a day like today

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.

 

 

oil right now–the Iran situation

For almost a year I’ve owned domestic shale-related oil stocks, for several reasons:

–the dire condition of the oil market, oversupplied and with inventories overflowing, had pushed prices down to what I thought were unsustainable lows

–other than crude from large parts of the Middle East, shale oil is the cheapest to bring to the surface.  The big integrateds, in contrast, continue to face the consequences of their huge mistaken bet on the continuance of $100+ per barrel oil

–there was some chance that despite the sorry history of economic cartels (someone always sells more than his allotted quota) the major oil-producing countries, ex the US, would be able to hold output below the level of demand.  This would allow excess inventories to be worked off, creating the possibility of rising price

–the outperformance of the IT sector had raised its S&P 500 weighting to 25%, historically a high point for a single sector.  This suggested professional investors would be casting about for other places to invest new money.  Oil looked like a plausible alternative.

 

I’d been thinking that HES and WPX, the names I chose, wouldn’t necessarily be permanent fixtures in my portfolio.  But I thought I’d be safe at least until July because valuations are reasonable, news would generally be good and I was guessing that the possibility of a warm winter (bad for sales of home heating oil) would be too far in the future to become a market concern before Labor Day.

 

Iranian sanctions

Now comes the reimposition of Iranian sanctions by the US.

Here’s the problem I see:

the US imposed unilateral sanctions like this after the Iranian Revolution in 1979.  As far as oil production was concerned, they were totally ineffective.  Why?  Oil companies with access to Iranian crude simply redirected elsewhere supplies they had earmarked for US customers and replaced those barrels with non-Iranian output.  Since neither Europe nor Asia had agreed to the embargo, and were indifferent to where the oil came from, the embargo had no effect on the oil price.

I don’t see how the current situation is different.  This suggests to me that the seasonal peak for the oil price–and therefore for oil producers–could occur in the next week or so if trading algorithms get carried away, assuming it hasn’t already.

 

 

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.

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.