia, having learned a bitter lesson from the 1980s, has actually increased production slightly.

 

I think this means that the bottom for oil will come much more quickly than in the 1980s.  It may be happening now.

I don’t think there will be a quick rebound, however, even though the excess supply now present in the world may only amount to 2% – 3% of total demand.  That’s because:

–demand is growing more slowly than experts have been predicting

–hydraulic fracturing is proving less vulnerable to lower prices, as frackers streamline their procedures to lower costs (no one worried about efficiency when oil was $100 a barrel)

–removal of economic sanctions on Iran will give a one-time boost to supply of about 500,000 barrels a day (on world production of roughly 90 million bbl/’day).

my thoughts

If I had to guess, I’d say that fracking has permanently changed the supply/demand situation in oil.  New capacity can be added quickly, in lots of small increments, at around $60 a barrel.  I think this puts a (permanent?) ceiling on the oil price, or at least one that lasts for longer than we as investors need to worry about.

The bottom is harder to figure out.  If we were back in 1980, when world demand was about 60 million barrels a day and almost half came from ultra-low-cost sources in OPEC, revisiting the 1986 lows might be an ugly but realistic option.  However, with production now around 90 million and the Middle East closer to an afterthought than a real price-setting power, enough output is being curtailed at current prices that I think we’re probably in the bottoming process now.

At some point, aggressive investors will sift through left-for-dead small exploration companies to find survivors.  I’m sure industry experts are already doing so.  I’m not an expert any more.  I’m not doing so yet.  My inclination is to look for consumer or tech companies that stand to benefit from the boost to economic activity created by lower oil.

 

thinking about 2016

October 19, 2015 By in Current Market Thoughts, Long-term themes, Recent Market Action, Strategy Tags: , , , , , , , , Leave a comment

At present, world stock markets appear to me to be obsessively focused on the smallest details of the here and now.  This may be fine for short-term traders, but getting caught up in this mindset is the surest recipe for trouble for us as long-term investors.  Our biggest advantage against professional traders is taking a longer view.

So it makes sense that we should be shifting our focus toward the new year, even though (actually, because) I think the markets have yet to do so.

My thoughts (which will be presented in more detail in my yearly strategy posts in a few weeks):

interest rates

Rates will be somewhat higher a year from now than today.  The Fed, however, has made it clear that the journey back from emergency-low rates to normal–that is to say, from zero to perhaps 2% for overnight money–will take years.  In theory, higher rates make fixed income relatively more attractive to investors than stocks, mimplying that the stock market suffers price-earning multiple contraction.  I’ve written a number of times, and I still believe, that virtually all of this contraction has long since been factored into today’s stock prices.  Even if this is incorrect, next year’s rise is going to be quite small.  Absent a crazy panic, the potential headwind from PE contraction is likely to be extremely small.  

world economies

–the US will continue to be strong

–the EU has bottomed and will gradually strengthen, so next year will be better than this

–China ‘s transition from export-oriented growth to expansion led by domestic consumer spending is happening at a satisfactory pace.  While traditional economic indicators, which are generally speaking all focused on exports (the wrong place to look), continue to be ugly, overall economic growth next year will be at least as good as in 2015

–natural resource-producing emerging countries will continue to have troubles.  The main issue will not be lower commodity prices.  It will be dealing with excessive debt taken on when companies/governments believed in a perpetual commodities boom, and adjusting private/government spending downward to deal with lower levels of commodity income.

 

More tomorrow.

will the poor performance of Energy, Materials and Industrial sectors derail the S&P 500?

October 6, 2015 By in Current Market Thoughts, Energy, Japanese development, Portfolio management, securities markets, stock market, Strategy Tags: , , , , Leave a comment

In the course of doing a performance attribution for the S&P 500 year-to-date last week, I noted that the S&P 500 ex Energy, Materials and Industrials, is pretty close to flat so far this year on a total return basis.

But is it correct to conclude that the “healthy” sectors of the S&P will continue to be relatively immune to the economic illness caused by the price collapse of global mining commodities?   …or will they eventually be dragged down if, as I expect, commodity weakness continues for an extended period of time.

This isn’t as silly a question as it might seem at first.

In the early 1990s I was asked by the board of the company I worked for to present my views on the stock market in Japan at that time.  I created a presentation that divided the Topix index, which was trading at about 70x earnings, into three parts:

–highly speculative property-related companies that were trading at around 500x earnings and made up 10% of the market

–export-oriented industrials, such as the autos or tech companies like Canon, which were trading at 15-20x earnings and made up 30% of the market, and

–everything else, which made up 60% of the market and traded at around 25x.

I said what I believed:  that, while the index might do poorly as the speculatives came back to earth and the bulk of the market went sideways, the export-oriented stocks were cheap and would go up significantly in price–not only in yen but in dollars, too.  My model was the behavior of the US market throughout the second half of the 1970s, when former speculative favorites, the Nifty Fifty, were crushed while everything else went up.

An aside: a famous finance academic on the board, who made it clear he had not sought the opinion of a mere “practitioner” like me, objected that the low dividend yields of Japanese stock proved they remained wildly overvalued.  A little embarrassed (for him), I had to explain that Japanese tax laws did not provide the same preference for dividend income that the IRS did. In fact, dividend income was subject to income tax at an extremely high rate (up to 90%) in Japan.  Because of this, taxable investors (the majority at that time) had a very strong preference for (untaxed) capital gains.  Companies tended to make negligible cash payouts and to use stock dividends as a substitute.

Embarrassingly (for me), it turned out that my reasonable analysis was completely wrong.  Yes, the exporters were cheap, but for the next decade they significantly underperformed similar-quality companies elsewhere in the world.  In this case, the general economic funk that engulfed the Japanese economy hurt the stocks of all firms listed there.  There was no escape.

my thoughts

Thee aren’t a whole lot of relevant examples of this kind of situation to generalize from.  (Another might be the worldwide collapse in the price of mining commodities and of commodities stocks from 1982-86, which did not impede the upward progress of global stock markets from mid-1982 on.)

My hunch is that the contamination of “good” stocks in 1990s Japan is more a function of the continuing economic malaise in that country than of anything else.  What’s somewhat troubling is that the US today is very similar demographically to Japan back then, when lack of workforce growth was a significant contributor to Japan’s stagnation.  We have the same woes of extremely low interest rates and an impotent legislative arm tied to the status quo and unwilling to use fiscal policy to bolster the economy–another set of lead weights dragging Japan down.

 

At the end of the day, I’d argue that the US is inherently a much more dynamic country than others in the developed world.  Also, I see the commodities collapse as much more like an external shock than a sign of weakness in the domestic economy in the way the property collapse in Japan was.  So I see the chances that commodities/commodity stock softness will cripple the rest of the US stock market as low.  But there are enough similarities between us today and Japan 25 years ago to make me vaguely uneasy.

 

 

 

a tale of two markets …or three …or one?

October 2, 2015 By in Constructing a Portfolio, Current Market Thoughts, Keeping Score, oil and natural gas, Portfolio management, Strategy Tags: , , , , , , , Leave a comment

In yesterday’s Keeping Score, I outlined the performance by sector of the S&P 500 component sectors over the past one and three months.  Here’s the same information for 2015 to date, through the end of September:

 

Consumer discretionary          +2.9%

Staples          -2.9%

Healthcare          -3.3%

IT          -4.1%

S&P 500 (adjusted, as described below)          -4.3%

———————————–

S&P 500          -6.8%

Telecom          -7.4%

Financials          -8.4%

Utilities          -8.4%

———————————-

Industrials          -11.2%

Materials          -11.2%

Energy          -23.1% (ouch!!!).

 

Index performance falls pretty neatly into three categories:

–relative stars, which are clustered around/above the adjusted S&P 500.  These are, generally speaking, sectors with primarily a US/EU focus and which do well when economies are expanding and consumers are feeling good.  But they don’t depend on rip-roaring commodities-oriented, basic industry-based economic expansion.

–non-descripts, clustered around the index

–clunkers, either basic materials or the Industrial sector which serves basic industry (and also makes lawn mowers and other stuff for consumers)

my adjustment to the S&P

Energy (currently 6.9% of the S&P), Industrials (10.1%) and Materials (2,8%) make up about 20 percent of the S&P by market capitalization.  The three account for half the index’s losses so far this year, however.  The -4.3% return of the adjusted index is the aggregate performance of the other 80% of the S&P through the end of September.  Figure that a holder of those sectors has collected a dividend of around 2% and the total return of the adjusted index looks more like treading water than a catastrophe.

my thoughts

Of the clunkers, the simple story for Materials and Energy is that commodity producers are invariably their own worst enemies.  In good times, they plow their cash flow back into creating new capacity that ultimately floods the market with output and destroys pricing.  The most maladroit borrow the funds needed to shoot themselves in the foot.  Like the biblical seven years of famine following the seven years of plenty, we’re in the early stages of a long downturn.

Industrials are a little more complicated.  Many don’t make gigantic turbines or stamping or cutting machines that would fit comfortably in Soviet propaganda art.  Instead, they make paint, lamps, gardening equipment–any of the stuff consumers buy in a Home Depot.  I haven’t looked at the sector carefully enough to know whether some of the members are being punished unfairly (I suspect not, though, so I’m in no rush to find out.)

 

On a nine-month view, though, all the fear that seems to be pulsing through Wall Street seems misplaced.

 

why three markets?

Recent problems with Healthcare don’t reveal themselves in this performance analysis.  The straightforward explanation is that the current swoon is about valuation, and represents simply giveback of earlier outperformance.  Although/because I hold a lot of a healthcare mutual fund run by a super-competent former colleague, I don’t pay enough attention to this sector to have a strong opinion.  I do think, however, that Americans don’t take kindly to firms that make extortionate profits from the misery of others.  Recent revelations that acquisitive drug firms, spurred on by hedge fund backers, have aggressively raised the prices of drugs they’ve bought is probably inviting political backlash.  In any event, I think Healthcare will go its own way.

 

is this a stable situation?

In other words, will Wall Street simply shrug off the woes of the clunkers by shifting into other sectors, which has been the case so far?  Or will the problems of the 20% eventually drag down the rest?

To me, the answer isn’t obvious.

 

More on  Monday.

 

 

 

 

actively managed bond funds in a rising interest rate environment

September 24, 2015 By in Bond Environment, bond market, junk bonds, Portfolio management, securities markets, Strategy Tags: , , , , Leave a comment

During my working career as an equity portfolio manager, I experienced the US bear markets of 1980-82, 1987, 1990-91 and 2000-2002. Because I spent the majority of my career as a global manager, I also lived through the collapse of the Japanese stock market (then by far the largest in the world) in 1989 and the currency-triggered bear market in many smaller Asian countries in the late 1990s. I started writing this blog as a way of helping myself think about the bear market of 2007-09 and what would follow.

In other words, for equity managers there have been lots of bad times to help us along with the painful process of being able to, as they say, make the critical distinction between brains and a bull market.

Also, the bad periods themselves have been long enough to force us to recognize that different investment styles (growth or value) work best in different economic circumstances.  We certainly won’t change our overall philosophies.  However, successful equity managers all realize that for them there are some times to be in fifth gear with the gas pedal to the floor and others to be in second gear and tapping on the brakes.

 

Looking at the bond world from the outside, it seems to me that little of this has been the case for bonds and bond managers since the early 1980s.  Yes, junk bonds or emerging markets debt may have gotten ugly now and again.  Nevertheless, the continual decline in interest rates from the early Volcker years to the present has made for a remarkably smooth, and consistently bullish, ride for bond investors and managers.

The amazing part is not a long bullish period–after all, equities in the US had that for most of the 1990s–but the fact that the benign environment lasted over thirty years.  To have experienced an ugly time for bonds comparable to what happens to stocks every business cycle, you would have to have been a bond manager in the 1970s!

This is my main concern for actively managed bond funds.

We’re (already) in a period in which interest rates are not going to decline.  They may fluctuate for a while, even a long while, but the new main trend is going to be for rates to rise.  And we haven’t had circumstances that have forced bond managers to cope with a situation like this for decades.

Instead, the recipe for success over the past thirty-five years has been to throw caution to the winds and bet as heavily as possible on continuously declining rates.  The most successful managers would have been the most aggressive, the ones willing to double down on any bet gone wrong and to stack their portfolios full of risk.  Brash, bold, stubborn, no sense of nuance, not the brightest crayon but tenacious.  Think Jon Corzine and what happened to him.

 

Will bond fund managers be able to adjust to the changing trend?  I don’t know.

Bill Gross is another interesting case in point.  He became the “bond king” by betting aggressively on lower interest rates.  My reading of his results for his last several years at Pimco is that he tried to keep his performance numbers up by layering on extra amounts of risk to the main bet that had stopped providing results.  That didn’t work so well, in my view.  Since leaving for Janus, where he could express his ideas in his portfolio without an outside sanity check (outside interference?), he’s done poorly.

This is not about old dogs and new tricks in the sense of age but only in having the temperament and mental flexibility to adjust to changing circumstances.